The ESOP-Owned S Corporation: Bringing Ownership to Life with Synthetic Equity discusses how S Corporations can suffer from a cash drain as distributions are paid to shareholders to cover personal income taxes, ultimately putting the company in the same situation as a C Corporation. This can be avoided by creating a 100% ESOP-owned S corporation:
But what if the sole shareholder is a tax-exempt qualified retirement plan that is, an ESOP? In that event, neither the company nor its shareholder pays taxes on the company's net earnings, so no cash needs to leave the company in favor of the IRS. In effect, the ESOP-owned S corporation becomes a tax-exempt, for-profit business!
The article describes two limitations of using an ESOP as an employee ownership model: the limited flexibility in determining which employees should get how much ownership and how a dollar given to employees in ownership can have a lesser perceived value, decreasing the attractiveness of an ESOP to younger employees and recruits.
A solution to these problems is to supplement the ESOP with synthetic equity to "create incentive, a sense of ownership and pre-retirement liquidity." When developing a synthetic equity solution, it is imperative that the plan satisfy the IRC Section 409(p) Anti-Abuse Testing requirements. The article discusses the following synthetic equity solutions:
- Stock Options "A stock option plan allows a company to grant to individual employees a contractual right, or option, to buy a certain number of the company's shares at any time during a specified time period (usually 10 years), paying a price that is specified at the time of the grant (usually fair market value at the time of the grant)."
- Stock Appreciation Rights (SARs) "Stock appreciation rights, or SARs, are simply a contractual arrangement by which the company promises to make a cash payment to the individual at some point in the future, with the exact amount of money paid out to be determined by application of a formula tied to the appreciation in the value of the company's stock that occurs from the time the SARs are issued to the time that the payment is made."
- Equity-Based Deferred Compensation " a deferred compensation plan, in which managers give up some portion of their regular pay and, in exchange, are credited with "phantom stock units" that are held for them in a deferred compensation plan. Upon the conclusion of employment with the company, the individual would receive a cash payment equal to the number of phantom stock units credited to him multiplied by the current share price of the company's stock."
Three Points to Consider
- Don't forget about the IRC Section 409(p) Anti-Abuse Testing requirements and the draconian penalties for noncompliance.
- With any synthetic equity plan, make sure you are complying with the IRC Section 409A Nonqualified Deferred Compensation (NQDC) Plan Regulations.
- Be aware of how Rangel's Corporate Tax Proposal would negatively impact the use of synthetic equity in certain ESOPs.