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Clarity In Distributions In An S Corporation ESOP

In March 2014, the IRS issued a private letter ruling to an S corporation ESOP to clarify whether distributions from the S corporation (dividends in a C corporation) are what is called “annual additions” and limited under Internal Revenue Code Section 415(c)(2) to the annual contribution and other additions limit. Although this is the way many tax professionals interpreted the law, this confirmation through a private letter ruling is welcome news.

A private letter ruling (PLR 201424030) was requested by an S corporation that is 100% owned by the Company’s employee stock ownership plan (“ESOP”). Over a 10-year period, the ESOP purchased Company shares from the sole shareholder until the ESOP had purchased all stock issued and outstanding from the sole shareholder. The Company’s business was well managed and operated at a high-degree of efficiency with low employee turnover. The last stock purchase by the ESOP was with the aid of an exempt loan. The Company wanted to retain a certain sum of cash for the reasonable needs of the business and desired to make S corporation distributions of the remaining amount to the ESOP. The IRS noted that the amount to be distributed to the sole shareholder, the ESOP, would not exceed the Company’s accumulated adjustments account as described in Code Section 1368(e)(1).

In considering this request and applicable law, the IRS concluded that the amounts to be distributed to the ESOP are earnings to the Company’s shareholder and not contributions or other additions with respect to the participants of the ESOP. The IRS clarified that S corporation distributions to the ESOP are not employer contributions, employee contributions, or forfeitures, and do not fall within the definition of annual additions as defined in Code Section 415(c)(2). In fact, the IRS ruling is that there is no plan limit on the proposed S corporation distributions to the ESOP by the Company. Of course, the Company could make contributions to the ESOP which would be allocated to participants based on relative compensation. The S corporation distributions would be allocated to participants based on shares of Company stock held in the participant’s stock accounts. Both the contributions, earnings on contributions, and S corporation distributions may be used to repay the exempt loan which was used to buy the ESOP stock.

Although this private letter ruling is not binding on the IRS, is directed only to the Company that requested it, and may not be used or cited by others as precedent, it clarifies the IRS’ position on S corporation distributions not being annual additions for plan purposes.

If you have any questions regarding this matter or would like our help in working with your ESOP, please do not hesitate to contact your McGrath North attorney.