Washington (Jan. 30, 2004) --A new revenue ruling by the Internal Revenue Service takes aim at abusive transactions involving S corporation ESOPs by making them “listed transactions” for tax shelter disclosure purposes.

Employee stock ownership plans, or “ESOPs,” are a type of retirement plan that invest primarily in employer stock. Congress has allowed an S corp to be owned by an ESOP, but only if the ESOP gives rank-and-file employees a meaningful stake in the S corporation.  When an ESOP owns an S corp, the profits of that corporation generally are not taxed until the ESOP makes distributions to the company’s employees when they retire or leave the job.  The tax break allows the company to reinvest profits on a tax-deferred basis for the ultimate benefit of employees who are ESOP participants.

The effect of the IRS ruling, Revenue Ruling 2004-4, is to shut down transactions that move business profits of the S corporation away from the ESOP, so that rank-and-file employees do not benefit from the arrangement.  For example, the ruling prohibits using stock options on a subsidiary to drain value out of the ESOP for the benefit of the S corporation’s former owners or key employees. The ruling will be published in Internal Revenue Bulletin 2004-6, dated Feb. 9, 2004.

“Congress recognized the potential for attempts to circumvent the rules and specifically authorized the Treasury and the IRS to prevent it.  This notice does just that, imposing a 50 percent excise tax on the option holders in cases where rank-and-file ESOP participants are deprived of the business profits,” said Treasury assistant secretary for tax policy Pam Olson.

-- WebCPA staff

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