IRS Issues Alert to S Corporations over Abusive ESOP Schemes

December 22, 2004 ( - The Internal Revenue Service has sent letters to 1,700 businesses which are plan sponsors warning of new income and excise taxes on abusive S corporation employee stock ownership plans (ESOPs).

>The letter from the IRS is being mailed to S corporations with 10 or fewer employees who are participating in ESOPs, according to an IRS news release. It alerted them to recently issued guidelines regarding section 409(p) of the IRS Code, where it states that S Corporations that have abusive arrangements to pass corporate income to a tax-exempt ESOP to only a few employees will see impositions of income and excise taxes.

>For S corporations in existence as of March 14, 2001, section 409(p) rules – specifically, the income and excise tax on abusive schemes – will be effective for plan years beginning December 21, 2004. The delay was due to a need for businesses to restructure plans in order to avoid the taxes.

>The letter also called attention to other abusive practices connected with S corporation ESOPs – namely abuses of qualification requirements found in section 410(b). The IRS release warned that when an ESOP does not qualify, subchapter S corporations may be taxable as a C corporation and any highly compensated ESOP participants can be taxed on the account’s balance.

>The IRS news release warned that anyone who finds themselves in such a situation should contact a tax advisor; if the advisor determines that the arrangement is abusive, an amendment return should be filed for all years affected by the abusive arrangement.