Employee Stock Ownership Plans (ESOP) have always stood out as an attractive option for employers seeking to achieve various objectives through a comprehensive benefits program. A well-structured and effectively managed ESOP has the potential to enhance employee engagement, offer tax advantages, and assist in ownership transition planning.
However, the rules for setting up and running an ESOP are far from simple. And some employers may be inadvertently or even intentionally abusing those rules to exploit the tax advantages of these plans. Recently, the IRS issued an explicit warning to plan sponsors regarding ESOP compliance issues.
How It Works Under An ESOP
Under an ESOP, participants invest primarily in their employer’s stock as a way to save for retirement. They also thereby become partial owners of the business or organization itself. To implement an ESOP, the employer establishes a trust fund and either:
- Contributes shares of stock or money to buy the stock (an ‘unleveraged’ ESOP)
- Borrows funds to initially buy the stock, and then contributes cash to the plan to enable it to repay the loan (a ‘leveraged’ ESOP)
The shares in the trust are allocated to individual employees’ accounts, often using a formula based on their respective compensation. The employer must formally adopt the plan and submit plan documents to the IRS, along with certain forms.
Among the biggest benefits of ESOPs is that the IRS considers them ‘qualified’ for tax purposes. Thus, plan contributions are typically tax-deductible for employers. However, employer contributions to all defined contribution plans, including ESOPs, are generally limited to 25% of covered payroll.
However, C corporations with leveraged ESOPs can deduct contributions used to pay interest on the loans. That is, the interest isn’t counted toward the 25% limit. Furthermore, dividends paid on ESOP stock passed through to employees or used to repay an ESOP loan may be tax-deductible for C corporations, so long as they’re reasonable. Dividends voluntarily reinvested by employees in company stock in the ESOP also are usually deductible by the employer.
In a recent news release (IR-2023-144), the IRS warns businesses and tax professionals specifically to watch out for ESOP compliance issues. The tax agency alludes to the problem of the “tax gap” — which is generally defined as the amount of tax revenue the government should receive and the tax revenue it actually does.
“The IRS is now taking swift and aggressive action to close this gap,” IRS Commissioner Danny Werfel states in the news release. “Part of that includes alerting higher-income taxpayers and businesses to compliance issues and aggressive schemes involving complex or questionable transactions, including those involving ESOPs.”
In its current compliance efforts, the tax agency has encountered problems such as:
- Valuation issues with employee stock
- Prohibited allocation of shares to disqualified persons
- Failure to follow tax-law requirements for ESOP loans, which may cause some loans to become prohibited transactions
In the past, the IRS didn’t always have the budget to investigate these kinds of abuses. However, the Inflation Reduction Act has provided funding so that the tax agency can now pursue wealthy parties that contribute to the tax gap and crack down on the financial tools they misuse — one of which is the ESOP.
A Good Time
If your organization currently sponsors an ESOP, now may be a good time to review or even audit your plan to help ensure it’s not in danger of falling out of compliance with IRS rules. Contact us with questions or for further information.