Last week, the IRS announced it was increasing enforcement strategies aimed at Employee Stock Ownership Plans “ESOPs”. The IRS stated this new focus on ESOPs is part of the effort to ensure tax laws are applied fairly and that high-income filers pay the taxes they owe. As part of this initiative, the IRS Commissioner commented that the IRS is taking swift and aggressive action to alert individuals to compliance issues and aggressive schemes involving complex or questionable transactions, including those involving ESOPs.

ESOPs are a type of retirement plan that permits employees to own stock in their employer’s company. Any company that has stock can sponsor an ESOP for its employees as long as the ESOP invests primarily in the securities of the employer. Establishing an ESOP can be complex as it typically involves loans to either the plan sponsor or the plan to purchase the shares. In addition, a valuation of the business must be completed to obtain an accurate price for the shares. The valuation, loan, and share purchase all are complex in their own right and when combined, there can be numerous opportunities for error or even fraud.

Current IRS compliance efforts include verification of stock valuations; prohibited allocation of shares to disqualified persons; and investigating the failure to follow tax law requirements for ESOP loans causing the loan to be a prohibited transaction. Additionally, the IRS announced it has seen vendors promoting ESOP arrangements that are potentially abusive.  The IRS cited schemes where a business creates a “management” S corporation whose stock is wholly owned by an ESOP for the sole purpose of diverting taxable business income to the ESOP. The S corporation purports to provide loans to the business owners in the amount of the business income to avoid taxation of that income. These types of arrangements, among others, could be a violation of current tax law and cause the loss of S corporation status.

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