IRS Issues First Ruling on S ESOP Abuses

In Revenue Ruling 2003-6, the IRS has struck decisively at companies that want to use S corporation ESOPs to benefit a small number of people while providing insubstantial benefits to employees. This ruling specifically addresses S ESOPs established before March 14, 2001, the "grandfathering" date provided by EGTRRA 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 ESOP because they do not meet the "disqualified person" test of EGTRRA -- 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 do not qualify as ESOPs, meaning the individuals setting them up till now face extraordinarily punitive tax costs of EGTRRA. 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 makes it clear that the IRS intends to follow 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. The IRS has not yet ruled on the issue of S ESOP 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 this ruling should provide cold comfort to promoters of these schemes as well.