A successful Kansas orthopedic surgeon, a Dr. Prohaska, set up a new corporation, DNA Prof Ventures, with his wife. The surgeon and his wife were the only DNA employees. On the day it was incorporated, DNA created an employee stock ownership plan for its employees.
Problems arose. Tax Court Judge Dawson tells the story:
On December 31, 2008, DNA issued 1,150 shares of class B common stock to the trust with a par value of $10 per share. The trust then allocated the 1,150 shares of DNA stock to Dr. Prohaska’s ESOP account in 2008.
During 2008 DNA did not pay any salaries, wages, or other officer’s compensation. For 2009 DNA issued separate Forms W-2, Wage and Tax Statement, to Dr. and Mrs. Prohaska reporting the respective amounts of $4,500 (during its fourth quarter beginning October 1). DNA issued Forms W-2 for 2010 to Dr. and Mrs. Prohaska reporting the respective amounts of $3,000.
DNA deducted a $1,350 retirement plan contribution on its Form 1120, U.S. Corporation Income Tax Return, for 2009.
Although DNA was the sponsor of the ESOP, it did not file any Forms 5500, Annual Return/Report of Employee Benefit Plan, for plan years 2008, 2009, and 2010.
The IRS examiners found problems with this and other aspects of the way the ESOP was run (my emphasis):
In this case, the ESOP had two separate failures to follow its plan document during 2008. First, the ESOP sponsored by DNA Pro Ventures allowed Dr. Daniel J. Prohaska and Amy Prohaska to participate in the ESOP as of the plan year ending December 31, 2008, in violation of the terms of the ESOP plan document regarding eligibility and participation. Second, the ESOP plan document required the ESOP to use appraisal rules substantially similar to those issued under I.R.C. sec. 170(a)(1) when it obtained annual appraisals for the same plan year. The ESOP, however, failed to obtain any appraisal for the 2008 plan year or for any plan year.
That led to a bad result:
For the reason stated above, it is determined that the ESOP is not qualified under I.R.C. sec. 401(a) for the plan years ending December 31, 2008 and all subsequent plan years. As a result, the Plan is not exempt from taxation under I.R.C. sec. 501(a) for trust years ending December 31, 2008 and all subsequent plan years.
A Google search reveals that the ESOP reported net assets of nearly $400,000 at the end of 2012. That would mean that much additional income for the ESOP participants over the term of the ESOP. That’s an expensive sacrifice to the tax fairy. As the ESOP was set up the same day as the corporation, it appears likely that the purpose of the corporation was to feed the ESOP. Iowa has been a hotbed for bad ESOPs. While there is no evidence showing that this is linked to any other bad ESOPs, I note that the corporation had an Iowa mailing address.
The Moral: ESOPs aren’t easy. They can be useful under the right circumstances, but they require appraisals and careful compliance with the plan document an ESOP rules. They aren’t an easy tax shelter, and there is no ESOP Tax Fairy.
It’s Tuesday, so it’s Buzz-day for Robert D. Flach. He rounds up news ranging from the developments in the Section 105 $100-per-day penalty (Tax Update coverage here) to the ongoing problems in keeping EITC from squirting all over the place.
Kay Bell, IRS says ‘No’ to tax-exempt status for pet care group offering heated spa, massages and other animal amenities. My beagle would approve this exemption.
Jason Dinesen, Glossary: MACRS. “MACRS refers to “modified accelerated cost recovery system,” which is the default depreciation method used for tax purposes.”
Russ Fox, Well, That’s One Way to Avoid ClubFed. But fatal heart attacks have serious non-tax drawbacks.
Peter Reilly, Boston Bernie Backers Probably Not Bashing Bruins
Joseph Thorndike, The ‘Cadillac’ Tax Shows Why Obamacare Was Never Built to Last (Tax Analysts Blog). “All of which suggests that Obamacare will be in trouble for a long time.”
TaxProf, The IRS Scandal, Day 880
Joseph Henchman, California Supreme Court to Decide Fate of 48-Year-Old Multistate Tax Compact. (Tax Policy Blog). “Maybe it’s time we accept that the MTC isn’t working, and the Gillette case might be the first step of that realization.”
Renu Zaretsky, Evasion, Cuts, Hikes, and Drops. Today’s TaxVox headline roundup covers a planned “global crackdown” on tax evasion, business tax cuts in New Hampshire, and much more.
Leslie Book, District Court Hands IRS Loss in its Bid to Exclude Discretionary Treaty Benefits From Judicial Review (Procedurally Taxing).
Robert Wood, As IRS And DOJ Hunt Offshore Accounts, Banks Pony Up.
News from the Profession. Oh Great, Public Accounting Discovered the Selfie Stick (Caleb Newquist, Going Concern)