Conversion of S Corporation to C Corporation: Effective January 1, 1998, the purchase of company stock of an S corporation by an ESOP no longer terminates the S election. However, stock acquired by an ESOP adopted by an S corporation is not eligible for tax-free rollover treatment under Section 1042 of the Code or for deductible dividend treatment under Section 404(k) of the Code. Accordingly, if shareholders want to take advantage of tax-free rollover treatment under Section 1042, they must terminate the S corporation election. In addition, since the purchase of common stock by an S corporation will not automatically terminate the S corporation election, they must take affirmative action to revoke the S corporation status before the ESOP purchases stock.

Conversion of C Corporation to S Corporation: Under the provisions of the 1997 tax law, the ESOP's share of an S corporation's taxable income is exempt from federal income taxes. Since the tax-free rollover provisions do not apply to shareholders of S corporations, many practitioners have proposed that the shareholders consummate the tax-free rollover transaction as C corporation shareholders and then convert the company to S corporation status. If this approach is taken, the conversion to S corporation status should be made in a subsequent fiscal year and should be made at least six months subsequent to the sale transaction in order to avoid any challenge under the the step transaction doctrine.

Please Note: The President's fiscal year 2000 budget proposes to retroactively repeal the 1997 tax law exemption for the ESOP's share of the S corporation's taxable income.

S Corporation Contribution Limits: In the case of an ESOP that is maintained by an S corporation, contributions to the plan (including contributions necessary to pay loan interest) are limited to 15% of payroll in the case of an ordinary ESOP, or 25% of payroll in the case of an ESOP that is designed as a combined stock bonus plan and money purchase pension plan. Accordingly, in the case of an ESOP maintained by an S corporation, it will probably be necessary to structure the loan repayment from the ESOP to the company over a period of 10 to 15 years, so that both the interest and the principal can be repaid with contributions equal to 15% of payroll, or 25% of payroll, as mentioned above. In addition, the ESOP can use its share of S corporation distributions (but only to the extent of distributions attributable to unallocated shares) to make principal and/or interest payments on an ESOP loan.

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