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Home > ESOPs > Articles Online > ESOP Forum >
Recent case law and private letter rulings have demonstrated that the Internal Revenue Service (IRS) has the capacity and wide discretion to recharacterize transactions in an unpredictable manner. Such recharacterizations can have extremely adverse effects on the taxpayer and on the participants of an employee stock ownership plan and trust (ESOP). This issue of the ESOP Forum describes two instances of such recharacterizations, one of which involved circumstances in which the Tax Court and the IRS probably reached the "right" result and a second in which the result does not make sense.
Tax Court Concludes That IRS Has Authority to Recharacterize Dividends as Employer Contributions So They Are Treated As "Annual Additions" Under Internal Revenue Code Section 415. In Steel Balls, Inc. v. Commissioner (dated June 15, 1995), the United States Tax Court upheld in a Memorandum decision the IRS' disqualification of an ESOP because after recharacterizing as employer contributions certain amounts that were reported on the ESOP's Form 5500s as dividends, "annual additions" to the sole ESOP participant's account exceeded the limits under section 415 of the Internal Revenue Code of 1986, as amended (Code).
An ESOP is not "qualified" for purposes of Code section 401(a) unless it meets the requirements of Code section 415. An employer's contributions to an ESOP must not exceed the limits set by Code section 415. Section 415(c)(1) of the Code limits total "annual additions" to each participant's account to the lesser of 25% of compensation or $30,000 (as adjusted by the IRS for cost of living increases). "Annual additions" include employer contributions, employee contributions (voluntary nondeductible, not pretax to a 401(k) plan) and forfeitures. Dividends on ESOP stock that are used to repay an ESOP loan, that are passed through to ESOP participants or that remain in the ESOP do not constitute "annual additions."
Steel Balls issued a substantial amount of dividends on ESOP stock that were used to repay an ESOP loan that was incurred to purchase Steel Balls' stock. Because of the egregious circumstances in the Steel Balls case, a discussion of which is beyond the scope of this article, the Tax Court apparently viewed the arrangement for paying dividends on ESOP stock as a device set up specifically to avoid the section 415 limits, and recharacterized the dividends as employer contributions that were subject to the section 415 limits. The Tax Court also found that the Steel Balls ESOP did not serve as a source for providing independent financing for Steel Balls or for effecting any transfer of ownership of Steel Balls' stock.
This opinion is still significant, however, because it establishes a precedent for the IRS' authority to recharacterize otherwise deductible dividends, which are not subject to the section 415 limits because they constitute earnings, as employer contributions that can be treated as annual additions.
The Tax Court's Opinion in the Steel Balls Case Is Disturbing Because the IRS Has Previously Characterized a Portion of the Proceeds from the Sale of ESOP Suspense Account Stock as Annual Additions Under Section 415. The IRS issued a number of private letter rulings (PLRs) during 1994 (9416043, 9417032, 9417033 and 9426048) concerning the use of proceeds from the sale of stock held in an ESOP suspense account to prepay the outstanding principal balance on the ESOP loan.
In the IRS' view, the portion of the sales proceeds that is allocated to the ESOP participants' accounts following the repayment of the ESOP loan is an "annual addition" for the purpose of calculating the Code section 415 limitations. Notably, however, as described above, under Code section 415(c)(2) the only amounts that are included in the "annual addition" are "employer contributions, the employee contributions, and forfeitures." The allocation of excess proceeds (the earnings) cannot be even remotely characterized as any of the three forms of allocation that constitute part of the "annual addition." The IRS offered no specific support for its conclusion in these PLRs.
According to recent reports, the PLRs have motivated certain taxpayers to use the excess of these "annual additions" (that cannot be allocated to ESOP participants within the limits established by Code section 415) for corporate purposes, even though this may arguably result in a reversion to the taxpayer that is subject not only to a 50% excise tax but to income taxes. In addition, in some situations taxpayers have allocated the "annual additions" created by the PLRs to the employees of the acquiring taxpayer. In such cases, the employee participants who earned the "annual additions" ironically do not receive them.
In closing, each of these instances of recharacterization emphasizes the often unpredictable nature in which the IRS can treat transactions and highlights some of the difficulties that a taxpayer can encounter.
Copyright © 2002 by The National Center for Employee Ownership (NCEO) (phone 510/208-1300; email nceo@nceo.org; WWW http://www.nceo.org/). All rights reserved.
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