Beware of S Corporation ESOP Management Company Scams

Corey Rosen
Executive Director, NCEO

You've just come back from a really intriguing meeting. A seemingly knowledgeable tax advisor has told you that there is a way that a group of managers or other highly compensated employees can form a special kind of corporation called an S corporation ESOP. It sounds too good to be true, but it seems that a small group of you can set yourselves up as a separate company and avoid most or all taxes! True, it involves some complex corporate restructuring, but your advisor assures you that for the right fee it can all be done quite legally.

"Here's the deal," the advisor tells you. "Back in 1998, Congress made it possible for S corporations that were owned by an employee stock ownership plan (ESOP) to get a very special tax break. Specifically, the ESOP did not have to pay any tax on its share of the profits attributable to its ownership interest in an S corporation. As you know, in an S corporation, the corporation itself pays no tax. Instead, tax obligations are passed through to the owners pro rata to their ownership share. So if an ESOP owns 100% of the company, no federal income tax is due. In some, but not all, states, you still have to pay tax, but that's relatively small."

"But," you ask, "how does that help me and the other managers? I don't know a lot about ESOPs, but aren't they kind of like 401(k) plans and profit sharing plans in that they are supposed to be made available at least to most of your full-time employees? Frankly, I'm not that interested in sharing ownership with employees broadly—I just want to figure out a way to reduce taxes for myself and, if necessary other managers. Anyway, I can't believe Congress would pass a law that allows a group of managers or higher-income folks to avoid paying taxes. That's not the Congress I know."

You can see the twinkle in your tax advisor's eyes. It's the sparkling sign of dollars adding to his bank account, you suspect, but the potential tax break is too good not to consider. "Look," he says, "you're right about ESOPs technically. They are supposed to be made available on a nondiscriminatory basis at least to all full-time employees who have worked for 1,000 hours. There are some limited exceptions for employees covered by unions, there's a rule that lets you cover 70% of the eligible employees, and another rule if you have a separate line of business. But all those exceptions are still far too broad for what you need. But I have come up with a way to get around all that."

"But," you stammer, still skeptical, "surely Congress or the IRS is watching out for these kinds of deals. Wouldn't they do something to prevent this?"

"You're right," he added, "Congress has tried to limit this law so that it can't be used by a small group of employees to avoid paying taxes, even when they are excluding a larger group of employees from being in the ESOP. But Congress only went so far—and we know how to walk right up to that line. So I'm just engaging in that great American pastime—finding loopholes in the law. It's downright patriotic!"

You lean forward a bit in your seat. At least it will be interesting to see what the twist is. "The tax law is very complicated, you see. That's why you're paying me larger fees than you might with just an ordinary advisor." (Much larger, you suspect.) "But here's the basics. In 2001, Congress passed a law to prevent what it called ESOP S corporation abuses. Congress tried to make it impractical to use an ESOP in an S corporation just to benefit one or a few employees. The law is very complicated, but basically, what it does is prohibit S corporation ESOPs from allocating (making a contribution of) stock to what are called 'disqualified persons.' Here's how it works, step-by-step. I got this off the Web site of the National Center for Employee Ownership:"

First, you define "disqualified persons." Under the law, a "disqualified person" is an individual who owns 10% or more of the "deemed-owned" shares or who, together with family members (spouses or other family members, including lineal ancestors or descendants, siblings and their children, or the spouses of any of these other family members) owns 20% or more of the "deemed-owned" shares. The "deemed-owned" shares include (1) shares allocated in the ESOP, (2) each ESOP participant's pro-rata protion of the unallocated shares, and (3) synthetic equity, broadly defined to include stock options, stock appreciation rights, and other equity equivalents (such as certain deferred compensation arrangements).

Second, determine whether disqualified individuals own at least 50% of all shares in the company. In making this determination, ownership is defined to include (a) shares held directly, (b) shares owned through synthetic equity, and (c) allocated or unallocated shares owned through the ESOP. If disqualified individuals own at least 50% of the stock of the company, then these individuals may not receive an allocation from the ESOP during that year without a substantial tax penalty, nor can they accrue more than 10% of the plan assets or 20% as a family group. If such an allocation or accrual does occur, it is taxed as a distribution to the recipient, and a 50% corporate excise tax would apply to the fair market value of the stock allocated or accrued. If synthetic equity is owned, a 50% excise tax would also apply to its value as well. In the first year in which this rule applies, there is a 50% tax on the fair market value of shares allocated to or accrued by disqualified individuals even if no additional allocations are made to those individuals that year (in other words, the tax applies simply if disqualified individuals own more than 50% of the company in the first year).

For ESOPs in existence before March 14, 2001, the rules become effective for plan years beginning after December 31, 2004. For plans established after March 14, 2001, or for preexisting C corporation ESOPs that switched to S status after this date, the effective date is for plan years ending after March 14, 2001.

"Whew," you say. "That's all just too complicated. Let's just forget it."

