INSIGHT: ESOPs Are Trusts For Purposes of Related Party Deduction Limitations

The controlling shareholders of an S corporation, who contributed their stock to the corporation’s employee stock ownership plan, found themselves with income tax deficiencies totaling nearly $500,000 after the corporation deducted certain expenses owed to the ESOP beneficiaries in the year prior to when the payments were reported in the beneficiaries’ income.

Steven and Pauline Petersen and John and Larue Johnstun, the majority shareholders of Petersen Inc., an S corporation, argued that the ESOP wasn’t a trust for the purposes of tax code Section 267 and, thus, the ESOP could deduct the expenses in the year they accrued rather than the year they were paid. The U.S. Court of Appeals for the Tenth Circuit disagreed and ruled that ESOP was a trust and the expenses must be deducted in the year they were paid. (Petersen v. Commissioner, No. 17-9003 (10th Cir. 5/15/19)).

For 2009 and most of 2010, The Petersens and Johnstuns owned 79.6% of the stock of in Petersen Inc. The remaining 20.4% of the stock was held by Petersen Inc.’s employee stock ownership plan (ESOP). In October 2010, the ESOP acquired all of the Petersens’ and Johnstuns’ stock in Petersen Inc. and thereby became the sole owner of the corporation.

The ESOP was an employee benefit plan governed by ERISA. A corporation’s contributions to an ESOP are tax-deductible. Petersen Inc. was an accrual basis taxpayer, and its ESOP-participant employees were all cash basis taxpayers.

Tax code Section 267 restricts the timing of deductibility when an accrued expense is to be paid to a cash basis taxpayer that is related to the taxpayer. Such expenses cannot be deducted until the amount of the payment becomes gross income of the related taxpayer.

Here, Petersen Inc. deducted expenses for ESOP participants in the year that the expenses accrued even though it did not pay the expenses until the following year. The Internal Revenue Service decided that employees of Petersen Inc., who participated in the ESOP, were related to Petersen Inc. The agency therefore disallowed deductions taken for 2009 based on expenses accrued in that year but not paid to the related employees until 2010. The U.S. Tax Court upheld the IRS’s determination, and the Petersens and Johnstuns appealed.

Section 267(a)(2) provides that if the taxpayer and a person to whom the taxpayer is to make a payment are related parties as specified in Section 267(b), then the amount of the payment cannot be deducted until it is paid or is includible in the recipient’s gross income. Section 267(e) provides that an S corporation and a person who ownsany of the stockare to be treated as persons specified in Section 267(b). In other words, an S corporation and a shareholder are related for purposes of Section 267. Because the ESOP owned much of the shares of Petersen Inc., Petersen Inc. and the ESOP were related.

Section 267(c) provides for purposes of determining the ownership of stock—stock owned by a trust shall be considered owned proportionately by its beneficiaries. If the stock held by an ESOP is held “in a trust” and if the employees participating in the ESOP are “beneficiaries” of that trust, then Petersen Inc. employees participating in the ESOP must be considered owners of stock of Petersen Inc. under Section 267(c). The court concluded that an ESOP trust had the requisite elements of a trust as that term is generally understood and, therefore, Petersen Inc.’s ESOP trust was a trust within the meaning of Section 267 and that the IRS properly applied that section to the Petersens and Johnstuns.

Appellants’ Arguments Unavailing

The Petersens and Johnstuns argued that an ERISA trust was distinguishable from a common law trust because it protected the interests of “participants,” who were distinguished from “beneficiaries” in ERISA. The court disagreed. “This argument relies on semantics rather than substance.” Both participants in the plan and their beneficiaries satisfied the definition of beneficiary in trust law. All ERISA does is use different terminology to describe two distinct classes of beneficiaries—those employees or former employees who participate in the plan, and the beneficiaries whose interests therein derive from such a participant. The common law of trusts, the court noted, allows for different beneficiaries “whose interests may be enjoyable concurrently or successively.”

The Petersens and Johnstuns argued that ERISA trusts were not “true” trusts because they were called “qualified trusts.” All that showed, the court observed, “is that an ESOP trust is a special type of trust, with special tax consequences for which it ‘qualifies.’” The adjective, qualified, modifying the word trust, does not signal that the entity was not a true trust.

The Petersens and Johnstuns contended that an ESOP trust does not satisfy the definition of trust in Treasury Regulation Section 301.7701-4(a). As the Petersens and Johnstuns saw it, an ESOP trust is distinct because it is not created by a will or an inter vivos declaration and is not generally subject to the rules of chancery or probate courts. The Petersens and Johnstuns, however, conveniently ignored the language later in the regulation: “…an arrangement will be treated as a trust … if it can be shown that the purpose of the arrangement is vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.” An ESOP clearly fulfills those requirements.

Section 318 Is in Subchapter C

The Petersens and Johnstuns pointed to Section 318(a)(2)(B)(i) which excludes employee-benefit trusts from the Section 318 constructive ownership rules. It states: “Stock owned, directly or indirectly, by or for a trust (other than an employees’ trust described in Section 401(a) which is exempt from tax under Section 501(a)) shall be considered as owned by its beneficiaries in proportion to the actuarial interest of such beneficiaries in such trust.” Thus, stock owned by an ESOP, quite clearly an employees’ trust, would not be considered as owned by its beneficiaries, i.e., its participants. Applying that exception to the present case, The Petersens and Johnstuns contended that Petersen Inc. stock owned by its ESOP should not be considered to be owned by Petersen Inc. employees—to whom the expenses at issue were owed—who participate in the plan. The argument, the court acknowledged, “may look persuasive, but there is a fatal flaw.”

The relevant language of Section 318 is: “For purposes of those provisions of this subchapter to which the rules contained in this subsection are expressly made applicable.” Consequently, this provision cannot exclude ESOP trusts from the meaning of trust in Section 267 for two independently sufficient reasons: (1) Section 267 is not in the same subchapter as Section 318 (it is in subchapter B rather than in subchapter C); and (2) Section 267 does not even mention Section 318, much less make it ”expressly… applicable…“ See Brick Milling Company v. Commissioner and Revenue Ruling 80-46.

In fact, the court noted, rather than supporting the Petersens and Johnstuns’ argument, Section 318 actually undermined it because the section implicitly assumes that an employees’ trust described in Section 401(a) would be considered a trust governed by that section (such that its beneficiaries would constructively own the stock actually owned by the trust) if it were not expressly excluded. Thus, the failure to expressly exclude employee trusts in Section 267, the way they are expressly excluded in Section 318, indicates that such trusts are included.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.