The Costly Tax Consequences of ESOP Disqualification

by Davis Brown Law Firm
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Over the past several years, the IRS has renewed its focus on auditing Employee Stock Ownership Plans (ESOPs), in part because of allegedly abusive arrangements (for a quick overview, see Courtney’s ESOP post).  Unfortunately, ESOPs organized in Iowa have been targeted particularly heavily.  When organized and operated properly, ESOPs can provide a myriad of tax benefits.  If an ESOP becomes disqualified, meaning the IRS has determined it is not organized properly, the tax consequences can be devastating to the company and its individual employees.  Some of the consequences that can stem from disqualification are summarized below.

Tax Consequences to the Employee Participants

When the IRS determines that a plan is disqualified, the employee plan participants face heavy tax burdens. The IRS imposes taxes on any vested contributions their employer made to the ESOP during the time the trust is disqualified. This is true even if the employees do not have a right to receive any of the benefits of the trust.


Example:

At the end of year 1, Steve has a vested account balance of $10,000.  In year 2, Steve receives a vested allocation of an additional $5,000, bringing his total vested account balance to $15,000.  The ESOP is disqualified in year 2.  The $5,000 contribution must be included in Steve’s income in year 2.  The $10,000 account balance is not taxed, because it was in the account prior to the ESOP’s disqualification.

Harsher Consequences for Certain Violations

The Internal Revenue Code imposes a plethora of requirements on ESOPs to maintain their qualified status.  Two requirements focus on ensuring that a sufficient number of employees are allowed to participate in the ESOP: 410(b) (focusing on certain coverage requirements) and 401(a)(26) (imposing minimum participation standards).  If one of these requirements is violated and leads to a disqualification of the ESOP, special rules apply. 

  • If the sole reason an ESOP is disqualified is due to the violation of one or both of these sections, the law dictates different tax results for employees considered to be highly-compensated employees (“HCEs”), like a CEO or a president, and those who are not.  In the case of such a disqualification, HCEs are taxed on the entire prior vested benefit, while non-HCEs are not currently taxed on any portion of their benefits. 
  • If a violation of 410(b) or 401(a)(26) is only one of multiple reasons the ESOP is disqualified, HCEs are still required to include their entire vested benefit in income, but non-HCEs are also included.  Non-HCEs must include the vested contributions made on their behalf during the years of disqualification.

Example:

Company has two employees Steve and Sam.  Steve is considered an HCE, while Sam is considered a non-HCE.  At the end of year 1, both Steve and Sam have a vested account balance of $10,000. During year 2, each receives an additional vested allocation of $5,000.  The ESOP is disqualified in year 2 for violation of 410(b) and for failure to use an independent appraiser (a violation under 401(a)(28)).  Because Steve is an HCE, he must include in his income, his entire balance of $15,000 in year 2.  By contrast, Sam, a non-HCE, must include only the $5,000 allocated during the years for which the plan was disqualified. 

Tax Consequences to the Trust

A trust meeting the requirements of 401(a) is entitled to tax-exempt status under 501(a). When the ESOP is disqualified, the underlying trust loses its tax-exempt status and becomes taxable for any years it is disqualified. Thus, upon disqualification, the trust becomes taxable on its investment income. This can be quite costly, as the income tax rates on trusts reach a maximum rate of 39.6% once income exceeds $12,500.

Tax Consequences to the Employer

Generally, an employer receives a deduction for contributions to disqualified plans only in the year in which the contribution is included in the income of the employee.  This deduction is only allowed if separate accounts are maintained for each employee, as most plans do.  In the case of certain types of ESOPs that do not maintain separate accounts, the deduction will be lost entirely.

Distributions from Disqualified Plans

Normally, a distribution from a qualified ESOP can be rolled over into certain qualified accounts to avoid immediate taxation.  Upon disqualification, however, a participant loses this ability.  Under IRS regulations, a distribution must be from a qualified plan in order to qualify for rollover treatment.  While the Second Circuit found in Greenwald v. Cmm’r that distributions attributable to contributions made during a period during which the ESOP was qualified were entitled to rollover treatment, most courts have held that none of the distributions qualify for such treatment.

Bottom Line

The disqualification of ESOPs holding a significant amount of assets can be extremely costly proposition. It is important to consult with an ERISA attorney when setting up an ESOP and when any changes are made to the plan.

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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