Why are they talking about changing our company into a Sub-S corporation?" asked one confused employee owner at a 100% employee-owned Ohio firm recently. "Aren't S corporations just for companies that employ a couple of people or own real estate?"

The new subchapter S corporation ESOP is causing many employee-owned companies to reexamine their incorporation status. It's also stirred up considerable controversy that may attract Congressional scrutiny. Employees in ESOP companies need to know about this issue.

The Subchapter S corporation combines the legal protections of the corporation for shareholders with the tax status of a partnership. While shareholders are protected as individuals against the liabilities of the Sub-S corporation, the Sub-S company does not pay separate corporate income tax; instead its income is taxable to individual shareholders in proportion to their ownership. In effect, it's a partnership with legal protection for the owners of the corporation. So it has become a very popular form of ownership for small companies.

Today there are about 2 million Sub-S corporations as compared to about 6 million C corporations. (The "C corporation" is what we think of as the standard corporation.)

Prior to 1996, the law did not permit qualified benefit plans to own stock in S corporations. However, the law was changed in 1996, so that benefit plans could own Sub-S stock effective January 1, 1998. But the initial Sub-S legislation was technically flawed and it was significantly amended by the Taxpayers Relief Act of 1997. The 1997 legislation added a significant tax advantage in exempting ESOPs from the "unrelated business income tax" on Sub-S earnings.

This tax provision, which went into effect January 1, 1998, is causing a huge stir in the ESOP world for rather different reasons than Congress intended.

The intent of this provision was to permit S corporations, which are uniformly closely held, to establish ESOPs without changing their incorporation to a C corporation.

While C and S corporations differ in a number of ways, the key difference in tax terms is that the profits of C corporations are taxed at the corporate level and then again at the individual level when they are distributed to individuals as dividends or as capital gains when they sell. By contrast, the profits of S corporations are taxed only as though they were individual earnings, and Sub-S corporations typically distribute enough earnings to shareholders to pay their individual taxes on the corporation's retained earnings.

The Sub-S ESOPs lack many of the tax advantages of C corporation ESOPs. Specifically, corporate contributions to Sub-S ESOPs are limited to 15% of ESOP participants' pay (instead of the 25% limit for leveraged ESOPs), that 15% limit includes interest, dividends on Sub-S ESOP shares are not tax deductible, and sellers to Sub-S ESOPs cannot get the 1042 capital gains deferral by rolling their proceeds over into qualified replacement securities. They are, however, relieved of the "unrelated business income tax" which burdens other qualified benefit plans which own Sub-S shares.

Consequently, most observers thought that the Sub-S ESOP was likely to be used more as a contributory benefit plan and less as a tool for ownership succession, except in cases where the owner had little capital gains.

At the Ohio Employee Ownership Center, we expected that the most significant uses in Ohio would be (1) to build up cash in the S-ESOP which then could be used when the S corporation converted to a C corporation to buy out exiting shareholders (who could now get the capital gains deferral because they were selling to an ESOP in a C corporation). In effect, the S-ESOP would be used to pre-fund the C-ESOP purchase from retiring owners. (2) The S-ESOP also offers a nice avenue to involve employees as ownership partners in an S corporation while retaining the tax advantages of the S corporation for the old owners.

Others thought that subchapter S ESOPs would be few until they too permitted the 1042 capital gains rollover for sellers.

The exemption of Sub-S ESOPs from the "unrelated business income tax" on Sub-S earnings opened other doors.

One of the barriers to qualified benefit trusts owning Sub-S shares has been the fact that the trust had to pay a tax on its share of Sub-S earnings at the "unrelated business income tax" rate. That tax rate was typically the top individual rate, or 39.6%.

As mentioned above, effective January 1, 1998, the new tax law gives ESOPs an exemption from this tax.

The intent of this special exemption was to encourage the creation of ESOPs in existing Sub-S corporations. The unintended consequence, however, has been to encourage existing closely held ESOP to consider changing its incorporation from C to S.

The reason: the ESOP's share of Sub-S earnings is tax free. Thus, for example, if an ESOP owns 35% of a profitable C corporation, all the profits of the corporation are taxable. On the other hand, if the company changes its registration to a Sub-S, 35% of the company's profits are suddenly tax free.

Or take the 100% employee-owned C corporation. By changing its registration to a Sub-S, it avoids all corporate income taxes!

Eventually, of course, employees will cash out their ESOP shares and pay taxes, but that is far down the road.

Changing a company's election of incorporation from C to S has a number of other consequences, some of them quite problematic. (For an account of these, see David Ackerman, "ESOPs and S Corporations" appearing in the Winter 1998 issue of the Journal of Employee Ownership Law and Finance.) Still, "not to change to a Sub-S borders on fiduciary malfeasance," one trustee of a 100% ESOP-owned C corporation told us. "For your attorney not to recommend it could be construed as malpractice."

So the law as it currently stands could slash taxes paid by partial ESOP companies and eliminate them entirely for 100% ESOP-owned firms if they change their incorporation. Will this provoke Congressional scrutiny and cutbacks in the Sub-S ESOPs because of a revenue hemorrhage?

That probably depends on what the tax loss turns out to be.

The ESOP Association's Michael Keeling believes that it will be somewhat higher than the original Congressional revenue estimate of $100 million over five years -- which didn't take into account existing C corporations converting to Sub-S incorporation to get the ESOP tax break. Still, he doesn't think it will be a great deal higher. Keeling points out that closely held companies pay only about 15% of the corporate income tax anyway, and conversion is complicated and often troublesome.

Keeling anticipates that few ESOP C corporations will convert to S corporations except when they are 100% employee owned. "Attorneys talk about minority ESOPs converting, but I just don't see it happening. I've talked to a fair number of 100% employee-owned ESOP companies and to a couple of other majority ESOP companies, but not a single minority ESOP has called me to discuss changing its incorporation."

Keeling says that the 1996 changes in the S corporation laws surely caused far more C corporations to change their election and more loss of tax revenue than the ESOP provisions ever will. "But after all," says Keeling, "the purpose of those changes was to make S corporations more attractive."

"Besides," says Keeling, "this is not a tax exemption. It's a tax deferral. When employees cash out, they will have to pay their taxes."

In the meantime, it looks like a good deal for some ESOP participants.