S Corporation Election
Recent changes in the tax laws provide a significant opportunity for companies with ESOPs that are eligible for S corporation status. By becoming an S corporation, all income generated by a company is no longer taxed at the corporate level. Rather shareholders must include a pro rata portion of the S corporation's income in their tax filing, and each is liable for their share of the income at individual tax rates. The net effect is the elimination of "double taxation" incurred by C corporations-once at the corporate level and again at the shareholder level when after-tax corporate earnings are distributed to the shareholders.
A key provision of the new tax laws provides that the ESOP shareholder, in this case the ESOP Trust, is not required to pay any taxes on its pro rata portion of a company's income. If a company becomes 100 percent owned by the ESOP, there is no federal income tax liability to the shareholders. However, the income tax liability is only deferred and remains with individual participants at individual tax rates until participants eventually retire and make withdrawals from their qualified retirement accounts.
The Company has discretion with company income whether to make per share distributions of income, ESOP contributions of cash and stock, or to retain the income for general business purposes. Company policy may provide for making distributions and contributions in consideration of (i) prior contribution levels, (ii) the estimated tax liability on an "as if" C corporation basis, and (iii) estimated Company repurchase obligations. Distributions received by ESOP participants generally relate to levels of share ownership, while contributions received relate to levels of compensation.
For valuation purposes only, adjustments to the Company's financial data on an "as if" C corporation basis reflect our recommended treatment of ESOP contributions as noted below.
Treatment of ESOP cash and stock contributions for valuation purposes: Cash contributions are fully expensed as the cash leaves the corporation and enters the ESOP trust account. Cash contributions may positively affect the company's future repurchase obligations. Stock contributions are fully added back to the amount of "as if" before-tax earnings and are also tax-adjusted at the estimated "as if" C corporation income tax rate for the particular period; and the net result is added back to "as if" after-tax earnings (i.e., earnings after-tax and before ESOP stock contribution expense). Stock contributions to the ESOP represent a non-cash expense, wherein the representative cash value remains with the firm and does not decrease the Company's capital account. The positive economic effect of stock contributions is often offset by the necessary consequence of dilution of the value per share when issuing new shares to the ESOP.
<top