United States

S corporation denied deduction for amount payable to ESOP participants

Related party rules resulted in deferral of deduction until paid

TAX ALERT  | 

On June 13, the Tax Court concluded that an S corporation and its employees who participate in an employee stock ownership plan (ESOP) are considered to be related parties, meaning that, an accrual basis S corporation could only deduct amounts payable to those employees in the year the amounts were actually paid.

Background

Tax rules generally prevent related parties that utilize different methods of accounting from capitalizing on that difference to accelerate deductions while deferring income. In particular, section 267(a)(2) defers deductions for amounts paid to a related party until the year in which the payment is includable in the related party’s income.

The case

The question that surfaced in Petersen, Steven M. et ux. et al. v. Commissioner (148 T.C. No. 22) was whether employee participants in an ESOP, which itself owns shares in an S corporation, are considered to be related to the S corporation for this purpose. The employees did not own shares in the S corporation directly. Nonetheless, the tax court concluded that the ESOP participants were related parties, preventing the S corporation from deducting accrued payroll expenses until the amounts were actually paid.

The key to the case was whether an ESOP is considered a trust for purposes of these related party rules. Under constructive ownership rules, beneficiaries of a trust are considered to directly own their proportionate share of assets owned by a trust. Therefore, to the extent an ESOP is considered to be a trust, its participants would be considered direct owners of the S corporation, which would in turn invoke the expense deferral the IRS sought.

The court concluded that an ESOP is a trust for this purpose and ruled in favor of the IRS.

Takeaways

This decision is not surprising. It is a good reminder, however, that S corporations with an ESOP owner must be diligent about scrubbing their year-end accruals for amounts that are payable to ESOP participants. S corporations that might be setting up an ESOP should also consider how this rule might impact the timing of certain payments immediately before or after such a transaction.

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