As part of its renewed attention to wealthy taxpayers, the IRS is looking sharply at employee stock ownership plans.
Prior to last summer’s federal Inflation Reduction Act, more than a decade of budget cuts reportedly prevented the IRS from keeping pace with the “increasingly complicated set of tools” that some taxpayers may use to hide income and evade taxes, the agency said in an announcement.
The agency has since been the receipient of a funding boost from the Biden administration and has promised a concerted effort to root out tax cheats, particularly among wealthy filers.
“Flush with new funding … and certainly cognizant of the massive fiscal budget deficits, the IRS is very interested in what they deem may be low-hanging fruit in abusive tax schemes,” said Brett Walters, financial planner at TBH Advisors in Brentwood, Tenn.
ESOPs, which are retirement plans that allow employees to own stock in their employer’s company, are unsurprisingly a prime target of IRS auditors, advisors say.
“There’s certainly a distinction to be made between the inherent complexity of an ESOP transaction—through which an owner sells their stock to an ESOP to share the benefits of ownership with those who helped build a business—and the complexity that arises out of owners who misuse an ESOP structure,” said partner Michael Wieber, an ESOP and employee benefits attorney with the law firm Quarles & Brady. “[Most] ESOPs are done to provide an exit strategy for successful business owners while sharing the wealth with employees.
“The problem, as so often is the case, is that the relatively few misuses of this valuable business transition vehicle grab the headlines,” Wieber said.
Walters added that currently there are slightly more than 6,200 unique companies with an ESOP in the U.S., with assets of more than $1.6 trillion.
“That may not seem like a lot of companies with these types of plans, but the challenge the [IRS] will face is the inherent complexity of ESOP structures,” he said. “Each component of the ESOP requires what might be very tedious and laborious examination.
“Each step in the structure has potential for abuse and each step requires specialized expertise by the examiner to distinguish the plans seeking to follow the letter of the law from those more liable for abuse,” Walters said. “Likely, the IRS will seek to identify specific promoters of what they determine to be abusive ESOP structures to narrow the list of potential candidate companies to examine. Even more likely, they’ve already identified some of these promoters.”
“Benefits of ESOPs can be significant, but the regulations governing them are extremely complex,” Lisa Cappiello, a partner in private client services at Eisner Advisory Group LLC. Though ESOPs more typically own C corps’ stock, they’re also permitted to own S corporation stock, “affording them tax-free treatment on the S corporation earnings,” she said.
“In instances where the S corporations are wholly owned by ESOPs solely for obtaining this tax-free treatment, the IRS is considering these arrangements as potentially abusive,” Cappiello said. “Additionally, when an S corporation provides loans to owners solely to avoid taxation of the S corporation income, the IRS is emphasizing that the loans should be taxable income to the owners.”
ESOP distributions can be rolled into a retirement account or IRA and accumulate gains that will be taxed at the preferential capital gains rate later, Cappiello said. “Taxpayers should work with tax advisors to ensure there are no prohibited allocation of shares to disqualified persons, the valuation of employee stock is correct and ESOP loans aren’t structured in a manner that would make them prohibited transactions,” she said.
For wealthy taxpayers who have considered or have already completed creation of an ESOP, “the best thing they can do is seek the assistance of qualified advisors—legal and tax, in particular,” Wieber said. “For those who have not yet sold their company to an ESOP, advice from advisors whose compensation does not depend on the exit strategy selected … will help dispel the negative headlines. For those who have already sold to an ESOP, retaining good records of the terms of the sale and hiring strong counsel, valuation specialists and third-party administrators to carry out the ESOP pays off.”
Specialists who work regularly with ESOPs know the structure isn’t for everyone, “but also [we] have too often seen companies that are great candidates for an ESOP go another direction due to misinformation and unfounded concerns,” Wieber said.
