Does Kansas tax the unrelated business taxable income of an ESOP that owns 100% of an S corporation's stock?

Plain-English summary

A representative wrote on behalf of an S corporation whose 100% shareholder is an Employee Stock Ownership Plan (ESOP), and asked two things: does Kansas recognize an ESOP as a shareholder of an S corporation, and if so, is the ESOP a taxable entity in Kansas? The Department answered by pointing to Kansas's conformity with federal tax treatment: the ESOP's income is exempt in Kansas to the same extent it is exempt federally.

The federal rule. Under I.R.C. Section 512(e), when a tax-exempt organization holds stock in an S corporation, that interest is generally treated as an interest in an unrelated trade or business, and the S corporation's income items and any gain on the stock flow into the organization's unrelated business taxable income (UBTI). But Section 512(e)(3) carves out an exception for ESOPs — that subsection does not apply to employer securities held by an employee stock ownership plan (within the meaning of I.R.C. sections 409(l) and 4975(e)(7)). So certain UBTI of ESOPs is excluded from the general federal income tax.

Kansas mirrors the federal treatment. K.S.A. 79-32,113 provides that a person or organization exempt from federal income tax is also exempt from Kansas income tax in each year it satisfies the federal requirements — and if the federal exemption is limited or qualified, the Kansas exemption is limited or qualified in the same way. Because Kansas law "mimics the federal tax treatment of entities exempt from federal tax," the Department concluded that the unrelated business taxable income of ESOPs is exempt from Kansas taxation to the same extent that income is exempt from federal taxation.

Filing. Exempt entities are not required to file Kansas income tax returns unless they have taxable income or are ordered to prove their exempt status by the Director of Taxation (K.A.R. 92-12-14).

Bottom line: Kansas follows the federal rules for an ESOP that owns an S corporation — under 79-32,113, the ESOP's UBTI is exempt from Kansas income tax to the same extent it is exempt federally (per I.R.C. 512(e)(3)), and the ESOP generally need not file a Kansas return unless it has taxable income.

What this means for you

ESOP-owned S corporations

Kansas defers to the federal treatment. Because I.R.C. 512(e)(3) excludes an ESOP's employer-securities income from the general UBTI rule, and K.S.A. 79-32,113 conforms Kansas to the federal exemption, the ESOP's income that is exempt federally is likewise exempt from Kansas income tax.

Watch the "same extent" limitation

The Kansas exemption is coextensive with the federal one — no broader, no narrower. If the federal exemption for a given item is limited or qualified, Kansas applies the same limit. Confirm the federal treatment of each income item before assuming Kansas exemption.

Filing obligations

An exempt entity generally need not file a Kansas income tax return — but it must file if it has taxable income, or if the Director of Taxation orders it to prove its exempt status (K.A.R. 92-12-14). Keep documentation of the ESOP's federal exempt status available.

Common questions

Q: Does Kansas tax an ESOP that owns 100% of an S corporation?
A: Only to the extent the income is taxable federally. Under K.S.A. 79-32,113, the ESOP's unrelated business taxable income is exempt from Kansas tax to the same extent it is exempt from federal tax (per the I.R.C. 512(e)(3) ESOP exception).

Q: Why does the federal treatment control?
A: K.S.A. 79-32,113 makes an organization exempt from federal income tax also exempt from Kansas income tax, with the same limits or qualifications — so Kansas mirrors the federal result.

Q: Does the ESOP have to file a Kansas return?
A: Not unless it has taxable income or is ordered by the Director of Taxation to prove its exempt status (K.A.R. 92-12-14).

Citations and references

• K.S.A. 79-32,113 — exempts from Kansas income tax any person or organization exempt from federal income tax (with the same limits/qualifications); the basis for exempting the ESOP's income to the same extent as federally.
• K.A.R. 92-12-14 — exempt entities need not file Kansas income tax returns unless they have taxable income or are ordered to prove their exempt status by the Director of Taxation.
• I.R.C. Section 512(e)(3) — the federal exception for ESOPs (employer securities within the meaning of sections 409(l) and 4975(e)(7)), which Kansas conforms to; discussed in the ruling as the source of the federal exemption.

Source

• Landing page: Kansas Department of Revenue Policy Information Library
• Original document: P-2001-067

Original ruling text

Private Letter Ruling

Body:

Office of Policy & Research

July 2, 2001

XXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXX

Dear XXXXXXXXXXX:

I have been asked to respond to your letter dated June 15, 2001. In it, you ask for guidance on the tax status of an ESOP, which is the owner of 100% of the stock of an S-Corporation.

In your letter you stated:

Facts:

· XXXXXXXXX elected S-Corporation status to be effective for tax year beginning 07/01/2000
· XXXXXXXXXXX. has a 100% shareholder who is an ESOP (Employee Stock Ownership Plan) for tax year beginning 07/01/2000

Questions:

· Does your state accept an ESOP as a shareholder for an S-Corporation? Please cite state regulations, laws, etc. which support your answer.
· If the state recognizes an ESOP as a shareholder, is this a taxable entity for your state? Please cite state regulations, laws, etc. which support your answer.

Internal Revenue Code Section 512 states in pertinent part:

“(e) Special rules applicable to S corporations

(1) In general

If an organization described in section 1361(c)(6) holds in an S corporation -

(A) such interest shall be treated as an interest in unrelated trade or business, and

(B) notwithstanding any other provision of this part -

(i) all items of income, loss, or deduction taken into account under section 1366(a), and

(ii) any gain or loss on the disposition of the stock in the S corporation,

shall be taken into account in computing the unrelated business taxable income of such organization.

(2) Basis reduction

Except as provided in regulations, for purposes of paragraph (1), the basis of any stock acquired by purchase (as defined in section 1361(e)(1)(C)) shall be reduced by the amount of any dividends received by the organization with respect to the stock.

(3) Exception for ESOP’s

This subsection shall not apply to employer securities (within the meaning of section 409(l)) held by an employee stock ownership plan described in section 4975(e)(7).”

K.S.A. 79-32,113 states:

“Exempted organizations.

(a) A person or organization exempt from federal income taxation under the provisions of the federal internal revenue code shall also be exempt from the tax imposed by this act in each year in which such person or organization satisfies the requirements of the federal internal revenue code for exemption from federal income taxation. If the exemption applicable to any person or organization under the provisions of the federal internal revenue code is limited or qualified in any manner, the exemption from taxes imposed by this article shall be limited or qualified in a similar manner.

Per the I.R.C. Section 512(e)(3), certain unrelated business taxable income of employee stock ownership plans (“ESOP’s”) are excluded from the general imposition of federal income tax. Kansas law as contained in Chapter 79-32,113 mimics the federal tax treatment of entities exempt from federal tax. Therefore, it is the opinion of the Kansas Department of Revenue that the unrelated business taxable income of ESOP’s is exempt from taxation by Kansas to same extent said income is exempt from federal taxation.

Exempt entities are not required to file income tax returns with Kansas unless they have taxable income or are ordered to prove their exempt status by the Director of Taxation. K.A.R. 92-12-14

This is a private letter ruling pursuant to Kansas Administrative Regulation 92-19-59. It is based solely on the facts provided in your request. If it is determined that undisclosed facts were material or necessary to an accurate determination by the department, this ruling is null and void. This private letter ruling will be revoked in the future by operation of law without further department action if there is a change in the statutes, administrative regulations, or case law, or a published revenue ruling, that materially affects this ruling.

Sincerely,

Mark D. Ciardullo
Tax Specialist

MDC:mdc

Date Composed: 07/06/2001 Date Modified: 10/10/2001

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