IRS warns of tax compliance issues at ESOPs

The Internal Revenue Service is cracking down on the use of employee stock ownership plans as a way to avoid taxes.

The IRS warned plan sponsors Wednesday to beware of tax compliance issues. ESOPs are retirement plans that enable employees to own stock in their employer’s company, but they can be complicated arrangements since the ESOP can borrow funds from the employer or a third party to buy shares of the employer.

The IRS has flagged a number of issues with the plans, including valuation issues with employee stock, prohibited allocation of shares to disqualified individuals, and failure to follow the tax law requirements for ESOP loans, making them prohibited transactions.

The IRS said it has also seen promoted arrangements using ESOPs that may be abusive in terms of the tax rules. In some schemes, a business may create a “management” S corporation whose stock is completely owned by an ESOP just for the purpose of diverting taxable business income to the ESOP. The S corp pretends to provide loans to the business owners, but they’re for the same amount as the business’s income, as a way to avoid income taxes. The IRS disputes how taxpayers are interpreting such transactions and believes these purported loans should count as taxable income for the business owners. The transactions also affect whether an ESOP satisfies the requirements of the tax laws and could lead to the management company losing its S corp status.

“The IRS is focusing on this transaction as part of the effort to ensure our tax laws are applied fairly and high-income filers pay the taxes they owe,” IRS Commissioner Danny Werfel said in a statement Wednesday “This means spotting aggressive tax claims as they emerge and warning taxpayers. Businesses and individual taxpayers should seek advice from an independent and trusted tax professional instead of promoters focused on marketing questionable transactions that could lead to bigger trouble.”