FROM THE OFFICE OF PUBLIC AFFAIRS

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Today, the Treasury Department and the IRS issued temporary and proposed regulations to shut down abusive arrangements involving certain employee stock ownership plans (ESOPs) holding stock in S corporations.  The regulations, issued under section 409(p), will go into effect in 90 days for certain S corporation ESOPs.

Congress enacted section 409(p) as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 to prevent the owners of an S corporation from using an ESOP to shelter business income from tax.  Stockholders in an S corporation normally pay tax currently on the S corporation's income, but an ESOP is exempt from tax.  Section 409(p) requires that an ESOP owning stock in an S corporation must provide meaningful benefits to a broad group of rank-and-file employees of the S corporation.  

Treasury and the IRS have become aware of arrangements marketed to avoid section 409(p).  These arrangements include giving former owners of the S corporation deferred compensation from a management company related to the S corporation or special rights to acquire assets of the S corporation.  The new regulations make clear that the deferred compensation and the special rights will be treated as “synthetic equity” - typically resulting in both income and excise taxes to the former owners of the S corporation.

Assistant Secretary for Tax Policy Pamela Olson said, “With section 409(p), Congress made clear that S corporation ESOPs should be used for rank-and-file employees to benefit from company ownership, and not as a tax shelter for a small group of former owners and executives.  These regulations are a first step in targeting arrangements that abuse the S corporation ESOP rules.  They are not the final step - we expect to continue to work with the ESOP community to develop guidance addressing other arrangements that attempt to skirt the rules.”

The temporary regulations are effective in 2005 for S corporation ESOPs that were in existence on March 14, 2001.  For other S corporation ESOPs, these regulations are effective for taxable years ending after the date that is 90 days after publication of the regulations.

Related Documents:

• Temporary Regs
• Proposed Regs