NEW TAX INCENTIVES FOR ESOPs

An exciting new opportunity now exists for a company owned in whole or part by an ESOP - or a company considering implementing an ESOP - to avoid tax on all or part of its income by electing S corporation status, and thus increasing net worth more rapidly. An ESOP (employee stock ownership plan) is a form of retirement plan which allows a corporation's employees to own shares of its employer's securities.

Changes made in Federal tax law during 1996 and 1997 make it possible for an ESOP to be a shareholder in an S corporation. An ESOP will be considered as one shareholder regardless of the number of participants. Congress originally declared that all items of income or loss from the S corporation would flow through to the ESOP and be taxed as unrelated business taxable income (UBTI). However, this would result in income being taxed twice, once at the ESOP level and again when distributions were made to the participants. When they realized that there would be a double tax, Congress repealed the application of unrelated business taxable income to S corporation ESOPs. As a result, an ESOP will not pay tax on S corporation earnings which are passed though to it based on stock ownership. This new law takes effect for tax years beginning after December 31, 1997.

The main difference between a C corporation and an S corporation lies in the treatment of is taxed at the corporate rates; if a loss exists, it is available for limited carryback/carryforward to offset income in earlier/later years. When income is distributed to stockholders as dividends, it is taxed again. An S corporation, with a few exceptions, incurs no tax at the entity level; all items of income or loss are passed through to the shareholders to be reported on their tax return. There may be a tax due at the state level since not all states recognize S corporations.

The one tax most likely to affect a corporation electing S status today, especially a corporation on the cash basis, is the built-in gains (BIG) tax. A C corporation electing S status after 1986 will be taxed on any built-in gain resulting from the disposition of any asset during the 10-year period beginning on the first day of the first tax year a corporation is an S corporation. A corporate level tax is imposed on the S corporation to the extent that the income or gain realized upon sale reflects net appreciation in the asset which arose prior to the election of S status.

A full explanation of built-in gains tax is beyond the scope of this letter, but it is important to note that with proper planning before electing S status the built-in gains tax can be minimized or eliminated. A corporation's balance sheet should be carefully analyzed prior to S election to determine the company's potential exposure to this tax.

In order for an existing C corporation to elect S status for the calendar year beginning January 1, 1998, a Form 2553 must be filed by March 15, 1998 (a non-calendar year corporation must make the election by the 15th day of the 3rd month of its tax year in order for it to be effective for the first day of that year).

We will be pleased to meet with you to discuss these and other tax planning opportunities. Call any of our shareholders or managers at (301) 564-3636.