Making The S Election is a Terrible Idea

Correcting the S election by a ROBS corporation must be done as soon as possible. Time is money when it comes to the tax consequences and the significant potential PT consequences. If you have a ROBS corporation and you have made the S election, contact an ERISA attorney immediately for help with the correction.

The ROBS Exemption from the Prohibited Transactions Rules is Meant for C Corps

The ROBS funding transaction is a transaction in plan assets; the plan pays cash to the corporation in exchange for the employer stock which it holds for the benefit of the ROBS owner as a plan participant. As a transaction in plan assets, the ROBS investment  would be prohibited if it were not for an exemption that is provided by statute at ERISA section 408(e) and IRC sec. 4975(d)(13) (for convenience, this exemption is referred to hereinafter as the ROBS PT Exemption). To avoid becoming the subject of a substantial PT and costly excise tax, it is vital for a ROBS plan to meet several factual conditions so that it may meet the requirements of the ROBS PT Exemption. One such condition is that the stock must be issued by a corporation. If issued by a C corporation, the stock transaction is eligible for key exemptions from the Prohibited Transactions rules set forth at Internal Revenue Code section 4975 et seq. (the PT rules). 

However, if the stock becomes stock of an S corporation, and if a ROBS owner holds more than 5% of the corporation’s outstanding stock as an individual (outside the plan - a so-called “shareholder-employee”), the Section 4975 PT exemptions disappear for that shareholder-employee with regard to any post-S election transactions. The exemptions disappear completely for any post-S transactions between the plan and the corporation, if the shareholder-employee has at least 50% control, directly and/or indirectly, of the corporation.

S Corp Income is Now Reportable and Taxable to the Plan

A qualified retirement plan, including a ROBS plan, is normally tax exempt. However, a plan (other than an ESOP) that is invested in an S corp operating an active trade or business is not tax-exempt. It receives a K-1 reporting net income earned by the S corporation, in proportion to the plan’s percentage of ownership. The plan trust files Form 990-T with the IRS and pays tax of 15% up to $15,000 of income, and 37% for amounts above $15,000. To avoid/minimize this disastrous tax burden, the ROBS entity must remain a C corp and revoke any S election as soon as possible. 

The S corporation problem is of particular relevance to ROBS plan sponsors because corporations are often advised by unknowledgeable tax preparers that S corporation status is more advantageous than the C status, from an income tax perspective. Unfortunately, however, S corporation status actually incurs income tax to the plan itself, as well as creating conditions that can very easily lead to a PT.

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