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What to know about ESOP compliance issues

Posted on September 8, 2023

“Beginning this tax year,” warns Mike Poynter of Teipen CPA Group, “the IRS has expanded their focus toward high-income taxpayers. They will be especially alert to aggressive tax claims and compliance issues associated with Employee Stock Ownership Plans (commonly referred to as ESOPs). By focusing on these transactions, the IRS is signaling their effort to ensure that tax laws are applied fairly, and that high-income filers pay the taxes they owe.”

Prior to the Inflation Reduction Act, more than a decade of budget cuts prevented IRS from keeping pace with the increasingly complicated set of tools that the wealthiest taxpayers may use to hide their income and evade paying their share.

The IRS is now taking swift and aggressive action to close this gap. Part of this action includes alerting higher-income taxpayers and businesses to compliance issues and aggressive schemes, including those involving ESOPs.

ESOPs refer to retirement plans that allow employees to own stock in their employer’s company.

  • Any company that has stock can sponsor an ESOP for its employees as long as the ESOP invests primarily in the securities of the employer.
  • ESOPs can be complex arrangements since the ESOP can borrow funds from the employer or a third party to purchase shares of the employer.

“In light of the complexity of ESOPs,” continues Poynter, “the IRS has and will continue to undertake enforcement strategies to ensure compliance with tax law requirements by employers sponsoring an ESOP.”

The IRS has identified numerous interests, 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.

Additionally, the IRS is looking into promoted arrangements using ESOPs that are potentially abusive. For instance, the IRS has seen schemes where 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.

Over the next year, the IRS will continue to use a range of compliance tools, including education, outreach and additional examinations to address compliance issues associated with ESOPs.

Businesses and individual taxpayers should seek advice from an independent and trusted tax professional instead of promoters focused on marketing questionable transactions.

Reporting ESOP scams
The IRS encourages people to report individuals who promote improper and abusive tax schemes as well as tax return preparers who deliberately prepare improper returns.

To report an abusive tax scheme or a tax return preparer, people should mail or fax a completed Form 14242, Report Suspected Abusive Tax Promotions or Preparers, including any supporting materials to the IRS Lead Development Center. Or call Teipen CPA Group with your questions. We’ll help walk you through any potential compliance issues and legalities.