On August 9th, the Internal Revenue Service IRS issued a cautionary advisory to businesses and tax professionals, urging them to remain vigilant about a range of compliance issues associated with Employee Stock Ownership Plans (ESOPs).
Addressing the significance of this move, IRS Commissioner Danny Werfel stated, as part of our commitment to equitable application of tax laws and ensuring that high-income taxpayers fulfill their tax obligations, we are intensifying our scrutiny of these transactions.
IRS Compliance and Addressing Challenges in Tax Regulation
This involves identifying and preemptively addressing aggressive tax claims and alerting taxpayers. Instead of engaging with promoters promoting dubious transactions that could lead to serious consequences, businesses and individual taxpayers are advised to consult impartial and reliable tax professionals.”
This alert is a component of the IRS’s broader initiative aimed at enhancing tax compliance among high-income individuals, as highlighted by Werfel.
Preceding the Inflation Reduction Act, a prolonged period of budgetary constraints hindered the IRS’s ability to keep up with the increasingly intricate methods employed by the wealthiest taxpayers to conceal income and evade their tax responsibilities. This warning marks the IRS’s rapid and forceful response to bridge this gap.
ESOPs function as retirement plans enabling employees to possess company stock within their employing organization. Any company with stock is eligible to sponsor an ESOP for its workforce, provided the ESOP primarily invests in the employer’s securities. Given that ESOPs can involve intricate arrangements, it’s notable that these plans might involve borrowing funds from the employer or a third party to procure shares of the employer’s stock.
The IRS emphasizes its commitment to ensuring compliance with tax law obligations by employers who sponsor Employee Stock Ownership Plans (ESOPs), given the intricate nature of these arrangements. As part of its ongoing efforts to ensure adherence, the IRS has identified various issues in its current compliance endeavors:
- Valuation Challenges with Employee Stock: The IRS has encountered difficulties in accurately valuing employee stock within ESOPs.
- Improper Allocation of Shares: Instances have arisen where shares have been allocated to disqualified individuals in violation of regulations.
- Non-Compliance with ESOP Loan Tax Rules: Failures to adhere to tax law guidelines regarding ESOP loans have led to these loans being considered prohibited transactions.
Furthermore, the IRS has observed potentially abusive arrangements involving ESOPs. An example is the creation of a “management” S corporation by a business, with the ESOP wholly owning its stock. This arrangement’s purpose is to divert taxable business income to the ESOP. The S corporation claims to lend the business owners an amount equivalent to the business income to evade taxation.
The IRS disputes taxpayers’ interpretations of this transaction, asserting that these alleged loans should be categorized as taxable income for the business proprietors. These actions also influence whether the ESOP meets specific tax law prerequisites, potentially leading to the loss of S corporation status for the management entity
Looking ahead, the IRS plans to employ a variety of compliance tools, including education, outreach, and increased audits, throughout the coming year to tackle the compliance concerns linked to ESOPs.
DOL Actions
In the meantime, the matter of valuing employee stock has become the focal point of numerous legal disputes in recent times. In fact, this concern has been specifically addressed in the Worker Ownership, Readiness, and Knowledge (WORK) Act, a component of the SECURE 2.0 Act. Alongside establishing the Employee Ownership Initiative within the Department of Labor (DOL) to foster employee ownership, this legislation mandates the DOL to release formal guidelines outlining “acceptable standards and procedures” for establishing a good-faith fair market value of business shares to be acquired by an ESOP.
Ali Khawar, serving as the Principal Deputy Assistant Secretary for the DOL’s Employee Benefits Security Administration (EBSA), informed attendees that a pivotal element driving much of the DOL’s enforcement efforts pertains to whether an ESOP is appropriately compensating for the value it’s acquiring.
Khawar expressed optimism that the supplementary guidance will bring clarity to the operational norms for all parties involved, leading to a scenario where enforcement becomes less imperative. He noted that the anticipated behavioral alignment with expectations might naturally render enforcement measures less necessary. Khawar underscored the significance of the ESOP project, deeming it highly important.