IRS warns against compliance issues associated with ESOPs

Reminder of things ESOP plan sponsors need to be on the lookout for

Aug 18, 2023
Labor and workforce Succession planning ESG Compensation & benefits
ESOPs Business tax Employee benefits Tax policy

Executive summary

IRS cautions plan sponsors to be alert to compliance issues associated with Employee Stock Ownership Plans (ESOPs)

As part of an expanded focus on ensuring high-income taxpayers pay what they owe, the IRS warned businesses and tax professionals to be alert to a range of compliance issues that can be associated with ESOPs.

IRS warns against compliance issues associated with ESOPs

In a news release on Aug. 9, 2023, the IRS cautioned plan sponsors to be alert to compliance issues associated with ESOPs.

"The IRS is focusing on this transaction as part of the effort to ensure our tax laws are applied fairly and high-income filers pay the taxes they owe," IRS Commissioner Danny Werfel said. "This means spotting aggressive tax claims as they emerge and warning taxpayers. Businesses and individual taxpayers should seek advice from an independent and trusted tax professional instead of promoters focused on marketing questionable transactions that could lead to bigger trouble."

"The IRS is now taking swift and aggressive action to close this gap," Werfel said. "Part of that includes alerting higher-income taxpayers and businesses to compliance issues and aggressive schemes involving complex or questionable transactions, including those involving ESOPs."

ESOPs are not new, but the benefits are still not commonly understood. ESOPs are qualified retirement plans that invest primarily in employer stock, putting ownership in the hands of employees via their accounts in the retirement plan and giving them a higher stake in the company’s success. ESOPs may come onto the radar of a business owner when evaluating business succession planning options or by employers as an employee retention tool. The shift to focus on environmental, social and governance (ESG) concerns creates another reason why an ESOP may be an attractive option for businesses.

In light of the complexity of ESOPs, the IRS has and will continue to undertake enforcement strategies to ensure compliance with tax law requirements by employers sponsoring an ESOP and shareholders selling stock to ESOPs. In its current compliance efforts, the IRS has identified numerous issues, such as valuation issues with stock; prohibited allocation of shares to disqualified persons; and failure to follow tax law requirements for ESOP loans causing the loan to be a prohibited transaction.

Some other common issues ESOP sponsors may struggle with include:

  • Allocation restrictions on securities acquired in a section1042 transaction,
  • C corporation dividend deductions,
  • Section 409(p) compliance for S corporations,
  • Aggregation rules applicable for minimum participation testing when the employer sponsors other qualified plans; and
  • Limitations on allocation formulas for employer contributions that other qualified plans may be able to use.

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.

RSM contributors

  • Bill O'Malley
    Senior Director
  • Christy Fillingame
    Christy Fillingame
    Senior Director
  • Lauren Sanchez
  • Chloe Webb
    Senior Associate

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