Bad Tax Consequences for Disqualified ESOP

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[author: Angela Bohmann]

A recent tax court decision considered the impact on a highly compensated participant of an ESOP that was disqualified retroactively for the period 2000-2004. The highly compensated participant was fully vested in the ESOP from its inception to its disqualification. The highly compensated participant argued that only the portion of the benefit that accrued during 2004, which was the only year for which the statute of limitations was still open, could be included in his income. The IRS argued that under Section 402(b)(4)(A) of the Internal Revenue Code the entire vested accrued benefit should be included in the participant’s income in the year that the plan was disqualified. In other words, even though the benefits had accrued over a number of years, according to the IRS, the participant should be taxed on the entire vested benefit in the year the plan was disqualified. The court agreed with the IRS: Because the participant had never paid tax on any of the accrued benefit, the entire vested benefit was included in income in that year. The case highlights the fact that plan disqualification can result in adverse tax consequences to highly compensated plan participants, in addition to the adverse tax consequences experienced by the plan sponsor.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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