IRS Takes Further Steps Against ESOP S Abuses

In Revenue Ruling 2004-4, the IRS ruled that ESOP S corporation structures in which individuals are given options to buy stock in subsidiaries of the parent corporation will be subject to rules limiting synthetic equity holdings of plan participants. The IRS specifically addressed three examples of these structures. In each case, a parent professional services corporation owned subsidiaries that had one or more employees. Customers are assigned to do business with the various subsidiaries. The employees of the subsidiaries are paid a salary much less than the income they generate; retained income from the subsidiary is assigned to the subsidiary rather than being paid out to the employee. One employee in each subsidiary retains stock options that can be exercised to buy the subsidiary. Because the parent is a 100% ESOP, no taxes are paid on earnings at the parent or subsidiary level. The number of employees with the options in the three examples is one, five, and eleven.

The IRS concluded that in each case, the option represents synthetic equity in the parent and that the individual option holders are disqualified persons, whether they a) own more than 10% of the deemed owned shares of the company or not and b) whether or not there are other employees in the subsidiary who participate in the ESOP. That is because the subsidiary structure gives them effective ownership of the profits of the subsidiary, and these subsidiaries are themselves the equivalent of S corporations owned by an ESOP. Putting actual employees in the subsidiary does not provide protection because the profits are being captured by the option holder, not the employee.

The IRS further announced that any structures of this type must be listed as tax shelters. Specifically, these include any cases in which the following characteristics are present: a) 50% or more of the stock is held by an ESOP in an S corporation, b) profits generated by a specific individual are accumulated and held for that individual's benefit in a subsidiary, c) the profits are not paid out within 2 1/2 months after the end of the year, and d) the individual has a right to acquire more than 50% of the subsidiary. Structures that are similar in intent also must be listed.