The Tenth Circuit has confirmed in Petersen v. Commissioner (2019) that S corporations cannot deduct wages payable to employee stock ownership plan (ESOP) participants until the employees receive payment. The ruling affirms a prior Tax Court ruling.
The court agreed with the Tax Court’s finding that certain related party rules apply to an S corporation with an ESOP shareholder because an ESOP is considered to be a ‘trust,’ and its participants are considered to be ‘beneficiaries’ for purposes of these related party rules. In its ruling, the court rejected the taxpayer’s argument that distinctions in other areas of the Internal Revenue Code change the essential nature of an ESOP as a trust.
Consequently, the court concluded that constructive ownership rules would cause ESOP participants to be treated as owning S corporation stock, which would prevent the S corporation from deducting amounts payable to those participants until payment actually occurs.
The court’s decision serves as a worthwhile reminder that an accrual basis S corporation with an ESOP owner must scrutinize its expense accruals for any amounts payable to ESOP participants. Failure to recognize those timing issues can generate unwelcome tax adjustments at year-end or on audit.