A stock bonus plan is a profit sharing plan that holds employer securities and generally distributes those securities to participants when benefits are paid.¹ These plans can be funded through contribution of employer securities, cash, or both. Traditionally, the IRS has taken the position that the distribution must be in the form of employer stock (except for the value of a fractional share).² The Tax Court has upheld this requirement.³ A stock bonus plan may provide for payment of benefits in cash if certain conditions are met (Q 3819). For the purpose of allocating contributions and distributing benefits, the plan is subject to the same requirements as a profit sharing plan.

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An Employee Stock Ownership Plan (“ESOP”) is a defined contribution plan and can be either a qualified stock bonus plan or a profit sharing or money purchase pension plan, or any combination.¹ The unique feature of this type of plan that distinguishes it from stock bonus plans is that an ESOP is permitted to purchase employer securities through a loan. A similar purchase under any other plan would be a prohibited transaction.² The loan can be from the employer or another party, such as a bank. Although an ESOP is designed to invest primarily in employer securities, the trustee of the ESOP must make a determination as to whether the purchase of employer securities for the plan is prudent. In Fifth Third Bancorp v. Dudenhoeffer,³ the Supreme Court held that a trustee is not entitled to a presumption of prudence in making this determination.

The IRC specifies that an ESOP must be designed to invest primarily in “qualifying employer securities.”⁴ Qualifying employer securities are shares of common stock issued by the employer (or a member of the same controlled group) that are (1) readily tradable on an established securities market or, in case there is no such readily tradable stock and (2) have a combination of voting power and dividend rights at least equal to the class of common stock having the greatest voting power and the class of common stock having the greatest dividend rights.

Noncallable preferred shares also qualify if they are convertible into stock meeting the requirements of (1) or (2), above, (as appropriate) and if the conversion price is reasonable at the time the shares are acquired by the plan.⁵ The IRS determined that the common stock of a corporation did not constitute employer securities with respect to employees of a partnership owned by the corporation’s subsidiary because a partnership is not a corporate entity. As a result, the employees of the partnership could not participate in the corporation’s ESOP.⁶

Certain tax-exempt entities (such as a qualified retirement plan trust) are eligible to be shareholders of S corporations; consequently, S corporations may adopt ESOPs.⁷ Rigorous restrictions apply when the employer is an S corporation (Q 3731, Q 3824, Q 3825).

An ESOP is an “eligible individual account plan” (Q 3818) subject to additional, stricter requirements. The significant tax advantages of meeting the stricter requirements for an ESOP are that certain loan transactions, including a loan guarantee, between the plan and the employer are exempt from the prohibited transaction rules against loans between plans and parties-in-interest,⁸ certain forfeitures and contributions are excluded from the annual additions limit (Q 3868, Q 3728), and increased deductions by a C corporation employer are permitted on loan repayments (Q 3824).

For loans made prior to August 21, 1996, certain lenders were permitted to exclude from income 50 percent of the interest received on certain loans to an ESOP or sponsoring corporation used to purchase employer securities.⁹ This exclusion was repealed, but certain refinancings and loans pursuant to a written contract in effect on June 10, 1996, are treated as having been made prior to the effective date of the repeal.¹⁰

Yes, but under limited circumstances and normally only under a profit sharing plan.If, immediately after the acquisition, the aggregate fair market value of the employer securities and of employer real property held by the plan exceeds 10 percent of the fair market value of the plan’s assets, then only an “eligible individual account plan” that explicitly provides for the acquisition and holding of “qualifying employer securities” may acquire the employer securities.¹

An eligible individual account plan is an individual account plan that is a profit sharing, stock bonus, thrift, or savings plan, or an employee stock ownership plan (Q 3817). A money purchase plan (a defined contribution pension plan) that was in existence on September 2, 1974, and that on that date invested primarily in qualifying employer securities, has certain grandfathered rights as to employer securities. Qualifying employer securities are employer stock and certain marketable obligations.²

S corporation stock generally may be held by an exempt plan or a tax-exempt organization; thus, S corporations may establish a plan designed to invest primarily in employer securities, including an ESOP (Q 3817, Q 3819, Q 3825).³ These plans also may be installed by other small closely held corporations, as well as by corporations with shares that are publicly traded. The transfer of stock to such a plan by the employer is exempt from the prohibited transaction restrictions if the transfer is for an adequate value and no commission is charged.⁴

