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IRS SENDS SEASONS GREETINGS TO ESOP-OWNED S CORPORATIONS

December 23, 2004

Mixed in with their assortment of colorful holiday cards, about 1,700 S corporations with ESOPs are getting a thoughtful message from the IRS in their mail:

   As you are aware, ESOPS are subject to various 
   requirements under the Code which must be met in 
   order for the ESOP to be tax-exempt and to qualify for 
   other tax benefits. We have determined that many of 
   the existing arrangements designed to take advantage 
   of the S corporation ESOP rules would not only violate 
   section 409(p), but also violate other qualification 
   requirements of the Code.

The letter is being mailed to S corporations with ESOPs having 10 or fewer participants.

The letter reminds taxpayers that new rules imposing severe excise taxes on ESOP-S corporations with too few participants take effect January 1, 2005. The letter also warns taxpayers against a scheme that has been marketed to use S corporation ESOPs as a flaky tax shelter:

   In these arrangements, taxpayers attempt to exclude 
   the income of an operating business through the use 
   of a combination of an S corporation and ESOP. In a 
   typical case, the owner of an operating business 
   creates an S corporation and causes the two entities 
   to enter into an agreement under which the operating 
   business pays a fee to the S corporation in exchange 
   for management or other services. In addition, the S 
   management corporation adopts an ESOP that 
   becomes the sole shareholder of the S management 
   corporation and in which the owner is the sole 
   participant.

The IRS defeated a Des Moines-based prototype of this setup in Beals Bros. Management Corp. (TC Memo 2001-234)

TIME TO TERMINATE?

S corporations receiving these letters shouldn't panic, but they should do some thinking. If they use the Beals Bros. plan, they should probably do something else. If they are just small, they should make sure they comply with the Section 409(p) rules that take effect next month. If not, they may need to terminate their S elections; they can do so effective January 1, 2005 no later than next March 15.

UPDATE: BenefitsBlog has more.

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