ESOPs in Iowa Gone Wrong

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An Employee Stock Ownership Plan (ESOP) is an employee benefit plan designed to give company stock to its employees.  The benefits of using an ESOP are that it creates a market for the shares of departing owners of successful closely held companies, motivates and rewards employees, and allows the company to take advantage of various tax incentives. 

The first ESOP was created in 1956 and in 1974, the Senate passed the Employee Retirement Security Act of 1974 (ERISA) and established rules to provide the legislative framework for ESOPs.

However, despite this framework, a market developed for using ESOPs with S corporations (a corporation that elects to be taxed more as a pass through entity) to avoid paying income tax on earnings. In 2001, the IRS took action by adding Section 409(p) to the Internal Revenue Code, imposing income and excise tax on these abusive tax shelters.

What does an abusive ESOP look like?

A typical abusive transaction is as follows:

Dan has a company called Specialty Shop that sells sports equipment.  He creates an S Corporation called Management Inc. of which he is the sole employee. Specialty Shop and Management Inc. enter into an agreement in which the sports equipment business pays a fee to Management Inc. in exchange for management or other services and also adopts an ESOP that is the sole owner of Management Inc.

This is abusive because the sports equipment business, Specialty Shop, deducts payments to Management Inc. as a management fee (typically wiping out most of its taxable income).  Then the income that Management Inc. receives is passed through to the ESOP as the sole owner and is a tax-free contribution. Thus, all tax is avoided in the business…until much later when Dan wants to retire. The IRS considers this tax deferment abusive.

The IRS tried to stop this practice. In a 2006 rule, they stated there is an excise tax of 50% due on these amounts in certain situations where S corporation ownership is so concentrated that disqualified persons (persons who own at least 10% of the stock held by the ESOP) own or are deemed to own at least 50% of the company shares.

Unfortunately, it appears that Iowa has led the charge in many of the abusive ESOP transactions due in particular to a few practitioners who structured many of these transactions for their Iowa clients.

Warning signs

Typically, there are a few warning signs in these situations. These warning signs may not create the abusive transactions by themselves, but have been in many of these abusive transactions, and may also disqualify the ESOP and create some major tax liabilities for the owners. Warnings signs include:

  • transactions that are structured where the company is a PLC (professional liability company) with one or two highly compensated employees, and the owner is an ESOP;
  • transactions that are structured where the company is an LLC and is owned by an ESOP;
  • the ESOP fails to make distributions from the plan upon the owner’s retirement or reaching age 70½; or
  • the ESOP fails to have a qualified independent appraisal (completed by someone other than the person who wrote the ESOP or helped set it up generally). 

Bottom line

An ESOP which is set up merely to avoid paying taxes can be abusive if not done properly and the tax, interest, and penalties charged to an individual to correct abusive ESOPs can easily wipe out any retirement savings than an individual has accumulated by using the ESOP.

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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