An investment in employer securities must satisfy ERISA’s fiduciary standards, which require that an investment in employer stock be prudent. An individual account plan (whether profit sharing, stock bonus, thrift, or savings, and whether qualified or not) designed to invest in more than 10 percent of qualifying employer securities is exempt from the requirement that a plan trustee diversify the trust’s investments.⁵

Investments in employer securities by qualified plans must satisfy IRS requirements that the plan be for the exclusive benefit of employees or their beneficiaries.⁶ The Conference Committee Report on ERISA indicates that to the extent a fiduciary meets the prudent investment rules of ERISA, it will be deemed to meet the exclusive benefit requirements of Revenue Ruling 69-494.⁷

To qualify, a plan must meet the applicable requirements set forth in Q 3726, Q 3751, and Q 3838. Notice that Q 3726 explains that profit sharing plans are not required to pass through voting rights. If a plan is not qualified, it is subject to the rules in Q 3532 to Q 3539.

In addition to meeting all of the requirements of IRC Section 401(a), stock bonus plans and employee stock ownership plans (“ESOPs”) (Q 3820) must meet certain additional requirements as to employer stock that is held by the plan. There are requirements concerning distribution of employer securities, diversification, and certain pass-through voting requirements.¹

Furthermore, an ESOP that holds stock in an S corporation must provide that no “prohibited allocation” will take place with respect to any portion of the assets of the plan attributable to such securities.²

Where employer securities are not readily traded on a public market, any transactions involving stock require an independent valuation of the stock for that transaction.

A stock bonus plan or ESOP generally is required to give participants the right to demand benefits in the form of employer securities. If employer securities are not readily tradable on an established market, the participant must have the right to require the employer (not the plan) to repurchase employer securities under a fair valuation formula (a “put option”).³

The requirement that participants have the right to demand benefits in the form of employer securities does not apply to the portion of a participant’s ESOP account that has been reinvested under applicable diversification rules (Q 3732, Q 3820).⁴ The requirement also does not apply in the case of an employer whose charter or bylaws restrict the ownership of substantially all outstanding employer securities to employees, to a qualified plan trust, or to an S corporation (Q 3826).⁵ Anti-cutback relief generally is available for ESOPs that are amended to eliminate the right of participants to demand benefits in the form of employer securities (Q 3876).⁶

The put option must be available for at least 60 days following distribution of the stock and, if not exercised within that time, for another 60 day period (at a minimum) in the following year.⁷

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Planning Point: Regulations have not yet been issued governing when the second option period should begin. One realistic approach is for the second 60 day period to begin after the next plan year’s appraisal has been obtained by the plan trustee. Martin Silfen, J.D., Brown Brothers Harriman Trust Co., LLC.

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The plan may repurchase the stock instead of the employer, but the plan cannot be required to do so. Banks prohibited by law from redeeming or purchasing their own shares are excused from the requirement that they give participants a put option.⁸

If, pursuant to a put option, an employer is required to repurchase securities distributed to an employee as part of a “total distribution,” the amount paid for the securities must be paid in substantially equal periodic payments (at least annually), over a period beginning within 30 days after the exercise of the put option, and not exceeding five years. Adequate security must be provided, and a reasonable interest paid on unpaid amounts. A total distribution is a distribution to the recipient within one taxable year of the balance to the credit in his or her account.⁹ If an employer is required to repurchase securities distributed to an employee as part of an “installment distribution,” the amount paid for the securities must be paid within 30 days after the put option is exercised.¹⁰

Distributions are subject to mandatory 20 percent withholding, unless the employee elects a direct rollover.¹¹ The mandatory withholding requirement does not apply to any distribution that consists only of securities of the employer corporation and cash of up to $200 in lieu of stock. The maximum amount to be withheld under the mandatory withholding rules may not exceed the sum of the amount of money received and the fair market value of property other than securities of the employer corporation received in the distribution.¹²

The plan must provide that if a participant with the consent of his or her spouse so elects, the distribution of the account balance will commence within one year after the plan year (1) in which the participant separates from service by reason of attainment of the normal retirement age under the plan, disability, or death, or (2) which is the fifth plan year following the plan year in which the participant otherwise separated from service. Distribution under (2) will not be required if the participant is re-employed by the employer before distributions actually begin.¹³ Special rules, explained below, apply to leveraged ESOPs where the loan or loans used to acquire the employer securities remain outstanding.¹⁴

