ESOP Ownership of S Corporations: Good Use or Bad Abuse?

The IRS issued Rev. Rul. 2003-6 to counteract shelving of inactive employee stock ownership plans (ESOPs) that use S corporations without substantial assets or a business purpose, to take advantage of the delayed Sec. 409(p) effective date until plan years ending after 2004.

Background

In the late 1990s, Congress enacted law that permitted ESOP ownership of S corporations (SESOPs). Subsequent legislation added significant benefitSESOPs could avoid unrelated business income tax on the S income. The opportunity to create tax-free business income encouraged some tax practitioners to create new planning techniques. They developed approaches allowing SESOPs to indirectly benefit business owners without providing significant benefits to a broad base of employees.

To offset this type of planning, Section 656(a) of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) amended Sec. 409(p). As amended, Sec. 409(p) provides that a SESOP that makes a prohibited allocation (as defined in Sec. 409(p)(1)) of employer stock to a disqualified person (as defined in Sec. 409(p)(4)) for a nonallocation year (as defined in Sec. 409(p)(3)) is subject to a 50% excise tax on such allocation.

According to the legislative history, the provision will limit the establishment of SESOPs to entities that provide broad-based employee coverage and that benefit rank-and-file employees, not just highly compensated employees and historical owners. In addition, Congress expressed its concern about techniques that corporations might use to avoid or evade the Sec. 409(p) requirements. Thus, Sec. 409(p)(7)(A) gave Treasury the power to establish regulations and other guidance to implement Sec. 409(p) to accomplish this purpose.

Effective Date

Sec. 409(p) is effective for plan years ending after March 14, 2001 for SESOPs established after that date, or, if employer securities held by a plan consisted of stock in an S corporation that did not have an S election in effect on that date. Notice 2002-2 provided that an S corporation would not have an election in effect on March 14, 2001, unless it had actually filed an election on or before that date that was also effective on or before that date. Plans with S elections effective before March 14, 2001 are not subject to the effective-date provisions until plan years beginning after 2004.

Facts

In anticipation of the EGTRRA tax law change, some advisers apparently created SESOPs, even though those corporations had little business activity and their employees had insubstantial benefits under the plan. Rev. Rul. 2003-6 addressed such a fact pattern.

In the ruling, an adviser would arrange for the establishment of a number of S corporations, as well as for the formation of SESOPs to own these entities. The adviser took the position that some or all of the employees would be eligible to participate under the SESOPs terms.

The adviser would then transfer these arrangements to taxpayers owning other profitable and taxable activities, who would restructure their business so that the S corporations would receive income from the active businesses. After the restructuring, the S corporations would be wholly or substantially owned by the SESOPs. However, after the restructuring, one or more individual taxpayers would became disqualified persons under current Sec. 409(p).

IRSs Analysis

The IRS denied the anticipated benefit of these arrangements. It found that there was no reasonable expectation that the employees would accrue more than meager benefits under the plan or more than a minor share in the S corporations. Significantly, the initial employees of the entity forming the SESOP would not ultimately receive more than insubstantial benefits or insubstantial ownership through the SESOP.

For purposes of the Sec. 409(p) effective date, a SESOP is not established until it is adopted by the employer to (1) enable its employees to participate in a more-than-insubstantial manner in the ownership of the business and (2) provide its employees with more-than-insubstantial benefits under the SESOP. Thus, the Service concluded that the SESOP was not established by March 14, 2001, and was not entitled to any delayed application of Sec. 409(p).

In addition, the transactions were listed transactions for purposes of the Codes various tax shelter provisions. Categorization of the transactions in this fashion would create registration requirements and consideration of a variety of penalty provisions.

Conclusion

Based on Rev. Rul. 2003-6, the attempt to create a tax-saving strategy that rests on formalities but which, in substance, produces a result contrary to Congressional intent, will attract significant IRS scrutiny. In such cases, Treasury will probably seek the legal analysis necessary to move such transactions away from their intended result.

From Christopher C. Adler, CPA, Timonium, MD