"No, wait!" the advisor says, clutching his wallet fiercely. "We can get around this. Here's what we do:

"We spin off a separate management company. We'll call it AvoidTaxCorp (ATC) for now. It has 11 employees. You see, with 11, we can easily get around the math problem the new law creates because no one will own more than 10% of the allocations.
"ATC gets a contract to manage the operating company, now an independent corporation. Its fees are high enough to take most of the operating company's profit.
"We put shares in every ATC employee's account, making sure we stay within the rules for S corporation ESOPs. 100% of the company is owned by the ESOP.
"The profits are paid out to the employees' accounts every year, building bigger and bigger nest eggs. But because they stay in the ESOP, they are not taxable. Then, when someone leaves, the ESOP buys their shares and reallocates them to those who remain. You can take your distribution and put it into an IRA.

Another variation on this theme involves setting up an ESOP in which all the employees, including those of the operating company, participate in an ESOP in the management company. Typically, there is not much value on the operating company, so the employees never own much of anything. But the point of this particular scam is not to put value in the ESOP. Instead, it gives managers a large deferred compensation benefit, which is tax-sheltered because the S corporation, being 100% owned by the ESOP, is not taxable.

Yet another variation has the operating company setting up the ESOP. It will then set up a management corporation it will own. As a 100% ESOP company, it can still have the managers participate in a large deferred compensation plan. It won't be taxable because the company pays no federal income tax. The management company can then siphon off a large share of the profits by charging a high fee to the operating company.

At this point, you must admit, you're intrigued. It's a lot of money to save. So what should you do?

Our answer is simple:

DON'T DO IT!

The structure described here is one of the common scams being proposed. There are many variations on the theme. Most are much more complicated than what we presented here—and all of them, you will be assured by the "advisors" trying to sell them to you, are much more sophisticated and clever and won't raise the problems described above. After discussing these matters with leading attorneys in the ESOP field, we have sent copies of these proposed plans to the IRS compliance office and urged that the IRS consider disqualifying any plans with these characteristics. So just keep a few points in mind as you go through this:

Most importantly, the IRS has already specifically outlawed all of the scams described here, as well as others. It has also announced that it will be issuing more regulations to catch any plans that haven't been caught so far that are not intended to benefit employees broadly. For instance, the IRS has prohibited using "shell" ESOPs set up before the grandfathering date, has ruled that deferred compensation must be counted as equity (thus making the deferred compensation approach described above subject to over 100% taxation), and prohibited related entity ownership approaches, such as any kind of separate management company. So no matter how clever your adviser may seem to be, chances are the IRS has or soon will nail them and, more important, nail you. You'll pay more taxes than you ever thought possible, plus you'll pay your advisers (and maybe a lawyer to then sue them for malpractice).
Your advisor wouldn't be peddling these proposals if there were not very large fees involved. If up-front fees seem small, don't worry--down the road, they'll grow.
Even if it passes muster today, Congress and the entire ESOP professional community are determined to prevent these scams. So they'll be made illegal in the future.
The Administrative Committee of the ESOP Association of America has circulated a petition that has been signed by the leading ESOP practitioners saying that plans of this sort are improper, not in the spirit of the law, and unethical. They have pledged not to be a party to any of these transactions.
The board of the National Center for Employee Ownership has stated its strong disapproval of any plans intended to get around the intentions of the law.
If none of these provisions catch you, then the general rules of the Employee Retirement Income Security Act can. The law states the authority of the IRS quite clearly. "If the plan is so designed as to amount to a subterfuge for the distribution of profits to shareholders, it will not qualify as a plan for the exclusive benefit of employees even though other employees who are not shareholders are also included under the plan. The plan must benefit the employees in general, although it need not provide benefits for all of the employees. Among the employees to be benefited may be persons who are officers and shareholders. . . . All of the surrounding and attendant circumstances and the details of the plan will be indicative of whether it is a bona fide stock bonus, pension, or profit-sharing plan for the exclusive benefit of employees in general. The law is concerned not only with the form of a plan but also with its effects in operation."
As you will see, the language in the law is much broader than what you probably have been told—broad enough to give the IRS discretionary authority not just to disallow these plans, but to provide sever punitive taxes for them. Do you really want to fight the IRS on this—even if you win?

The Many Ways You Can Be Caught

Aside from falling under the specific rules described above, your plan can run into trouble for a number of other reasons. All of them are designed to make sure that ESOPs serve their original legislative purpose—to provide ownership broadly to employees. Chances are, if this is not really your intention, you're going to end up paying a ton of money to set up one of these plans and have a good chance of having the plan disqualified. If it is disqualified, you'll have to pay ordinary income taxes on all the income you took as a deduction, plus interest, penalties, and substantial legal fees. Both participants and the company will owe taxes. It's not pretty. Here's some of the ways you can end up having the plan disqualified:

