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Management S Corporation ESOPs: Scam or Opportunity?

By NCEO Senior Staff Member Corey Rosen

In the past, lots of companies were approached by an advisory firm with an idea that seemed too good to be true. While there are many variations on this theme, the core concept was that by creating an S corporation employee stock ownership plan (ESOP) that is carefully structured, you could channel tax-free income and/or capital gains primarily to a small group of managers or other highly paid people without having to share much, if any value with the employees generally, who under the law are supposed to be the primary beneficiaries of the plan. Often, there are substantial insurance policies tied to these approaches. The advisors would tell you they have received government approval for these plans and set up a lot of them. So was it safe to proceed? Is is still today.

Hardly. The IRS takes a very dim view of these transactions. It has closed several lawsuits against them with devastating penalties to the plan sponsors. In general, tax law states that any transaction whose primary purpose is avoiding taxation is a "listed" transaction that will be undone and subject to severe penalties. IRS regulatory rulings specific to S corporation ESOPs, as well as laws enacted to prevent S corporation ESOP scams, provide another tool for the IRS to intervene. You may get lucky and not get audited, but I guarantee you, if you do, you have a high chance of ending up paying taxes so punitive you will go out of business. If your ESOP, like thousands of others, is meant to provide benefits broadly to employees, S corporation tax law will provide you with substantial tax benefits, but schemes to avoid these rules are trouble.

Today, these scam ESOP proposals hardly ever get made. A law that became effective in 2004 made them unworkable. If you have an S ESOP, or are considering one, you should focus on these new laws, which are included in the Tax Code as Section 409(p). We discuss these in detail in our article ESOPs in S Corporations.

But if you want to remember what these scam artists were trying to do in the early days of S ESOPs, here is what we wrote.

The Pitch

"Here's the deal," the advisor tells you. "Back in 1997, Congress made it possible for S corporations that were owned by an employee stock ownership plan (ESOP) to get a very special tax break. Specifically, the ESOP did not have to pay any tax on its share of the profits attributable to its ownership interest in an S corporation. As you know, in an S corporation, the corporation itself pays no tax. Instead, tax obligations are passed through to the owners pro rata to their ownership share. So if an ESOP owns 100% of the company, no federal income tax is due. In some, but not all, states, you still have to pay tax, but that's relatively small."

"But," you asked, "how does that help me and the other managers? I don't know a lot about ESOPs, but aren't they kind of like 401(k) plans and profit sharing plans in that they are supposed to be made available at least to most of your full-time employees? Frankly, I'm not that interested in sharing ownership with employees broadly—I just want to figure out a way to reduce taxes for myself and, if necessary other managers. Anyway, I can't believe Congress would pass a law that allows a group of managers or higher-income folks to avoid paying taxes. That's not the Congress I know."

You saw the twinkle in your tax advisor's eyes. It's the sparkling sign of dollars adding to his bank account, you suspect, but the potential tax break is too good not to consider. "Look," he said, "you're right about ESOPs technically. They are supposed to be made available on a nondiscriminatory basis at least to all full-time employees who have worked for 1,000 hours. There are some limited exceptions for employees covered by unions, there's a rule that lets you cover 70% of the eligible employees, and another rule if you have a separate line of business. But all those exceptions are still far too broad for what you need. But I have come up with a way to get around all that."

"But," you stammered, still skeptical, "surely Congress or the IRS is watching out for these kinds of deals. Wouldn't they do something to prevent this?"

"You're right," he added, "Congress has tried to limit this law so that it can't be used by a small group of employees to avoid paying taxes, even when they are excluding a larger group of employees from being in the ESOP. But Congress only went so far—and we know how to walk right up to that line. So I'm just engaging in that great American pastime—finding loopholes in the law. It's downright patriotic! The tax law is very complicated, you see. That's why you're paying me larger fees than you might with just an ordinary advisor." (Much larger, you suspect.)

"Basically, we spin off a management company of just a limited number of people. The operating company—say a manufacturer—retains its own independent form. Each sets up an ESOP. Each year, the operating company makes a profit, and much or all of that goes to the management company. The employees in the operating company are all in the ESOP, so no problem there with discrimination rules. Of course, the profits of the operating company are very limited by this agreement, so the stock is not worth much at all. But the management company has lots of profit and makes a lot of money."

Now, for complicated reasons, this might not work for you. The ESOP rules make it very hard to have an ESOP in an S corporation with fewer than 10 or 15 employees. "Don't worry, though," he said. "We have a plan B. Let's say, for instance, you are a medical practice with 9 doctors who own it and 30 people who work in the office. You set up the ESOP in the operating company and make it a 100% S corporation, meaning it pays no taxes. Now the operating company buys key-person life insurance and annuities in your names. The operating company has a contract with you to perform services. The operating company pays the premiums. After all, without the doctors, the operating company would be out of business. Normally, that is not a deductible expense, but a 100% ESOP pays no taxes anyway. The doctors can now borrow against the premiums for the policies in their names but do not have to pay any taxes till they die."

"These are just a couple of the variants, but we can come up with others if needed. For instance, we can set up an ESOP in which all the employees, including those of the operating company, participate in an ESOP in the management company. Because we don't want the employees to actually end up with shares worth a lot of money, we give managers a large deferred compensation benefit, which is tax-sheltered because the S corporation, being 100% owned by the ESOP, is not taxable. But because there is so little profit, the shares are not worth much for the employees, so you never have to spend a lot of money buying them back when employees leave."

