Iowa gets all of the good bad ESOP cases. Thanks largely to the energetic work of a single ESOP evangelist in the 1980s and 1990s, Iowa has been treasure trove of cases involving faulty employee stock ownership plans. The pinnacle of these cases may have been the Martin v. Feilen case, finding violations sufficient for the Eighth Circuit to rule that a district court “abused its discretion” by not banning the Iowa ESOP evangelist from doing any further ERISA work.
Iowa’s bad ESOP history got another chapter yesterday in Tax Court. The ESOP involved a Rockwell, Iowa S corporation, which had an ESOP owner. The non-ESOP shares were owned by the corporation’s sole employee and his wife.
So many things can go wrong with this sort of arrangement, and they all did — starting with Sec. 409(p). Judge Kroupa explains (some citations omitted, emphasis added):
Responding to perceived abuses, Congress in 2001 enacted section 409(p), which generally limits the tax benefits available through an ESOP that owns stock of an S corporation unless the ESOP provides meaningful benefits to rank-and-file employees.
There are significant tax consequences when an ESOP violates the section 409(p) requirements. For one, an excise tax equal to 50% of the total prohibited allocation is imposed. Sec. 4979A. Furthermore, the ESOP will not satisfy the requirements of section 4975(e)(7) and will cease to qualify as an ESOP.
Those are pretty severe penalties. So how do you violate Sec. 409(p)? Roth and Company alum Nancy Dittmer explains:
Section 409(p) is satisfied if “disqualified persons” do not own 50% or more of the S corporation’s “stock.” This stock includes allocated and yet-to-be allocated ESOP shares, synthetic equity of the S corporation, and any shares held directly in the S corporation. The ESOP shares and any synthetic equity are considered to be “deemed-owned” shares for purposes of Section 409(p).
In general, a disqualified person is any ESOP participant who owns 10% or more of the ESOP’s stock.
As our Rockwell taxpayer was the only employee of the S corporation and, by attribution, the only owner of the ESOP, he owned 100% of the shares. Those of you who are good at math will realize that 100% exceeds 50%, and 409(p)’s excise tax and plan disqualification applies.
So things looked dark for the Rockwell ESOP. Yet there was a glimmer of hope — not only was the ESOP screwed up, so was the S corporation. The corporation had 2 classes of stock, which normally disqualifies an S corporation election. If the corporation isn’t an S corporation, it can’t violate 409(p)! Alas, Judge Kroupa decided here that two (OK, more than two) wrongs didn’t make a right:
Petitioner represented to respondent that it qualified as an S corporation for 2002 when it filed its election to be treated as such. Respondent relied on this representation for 2002 because petitioner reported on its 2002 Form 1120S that it owed no income tax because of its electing to be treated as a passthrough entity under subchapter S. The statute of limitations on assessment now bars respondent from adjusting petitioner’s income tax liability for 2002. See sec. 6501(a).
Petitioner was silent regarding its desire to be treated as something other than an S corporation for 2002. Petitioner cannot avoid the duty of consistency, however, by simply remaining silent. Allowing silence to trump the duty of consistency would only encourage gamesmanship and absurd results. Therefore, we will treat petitioner as an S corporation for 2002 under the duty of consistency.
This bundle of bad facts resulted in $161,200 in taxes and another $76,000 or so in penalties.
The moral? In spite of media reports, it can be dangerous to game the ESOP rules to avoid tax on S corporation income. There are many hazards and much legal complication. If you want to have an ESOP, be sure to bring in a specialist.
Paul Neiffer, Not Too Late to Make Portability Election! I have more here.
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Kyle Pomerleau, The U.S. Has the Highest Corporate Income Tax Rate in the OECD (Tax Policy Blog):
And as Iowa has the highest corporate rate in the U.S., at 12%, we’re number 1! In a bad way.
Robert D. Flach is right on time with your Tuesday Buzz!
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