In addition to the restrictive rules outlined in the legislation, the Congressional conference report that accompanied the law directed the IRS to develop regulations to define existing plans as subject to this legislation, regardless of when they were established, if their purpose is "in substance, an avoidance or evasion of the prohibited allocation rule." What that means is that you set up the plan as a way to allocate stock to people who, under the normal procedures for making allocations in ESOPs, should not have gotten it. If your goal is to get around the law, rather than comply with it, this language is meant to catch you.
If your management company manages an operating company, especially if it was part of the operating company before, it will fail the "affiliated group" test. The law and the IRS are not as dense as some advisors seem to think. Both recognize that companies might try to avoid the law by pretending that two companies are really different companies. One of them just happens to include mostly managers or highly paid people, of course. The law and the IRS say that when testing to see if an ESOP or other benefit plan covers enough people, you must assess the combined employment of all affiliated groups. That definition essentially means companies under a common legal structure that are not separate lines of business or that, form aside, in substance are such groups.
The ESOP must be primarily invested in company stock. In some of the proposed structures, after the ESOP is set up, and there is no more stock to buy, the company just flows profit into the ESOP. But that means the ESOP will end up mostly invested in cash, not stock, and will be disqualified.
Finally, broad IRS authority allows it to go after tax shelters that have no legitimate business purpose. Separating out a management company from an operating company for the purpose of saving taxes for the management company's employees is not a valid business purpose.

Is This Really Worth the Risk?

I'll be honest. There may be a chance that you'll get away with one of these schemes. But honesty compels me to tell you that there is a very good chance you won't, and the costs will be very high. Even if you slip by, will that be something you'll feel good about? Want to tell your grandchildren about? Want to brag to your employees about? Is it something you can honestly say you want to be remembered for? Would a eulogy saying "Bill was really clever—he found a way to use a tax law meant to share ownership broadly with employees just to save taxes for himself and a few of his cronies—and he helped out a needy tax scam professional in the process" be one you'd be glad to have read to grieving friends and family?

S corporation ESOPs can be a great deal when done legitimately. But when they're not, stay away. You'll sleep better at night.

What Makes a Legitimate S Corporation ESOP

After reading this article, some readers may think maybe it's best to stay away from this area altogether. Nothing could be farther from our intention. S corporation ESOPs are extraordinary opportunities. Congress explicitly wrote the law to encourage companies to set up and expand their ESOPs, even to the point that they become 100% owned by their ESOP and free from federal income tax. The provisions were not loopholes; they were the result of a deliberate and considered discussion. What Congress did want to encourage is the ESOP that covers at least most or all full-time people who have worked for the company for one year or more. That means the ESOP includes the receptionist and the CFO; the sales clerk and the vice-president for marketing; the machine operator and the COO. The plans are intended to own the operating assets of the company; management sees the plans as a way to provide meaningful benefits to everyone, not primarily a way to siphon them off to a few. Fortunately, the vast majority of S corporation ESOPs meet these criteria, and many go much further, creating a real culture of ownership as well. If that is the kind of company you plan with an S corporation ESOP, the law supports you all the way.

Recent Developments: IRS to Crack Down on S Abuses

In Revenue Ruling 2003-6, the IRS has struck decisively at companies that want to use S corporations ESOPs to benefit a small number of people while providing insubstantial benefits to employees. This ruling specifically addresses S ESOPs established before March 14, 2001, the "grandfathering" date provided by EGTRRA for the new rules to discourage abuses of the S corporation ESOP model. Some advisors set up what were in effect shell ESOP companies, companies with no or few assets. The advisors then set up ESOPs for these companies that provided nominal benefits to employees. The shell companies were then sold to one or more taxpayers who would restructure their own businesses so that the shell S ESOP now owned most or all of their companies. These individuals would be precluded from participating in an S ESOP because they do not meet the "disqualified person" test of EGTRRA -- except for the fact that ESOPs set up before March 14, 2001, were grandfathered under the old rules. These advisors believed that these structures would qualify as ESOPs for the March 14 test.

The IRS decisively disagreed, saying that an ESOP cannot be considered established if "the initial employees of the entity forming the ESOP do not receive more than insubstantial benefits or more than insubstantial ownership." So these pre-March 14 ESOPs do not qualify as ESOPs, meaning the individuals setting them up till now face extraordinarily punitive tax costs of EGTRRA. In addition, the IRS was very clear that transactions that are the same as, or substantially similar to, these transactions will have to register as tax shelters.

The ruling's language makes it clear that The IRS intends to follow the spirit and the letter of the law on this topic. In particular, its attack on ESOPs providing insubstantial benefits to employees should signal that other arrangements than the one described here, but with the same effect, will not work. The IRS has not yet ruled on the issue of S ESOP corporations in which the tax trick is to exclude management from the ESOP, but pay them large deferred (and, because the company pays no federal income tax if 100% ESOP owned, tax sheltered) benefits. But this ruling should provide cold comfort to promoters of these schemes as well.

ESOP experts expect further IRS rulings to knock down other S ESOP arrangements that are intended primarily to shelter income for a limited number of people. Individuals choosing to try to get around the provisions of EGTRRA could very likely end up in the same situation as the individuals covered by this ruling -- facing huge back taxes, the disqualification of their plans, and wasting the substantial sums they paid advisors to set up these doubtful transactions. Anyone now contemplating "risking it" should obviously think again.

A copy of the ruling in PDF format is available at the IRS Web site.

Corey Rosen is the NCEO's executive director. He can be reached at CRosen@nceo.org.

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