IRS Outlines Conditions for S Corp. ESOP Rollover

February 24, 2003 ( - The Internal Revenue Service (IRS) gave plan sponsors some helpful guidance last week on rollovers of S corporation stock to an individual requirement account (IRA).

In Revenue Procedure 2003-23, the IRS said that employee stock ownership plans (ESOPs) can direct rollovers of distributions of S corporation stock to IRAs without terminating the corporation’s S election, as long as certain conditions were met.

ESOP Basics

In the Rev Proc, the IRS noted that a fundamental purpose of an ESOP was to provide participants with an equity ownership interest in the stock of their employer, including the distribution of employer securities.   The Service went on to note that an ESOP must give participants the right to demand that their benefits be distributed in the form of employer securities.   However, Section 409(h)(2)(B) provides that an ESOP maintained by an S corporation can only distribute cash or employer securities subject to a repurchase requirement (that meets the requirements of § 409(h)(1)(B)).

Qualified plans, including ESOPs, must allow the distributee of any eligible rollover distribution to have the distribution paid in a direct rollover to an eligible retirement plan.   Consequently, an ESOP that holds S corporation stock and permits distributions in the form of employer securities is also required to permit participants to elect to have any distribution of S corporation stock that is an eligible rollover distribution paid in a direct rollover to an eligible retirement plan specified by the distributee – including an IRA.   

IRA Exception

However, an IRA trustee or custodian, however, is not a permissible S corporation shareholder, according to the IRS, which in the new revenue procedure sets forth certain requirements related to an ESOP’s distribution of S corporation stock to an IRA in a direct rollover.

The IRS said it will accept the position that the distribution does not affect the S corporation’s election to be taxed as an S corporation, if the following requirements are met:

  • The terms of the ESOP require that the S corporation repurchase its stock immediately upon the ESOP’s distribution of the stock to an IRA;
  • The S corporation actually repurchases the S corporation stock contemporaneously with, and effective on the same day as, the distribution; and
  • No income (including tax-exempt income), loss, deduction, or credit attributable to the distributed S corporation stock under § 1366 is allocated to the participant’s IRA.

For further information regarding the S corporation aspects of the revenue procedure, the IRS says you may contact Craig Gerson of the Office of Associate Chief Counsel (Passthroughs and Special Industries) at (202) 622-3050.   For further information regarding the employee plans aspects of the revenue procedure, contact the Employee Plans’ taxpayer assistance telephone service at 1-877-829-5500 (a toll-free call) between the hours of 8:00 a.m. and 6:30 p.m. Eastern Time, Monday through Friday, or you may contact Steven Linder of the Employee Plans, Tax Exempt and Government Entities Division at (202) 283-9888.