The plan also must provide that, unless the participant elects otherwise, distribution of the account balance will be in substantially equal periodic payments (at least annually) over a period not longer than the greater of (1) five years, or (2) in the case of a participant with an account balance in excess of $1,380,000 (as indexed for 2024,  $1330,000 for 2023, $1,230,000 in 2022, $1,165,000 in 2021 and $1,150,000 in 2020), five years plus one additional year (not to exceed five additional years) for each $275,000 in 2024 (up from $265,000 in 2023, $245,000 in 2022 and $230,000 in 2020-2021), or fraction thereof, by which the employee’s account balance exceeds $1,380,000 (in 2024).¹⁵

If employer securities in an ESOP are acquired with the proceeds of a loan and repayments of principal are deductible under IRC Section 404(a)(9) (Q 3824), the securities are not considered to be part of a participant’s account balance for purposes of these rules until the close of the plan year in which the loan is fully repaid.¹⁶

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Planning Point: An employer whose stock is not publicly traded, and therefore is subject to the employer’s potential obligation to repurchase its stock from terminating plan participants, should be concerned about the impact that obligation could have on its cash flow. The employer should consider writing its plan to take the maximum time allowed, generally five years, to begin the process of distributing stock from the plan and then repurchasing that stock from former employees. Martin Silfen, J.D., Brown Brothers Harriman Trust Co., LLC.

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Notwithstanding these requirements, if the general rules for commencement of distributions from qualified plans (Q 3891) require distributions to begin at an earlier date, those general rules control.¹⁷

A stock bonus plan or ESOP must pass through certain voting rights to participants or beneficiaries. If an employer’s securities are “registration-type,” each participant or beneficiary generally must be entitled to direct the plan as to how securities allocated to him are to be voted.¹⁸ “Registration-type” securities are securities that must be registered under Section 12 of the Securities and Exchange Act of 1934 or that would be required to be registered except for an exemption in that law.¹⁹

If securities are not “registration-type” and more than 10 percent of a plan’s assets are invested in securities of the employer, each participant (or beneficiary) must be permitted to direct voting rights under securities allocated to his or her account with respect to approval of corporate mergers, consolidations, recapitalizations, reclassifications, liquidations, dissolutions, sales of substantially all of the business’ assets, and similar transactions as provided in future regulations.²⁰

A plan meets this requirement in the case of nonregistration-type securities if each participant is given one vote with respect to an issue and the trustee votes the shares held by the plan in a proportion that takes this vote into account.²¹ The IRS has ruled that an ESOP will not fail to comply in operation with these pass-through voting requirements merely because the trustee of the ESOP votes the shares of stock allocated to participants’ accounts for which no voting directions are timely received, whether the securities are registration type or nonregistration-type.²²

Stock bonus plans and employee stock ownership plans (“ESOPs”) must meet the requirements set forth in Q 3819; S corporation ESOPs must meet the special requirements described in Q 3825.ESOPs also must meet the requirements discussed below.

Qualified Sales

Provisions of the plan must ensure that, in the case of certain “qualified sales” of employer securities by a participant or executor to the ESOP, no portion of the assets of the plan (or any other qualified plan of the employer) attributable to the securities purchased by the plan may accrue or be allocated for the benefit of any of the following persons:

(1)    a taxpayer who has elected to have the gain on the sale and replacement of employer securities deferred under the qualified sales rules of IRC Section 1042 (Q 3731);

(2)    any individual who is a member of the family (brothers, sisters, spouse, ancestors, lineal descendants) or is related under the other rules of IRC Section 267(b) to the taxpayer described in (1);

(3)    any person not described in (1) or (2) who owns, or is considered as owning under the attribution rules of IRC Section 318(a), more than 25 percent (by number or value) of any class of outstanding stock of the employer or of any corporation which is a member of the same controlled group of corporations as is the employer (Q 3933). ¹ For purposes of determining whether this limitation applies, an individual is treated as owning any securities he owned during the one-year period ending on the date of the sale to the plan, or as of the date the securities are allocated to participants in the plan.²

No employer securities acquired by the plan in any transaction to which IRC Section 1042 applied can be allocated to such persons. Thus, an employee who sold his employer securities to an ESOP and elected nonrecognition under IRC Section 1042 could not receive allocations based on other employer securities acquired by the plan in a different IRC Section 1042 transaction.³

Nonallocation Period

After the later of the date that is 10 years after the date of the sale of securities or the date of the plan allocation attributable to the final payment on indebtedness incurred in connection with the sale, a plan may permit accruals or allocations for individuals described in (1) or (2), above, but not individuals described in (3). This 10 year period is referred to as the “nonallocation period.”⁴ This time period should not be confused with the “nonallocation year” (Q 3825).

