IRS Cracks Down on ESOP S Corporation Deferred Compensation Scams

In temporary and proposed regulations (Reg. 129709-03, T.D. 9081; the proposed regulations are the same text), the IRS has cracked down on S corporation ESOP scams using non-qualified deferred compensation and/or management company arrangements that are designed to avoid or evade the anti-abuse provisions of IRC Sec 409(p). The temporary and proposed regulations are the same, and are effective July 21, 2003, and are applicable for plan years ending after October 20, 3003.except for legitimate S corporation ESOPs that were established on or before March 14, 2001, and eligible for the delayed effective date of January 1, 2005.

The new regulations provide that non-qualified deferred compensation, even if not payable in stock, will be considered to be synthetic equity and subject to a present value calculation.. The synthetic equity attributable to non-qualified deferred compensation arrangements will then be added to other equity interests held by disqualified persons in determining the amount of deemed-owned shares to see if the ESOP has a non-allocation year. If it does, severe tax penalties apply. Companies can avoid having non-qualified deferred compensation benefits treated as synthetic equity by paying out non-qualified deferred compensation on or before July 21, 2004. It is important to note that rights to acquire stock or other similar interests in a related entity that is the only significant asset of the S corporation and of which the S corporation is the only significant owner are also treated as synthetic equity (other ownership arrangements will be looked at next). However, a right of first refusal as part of a buy-sell arrangement is not per se such a right. The IRS said it may issue additional rules for situations where the entity is not the only asset of the S corporation and is not primarily or entirely owned by it.

The rules are intended to prevent scams in which an ESOP management company is (typically) set up as an ESOP S corporation. It sets up or spins off an operating company and contributes all or most of its stock to it. The operating company also has an ESOP. The operating company then pays the management company most of its profits as a fee, and management may receive substantial non-qualified deferred compensation benefits. Alternatively, there may be no management company, but management is paid large amounts of non-qualified deferred compensation. In either case, ESOP shares end up with little value because equity value is diverted away from shareholders. The IRS said these arrangements are clearly not intended to benefit employees and the IRS intends to continue to this regulatory project to assure that S ESOPs are set up to benefit employees broadly, not just save taxes and benefit a limited number of executives.