IRS’s ESOP Warning Shouldn’t Signal an Enforcement Sea Change

The IRS issued a notice last month warning plan sponsors to be alert to compliance issues associated with employee stock ownership plans. The notice used broad and vague language cautioning “higher-income taxpayers and businesses” against implementing “aggressive schemes involving complex or questionable transactions, including those involving ESOP” to avoid paying the “taxes they [rightfully] owe.”

Unfortunately, in doing so, the IRS didn’t provide specifics on what it thought could be questionable or impermissibly structured to avoid the proper taxation of income.

As a result of the imprecise language, this notice has created a wave of concern in the ESOP community, with questions focused on IRS scrutiny in an area where enforcement has historically and primarily been driven by the Department of Labor. Among other concerns, ESOP plan sponsors question whether the IRS’s bulletin sets in motion new and perhaps contradictory rules concerning ESOP enforcement and the retroactivity of such enforcement on ESOPs that have recently been a party to one or more stock sale transactions.

After reviewing the language and considering past investigative focus of the IRS, we don’t believe the IRS bulletin signals a new wave of ESOP oversight; rather, we view it as the IRS’s continued focus on truly abusive transactions, which stems from IRS enforcement steps dating back decades.

As such, we’re hopeful the rhetoric intends to draw a bead on questionable transactions and remind high income taxpayers that tax planning should use the tools available to them without over-expansion of the unique opportunities presented by ESOP ownership, and remind plan sponsors that ESOPs are intended to benefit a broad base of employees for retirement purposes.

Why do we think this? While the IRS arguably does note some broader topics of scrutiny in the bulletin beyond its historical focus—such as “valuation issues with employee stock”—it gives no indication that it intends to broadly take on ESOP valuation issues, which have historically been a DOL focus area. The motivation here does seem to be truly on identifying dubious and aggressive events that are geared at tax avoidance at the expense of retirement benefits.

After warning about abusive ESOP transactions, perhaps the conclusion of the IRS bulletin is the most appropriate indication of its scope. It ends by sharing how to “report individuals who promote improper and abusive tax schemes.”

The news release is troubling in its brevity and offers little guidance on how to enter into appropriately structured and motivated ESOP transitions of ownership. Instead, it largely echoes a concern for those groups that may seek to use the tax-favored ESOP structure to shield income while providing little (or a lessened) benefit to ESOP participants.

The IRS has a history of using strong language to remind taxpayers of their obligation to use tax structures appropriately. The latest announcement is reminiscent of IRS rhetoric following the issuance of Section 409(p) of the tax code, which was enacted in 2001. It aimed to prevent the use of S corporation ESOPs as abusive tax shelters and to ensure that a broad range of rank-and-file employees benefit from ESOP tax advantages.

Section 409(p) was a reaction to the concept of a one-person ESOP (or a similar construct), where tax favored value was concentrated in the hands of a single “employee” or a small number of people. Following the issuance of proposed regulations under Section 409(p) in December 2004, the IRS warned of new effective dates for income and excise taxes that would apply to S corporation ESOPs, as well as consequences of “participating in abusive schemes.”

In statements issued at this time, the IRS sought to “address concerns about ownership structures involving S corporations and ESOPs that concentrate the benefits of the ESOP in a small number of persons.” It also urged tax advisers to take action if they suspected any possible abuse from plan sponsors. Ultimately, the IRS sought to penalize those engaging in what it believed were “abusive transactions” versus imposing inarticulate rules on proper ESOP events.

Although the volume of IRS investigations over the past two decades has fluctuated since Section 409(p) was added, the IRS has maintained a consistent investigative authority over ESOPs. It predominantly has focused on administrative and compliance issues, including discrimination testing, appropriateness of distributions, appropriate vesting, and related items, as such are governed by the tax code.

The DOL, by contrast, has perhaps taken a broader view of its enforcement responsibilities and has focused on less black-and-white concepts such as whether a certain action is fiduciary in nature, whether the ESOP was paying too much for company stock, and related issues.

From our perspective, the IRS’s bulletin tells us first and foremost that the agency will continue to include ESOPs in their work plan for specialty programs subject to audit. We have been working with clients on a more robust IRS focus on ESOPs since 2017, with such audits and investigations appropriately policing compliance with tax code requirements.

In our experience, ESOPs established to provide for broad based employee retirement benefits that are designed to share an employer’s equity value with participants versus diverting value to former owners or other constituents should continue to be viewed as an appropriate ownership structure. The IRS notice emphasizes its critique of abusive tax shelters; it shouldn’t quell appropriately designed ESOP transactions.

As the IRS continues to mimic past bulletins and cautions on abuse, we don’t believe the latest bulletin signals a change in how the IRS views ESOP requirements. The IRS will police and penalize truly abusive transactions, which stems from IRS enforcement steps dating back decades. For these reasons, we don’t believe (and we do hope) this isn’t a sea change in the ESOP enforcement space.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Allison Wilkerson is a partner at McDermott Will & Emery. She focuses her practice on employee benefits matters and has extensive experience handling issues pertaining to the Employee Retirement Income Security Act of 1974 and ESOPs.

Christian Nemeth is a partner at McDermott Will & Emery and is co-head of the firm’s ERISA litigation practice. He provides legal counsel on complex commercial litigation and government investigations, including ERISA matters, financial and banking cases, business torts, and breach of contract actions.

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