IRS reinforces that ESOP plan document terms matter.

• Author: O'Malley, William P.
• Position: Employee stock ownership plan

Like any other retirement plan, an employee stock ownership plan (ESOP), in order to be and remain qualified, must meet the requirements of the Code in both form and operation (Regs. Sec. 1.401-1(b)). A form failure occurs when a plan document does not contain required language or terms, and an operational failure occurs when a plan, in operation, does not meet the Sec. 401(a) requirements or fails to follow the terms of the plan document. In a qualified plan situation, the statute of limitation may close a tax year for disallowed contribution deductions, employee income inclusion, etc. However, any form or operational failure that occurred in a closed year remains a continuing failure that can still adversely affect a plan's tax-qualified status. The passage of time does not cure those errors.

Sec. 4975(e)(7) defines an ESOP as a tax-qualified retirement plan designed to invest primarily in the stock of the company that employs the plan participants. An ESOP can provide significant tax, financial, and employee motivational advantages to an employer that adopts one. Chief among these advantages is the employer's ability to use an ESOP as a way to redeem departing shareholders' shares on a tax-deductible basis and, if necessary, have the ESOP borrow money to fund the redemption. What too many taxpayers seem to miss is that an ESOP, like any tax-qualified plan, will only receive these promised benefits if the employer follows all of the statutory and regulatory requirements related to establishing and maintaining a tax-qualified plan. In other words, the plan must follow the rules.

The Tax Court, in DNA Pro Ventures, Inc. Employee Stock Ownership Plan, T.C. Memo. 2015-195, and Fleming Cardiovascular, PA., T.C. Memo. 2015-224, reiterated that lesson in cases involving two Kansas corporations that used the same ESOP adviser.

DNA Pro Ventures

On Nov. 12,2008, DNA Pro Ventures Inc. (DNA), a Kansas corporation, was established with Dr. Daniel J. Prohaska and his wife, Amy Prohaska, serving as the initial directors and officers of the corporation. The Prohaskas were DNA's sole employees. On that same date, DNA established the DNA Pro Ventures, Inc. Employee Stock Ownership Plan (the DNA ESOP). On Dec. 31, 2008, DNA issued 1,150 shares of class B common stock with a par value of $10 per share to the ESOP trust. The trust then immediately allocated those 1,150 shares of DNA stock to the ESOP account of Dr. Prohaska. During 2008, DNA paid no...