Bret Keisling discusses a recent Internal Revenue Service press release and subsequent clarification that warned of potential IRS issues with ESOPs including valuation issues with employee stock, prohibited allocation of shares to disqualified persons, and failure to follow tax law requirements that would cause an ESOP loan to be a prohibited transaction, none of which are unusual issues for the IRS to highlight. Notably, the IRS highlighted ESOP Management companies (not holding companies) that seem designed to replace taxable income with loans as a way for high earners to avoid taxes.
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Mini-cast 242 Show Notes
The IRS Press Release.
The National Center for Employee Ownership's (NCEO's) release on the IRS update and clarification.
Legal update from Levenfeld Pearlstine: IRS Clarifies Its Current Focus on ESOP Plans.
Morgan Lewis' blog post: IRS Warns of Compliance Actions Related to ESOPs and High-Income Taxpayers.
RSM article: IRS warns against compliance issues associated with ESOPs.
Mini-cast 242 Transcript
[00:00:00] Bret Keisling: Welcome to the EsOp Mini-cast thank you so much for listening. My name is Bret Keisling and, as it says on my business cards, I'm a passionate advocate for employee ownership. In August of this year, the IRS raised a lot of eyebrows and caused some agita in the ESOP community when they issued a press release that was designed to quote, "[Warn] businesses and tax professionals to be alert to a range of compliance issues that can be associated with Employee Stock Ownership Plans [or] ESOPs," unquote.
[00:00:38] Bret Keisling: The press release went on to say that the IRS was focused on a number of compliance issues, such as valuation issues with employee stock, prohibited allocation of shares to disqualified persons, and failure to follow tax law requirements that would cause an ESOP to be a prohibited transaction.
[00:00:56] The three items I just mentioned are not new issues for the IRS. Usually, all of the major litigation cases that I've seen have had valuation issues at the heart of them. It's been very frustrating for ESOP practitioners who have clamored for years to get better guidance from the IRS and the Department of Labor about proper valuation protocols.
[00:01:18] Similarly, it was not surprising for the IRS to make reference to prohibited allocation of shares to disqualified persons. This strikes me as a straightforward reminder that the company and its trustee has to work with competent and experienced ESOP lawyers and third-party administrators to make sure that any allocation of ESOP shares complies with relevant law and the ESOP plan documents.
[00:01:43] Similarly, the reference to prohibited transactions with ESOP loans has always been a concern. If an ESOP transaction was found to be prohibited under relevant tax law, it could have devastating consequences to the company, parties to the transactions, for example selling shareholders, and the ESOP participants themselves. Prohibited transactions would also have a very negative effect on the ESOP professionals, as they're the ones that all of the others count on to make sure that a prohibited transaction doesn't take place.
[00:02:16] So generally, up to this point, the press release covered issues that are almost a rehash of IRS guidance that's occurred throughout my 15 years in the ESOP community. But then the IRS raised another issue and referenced ESOPs it deemed potentially abusive, quote:
[00:02:31] "For instance, the IRS has seen schemes where a business creates a 'management' S corporation whose stock 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."
[00:02:54] The IRS then goes on to share its view that these purported loans should be taxable income to the business owners and can impact whether the type of ESOP complies with tax law, which could result in the management company losing its S corporation status.
[00:03:10] Now, to be clear, the management company outlined here is not the same thing as an ESOP holding company, which is gaining popularity.
[00:03:17] The ESOP holding companies that I'm familiar with, such as Empowered Ventures to name just one, are great examples of using ESOPs for what I consider to be their intended purpose, to benefit the employee owners. Frankly, I'm not aware of any management companies as described in the IRS press release and searching online didn't find any examples. But, taking the press release at face value, if these management companies are set up with ESOP connections primarily as a way to minimize the manager's taxes, as opposed to increasing the wealth for the employee owners, then I'm okay with the IRS taking a tough stance because these management companies don't represent what employee ownership means to me.
[00:03:59] The IRS has since clarified that it's an extremely small segment of companies that could be impacted and seems to imply that there were very small number of practitioners who were promoting these type of management schemes. I suspect that these promoters are outside of the mainstream ESOP communities. I haven't heard these as topics at mainstream ESOP and employee ownership conferences.
[00:04:20] In October, a deputy associate chief counsel of the IRS spoke at a virtual conference for the American Bar Association and clarified that the IRS had no current plans to launch a wholesale audit of ESOPs, but that it will only target high income employers that attempt to escape taxable income by loaning it to worker participants.
[00:04:42] So, it seems that the traditional ESOP transactions, which we talk about frequently here, where ESOPs are created by selling shareholders looking to transition their companies to employee ownership will not see an increase in litigation or enforcement. But those involved in what the IRS views as inappropriate schemes to avoid taxes through management ESOPs will see heightened enforcement. And, generally speaking, I'm okay with that.
[00:05:07] We'll include the IRS press release and several blog posts from ESOP professionals and the NCEO in our show notes. I hope you'll check them out.
[00:05:16] With that, we'll wrap up this episode of the Mini-cast. Thank you so much for listening. This is Bret Keisling. Be well.
[00:05:23] Bitsy McCann: We'd love to hear from you! You can find us on Facebook at EO Podcast Network and on Twitter [X] @EsOpPodcast. This podcast has been produced by Bret Keisling for the EO Podcast Network. Original music composed by Max Keisling. Branding and marketing by BitsyPlus Design. And I'm Bitsy McCann.
Standard Disclaimer: The views expressed herein are my own and don't represent those of my own firms or the organizations to which I belong. Nothing in the podcast should be construed as guidance or advice of any kind in any field and the fact that I mentioned an organizational website or an advocate or a company on a podcast does not reflect an endorsement, but if you've heard your name or your group's name mentioned on this podcast, I'd love to have you come on and talk about it yourself.
A note on the transcript: This transcript was produced by Descript, an automated transcription service. While it has been reviewed by The EsOp Podcast, we cannot guarantee the accuracy of the transcription. Please refer to the original audio when citing sources.