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The IRS this week warned businesses and tax professionals to be alert to a range of compliance issues associated with employee stock ownership plans (ESOPs) because the agency will be cracking down on taxpayers that use these plans to avoid paying taxes. 

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 if it invests mainly in the employer’s securities. ESOPs can be complex arrangements since the ESOP can borrow funds from the employer or a third party to purchase shares of the employer. 

“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,” Werfel said. “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.” 

The IRS said that because of the complexity of ESOPs it will pursue enforcement strategies to ensure tax law compliance by employers that sponsor an ESOP. The IRS has already identified numerous problems, 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. 

The IRS said it has seen “potentially abusive” ESOP arrangements, such as when a business creates a 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 then purports to provide loans to the business owners in the amount of the business income to avoid taxation of that income, the IRS said. 

“The IRS disagrees with how taxpayers interpret this transaction and emphasizes that these purported loans should be taxable income to the business owners,” the IRS said in a statement issued on Thursday. “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 said it will continue to use a range of tools, including education, outreach and additional tax examinations to address compliances issues associated with ESOPs.