The Tenth Circuit Court of Appeals, sustaining a 2017 published Tax Court Decision[1], held that an ESOP plan is a trust for tax purposes, and thus the corporation was barred from accruing wages to be paid to participants in the ESOP under the provisions of IRC §267. In Petersen v. Commissioner, CA 10, Cases Nos. 17-9003 and 17-9004.

We had covered this case on this site when the Tax Court issued its opinion in 2017.[2]

IRC §267(a) contains a special rule meant to prevent taxpayers from obtaining a tax benefit for a related accrual basis taxpayer for an item that won’t be treated as income for the related party until a later year. The law states at §267(a)(2):

(2) Matching of deduction and payee income item in the case of expenses and interest

If—

(A) by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not (unless paid) includible in the gross income of such person, and

(B) at the close of the taxable year of the taxpayer for which (but for this paragraph) the amount would be deductible under this chapter, both the taxpayer and the person to whom the payment is to be made are persons specified in any of the paragraphs of subsection (b),

then any deduction allowable under this chapter in respect of such amount shall be allowable as of the day as of which such amount is includible in the gross income of the person to whom the payment is made (or, if later, as of the day on which it would be so allowable but for this paragraph). For purposes of this paragraph, in the case of a personal service corporation (within the meaning of section 441(i)(2)), such corporation and any employee-owner (within the meaning of section 269A(b)(2), as modified by section 441(i)(2)) shall be treated as persons specified in subsection (b).

IRC §267(e) provides that, for an S corporation, the relationship denying the deduction exists between the S corporation and a holder of any interest in the corporation, whether it be a direct or indirect interest, no matter how small.

IRC §267(c) provides constructive ownership rules for stock. Under §267(c)(1), a beneficiary of a trust is deemed to constructively own his/her proportionate share of any stock held by a trust.

In the original case, the Tax Court held that an employee stock ownership plan (ESOP) was to be treated as a trust for these purposes. The Court noted that such entities were legally treated as a trust under state law, though ERISA does pre-empt state law for many purposes related to the trust. While the trust is treated differently from other trusts, the Court found nothing in §267 indicated that such differences were relevant in treating the shares as being constructively held by the beneficiaries.

In this case, the corporation was denied a current deduction for any accrued wages or bonus for amounts due to any beneficiary of the ESOP even if that beneficiary did not personally hold any shares of the corporation.

The taxpayer in this case appealed the decision to the Tenth Circuit. The Tenth Circuit panel’s opinion begins by noting that the Employee Retirement Income Security Act of 1974 (ERISA) requires that the assets of the ESOP be held in a trust to protect the employees’ interests.

The panel was not impressed with the taxpayers’ attempts to argue that the ESOP plan should not be treated as a trust for tax purposes, noting:

Taxpayers’ brief has a jumble of arguments that an ESOP trust is not a “trust” within the meaning of the term in IRC § 267. But to the extent that we can understand these arguments, they are unconvincing.

Fundamentally, the panel did not accept the argument that an ERISA trust should be treated as anything other than a trust for §267 purposes. The opinion states:

Taxpayers argue that an ERISA trust is distinguishable from a common-law trust (and thus is not covered by § 267) because it protects the interests of “participants,” who are distinguished from “beneficiaries” in ERISA. But this argument relies on semantics rather than substance. As previously noted, a beneficiary “is the person for whose benefit the trustee holds the trust property.” Bogert § 1. The property in an ERISA trust “shall be held for the exclusive purposes of providing benefits to participants in the plan and their beneficiaries and defraying reasonable expenses of administering the plan.” 29 U.S.C. § 1103(c)(1). Both participants in the plan and their beneficiaries satisfy the definition of beneficiary in trust law. All ERISA does is use different terminology to describe two distinct classes of beneficiaries — those employees or former employees who participate in the plan, and the beneficiaries whose interests derive from a participant. See 29 U.S.C. § 1002(7) (defining participant), (8) (defining beneficiary as “a person designated by a participant, or by terms of an employee benefit plan, who is or may become entitled to a benefit thereunder.”). The common law of trusts allows for different beneficiaries “whose interests may be enjoyable concurrently or successively.” Restatement Third § 44 cmt. a. ERISA's use of the term participant to describe certain beneficiaries does not remove ERISA trusts from the IRC definition of trusts. The term beneficiary in § 267 has been interpreted quite broadly, see Wyly v. United States, 662 F.2d 397, 402 (5th Cir. 1981) (taxpayers were beneficiaries of trust even though they would receive nothing unless their four children died without issue); and in any event, there is no need for such a broad construction here, since every participant easily satisfies the common-law definition of beneficiary.

The panel also did not accept the argument that they were different under the IRC because they are referred to as qualified trusts at points in the IRC. The opinion continues:

[1] Petersen v. Commissioner, 148 TC No. 22

[2] Ed Zollars, “ESOP Participants Accrued Compensation Found Not Deductible Until Paid,” Current Federal Tax Developments website, https://www.currentfederaltaxdevelopments.com/blog/2017/6/15/esop-participants-accrued-compensation-found-not-deductible-until-paid?rq=Petersen, June 15, 2017