Although the IRS has recently focused its cautionary statements on the employee retention tax credit, News Release IR-2023-144[1] saw the agency shift its focus to compliance concerns related to employee stock ownership plans (ESOPs).

Part of IRS Focus on High Income Taxpayers

The news release begins by explaining that this warning related to ESOPs is part of the IRS’s focus on compliance issues for high-income taxpayers.

As part of an expanded focus on ensuring high-income taxpayers pay what they owe, the Internal Revenue Service today warned businesses and tax professionals to be alert to a range of compliance issues that can be associated with Employee Stock Ownership Plans (ESOPs).

“The IRS is focusing on this transaction as part of the effort to ensure our tax laws are applied fairly and high-income filers pay the taxes they owe,” IRS Commissioner Danny Werfel said. “This means spotting aggressive tax claims as they emerge and warning taxpayers. Businesses and individual taxpayers should seek advice from an independent and trusted tax professional instead of promoters focused on marketing questionable transactions that could lead to bigger trouble.”

Werfel noted the IRS is working to ensure high-income filers pay the taxes they owe. Prior to the Inflation Reduction Act, more than a decade of budget cuts prevented IRS from keeping pace with the increasingly complicated set of tools that the wealthiest taxpayers may use to hide their income and evade paying their share.

“The IRS is now taking swift and aggressive action to close this gap,” Werfel said. “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.”[2]

The stress on these aspects suggests that the IRS expects advisers to high-income taxpayers, as well as the taxpayers themselves, to approach promotions related to such plans with professional caution. The agency is essentially alerting these entities that the IRS might scrutinize those initiating such programs and challenge any claimed tax benefits.

The news release further clarifies this warning, suggesting the agency has pinpointed multiple areas plagued by compliance concerns.

ESOPs are retirement plans that allow employees to own stock in their employer’s company. 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.

In light of the complexity of ESOPs, the IRS has and will continue to undertake enforcement strategies to ensure compliance with tax law requirements by employers sponsoring an ESOP. In its current compliance efforts, the IRS has identified numerous issues, such 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.[3]

IRS Specifically Identifies Management S Corporation Arrangements as Potentially Abusive

The news release continues, spotlighting a specific arrangement garnering the agency's attention. In this scheme, an S corporation is established to provide ambiguously outlined management services for a business. The IRS perceives this as a strategy to divert business profits, protecting them from taxation, while still channeling funds to the business owners in the form of loans.

…[T]he IRS has seen promoted arrangements using ESOPs that are potentially abusive. For instance, the IRS has seen schemes where 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.[4]

The release further states that the IRS intends to both enlighten taxpayers regarding the dangers of such tactics and to conduct investigations in this realm.

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.[5]

The agency also encourages people to report both the promoters of these schemes and preparer who prepare returns they know or should know are improper.

The IRS encourages people to report individuals who promote improper and abusive tax schemes as well as tax return preparers who deliberately prepare improper returns.

To report an abusive tax scheme or a tax return preparer, people should mail or fax a completed Form 14242, Report Suspected Abusive Tax Promotions or Preparers, and any supporting materials to the IRS Lead Development Center in the Office of Promoter Investigations.[6]

[1] “IRS cautions plan sponsors to be alert to compliance issues associated with ESOPs,” News Release IR-2023-144, August 9, 2023, https://www.irs.gov/newsroom/irs-cautions-plan-sponsors-to-be-alert-to-compliance-issues-associated-with-esops (retrieved August 11, 2023)

[2] “IRS cautions plan sponsors to be alert to compliance issues associated with ESOPs,” News Release IR-2023-144, August 9, 2023

[3] “IRS cautions plan sponsors to be alert to compliance issues associated with ESOPs,” News Release IR-2023-144, August 9, 2023

[4] “IRS cautions plan sponsors to be alert to compliance issues associated with ESOPs,” News Release IR-2023-144, August 9, 2023

[5] “IRS cautions plan sponsors to be alert to compliance issues associated with ESOPs,” News Release IR-2023-144, August 9, 2023

[6] “IRS cautions plan sponsors to be alert to compliance issues associated with ESOPs,” News Release IR-2023-144, August 9, 2023