Date: August 25, 2023Attorney: Martin D. Hauptman

The IRS has sounded the alarm bell for businesses and tax professionals over compliance issues concerning Employee Stock Ownership Plans (ESOPs). As part of its commitment to ensure fair application of tax laws and that high-income filers pay the required taxes, the IRS announced a comprehensive plan to increase compliance enforcement on ESOPs (IR 2023-144, 8/9/2023).

ESOPs: An Overview

ESOPs serve as retirement plans, offering employees ownership of stock in their employer’s company. These plans are open to any company with stock, enabling them to sponsor an ESOP for their employees. The primary investment within an ESOP is the employer’s securities.

However, what has caught the IRS’s attention is the potential misuse of ESOPs, mainly since they can borrow funds from the employer or third parties to buy employer shares.

Compliance Issues:

The IRS has pinpointed several compliance issues during its latest ESOP compliance efforts:

  1. Valuation of Employer Stock: Accurate valuation is a common challenge, potentially leading to improper pricing.
  2. Prohibited Allocation of Shares to Disqualified Persons: This involves the improper distribution of shares to individuals not qualified under the ESOP rules.
  3. Failure to Adhere to Tax Law Requirements for ESOP Loans: This could render the loan as a prohibited transaction, causing complications in tax treatments.
  4. Potentially Abusive Schemes: The IRS has identified certain schemes that may lead to abusive arrangements. For example, some “management” S corporations owned by ESOPs have been found to make loans to business owners to evade income taxation. Such transactions could jeopardize the ESOP’s tax-exempt status.

IRS’ Call for Public Assistance:

The IRS is actively seeking public help to root out improper and abusive ESOP practices. Individuals can report suspected promoters of these schemes by mailing or faxing Form 14242 to the IRS Lead Development Center in the Office of Promoter Investigations.

Moreover, by submitting Form 211 to the IRS Whistleblower Office, those who provide original information may qualify for a monetary reward.

The latest announcement by the IRS highlights a significant focus on ESOPs and the potential misuse therein. The call for stricter compliance and public assistance in identifying abuses indicates a broader commitment to fair taxation. IRS Commissioner Daniel Werfel’s advice for businesses and individual taxpayers to consult independent and trusted tax professionals, rather than promoters selling questionable transactions, echoes the IRS’s dedication to an ethical approach in ESOP management.

The news serves as a warning for those engaging with ESOPs to ensure full compliance and awareness of the regulations, as the IRS is clearly increasing scrutiny in this area.