Additionally, the IRS has seen promoted arrangements using ESOPs that are potentially abusive. For instance, the IRS has seen schemes where a business creates a ‘management’ S corporation whose stock is wholly owned by an ESOP for the sole purpose of diverting taxable business income to the ESOP. The S corporation purports to provide loans to the business owners in the amount of the business income to avoid taxation of that income. The IRS disagrees with how taxpayers interpret this transaction and emphasize that these purported loans should be taxable income to the business owners. These transactions also impact whether the ESOP satisfies several tax law requirements which could result in the management company losing its S corporation status.
Over the next year, the IRS will continue to use a range of compliance tools, including education, outreach and additional examinations to address compliance issues associated with ESOPs.
While there are some bad actors and the rules are complex, ESOPs are great tools in the right circumstances and their complexity should not deter companies from using them. ESOP sponsors and selling shareholders should engage competent advisors, including tax professionals, to assist with the various compliance issues. If you sponsor an ESOP, or are considering implementing a new ESOP, discuss the rules with your advisors or reach out to one who is well-versed in ESOPs.