IRS Plans Increased ESOP Enforcement

The IRS has expanded its focus on ensuring high-income taxpayers pay what they owe, warning businesses and tax professionals to be alert to a range of compliance issues that can be associated with employee stock ownership plans, the tax regulator announced this week.

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

“This means spotting aggressive tax claims as they emerge and warning taxpayers,” IRS Commissioner Danny Werfel said in a statement. “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.”

Werfel credits the IRS’ renewed enforcement to a bolstered budget at the agency, including funding for agency enforcement included in the Inflation Reduction Act. Prior to the bill’s passage, more than a decade of budget cuts had prevented the “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,” he stated.

ESOPs are a type of defined contribution retirement plan that permits 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, the IRS explained.  

ESOPs can be complex plan arrangements, because the stock ownership plan can borrow funds from the employer or a third party to purchase shares of that employer, the IRS stated.

“The IRS has seen promoted arrangements using ESOPs that are potentially abusive,” the agency announced.

For example, the IRS is concerned about arrangements in which a business creates a ‘management’ S corporation, the stock of which 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 agency stated. “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 has identified “numerous” issues in its compliance efforts, including validation issues with employee stock; prohibited allocation of shares to disqualified personnel; and failure to follow tax law requirements for ESOP loans, resulting in prohibited transactions, the agency announced.