It all sounds complicated and maybe a bit iffy, but the advisors assure you they are experienced and have had a lot of success with these models.

Here is our advice: Don't Do It. The IRS flags ESOPs like this, and they are subject to a far greater chance of audit. If they determine this is a scam, and there is a very good chance they will, your business will likely be bankrupted by the taxes and penalties.

What the Law Requires

The IRS, the ESOP community, and Congress all were eager to find a way to shut down these scams. The IRS said that these and similar deals would be listed transactions that would be undone with back taxes and penalties. Congress moved to create a law to shut them down as well. It was tricky to craft a bill that would not penalize legitimate ESOPs, and the result (Section 409(p) of the Internal Revenue Code and the regulations thereunder) is not perfect, but largely works well.

The law says you have to do two tests every year. First, you define "disqualified persons." Under the law, a "disqualified person" is an individual who owns 10% or more of the "deemed-owned" shares or who, together with family members (spouses or other family members, including lineal ancestors or descendants, siblings and their children, or the spouses of any of these other family members) owns 20% or more of the "deemed-owned" shares. The "deemed-owned" shares include (1) shares allocated in the ESOP, (2) each ESOP participant's pro-rata portion of the unallocated shares, and (3) synthetic equity, broadly defined to include stock options, stock appreciation rights, and other equity equivalents (such as certain deferred compensation arrangements).

Second, determine whether disqualified individuals own at least 50% of all shares in the company. In making this determination, ownership is defined to include (a) shares held directly, (b) shares owned through synthetic equity, and (c) allocated or unallocated shares owned through the ESOP. If disqualified individuals own at least 50% of the stock of the company, then these individuals may not receive an allocation from the ESOP during that year without a substantial tax penalty, nor can they accrue more than 10% of the plan assets or 20% as a family group. If such an allocation or accrual does occur, it is taxed as a distribution to the recipient, and a 50% corporate excise tax would apply to the fair market value of the stock allocated or accrued. If synthetic equity is owned, a 50% excise tax would also apply to its value as well. In the first year in which this rule applies, there is a 50% tax on the fair market value of shares allocated to or accrued by disqualified individuals even if no additional allocations are made to those individuals that year (in other words, the tax applies simply if disqualified individuals own more than 50% of the company in the first year).

For ESOPs in existence before March 14, 2001, the rules became effective for plan years beginning after December 31, 2004. For plans established after March 14, 2001, or for preexisting C corporation ESOPs that switched to S status after this date, the effective date was for plan years ending after March 14, 2001.

The IRS Steps In

The IRS was in no mood to approve any of this. ESOPs were created to benefit employees broadly, not to provide exceptional tax benefits to a very few unusually highly paid people. In Revenue Ruling 2003-6, the IRS struck decisively at companies that want to use S corporations ESOPs to benefit a small number of people while providing insubstantial benefits to employees. This ruling specifically addresses S corporation ESOPs established before March 14, 2001, the "grandfathering" date provided by for the new rules to discourage abuses of the S corporation ESOP model. Some advisors set up what were in effect shell ESOP companies, companies with no or few assets. The advisors then set up ESOPs for these companies that provided nominal benefits to employees. The shell companies were then sold to one or more taxpayers who would restructure their own businesses so that the shell S ESOP now owned most or all of their companies. These individuals would be precluded from participating in an S corporation ESOP because they do not meet the "disqualified person" test noted above—except for the fact that ESOPs set up before March 14, 2001, were grandfathered under the old rules. These advisors believed that these structures would qualify as ESOPs for the March 14 test.

The IRS decisively disagreed, saying that an ESOP cannot be considered established if "the initial employees of the entity forming the ESOP do not receive more than insubstantial benefits or more than insubstantial ownership." So these pre-March 14 ESOPs did not qualify as ESOPs, meaning the individuals who had been setting them up faced extraordinarily punitive tax costs. In addition, the IRS was very clear that transactions that are the same as, or substantially similar to, these transactions will have to register as tax shelters.

The ruling's language made it clear that the IRS follows the spirit and the letter of the law on this topic. In particular, its attack on ESOPs providing insubstantial benefits to employees should signal that other arrangements than the one described here, but with the same effect, will not work. In the years since the ruling, the IRS has not yet ruled on the issue of ESOP-owned S corporations in which the tax trick is to exclude management from the ESOP, but pay them large deferred (and, because the company pays no federal income tax if 100% ESOP owned, tax-sheltered) benefits. But given the IRS's history and stance on these issues, they are very unlikely to prevail either.

What Makes a Legitimate S Corporation ESOP?

After reading this article, some readers may think it may be best to stay away from this area altogether. Nothing could be farther from our intention. S corporation ESOPs are extraordinary opportunities. Congress explicitly wrote the law to encourage companies to set up and expand their ESOPs, even to the point that they become 100% owned by their ESOP and free from federal income tax. The provisions were not loopholes; they were the result of a deliberate and considered discussion. What Congress did want to encourage is the ESOP that covers at least most or all full-time people who have worked for the company for one year or more. That means the ESOP includes the receptionist and the CFO; the sales clerk and the vice-president for marketing; the machine operator and the COO. The plans are intended to own the operating assets of the company; management sees the plans as a way to provide meaningful benefits to everyone, not primarily a way to siphon them off to a few. Fortunately, the vast majority of S corporation ESOPs meet these criteria, and many go much further, creating a real culture of ownership as well. If that is the kind of company you plan with an S corporation ESOP, the law supports you all the way.

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