Compliance July 18, 2003

IRS Gets Tough On ESOP S Corp Tax Evaders

July 18, 2003 (PLANSPONSOR.com) - The proliferation of individuals attempting to skirt employee stock ownership plan (ESOP) S corporation income tax requirements has led to a temporary stopgap measure aimed at preventing further abuse.

Reported by

Eric Hazard

>The regulations, issued under section 409(p) by the Treasury Department and Internal Revenue Service (IRS), address the original intent of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) section of preventing owners of an S corporation from using an ESOP to shelter business income from tax. This section requires that an ESOP holding stock in an S corporation not allow the tax benefits of such a plan to accrue for someone who owns more than 20% of the stock in the S corporation within the family, or alone owns more than 10% of such stock, according to a news release.

>However, recently a number of arrangements have sprung up intending to circumvent the tax by giving former owners of the S corporation deferred compensation from a management company related to the S corporation or special rights to acquire assets of the S corporation. To put a stop to this practice, the new regulations define the deferred compensation and the special rights under the umbrella of “synthetic equity” – typically resulting in both income and excise taxes to the former owners of the S corporation.

“With section 409(p), Congress made clear that S corporation ESOPs should be used for rank-and-file employees to benefit from company ownership, and not as a tax shelter for a small group of former owners and executives. These regulations are a first step in targeting arrangements that abuse the S corporation ESOP rules. They are not the final step – we expect to continue to work with the ESOP community to develop guidance addressing other arrangements that attempt to skirt the rules,” said Assistant Secretary for Tax Policy Pamela Olson in a statement.

>The temporary regulations are effective in 2005 for S corporation ESOPs that were in existence on March 14, 2001. For other S corporation ESOPs, these regulations are effective for taxable years ending after the date that is 90 days after publication of the regulations.

More information can be found at http://www.treas.gov/press/releases/reports/409ptemppreg.doc and http://www.treas.gov/press/releases/reports/409ppropreg.doc .