It is rare that a combination of two tax regimes can, together, produce dramatic benefits not otherwise available under the Internal Revenue Code. This elixir is present however when employee stock ownership plans (ESOPs) become stockholders in Subchapter S corporations. The reason that this combination produces such tantalizing results is because S corporations (subject to certain exceptions) are “pass-through entities” which do not, themselves, pay a federal income tax. Instead, their income is taxed, pro-rata, to their stockholders.
But, since 1998 ESOPs have been eligible stockholders in S corporations without their share of the S corporation’s income being subjected to the unrelated business income tax (UBIT). Accordingly, since an ESOP is not a taxable entity, the income produced by an S corporation that is attributed to an ESOP stockholder is not subject to a current income tax. Then, when that income is ultimately distributed from the ESOP to its participants it will be subjected to a single-level federal income tax.
In the interim the full amount of that income can be advantageously used to expand the underlying business of the S corporation. Other tax exempt entities can now also qualify as S corporation shareholders, but their share of the S corporation’s income is subjected to the UBIT, which, in turn, exacts a tax on that income during the year that it is earned. Over time, the entitlement to indefinitely defer a single-level tax on earned income can produce rather astounding results for persons fortunate enough to be participants in an ESOP-owned S corporation.