Article | November 02, 2023

by Horty & Horty, P.A.

Employee Stock Ownership Plans (ESOPs) are a popular choice among businesses due to their tax advantages and effect on employee morale and succession planning. However, they require careful navigation to ensure compliance with IRS rules. 

ESOP basics

An ESOP is an employee benefit plan that allocates shares of the company’s stock to its employees, effectively giving them a partial ownership interest. You can think of an ESOP as a special kind of retirement savings account for employees. But instead of being filled with a mix of stocks, bonds, and mutual funds, it mainly holds shares of the company where the employees work. So, employees aren’t just working for a salary; they’re working to improve the value of the company, which in turn makes their own ESOP shares more valuable. 

In addition to the employee benefits, one of the most appealing aspects of ESOPs is the tax advantages they offer. If the plan meets specific criteria set forth by the Internal Revenue Code, it is considered “qualified,” and plan contributions are generally tax-deductible for employers.

Misuse

Unfortunately, any system that offers significant tax advantages can invite unethical gaming of the system, and the IRS has identified many practices that indicate misuse of ESOPs. As a result, the IRS has issued a firm warning to businesses, as it expects to increase its scrutiny of ESOPs. 

Notable concerns include issues related to the valuation of employee stock, the prohibited allocation of shares to disqualified individuals, and failure to adhere to the tax law requirements for ESOP loans. The latter can sometimes convert what should be a standard loan into what the IRS terms a “prohibited transaction.” 

They have also flagged particular transaction structures that seem crafted to exploit ESOP regulations. One such structure involves businesses setting up a “management” S corporation, which is wholly owned by an ESOP, purely to channel taxable business revenue to the ESOP. Let’s say ABC Corp. sets up an S corporation that is wholly owned by an ESOP. ESOPs are tax-exempt entities, so ABC Corp. channels $1 million in business revenue into the ESOP-owned S corporation, evading taxation. The S corporation then claims to give out “loans” equivalent to the business revenue to the owners of ABC Corp, which enables the owners to evade personal income taxation. The owners might attempt to justify these “loans” as the ESOP “reinvesting” in the company. However, the IRS considers this a legal fiction and states that these alleged loans are taxable income. 

Ensuring compliance

Given the IRS’s increased scrutiny and proactive action to close the tax gap, businesses currently sponsoring an ESOP must ensure they are in full compliance with IRS rules. Here are some tips to ensure your company’s ESOP is managed appropriately: 

  • Conduct regular inspections to ensure all activities align with tax laws.

  • Evaluate the valuation methods used for employee stock. 

  • Educate employees to ensure they understand the structure and benefits of the ESOP. 

  • Keep thorough records of all ESOP-related transactions, loan agreements, and stock allocations. 

  • Review loan agreements to comply with IRS rules and avoid prohibited transactions. 

  • Monitor share allocations to ensure they don’t go to disqualified persons. 

  • Establish internal policies and controls to prevent prohibited transactions and ensure overall compliance. 

  • Set up a feedback mechanism for employees or stakeholders to report concerns or potential issues related to the ESOP. 

By following these steps, companies can create a robust framework that not only ensures compliance but also maximizes the benefits of the ESOP for all stakeholders. 

This article is intended to provide a brief overview of IRS guidance related to ESOPs. It is not a substitute for speaking with one of our expert advisors. For more information, please contact our office.

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