A special rule provides that the prohibition under (2) does not apply to a lineal descendant of the taxpayer if the aggregate amount allocated for the benefit of all lineal descendants of the taxpayer during the nonallocation period is not more than 5 percent of the employer securities (or amounts allocated in lieu thereof) held by the plan which are attributable to a qualified sale by a member of any of the descendants’ families (brothers, sisters, spouse, ancestors, lineal descendants).⁵

If a plan fails to meet these requirements, not only is the plan likely to be disqualified, but a penalty tax equal to 50 percent of the amount of any prohibited accrual or allocation will generally be levied against the plan. Also, the amount of any prohibited accrual or allocation will be treated as if distributed to the individual involved and taxed as such.⁶

Regulations

An ESOP must meet requirements set forth in applicable regulations.⁷ The regulations require that an exempt loan be primarily for the benefit of participants and their beneficiaries. The proceeds of an exempt loan may not be used to buy life insurance; otherwise, the general rules applicable to the purchase of life insurance by qualified plans apply (Q 3830). The plan or employer may have a right of first refusal if the stock is not publicly traded.

Stock that is acquired after September 30, 1976, with the proceeds of an exempt loan and that is not publicly traded or that is subject to a trading restriction must be subject to a put option exercisable only by a plan participant or by the participant’s donees or successors. The option must permit a participant to “put” the security to the employer but must not bind the plan. Nonetheless, the plan may have the right to assume the employer’s obligation when the put option is exercised. An ESOP may not otherwise obligate itself to a put option or to acquire securities from a particular security holder on the happening of an event such as the death of the holder (e.g., a buy-sell agreement). Regulations provide rules for the current distribution of income. ESOPs generally may not be integrated with Social Security.⁸

An ESOP generally must provide for diversification of investments by permitting a plan participant (including one who has already separated from service with the employer) who has completed 10 years of participation in the plan and attained age 55 to elect to direct the investment (allowing at least three investment options) of a portion of his account balance. (This requirement does not apply to plans subject to the diversification requirement explained at Q 3732.)¹

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Planning Point: The IRS has issued relief from the anticutback rules of Section 411(d)(6) for a plan sponsor who amends a nonexempt ESOP to eliminate a distribution option that had previously satisfied the diversification requirements of Section 401(a)(28)(B) if the amendment occurs no later than the last day of the first plan year beginning on or after January 1, 2013 or by the deadline for the plan to satisfy Section 401(a)(35), if later.²

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Planning Point: An employer sponsoring an ESOP that does not otherwise offer directed investments complying with these diversification requirements may wish to design the ESOP to offer a distribution election in lieu of a diversification election, rather than make the administration of the plan needlessly complex. Martin Silfen, J.D., Brown Brothers Harriman Trust Co., LLC.

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In the case of an ESOP that had not existed for 10 years, the IRS permitted a plan participant to count years of participation in a terminated predecessor ESOP to meet the 10 years of participation requirement.³

The diversification election must be made within 90 days after the close of each plan year in the six-plan-year period, which begins with the plan year in which the employee becomes eligible to make the election. Generally, at least 25 percent of the account balance attributable to employer securities acquired by or contributed to an ESOP must be subject to the election; but in the last year of the six-plan-year period the 25 percent is increased to 50 percent.⁴

The amount that must be subject to the election at the end of a given year is generally equal to (1) 25 percent (or 50 percent in the last year) of the total number of shares of employer securities acquired by or contributed to the plan that have ever been allocated to the participant’s account on or before the most recent plan allocation date, minus (2) the number of shares previously diversified.⁵ Employer securities may not be one of the three investment options.⁶

