The Internal Revenue Service (IRS) recently issued IR-2023-144 (the Notice), warning stakeholders of compliance issues associated with employee stock ownership plans (ESOPs) related to the tax liability of high-income taxpayers. Although it is unclear what prompted the Notice, the IRS’s intent is clear—it has a new enforcement focus on ESOP-related tax avoidance, particularly with respect to S corporation ESOPs.
Background
ESOP formation has long been encouraged by Congress. When done correctly, ESOPs can provide a great benefit to employees’ retirement savings and the corporate landscape. As discussed in a prior blog post, the SECURE 2.0. Act (SECURE 2.0) contains one of the latest congressional pushes for ESOP creation. In July, the Department of Labor (DOL) announced the development of the Employee Ownership Division as part of SECURE 2.0 to promote employee ownership of companies and develop guidance on ESOP stock valuation standards.
Despite the advantages that ESOPs present for employees, abuses do exist. To address potential ESOP abuses, agencies have regulated ESOPs since their inception: the DOL maintains the ESOP project and the IRS periodically audits ESOPs to ensure compliance with Internal Revenue Code (Code) qualification and prohibited transaction provisions. Following increased funding from the Inflation Reduction Act, the IRS’s focus on addressing high-dollar compliance issues (including those related to high-income filers) through its audit practices has intensified.
Notice Summary
The Notice is one means by which the IRS is addressing what it views as problematic transactions and tax avoidance involving high-income taxpayers and ESOPs. Specifically, the Notice outlines the IRS’s concern with certain ESOP transactions—particularly those involving S corporation ESOPs—that include aggressive tax claims that benefit high-income taxpayers. The Inflation Reduction Act has enabled the IRS to take “swift and aggressive” action to address compliance issues and schemes involving complex transactions, such as ESOPs.
The Notice identifies the following areas of IRS concern:
- Valuation issues with employee stock
- Prohibited allocation of shares to disqualified persons
- Prohibited transactions with ESOP loans due to a failure to follow tax law requirements
In addition, the Notice highlights the problematic business scheme of a “management” S corporation, whose stock is wholly owned by an ESOP for the purpose of diverting taxable business income to the ESOP. In the Notice, the IRS mentions that if such an S corporation purports to provide loans to the business owners in the amount of the business income to avoid taxation of that income, such loans should be considered taxable income. The Notice cautions that this scheme may cause the management company to lose its S corporation status due to the ESOP failing certain tax law requirements.
The Notice provides a range of compliance tools to rein in violations, including increased education, outreach, and audits, as well as encouraging reporting those who promote improper and abusive tax schemes and tax return preparers who purposely prepare improper returns.
Implications and Considerations
Although problematic transactions are a small part of the ESOP landscape, they are at the forefront of regulatory investigations and compliance measures. The Notice is the latest in the IRS’s enforcement actions related to ESOPs, and it is one facet of the various oversight mechanisms applicable to these retirement plans.
Because creating and maintaining an ESOP is a complex process, ESOP sponsors, fiduciaries, and advisors should ensure they receive proper valuations of employer stock and pay particular attention to any conflicts of interest that may exist in ESOP transactions. In addition to the IRS’s growing focus on ESOPs, the DOL continues to actively pursue enforcement actions against ESOPs and ESOP-owned companies. Companies that maintain ESOPs should also be mindful of requirements applicable to them that are not directly due to their ESOP status, such as the DOL’s cybersecurity guidance, another area of active enforcement.
When creating and maintaining an ESOP, companies should consider the compliance requirements detailed above. Moreover, ESOP sponsors and fiduciaries may consider proactively reaching out to tax professionals to ensure that any transactions comply with the Code and related regulations.
How We Can Help
If you are interested in an ESOP compliance checkup, or if you have any questions about ESOP compliance generally, please contact the authors or your usual Morgan Lewis contact.