What restrictions apply to S corporation ESOPs?
A shareholder who sells S corporation stock to an ESOP is not eligible for the tax-free ESOP rollover described in Question 24 and the S corporation ESOP deduction limits are less favorable than the ESOP deductions available to C corporations. S corporation ESOP deductions are limited to 25 percent of covered compensation annually including both principal and interest on an exempt loan. In addition, corporate distributions to S corporation shareholders are not tax-deductible (See Question 31), and it may not be possible to defer distribution of S corporation shares acquired with a loan to participating employees who have left the company until the loan is repaid (See Question 40). However, legislation adopted in 2004 confirms that S corporation dividends paid on allocated shares of S corporation stock can be applied to repay an ESOP loan, in which case company stock equal in value to the distributions must first be allocated from the released shares in the manner described in Question