A plan may meet this diversification requirement by distributing the portion of an account for which an election is made.⁷ The diversification requirement can also be satisfied by allowing a participant to transfer that portion of an account for which an election is made into a qualified defined contribution plan which provides for employee directed investment and in which the required diversification options are available.⁸

Any form of diversification elected (i.e., the distribution, transfer, or implementation of an investment option) must be completed within 90 days after the close of the election period.⁹ An election to diversify may be revoked or amended, or a new election made, at any time during the 90 day election period.¹⁰

With respect to plan activities, all valuations of employer securities that are not readily tradable on an established securities market must be made by an independent appraiser whose name is reported to the IRS. For this purpose, an independent appraiser is an appraiser who meets requirements similar to those imposed under the charitable deduction rules of Section 170(a)(1).¹

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Planning Point: If the company hires an appraiser and decides the appraised value is too high, that information is discoverable in any subsequent legal dispute, such as with the IRS. But if the company’s attorney hires the appraiser, the appraisal remains in the files of the law firm and is subject to attorney-work product privilege. This allows the attorney to seek a lower appraisal, without fear that the appraisal for the higher amount will be discoverable and will create support for a finding of undervaluation. Lawrence Brody, J.D., LL.M, Bryan Cave LLP.

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A taxpayer or executor who sells qualified securities to an Employee Stock Ownership Plan (“ESOP”) (Q 3817) and purchases qualified replacement property may be able to elect to defer recognition of long-term capital gain on the sale.¹ This is referred to as a Section 1042 election. If the election is made, the taxpayer or estate recognizes gain on the sale only to the extent that the amount realized on the sale exceeds the cost of the securities purchased to replace the stock sold to the ESOP.²

The election must be made in a written “statement of election” and filed with the taxpayer’s return for the year of sale by the due date for that year, including extensions.³ The statement of election must contain specific information set forth in the regulations.⁴ The election cannot be made on an amended return, and, once made, is irrevocable.⁵ In the absence of such an election, the Tax Court denied the deferral of gain to a taxpayer whose estate argued that he had “substantially complied” with the election requirements.⁶ Similarly, where a taxpayer failed, through his accountant’s error, to make a timely election, the IRS strictly construed the statutory deadline.⁷

A taxpayer must file a statement from the employer whose employees are covered by the ESOP consenting to the application of an excise tax⁸ if the transferred securities are disposed of prematurely (see below) and a tax⁹ on prohibited allocations of securities acquired in the sale.¹⁰ Failure to substantially comply with the statement of election and statement of consent requirements has resulted in denial of nonrecognition treatment.¹¹

The qualified replacement property must be purchased during the period that begins three months before the sale of qualified securities and ends 12 months after the sale.¹² If the replacement property has not yet been purchased when the statement of election is required, the taxpayer must file a notarized statement of purchase with his or her income tax return for the tax year following the year for which the election was made. The statement of purchase must contain specific information and must be notarized within 30 days of the purchase.¹³ The IRS has found that taxpayers had substantially complied with the election requirement where they had relied on tax professionals concerning the election requirements and immediately acted to correct the noncompliance.¹⁴

Qualified securities, for purposes of a Section 1042 exchange, means stock (1) in a domestic C corporation (i.e., not an S corporation) that has no stock outstanding that is readily tradable on an established securities market, and (2) that was not (x) acquired from a qualified pension, profit sharing, or stock bonus plan, (y) acquired under an employer stock option plan or an employee stock purchase plan, or (z) transferred to the individual in connection with his or her performance of services to the corporation.¹⁵ In addition, the taxpayer must have held the qualified securities for at least three years before the sale to the ESOP.¹⁶ Nonrecognition does not apply to any gain on the sale of any qualified securities that is includable in the gross income of any C corporation.¹⁷

Qualified replacement property means securities issued by a domestic operating corporation that (1) did not have more than 25 percent of its gross receipts in certain passive investment income (including, generally, receipts from rents, royalties, dividends, interest, annuities, and sales and exchanges of stock or securities) for the taxable year preceding the tax year in which the security was purchased, and (2) is not the corporation or a member of its controlled group (Q 3933) that issued the qualified securities being replaced.¹⁸

