ESOP ownership of S corporations: good use or bad abuse?

• Author: Lerman, Jerry L.

The IRS issued Rev. Rul. 2003-6 to counteract shelving of "inactive" employee stock ownership plans (ESOPs) that use S corporations without substantial assets or a business purpose, to take advantage of the delayed Sec. 409(p) effective date until plan years ending after 2004.

Background

In the late 1990s, Congress enacted law that permitted ESOP ownership of S corporations (SESOPs). Subsequent legislation added significant benefit--SESOPs could avoid unrelated business income tax on the S income. The opportunity to create tax-free business income encouraged some tax practitioners to create new planning techniques. They developed approaches allowing SESOPs to indirectly benefit business owners without providing significant benefits to a broad base of employees.

To offset this type of planning, Section 656(a) of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) amended Sec. 409(p). As amended, Sec. 409(p) provides that a SESOP that makes a "prohibited allocation" (as defined in Sec. 409(p)(1)) of employer stock to a "disqualified person" (as defined in Sec. 409(p)(4)) for a "nonallocation year" (as defined in Sec. 409(p)(3)) is subject to a 50% excise tax on such allocation.

According to the legislative history, the provision will limit the establishment of SESOPs to entities that provide broad-based employee coverage and that benefit rank-and-file employees, not just highly compensated employees and historical owners. In addition, Congress expressed its concern about techniques that corporations might use to avoid or evade the Sec. 409(p) requirements. Thus, Sec. 409(p)(7)(A) gave Treasury the power to establish regulations and other guidance to implement Sec. 409(p) to accomplish this purpose.

Effective Date

Sec. 409(p) is effective for plan years ending after March 14, 2001 for SESOPs established after that date, or, if employer securities held by a plan consisted of stock in an S corporation that did not have an S election in effect on that date. Notice 2002-2 provided that an S corporation would not have an election in effect on March 14, 2001, unless it had actually filed an election on or before that date that was also effective on or before that date. Plans with S elections effective before March 14, 2001 are not subject to the effective-date provisions until plan years beginning after 2004.

Facts

In anticipation of the EGTRRA tax law change, some advisers apparently created SESOPs, even though those corporations...