An ESOP Too Far

Every now and then I read a tax case or summary that takes my breath away. I came across one recently. It has to do with an employee stock ownership plan (ESOP). ESOPs are specialized retirement plans. They are funded with company stock rather than with cash. As a participant in such a plan, your account would represent company shares. There is a way to turbocharge an ESOP by having the plan borrow money to buy the stock. The company sponsoring the plan then pays dividends, and the plan would use the dividends to repay the bank loan. I’ve seen a couple of ESOPs since I’ve been in Cincinnati. In my experience they have served primarily as a way to cash-out existing shareholders.

Back to our story. There is a dentist in Iowa. We’ll call him Michael C. Hollen. He incorporated his dental practice (Hollen PSC). The PSC began sponsoring an ESOP on 11/1/86. The plan chose a fiscal year-end of October, so its first and initial plan year was 10/31/87.

In 10/89, the plan borrowed approximately $415,000 and used those funds to purchase stock of Hollen PSC. Hollen PSC in turn contributed approximately $200,000 to the ESOP, which the plan put to good use by paying down its debt.

Problem One:

The plan allocated over $150,000 of the $200,000 to Dr. Hollen’s account. There are rules and regulations here. For this year, the “annual addition” limit was $30,000 or 25% of a participant’s compensation. Dr Hollen thought he got around this problem by calling the $200,000 a “dividend.” Generally, the annual addition would not include a dividend, but the IRS reserves the right to recharacterize a transaction if required to combat abuse. The court took pains to explain that it could not glance askance from a $200,000 “dividend,” especially where $150,000 went to Dr Hollen on a tax-deductible basis. This is a way of saying “abuse.”

The PSC hired Stephen Thielking, a CPA, as the plan’s accountant. Thielking appraised the stock held by the ESOP in 2001, 2002, and 2003. ESOPs have to appraise the stock.

Problem Two:

The IRS has procedures for one to be a “qualified” appraiser and eligible to do appraisals for an ESOP. Mr. Thielking could not be bothered with such trifling matters as following the procedures to be considered a qualified appraiser.

The Small Business Jobs Act of 1996 and the IRS Restructuring and Reform Act of 1998 amended any number of Code plan provisions. When this happens, plans are permitted a certain amount of time to review their documents and procedures and bring them into compliance.

Problem Three:

This was not done. More correctly, some of this was done but not all.

Qualified plans have to vest contributions in the participants. Vesting means that the employee has rights to an amount and can take it with him/her upon leaving the company.

Problem Four:

The plan did not keep its books on the same vesting schedule as its plan documents required. For reasons beyond my ken, the plan declined the IRS’ offer to participate in a closing agreement program (CAP), which would allow for retroactive compliance on this issue.

It appears clear to me that the court did not sympathize with Dr Hollen at all. The court twice disapprovingly mentioned Hollen’s failure to correct plan defects through the IRS-provided CAP program. In one footnote it sniffed that Dr Hollen had made assertions that “the record does not substantiate…” The court also swiped that Dr Hollen “offers no explanation why the vesting schedules … did not follow that schedule.”

So what happened? The Court disqualified the plan from inception – all the way back to 1987. The consequences are mind-boggling. The corporation took deductions to which it was not entitled. The plan contributions would represent taxable income to the participants, as there is no qualified plan to receive the contributions. A plan has to be qualified to defer tax recognition. Corporate returns have to be amended. Individual returns have to be amended. The penalties alone would be staggering.