If a taxpayer does not intend to reinvest the total amount required, under IRC Section 1042, to completely defer the gain on the sale in replacement securities, the installment method may be available for the gain that does not qualify for nonrecognition, provided that the sale otherwise qualifies as an installment sale. The amount of gain is the same proportion of the installment payment actually received in such year that the total gain to be recognized under IRC Section 1042 bears to the total amount realized. The gain is recognized in the taxable year in which the installment payment is made.¹⁹

A taxpayer’s basis in his or her replacement securities is reduced by the amount of gain not recognized. If more than one item is purchased, the unrecognized gain is apportioned among them.²⁰ If a taxpayer dies while still holding replacement securities, the basis provisions of IRC Section 1014 prevail and the replacement securities receive a stepped-up basis.²¹ The holding period of the replacement property includes the holding period of the securities sold.²²

To qualify for nonrecognition, the sale must meet certain additional requirements. The ESOP generally must own, immediately after the sale, at least 30 percent of each class of outstanding stock of the corporation that issued the qualified securities, or the total value of outstanding employer securities.²³

The IRS has determined that where a note acquired by a company’s owners from an ESOP in exchange for stock was a cash equivalent for tax purposes, the stock in a separate corporation acquired in exchange for the note constituted qualified replacement property.²⁴

If a taxpayer disposes of any qualified replacement property, he or she generally will recognize gain (if any) to the extent that it was not recognized when the replacement property was acquired.²⁵ If a taxpayer owns stock representing control of a corporation that issued the replacement property, he or she will be treated as having disposed of his or her qualified replacement property if that corporation disposes of a substantial portion of its assets other than in the ordinary course of its trade or business.

The recapture rules do not apply if the transfer of the qualified replacement property is:

(1) in a reorganization (if certain requirements are met);

(2) by reason of the death of the person making the original election;

(3) by gift (even if a charitable deduction is obtained);²⁶ or

(4) in a subsequent transfer that is eligible for an election not to recognize gain under the rules discussed above.²⁷

A transfer to a revocable trust by a taxpayer will not trigger recapture where the grantor (i.e., the taxpayer) will continue to be treated as the owner of the property transferred to the grantor trust.²⁸

The IRS also has determined that the distribution of qualified replacement property by a trust to its beneficiary was not a disposition for purposes of IRC Section 1042(e); thus, the recapture rules did not apply.²⁹

Although the transfer of qualified replacement property to a charitable remainder unitrust technically was a “disposition,” it did not result in recapture of the deferred gain, because the donors did not realize gain on the transaction.³⁰

Subsequent Dispositions by the ESOP

If, within three years, an ESOP disposes of stock acquired in a sale in which the seller was permitted to defer the recognition of income (as discussed above) and, as a result, the number of the ESOP’s shares falls below the number of employer securities held immediately after the sale, or the value is less than 30 percent of the total value of all employer securities, the disposition will be subject to a tax equal to 10 percent of the amount realized on the disposition, unless the disposition is a distribution made by reason of (1) the death or disability of an employee, (2) retirement of the employee after age 59½, or (3) separation of the employee from service for any period that results in a one year break in service.³¹

The deduction rules that apply to profit sharing, stock bonus, and money purchase pension plans (Q 3750) generally apply to Employee Stock Ownership Plans (“ESOPs”) (Q 3817) with a few exceptions that expand how much can be deducted. A C corporation with an ESOP is permitted to deduct additional amounts without regard to the deduction limits for profit sharing, stock bonus, and pension plans to the extent such additional amounts do not exceed the IRC Section 415 limits. The rules that follow generally are not available to ESOPs maintained by an S corporation.¹

An employer’s ESOP contributions that are used to repay the principal of a loan incurred to acquire employer securities are deductible up to 25 percent of the compensation paid to covered employees. This deduction limit is measured based on compensation paid in the employer’s tax year for which the deduction is taken. To be deductible, the contribution must have been both paid to the trust and applied by the trust to the repayment of the principal by the due date (including extensions) of the tax return for that year. For contributions exceeding 25 percent of compensation, a contribution carryover is permitted in succeeding years in which the 25 percent limit is not fully used (but contributions to a defined contribution plan in excess of the IRC Section 415 limits may not be carried over).²

In addition, contributions applied by the plan to the repayment of interest on a loan used to acquire employer securities may be deducted without limit in the tax year for which it is contributed if the contribution is paid by the due date (including extensions) for filing the tax return for that year.³

