Technical Issues: Update for S Corp ESOPs

1. Technical Issues: Update for S Corp ESOPs Helen H. Morrison Principal, Deloitte Becky Hoffman Principal Group Hugh Reynolds Crowe Chizek and Company LLC Tim Jochim Jochim Co., LPA 18th Annual Ohio Employee Ownership Conference April 16, 2004 Akron, Ohio

2. C Corporation Corporation under state law Separately taxable entity Shareholders subject to tax on dividend payments (now 15% tax for eligible dividends) S Corporation Corporation under state law “Pass through” entity Nature of income (for losses and expenses) retains its character in hands of shareholder) What is an “S Corp”?How does it differ from a “C Corp”?

3. What are the Advantages of S Corp over C Corp Status? • No double taxation • Increase in stock basis • Tax free distributions • Capital gain retains its character • Individual use of corporate earnings or losses • Sale of appreciated asset without double tax; Sale of business as asset sale • Exception: built-in gain tax • Sale of asset within 10 years of making the S corp election • Estate planning advantages • Highest corporate tax and individual tax rate are the same

4. Tax Model of Operations

5. Stock Sale Tax Model

6. Add the ESOP Tax Benefit • ESOP is a exempt from income tax • Under special rule also exempt from unrelated business tax (UBIT) • Seems too good to be true - where is the catch?

7. S Corporation Requirements • Limit of 75 shareholders • ESOP is a single shareholder • Shareholders may only be individuals, estates and certain trusts • No partnerships • Shareholders may not be nonresident aliens • Beware of community property states

8. S Corporation Requirements (cont) • Only one class of stock allowed • Debt ok, provided satisfies “safe harbor” or general test • Stock options, warrant ok, provided exercise price is at least 90% of fair market value • Phantom stock, SARs, nonqualified deferred compensation ok, provided reasonable compensation • Benefits allocation issue for less than 100% ESOP • IRC section 409(p) issue • Fringe benefit limitation for 2% or more shareholder • Shareholders must file state returns in every state of operation • Composite return mitigates this requirement • Recognition of income regardless of distribution

9. Requirements to Convert to S Corporation Status • Valid election must be filed within 2½ months of the effective date of the election • Form 2553 filing • 100% of the outstanding shareholders (including a spouse in a community property state) must sign a consent • LIFO reserve recapture over four years • Calendar year, unless 100% ESOP in which case can use ESOP plan year

10. Unique S Corporation ESOP Issues • Going from C to S to C • IRS permission required in first five after S termination. IRC §1362(g) • Possible solution: Minnow swallows whale merger • Two Classes of Stock • Voting and nonvoting permitted

11. Compliance and Practical Issues • Built-in Gains tax issues and planning techniques • Federal and State S Election / QSub Election Requirements • Tax Distributions to Outside Shareholders / Composite State Individual Returns

12. Compliance and Practical Issues • State Treatment of S Corporations Varies Widely • S Corporation Recognition • QSub Treatment • Built-in Gain Treatment • Composite Individual Return Requirements • Nonresident Withholding Requirements

13. The S Corp. ESOP Anti-abuse Rules The Reason Behind the Madness • Preventing abusive arrangements • Establish testing method to determine “good” ESOPs • Broad-based employee ownership is crucial to being considered a “good” ESOP • Some “good” ESOPs will be unfairly classified as abusive

14. Anti-Abuse Rules Effective Dates Code Section 409(p): • Was effective on enactment as to S Corporation ESOPs established on or after March 14, 2001 • As to S Corporation ESOPs in existence prior to March 14, 2001, effective for the first plan year beginning after December 31, 2004

15. Anti-Abuse Rules Effective Dates Temporary Regulations: • Effective for plan years ending after October 20, 2003 (i.e., effective as of January 1, 2003, for a calendar year plan) • NQDC distributed by July 21, 2004 will not be considered Synthetic Equity

16. Anti-Abuse Rules – Defined Terms • Deemed-Owned Shares • Allocated ESOP shares • Pro rata portion of shares in the ESOP loan suspense account • Synthetic Equity

17. Anti-Abuse Rules – Defined Terms • Synthetic Equity • Stock option, warrant, restricted stock, deferred issuance stock right, “similar” interest or right that gives the holder the right to acquire or receive stock • Stock Appreciation Right (SAR) or “similar” right to a future cash payment based on the value of stock or appreciation in value • Nonqualified deferred compensation • Right to acquire interests in certain related entities

18. Anti-Abuse Rules – Defined Terms • A “Disqualified Person” is a person who: • owns 10% or more of all of the Deemed-Owned Shares of a corporation, • is a member of a Family that owns 20% or more of the Deemed-Owned Shares of the corporation, or • [has Deemed-Owned Shares and] is a Family member of an individual who is a “Disqualified Person” under the 20% Family rule above

19. Anti-Abuse Rules – Defined Terms • “Family” is defined broadly to include: • the spouse of the individual, • an ancestor or lineal descendant of the individual or the individual’s spouse, • a brother or sister of the individual or the individual’s spouse and any lineal descendant of the brother or sister, and • the spouse of any individual in two or three above Don’t forget to ask about living ancestors who are not reported because they don’t have any ownership themselves.

20. Anti-Abuse Rules – Defined Terms • Nonallocation Year • Disqualified Persons own at least 50% of stock in S corporation at any time during the plan year • Ownership includes Deemed-Owned Shares and direct ownership • Attribution rules apply here

21. Prohibited Allocation No portion of the assets of the plan attributable to (or allocable in lieu of) the company stock may accrue for the benefit of any Disqualified Person during a Nonallocation Year.

22. Effect of Nonallocation Year If there is a Nonallocation Year, then: • The value of any prohibited allocation is taxed to the Disqualified Person • A 50% excise tax is imposed on the amount of the prohibited allocation • A 50% excise tax is imposed on Synthetic Equity of Disqualified Persons

23. First Nonallocation Year Rule In the first Nonallocation Year the excise tax is 50% of the total value of the Deemed-Owned Shares of all Disqualified Persons

24. How is Synthetic Equity Applied in the Testing? • Prior to temporary and proposed regulations we took a conservative approach, only using the Synthetic Equity of the individual or group being tested in the denominator. • The temporary and proposed regulations clarified the mechanics of including Synthetic Equity in the testing. The Disqualified Person test and the Nonallocation Year test are tested by including no Synthetic Equity and again by including ALL synthetic equity.

25. How are unallocated shares attributed to participants? • In the same proportions as the most recent stockallocation under the plan • Same manner as the total of all share allocations under the plan (contribution, forfeitures, recycled shares, etc.) • Same manner as released shares were allocated • Based on total stock balance to date

31. Applying the S Corp. ESOP Anti-abuse Rules Questions?

32. Administration of S Corporation ESOPs

33. S v. C Distribution Differences

34. S v. C Distribution Differences

35. S v. C Distribution Differences

36. S v. C: Contribution and Allocation Differences

37. S v. C: Contribution and Allocation Differences

38. S v. C: Contribution and Allocation Differences

39. S v. C Dividend Differences

40. S v. C Dividend Differences

41. S v. C Other Differences