IRS Warns Against ESOP and S Corp. Abuses

The Internal Revenue Service has issued letters to 1,700 businesses and retirement plan sponsors alerting them to new income and excise taxes applicable to S Corporation employee stock ownership plans, and warning of the consequences of participating in abusive schemes involving ESOPs and S Corporations. The letters are being mailed to S Corporation ESOPs reporting 10 or fewer participants. The letters follow recently issued temporary regulations on ESOPs and S Corporations, which provide guidance concerning the application of Internal Revenue Code section 409(p). Section 409(p) was enacted to address concerns about ownership structures involving S Corporations and ESOPs that concentrate the benefits of the ESOP in a small number of persons. For S Corporation ESOPs in existence on March 14, 2001, section 409(p) is effective for plan years beginning after Dec. 31, 2004. This delayed effective date has allowed existing S Corporations that maintain ESOPs some time to restructure the stock ownership in order to avoid the tax effects of section 409(p). The IRS letters also call attention to other abuses connected with S corporation ESOPs. "The IRS has determined that many existing arrangements designed to take advantage of the benefits of S corporation ESOP rules would not only involve taxation under section 409(p) but would also violate qualification requirements of the tax law, such as the coverage rules under Code section 410(b)," said Carol Gold, director of the IRS Employee Plans division."When an ESOP is not qualified under such circumstances, the subchapter S Corporation may be taxable as a C Corporation and any highly compensated ESOP participant may be taxable on the value of his or her account balance."