An employee stock ownership plan (ESOP) can produce significant income tax savings. This tax savings isn’t exactly free. One has to keep up with the ESOP and the relevant rules to ensure that the tax savings are achieved. This compliance work is required and failure to comply can be costly. The recent Ed Thielking v. Commissioner, T.C. Memo. 2020-5 case provides an example.
Facts & Procedural History
The taxpayer is an S corporation. It was an electrical contracting business. It had one shareholder.
The S corporation shareholder transferred a 50% partnership interest to the S corporation.
Then the S corporation adopted an ESOP in 2006. The ESOP provides for a one year service requirement for employees to participate. It also required 1,000 hours of paid employee service. The plan was not updated since it was adopted.
The partnership allocated income to the S corporation. This income was equal to the contribution the S corporation made to the ESOP for its shareholder. Thus, the income was fully offset by a deduction.
This tax strategy may have been used to shelter income from another source. It isn’t clear from the case, but the taxpayer may have opted to use this structure to shelter income from an entity that would not qualify to adopt an ESOP or to make contributions to such a plan (some of the tax reasons for this are described below).
While it did not appear to be the case here, other ESOPs are combined with insurance and/or loans. This can magnify the amount of the tax savings, depending on the circumstances and the taxpayer’s goals.
But back to this case. The IRS audited the plan. It determined that the ESOP failed to qualify as a tax-exempt entity. The taxpayer asked the court to decide whether the plan was qualified.
The ESOP is a retirement plan. It usually holds company shares for the benefit of employees. It is thought that employees who own the business in which they work are more likely to say, make the company profitable, etc.
Like other retirement plans, there are a number of rules as to who can participate in the plan, when and how contributions can be made and how much can be contributed, etc.
The plans themselves are often funded with loans, which allow the company to buy the shares from the founder or original owner. This serves as a mechanism for the founder or original owner to cash out of the business. This cash out can be tax deferred. The founder or original owner can typically rollover the gains from the sale to other investments tax-free. Thus, tax is only due on the sale of the investment that is purchased as a replacement.
The payments made by the business to the ESOP are deductible by the business. The earnings belonging to the ESOP as a shareholder are not taxable, as the ESOP is not subject to income tax. If the company is an S corp, the business can retain some or all of the income tax it would have paid. This retained cash can go to growing the business, etc., which can provide the business with a competitive advantage.
That brings us back to this case. The IRS’s primary argument in this case was that the shareholder was ineligible to participate in the ESOP. It also argued that the stock was not valued by an appraiser. Last, it argued that the plan documents were not updated, and therefore, were non-compliant with subsequent law changes.
The court agreed with each argument raised by the IRS. The shareholder was an ineligible individual. The plan required 1,000 hours of paid service. But the shareholder apparently didn’t pay the shareholder wages. The court did not accept the taxpayer’s argument that the ESOP contributions were compensation to the shareholder. The court concluded that the contribution limit was zero, given that no wages were paid to the shareholder.
The taxpayer was apparently a qualified appraiser. However, he could not be a qualified appraiser for his own ESOP. The rules do not allow an otherwise qualified appraiser to appraise their own stock for the ESOP. In addition, the appraisal wasn’t signed, etc. Absent a valid appraisal, the ESOP contribution was suspect. The court agreed that the valuation was too low, which means that the contribution of the stock was in excess of the contribution limit for the ESOP.
The taxpayer also failed to update its plan documents. This is one of the aspects of having an ESOP. The documents have to be amended from time to time to keep up with law changes. The failure to do so will invariably result in the plan being invalid. Because of this, some plan sponsors provide updates at little or no cost.
Unfortunately, there is often no time limit on when the IRS can raise these issues.
Tax Savings from ESOPs
This case highlights one way taxpayers can use ESOPs to reduce their tax. They can use the ESOP to shelter their income. If done correctly, this can significantly reduce the amount of tax the taxpayer has to pay. It can also allow for tax-free growth for the amounts inside of the ESOP plan.
These tax savings come with a cost. The ESOP is not a file it and done type of plan. One has to be willing to comply with the rules and keep the plan up to date. Failing to do so can result in significant IRS tax problems, including tax, penalties, and interest.