The IRS recently issued a press release warning businesses and tax professionals to be alert about a range of compliance issues that can be associated with certain aggressively marketed employee stock ownership plan (ESOP) structures that appear to shelter taxable income while not providing true, broad-based ownership to employees.
This article highlights specific points noted in the IRS’s warning, and how working with an experienced ESOP advisor can help mitigate these issues.
Tax Advantages of an ESOP
An ESOP is a type of broad-based, tax-qualified retirement plan. It is a powerful ownership transition tool that provides significant tax advantages to the selling business owner, the company sponsoring the ESOP, and its employees. For business owners, the Internal Revenue Code (IRC) enables certain shareholders (depending on entity tax structure) the opportunity to defer capital gains associated with stock sold directly to the ESOP. Further, if a company is an S corporation with an ESOP trust owner, the ESOP trust will be allocated its pro rata share of income/loss as a shareholder. Because an ESOP trust is exempt from federal (and most state) income taxes, the ESOP does not pay taxes on that allocation. Thus, S corporations that are 100% owned by an ESOP trust operate with significant tax and cash flow advantages. Lastly, employees participate in the company’s equity growth through a tax-deferred retirement vehicle, with no out-of-pocket cost to the employees.
Potential New Tax Abuse
The significant tax advantages listed above, while intended to incentivize employee ownership, also may invite abuse. The IRS’s August 9, 2023, warning noted that the IRS has expanded its focus on ensuring high-income taxpayers pay what they owe. The IRS is targeting promoters focused on marketing questionable transactions involving ESOPs that circumvent the intent of an employee ownership model. ESOPs are intended to provide value to all employees of the respective organization, not just to a limited set of individuals.
The IRS specifically expressed concern about new schemes whereby a business creates a “management” S corporation, 100% owned by an ESOP. IRS officials explained that they have become aware of promoters suggesting that the ESOP-owned S corporation lend the owners of its lower-tier business affiliates (who were the original owners of the S corporation before the ESOP owned 100% of the S corporation) a significant amount of the S corporation’s business income. Apparently, such loans are never intended to be repaid, thus transferring the S corporation’s income to a few highly paid individuals. In turn, those uncollectable loans reduce the value of the S corporation stock held by the ESOP, because cash is lent out and potentially worthless loans remain.
The IRS is concerned about the adverse impact that such “behind-the-scenes” loan arrangements may have on rank-and-file ESOP participants, particularly when they are entitled to receive their ESOP benefits. The IRS disagrees with how taxpayers interpret this transaction and emphasized that the purported loans should be treated as taxable income to the borrowers. In addition, such transactions impact whether the ESOP satisfies several tax law requirements, which could result in the management company losing its S corporation status.
For decades, ESOPs have evolved into a well-regulated ownership transition tool that can provide a sound business succession strategy. While the IRS is making an effort to reduce misuse of ESOPs, ambiguities in the August 9 warning have created unnecessary uncertainty for a structure that has benefitted thousands of employees across the country. Research continues to show that ESOPs improve retirement security and economic well-being.
Other ESOP Compliance Issues
In addition to the “management” S corporation ESOP scheme, the IRS identified three other ESOP issues that are part of its current enforcement and compliance efforts. Specifically, the IRS is focusing on improper valuation of employer stock, prohibited allocation of shares to disqualified persons, and failures to follow the prohibited transaction rules for ESOP stock acquisition loans. Qualified ESOP advisors can help clients avoid these common problems by following best practices.
Improper Valuation of Employer Stock
The valuation of employer stock has been an issue for the ESOP industry for many years. The Employee Retirement Income Security Act of 1974, as amended (ERISA) requires that ESOPs pay no more than “adequate consideration” (i.e., fair market value) for employer stock. To ensure this, ESOP transactions should be consummated with as much care and diligence as any arm’s-length transaction.
The SECURE 2.0 Act, which became law on December 29, 2022, directs the U.S. Department of Labor, Employee Benefits Security Administration (EBSA) to provide guidance on the definition of “adequate consideration” for ESOPs. As a best practice, any company considering an ESOP should engage an independent trustee to act as an ERISA fiduciary with respect to the ESOP participants. This independent trustee should rely on a qualified independent appraiser, as defined under ERISA rules, to determine the fair market value of the stock being sold to the ESOP.
Prohibited Allocation of Shares to Disqualified Persons
Prohibited allocations of employer stock to disqualified persons is an issue arising from IRC Section 409(p), an anti-abuse provision enacted to promote broad-based ownership by rank-and-file employees. ESOP transactions should be properly screened by those qualified to assess IRC Section 409(p) allocation issues. When a selling shareholder, their family members, or a highly compensated management team seems likely to receive a disproportionate allocation of company equity in the ESOP, there may be a compliance issue that should be addressed on the front end before the allocation is made. Companies should do their diligence, in consultation with qualified, reputable advisors, so that prohibited allocations are avoided. This due diligence involves detailed compliance testing before any ESOP transaction and continued monitoring post-transaction.
Prohibited Transaction Rules for ESOP Loans
Under IRC Section 4975(c)(1)(B), prohibited transactions include any direct or indirect sale, exchange, lending of money or extension of credit, or various other transactions between a qualified plan and a "disqualified person" (a person with certain relationships to the plan). Due to the nature of an ESOP transaction and the parties involved, in the absence of an exception, an ESOP transaction would inherently be defined as a prohibited transaction.
However, there is a statutory prohibited transaction exemption for stock acquisition loans made to ESOPs under IRC Section 4975(d)(3), as long as the loan is (1) primarily for the benefit of the plan participants, (2) at a reasonable interest rate, and (3) any collateral given to the disqualified person selling the shares consists solely of qualifying employer securities. Further, ERISA Section 408(e) provides a separate statutory exemption relating to the acquisition or sale by the plan of qualifying employer securities, provided that the acquisition or sale by the plan is (1) for adequate consideration (or for marketable securities, at a price no less favorable to the plan than the price determined under ERISA Section 407(e)(1)), (2) no commission is charged on the sale, and (3) the plan is an eligible account plan.
Receiving proper advice from qualified professionals throughout the plan implementation, transaction process, and the ongoing administration of the plan will greatly assist a prospective or current ESOP company to meet the above requirements.
It is important for any company and business owner considering an ESOP structure to engage a qualified ESOP advisor with the experience necessary to navigate the complex regulatory and tax requirements associated with ESOP transactions. BDO Capital Advisors has significant experience successfully guiding companies through ESOP transactions that avoid the pitfalls mentioned in the IRS press release. BDO Capital Advisors works closely with BDO USA professionals who have a deep understanding of the tax implications of the various options and can guide you through every step of an ESOP transaction.