Many of Mercer Capital’s clients have recognized the value of employee ownership in terms of employee loyalty and motivation as well as the numerous tax advantages to the business and maintain an Employee Stock Ownership Plan (“ESOP”). During the first part of 2001, we have performed hundreds of appraisals for purposes of establishing the value of shares held by ESOPs, proposed ESOP transactions as a result of mergers and acquisitions, and many other purposes. The most interesting development in the ESOP arena, however, is the increasing number of S corporations establishing ESOPs and ESOP-owned C corporations electing to convert to subchapter S status.

Although the provisions of the Small Business Protection Act of 1996 (the “Act”) enabled trusts such as an ESOP to be an S corporation shareholder, the Act included numerous provisions that presented significant barriers for S corporations to sponsor an ESOP. In 1997, however, Congress amended the Act to correct technical flaws relating to ESOPs. Most importantly, the revisions to the Act exempt ESOPs from the unrelated business income tax (“UBIT”), making ESOP ownership much more appealing. The revisions also allow S corporations to require cash distributions rather than stock distributions to departing employees to prevent potential disqualification of the subchapter S status (for example, an IRA is not a qualified S corporation owner, and an employee’s placing of S corporation stock in her IRA would result in the termination of S status under the Internal Revenue Code).

The valuation on S corporation stock is fundamentally identical to the valuation of an interest in a C corporation. However, a number of valuation approaches require the tax-effecting of earnings/distributions, an adjustment that will convert S corporation operations to a C corporation equivalent basis.

For example, the market approach to valuation includes a variety of methods that compare the subject company with transactions involving similar investments, including publicly traded guideline companies. A direct comparison between an S corporation and a publicly traded C corporation, however, is impossible, as demonstrated in the example in Table 1 top of page 2.

The S corporation’s hypothetical value based on $100 in pretax income and an after tax valuation multiple of 6x is $600, versus the C corporation’s value of $360. Say your company operated as a C corporation in 1998, operated as an S corporation during 1999, and operations were absolutely identical in both years. I am sure that you would agree that your Company’s value (everything else being equal) did not increase more than 65% simply because of the conversion to an S corporation. The flaw in the above analysis is, of course, the application of an after-tax multiple (which is commonly based upon publicly traded C corporations) on S corporation earnings. In order to allow for a meaningful comparison between your S corporation and the publicly traded C corporations, it is necessary to adjust the S corporation’s income for corporate taxes. On a C corporation equivalent basis, net income in the above example is $60 ($100 of taxable income tax-effected at an assumed tax rate of 40%), resulting in a value of $360 for the enterprise.

A similar adjustment is necessary when comparing a C corporation’s dividends with an S corporation’s distributions. C corporation shareholders pay income taxes at their applicable tax rate on dividends received. The S corporation shareholder, however, is responsible for the taxes on his or her share of the company’s income, whether a distribution occurred or not. As a result, it is necessary to convert distributions from an S corporation to a C corporation equivalent basis before any valuation inferences can be drawn. (For a more detailed description, please call us for a copy of “Converting Distributions From ‘S’ Corporations and Partnerships to a ‘C’ Corporation Dividend Equivalent Basis,” by J. Michael Julius, 1996).

The above examples illustrate that an S corporation’s value cannot be derived simply by applying after tax valuation multiples to S corporation net income or distributions. Similarly, we pointed out that there is no S corporation premium resulting simply from the conversion to a subchapter S corporation. If there is no increase in value as a result of conversion, however, what triggered the recent surge in conversions to S corporations?

The key incentive for ESOP ownership of an S corporation appears to be the fact that distributions to the ESOP are tax exempt. The higher the ESOP’s ownership stake in the company, the less taxes are paid. If the ESOP is the sole owner of the S corporation, the organization pays no income tax. While we demonstrated that an S corporation’s value does not differ from its C corporation peer, this ability to retain, accumulate, and reinvest significant amounts of cash can increase value over time as the operations and earnings grow. During the past year, some of our clients have been able to significantly expand their operations by using the incremental cash flow that resulted from their conversion to an S corporation.

At the same time, there are some potential disadvantages to the S corporation ESOP. First, a Section 1042 “Rollover” (the deferred recognition of gain on the sale of stock to an ESOP) is not available to S corporations. Second, contribution limits for S corporations to pay ESOP debt are limited to 15% of payroll (but increases to 25% if the ESOP contains money pension purchase provisions). Third, S corporations can only have one class of stock, and any distributions must be made pro rata. Since most S corporations distribute an amount at least equal to the shareholders’ tax liability and the ESOP has no tax obligation, funds that could be available for reinvestment have to be distributed to the ESOP. However, these funds could be used for a variety of purposes, including ESOP debt retirement, additional stock purchases, or payments to terminated employees.

C corporations with ESOPs desiring conversion to S status must also consider the following:

  • S corporations must operate on a calendar year.
  • The number of shareholders is limited to 75 (the ESOP counts as one shareholder, no matter how many participants).
  • Subchapter S election requires the consent of all shareholders.
  • Some fringe benefits paid to 2% or more owners are taxable.
  • S corporations using last in, first out (“LIFO”) accounting on conversion are subject to a LIFO recapture tax.
  • The sale of assets is subject to a built-in gains (“BIG”) tax on that sale for a period of ten years after conversion.
  • Net operating losses incurred as a C corporation are suspended while an S corporation but may be applied against the LIFO recapture tax and/or the BIG tax.
  • ESOPs may be subject to state unrelated business income tax in some states.

ESOP ownership in S corporations can create significant advantages for employers and employees. Employee ownership creates incentives for employees to contribute to “their” company’s success and motivate stakeholders to take an active part in the operations of the organization. Business owners have the opportunity to share the successes of their business with employees and reward loyal, long-time employees for their contributions to the business. While employee ownership provides many intangible advantages as compared to more traditional ownership structures, the ability of ESOPs to own a stake in an S corporation may very well be one of the most financially rewarding changes in tax legislation.

Reprinted from Mercer Capital’s, Volume 10, Number 1, 2001.