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IRS to Target Employee Stock Option Plan Noncompliance

S.J. Steinhardt
Published Date:
Aug 10, 2023

The IRS is increasing its enforcement efforts to ensure that high-income filers pay the taxes they owe by complying with the tax law requirements of employer-sponsored Employee Stock Option Plans (ESOPs).

“ESOPs are retirement plans that allow employees to own stock in their employer's company,” the IRS explained. “Any company that has stock can sponsor an ESOP for its employees as long as the ESOP invests primarily in the securities of the employer. ESOPs can be complex arrangements since the ESOP can borrow funds from the employer or a third party to purchase shares of the employer.”

That complexity has caused the IRS to notice noncompliance with tax law requirements through such issues as valuation issues with employee stock, prohibited allocation of shares to disqualified persons, and failure to follow tax law requirements for ESOP loans causing the loan to be a prohibited transaction.

In one example of a promoted arrangement that the IRS suspects of being potentially abusive, a business creates a "management" S corporation whose stock is wholly owned by an ESOP for the sole purpose of diverting taxable business income to the ESOP. The S corporation purports to provide loans to the business owners in the amount of the business income to avoid taxation of that income. The IRS disagrees with how taxpayers interpret this transaction and emphasizes that these purported loans should be taxable income to the business owners. These transactions also impact whether the ESOP satisfies several tax law requirements which could result in the management company losing its S corporation status.

The IRS credited the Inflation Reduction Act with providing it with the necessary resources to ensure compliance with the tax laws regarding ESOPs.

"The IRS is now taking swift and aggressive action to close this gap," said IRS Commissioner Daniel Werfel. "Part of that includes alerting higher-income taxpayers and businesses to compliance issues and aggressive schemes involving complex or questionable transactions, including those involving ESOPs."

Over the next year, the IRS will continue to use a range of compliance tools, including education, outreach and additional examinations to address compliance issues associated with ESOPs, it stated.

To learn more about employee benefit plans, register to attend the Foundation for Accounting Education's Employee Benefit Plan Update & Hot Topics for Experienced Auditors Webinar on Dec. 14.

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