It’s not unusual for an S Corporation to find that contributions to the company’s ESOP and 401(k) plans might exceed a deduction limit, particularly if the ESOP is leveraged. The combined deduction limit is limited to 25% of eligible compensation paid during the company’s fiscal year.
So your company makes deposits to its ESOP to provide the funds needed for debt service and distributions. You remember that your third party administrator (TPA) mentioned something last year about your company contributions being just within your deduction limit. It might be time to look at funding your ESOP with contributions and S Corporation distributions.
What does this mean to your ESOP? Most S Corporation ESOP documents provide that either contributions or S distributions may be used to pay down the ESOP loan. To the extent that the ESOP receives S Corporation distributions, other shareholders receive their pro rata share of such distributions based on their relative stock ownership.
Below is a brief description of the differences between contribution and S Corporation distribution allocations to participant ESOP accounts.
ESOP Contributions are generally allocated pro- rata based on eligible compensation. Some plans provide alternative formulas, such as compensation and service points or in another method or methods outlined in the Plan document. Eligible compensation is compensation paid to those who have met the plan’s initial eligibility requirements and have met the requirements for sharing in current - year contributions. A participant’s share of contributions and forfeitures from your plans can not exceed an annual limit. For plan years ending in 2016, this limit is $53,000. This limit can be exceeded if the difference consists of age 50 catchup salary deferral contributions.
S-Corporation Distributions are allocated based on shares held by the ESOP. They are apportioned between allocated shares and unallocated shares in suspense. The plan document outlines how amounts are then allocated among participant accounts.
- S-Corporation Distributions on allocated shares are generally allocated pro - rata based on the shares in a participant’s ESOP account. All active and terminated participants share in the S corporation distributions based on their relative stock holdings. To the extent permitted by the plan, dividends on allocated shares can be used to make debt service payments on the loan that was used to acquire those specific shares. A “fair value” rule also comes into play. If, for example, a participant’s dividend of $300 is used to pay ESOP debt, the participant needs to receive $300 in value, generally, in the form of shares released from the loan suspense account.
- S-Corporation Distributions on suspense shares are frequently allocated in the same manner as contributions. Alternatively, the plan document may provide that they are allocated as earnings (based on stock balances or total account balances) or the plan may provide another formula.
- Generally, S Corporation distributions will work in favor of those participants who have the most shares, which is certainly a factor to consider when providing funding for the ESOP.
These are only a few of the differences between contributions and S-Corporation distributions. It is important to know how each interacts with the ESOP so you can be ready to discuss funding and deduction limits with your TPA.