Pass Through Dividends

An employer sponsoring an ESOP also may deduct the amount of any dividend paid on stock held by the ESOP on the record date when the dividend is:

(1) paid in cash to the plan participants or their beneficiaries;

(2) paid to the plan and distributed in cash to the participants or their beneficiaries within 90 days after the close of the plan year;

(3) at the election of the participants or their beneficiaries (x) payable as provided in (1) or (2), or (y) paid to the plan and reinvested in qualifying employer securities (in which case the amounts must be fully vested);⁴ or

(4) used to make payments on an ESOP loan used to acquire the employer securities with respect to which the dividend is paid.⁵

Dividend payments described in IRC Section 404(k)(2) are not treated as distributions subject to withholding.⁶

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Planning Point: Dividends on Section 404(k) stock are not subject to the lower income tax rates enacted in 2003 for other types of dividend payments.⁷

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The IRS has issued guidance on numerous issues related to the election that employers can offer participants or their beneficiaries, as described in (3) above.⁸

The deduction for dividends that a participant elects to reinvest in qualifying employer securities, as described in (3) above, is allowable for the taxable year in which the reinvestment occurs or the election is made, whichever is later.⁹

The IRS may disallow the deduction for a dividend under IRC Section 404(k)(1) if the dividend constitutes, in substance, an avoidance or evasion of taxation.¹⁰

The authority of the IRS to recharacterize excessive dividends paid on ESOP stock as employer contributions was upheld by the Court of Appeals for the Eighth Circuit in a ruling that resulted in disqualification of the ESOP for its resulting failure to meet the IRC Section 415 limits.¹¹

The IRC permits certain qualified retirement plan trusts to be shareholders of S corporations; thus, an S corporation can adopt an ESOP.¹ When a tax-exempt entity (e.g., an ESOP) holds an ownership interest in an S corporation, the distributions from the S corporation received by the tax-exempt entity are not subject to income tax. This unique tax benefit is available to S corporation ESOPs only when certain requirements are met.

First, the IRC restricts the type of entities that can own an interest in an S corporation.

Second, the IRC places certain restrictions on the operation of the ESOP. These operational rules apply to the allocation of S corporation stock within the ESOP to certain individuals, and limit certain tax benefits otherwise available to ESOP sponsors. Those limits apply to the deductions for employer contributions to the plan and for dividends paid on employer securities, and do not permit the rollover of gain on the sale of stock to an ESOP (Q 3731, Q 3824).

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Planning Point: Because there is a possibility for abuse of this benefit, the IRS has targeted S corporation ESOPs for special attention.²

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The IRS has stated that an ESOP may direct certain rollovers of distributions of S corporation stock to an IRA, in accordance with a distributee’s election, without terminating the corporation’s S election, provided certain requirements are met. The effect of these requirements is that either the S corporation or the ESOP repurchases the S corporation stock immediately upon the distribution to the IRA and that no income, loss, deduction, or credit attributable to the distributed S corporation is allocated to the IRA.³

An S corporation that maintains an ESOP also generally is exempt from the requirement that employees be able to demand distribution of employer securities.⁴ To do otherwise could violate the IRC limit on the number of shareholders in an S corporation (Q 3819). An ESOP maintained by an S corporation will not be treated as receiving unrelated business income on items of income or loss of the S corporation in which it holds an interest.⁵

Prohibited Allocations of Stock

An ESOP that holds securities consisting of stock in an S corporation also must provide that no portion of the assets of the plan attributable to such securities will accrue or be allocated, directly or indirectly, to a “disqualified person” during a “nonallocation year.”⁶ Such an allocation is referred to as a prohibited allocation.

A disqualified person is any person for whom:

(1) the number of the person’s deemed-owned ESOP shares is at least 10 percent of the number of deemed-owned ESOP shares of the S corporation;

(2) the aggregate number of the person’s deemed-owned ESOP shares and synthetic equity shares is at least 10 percent of the aggregate number of deemed-owned ESOP shares and synthetic equity shares of the S corporation;⁷

(3) the aggregate number of deemed-owned ESOP shares of the person and his or her family is at least 20 percent of the number of deemed-owned ESOP shares of stock in the S corporation; or

(4) the aggregate number of deemed-owned ESOP shares and synthetic equity shares of the person and his or her family is at least 20 percent of the aggregate number of deemed-owned ESOP shares and synthetic equity shares of the S corporation.⁸

