Tax planning for ESOP-owned S corporations
The June 2017 Tax Court decision in Petersen is a good reminder of the unique tax considerations for S corporations owned by employee stock ownership plans (ESOPs). ESOPs provide a number of tax benefits to corporations that implement them including tax-deductible employee benefit expenses. In addition, S corporation income flowing to ESOPs escapes all current taxation (ignoring any built-in gains or other entity-level S corporation taxes), because an ESOP is tax-exempt.
Along with those tax benefits, though, come some tax compliance issues for the plan sponsor that sometimes go overlooked because they do not typically exist in other qualified retirement plan settings. Any plan that holds S corporation stock (usually, but not always, an ESOP) needs to consider carefully the impact of the plan being a shareholder of the corporation. One of these considerations is the interaction with the related party rules that can override the otherwise expected timing of an accrual basis taxpayer’s deductions for items paid to related parties, as in Petersen. This rule requires corporations that generally accrue payments to employees at year-end (such as bonuses, payroll, and vacation) to wait until the cash is paid for the tax deduction because the employees who participate in the ESOP are related parties to the corporation. Another consideration is the implication of section 409(p) which is an anti-abuse provision designed to ensure that total ownership of the company by certain disqualified persons (through synthetic equity or otherwise) is always less than 50 percent. The downside of not complying with section 409(p) is far worse than moving a deduction to a later year – among many penalties and other consequences it makes the company’s status as an S corporation invalid. While these are two of the commonly overlooked rules, there are others that have special considerations as well.
Complying with these rules is not rocket science, as they say, but it does require a good understanding of what an ESOP is, how it works, and how it interacts with various rules with which the plan sponsor must comply. Therefore, companies with ESOPs should add tax rules to their list of issues to gain a full understanding of when they implement an ESOP, or at least have a tax advisor on their side who has that full understanding. Otherwise, being caught off guard by some of these rules could make them more costly and burdensome than they should be. And a full appreciation of the rules can actually help you reap more benefits from an ESOP if you plan accordingly.