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Another New IRS Audit Target: Employee Stock Ownership Plans (ESOPs)

By Joel N. Crouch on August 14, 2023
In an August 9th announcement, the IRS said it has identified compliance issues for Employee Stock Ownership Plans (ESOPs). This is on the heels of recent IRS announcements regarding Malta Pension Plans, Puerto Rico Act 20/22/60 participants, Monetized Installment Sales, Cost of Goods Sold, and of course, Employee Retention Credits. According to IRS Commissioner Danny Werfel, "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. 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."

An ESOP is an employee benefit plan that gives workers ownership interest in the company in the form of shares of stock. ESOPs give the sponsoring company—the selling shareholder—and participants various tax benefits, making them qualified plans, and are often used by employers as a corporate finance strategy to align the interests of their employees with those of their shareholders. An ESOP can be very complex, but if done correctly, it can provide great benefits to a business owner and the employees.

According to the August 9th announcement, the IRS identified “numerous issues, such as valuation issues with employee stock; prohibited allocation of shares to disqualified persons; and failure to follow tax law requirements for ESOP loans causing the loan to be a prohibited transaction.” The IRS has also identified a promoted ESOP transaction in “which a business creates a ‘management’ S corporation whose stock is wholly owned by an ESOP for the sole purpose of diverting taxable business income to the ESOP. The S corporation purports to provide loans to the business owners in the amount of the business income to avoid taxation of that income. The IRS disagrees with how taxpayers interpret this transaction and emphasizes that these purported loans should be taxable income to the business owners. These transactions also impact whether the ESOP satisfies several tax law requirements which could result in the management company losing its S corporation status.”

The IRS plans to employ various compliance tools to address perceived issues associated with ESOPs, including education, outreach and additional examinations, all part of the $80 billion of additional funds available through the Inflation Reduction Act.

If you have any questions about this blog post or any other tax-related topic, please do not hesitate to contact me at jcrouch@meadowscollier.com or (214)749-2456.