Family member means the individual’s spouse, an ancestor or lineal descendant of the individual or spouse, a sibling of the individual or spouse, and lineal descendants of any siblings, as well as spouses of the aforementioned individuals (except in the case of a legal separation or divorce).⁹

Deemed-owned shares with respect to any person are the stock in the S corporation constituting employer securities of an ESOP that is allocated to such person’s account under the plan, and the person’s share (based on the same proportions as of the most recent allocation) of the stock in the corporation that is held by the ESOP but that is not allocated under the plan to participants.¹⁰

A nonallocation year means any plan year of the ESOP if, at any time during the year, the ESOP holds any employer securities that are shares in an S corporation and disqualified persons own at least 50 percent of the number of outstanding shares in the S corporation (including deemed owned shares) or the aggregate number of outstanding shares of stock (including deemed owned shares) and synthetic equity in the S corporation.¹¹ For purposes of determining whether there is a nonallocation year, the attribution rules of IRC Section 318(a) apply in determining stock ownership (except that the broader “family member” rules above apply), the IRC Section 318(a) rules regarding options do not apply, and an individual is treated as owning “deemed-owned” shares.¹²

In the event that a prohibited allocation is made in a nonallocation year to a disqualified person, the plan will be treated as having distributed the amount of the allocation to the disqualified person on the date of the allocation.¹³ In other words, the allocation is a taxable distribution to the individual.¹⁴ Furthermore, an excise tax of 50 percent of the amount involved is imposed on the allocation, and a 50 percent excise tax is imposed on any synthetic equity owned by a disqualified person.¹⁵ The 50 percent excise taxes are imposed against the employer sponsoring the plan.¹⁶

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Planning Point: The IRS has released “snapshot” guidance to help S corporations avoid a nonallocation year for employee stock ownership plan (ESOP) purposes. Pursuant to the snapshot, which is not precedential but can be helpful in understanding the IRS’ position on an issue, ESOPs may incorporate a “transfer method” into the plan document, pursuant to which the plan can transfer employee stock from a participant’s ESOP account if that participant is a disqualified person into a non-ESOP account of that same person. Alternative methods are also available, including excluding allocations for participants who may potentially be disqualified persons or increasing allocations to certain employees who are not highly compensated. These methods must also comply with all other qualification rules. Importantly, to use the transfer method, the method must be included in the ESOP plan document prior to the occurrence of a nonallocation year.¹⁷

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Synthetic equity includes any stock option, warrant, restricted stock, deferred issuance stock right, stock appreciation right payable in stock, or similar interest or right that gives the holder the right to acquire or receive stock of the S corporation in the future. Synthetic equity also includes a right to a future payment (payable in cash or any other form other than stock of the S corporation) that is based on the value of the stock of the S corporation or appreciation in such value, or a phantom stock unit.¹⁸

Synthetic equity also includes any remuneration under certain nonqualified deferred compensation arrangements for services rendered to the S corporation or a related entity.¹⁹ The stock upon which synthetic equity is based will be treated as outstanding stock of the S corporation and deemed-owned shares of the person owning the synthetic equity, if such treatment results in the treatment of any person as a disqualified person or the treatment of any year as a nonallocation year.²⁰

Final regulations explaining the prohibited allocation rules of the IRC apply to plan years beginning on or after January 1, 2016.²¹ For plan years beginning before January 1, 2016, temporary regulations explain the prohibited allocation rules.²²

With respect to qualification, plans of an S corporation (whether defined benefit or defined contribution) generally must meet the same requirements applicable to other corporate plans (Q 3838). The special rules that apply to S corporation ESOPs are explained at Q 3825.

Probably the only significant difference from other entities is in the way that the owner’s compensation is treated for plan purposes. Only wages paid to an S corporation employee-shareholder generally may be included in compensation for purposes of determining contributions, nondiscrimination testing, and classification of key or highly compensated employees. That is, S corporation distributions are not included. In contrast, the K-1 income paid to a member in an LLC taxed as a partnership or a partner in a partnership is treated as contributions for plan purposes. Certain abusive S corporation ESOPs will not be treated as qualified plans, will be subject to prohibited transaction penalties (Q 3980), and are among the “listed transactions” treated as corporate tax shelters (subject to additional penalties).¹