S Corporation ESOP Did Not Qualify Due to Operational and Form Failures

(Parker Tax Publishing January 2020)

The Tax Court held that an S corporation's employee stock ownership plan was not a qualified retirement plan under Code Sec. 401(a) for the plan year at issue and for all subsequent plan years. The Tax Court sustained the IRS's determination of the plan's operational failures, which included (1) allowing ineligible individuals to participate in the plan, (2) accepting contributions in excess of the limitations imposed by Code Sec. 401(a)(16) and Code Sec. 415(c)(1), and (3) failing to have an independent appraiser value employer securities as required under Code Sec. 401(a)(28)(C). Ed Thielking, Inc. v. Comm'r, T.C. Memo. 2020-5.

Background

Ed Thielking, Inc. is an S corporation owned by Ed Thielking. Mr. Thielking's father, Stephen Thielking, is an accountant who formed Ed Thielking, Inc. (the S corporation) for his son as a holding company for Ed's electrical contracting business. Ed transferred his 50 percent partnership interest in Gray Thielking Electric (GTE) - his primary asset - to the S corporation. For 2007 and each subsequent year, GTE issued a Schedule K-1 to the S corporation in accordance with its 50 percent interest in GTE. Ed and his wife, Amy, were the S corporation's officers and directors.

In March of 2006, the S corporation established an employee stock ownership plan (ESOP) and an employee stock ownership trust (ESOT). The ESOP agreement stated that participation in the ESOP began immediately after one year of service. In addition, employer contributions to the plan required at least 1,000 hours of service during a plan year. The ESOP agreement defined an hour of service as an hour for which an employee is paid or entitled to payment by the employer.

The S corporation's primary source of income in 2007 was the income allocation from GTE. The S corporation did not report any compensation of officers or salaries and wages as deductible expenses. It did not file employment and unemployment tax returns, Forms W-2, or Forms 1099 for 2007. In 2007, the S corporation issued a stock dividend to the participants of the ESOP. Ed, the only plan participant, elected for the dividend to be contributed to his ESOT account. The S corporation claimed a deduction with respect to the ESOT contribution, which largely offset the income allocation to it from GTE. The S corporation followed this course of action for 2007 through 2011, the years at issue. It also issued stock dividends to Amy as trustee of the ESOT. The only other contribution to the ESOT occurred in November of 2007, when the ESOT received a purported rollover contribution from Amy's Code Sec. 401(k) account. The S corporation's ESOT purchased additional shares with the funds contributed in the rollover.

The S corporation reported on a Form 5500, Annual Return/Report of Employee Benefit Plan, for 2007, only one participant, Ed. Ed's account consisted of 23,000 shares of the S corporation's stock. Stephen prepared a written appraisal that valued each share of the S corporation's stock at $1, resulting in a valuation of $23,000 for Ed's ESOT account. The appraisal, however, did not include Stephen's signature or his qualifications as an appraiser. The S corporation also reported Ed as the only participant in the ESOP on Form 5500 for 2008.

The plan received a rollover contribution on behalf of Amy during 2008, even though she was not reported as a plan participant for that period. The plan reported total assets of 59,434 shares of the S corporation's stock. Again, Stephen valued each share at $1, resulting in a net plan asset value of $59,434, but he again failed to sign the appraisal or include his qualifications as an appraiser. The S corporation finally reported that Amy was a second participant for the first time on its Form 5500 for 2009. Once again the S corporation relied on an unsigned appraisal prepared by Stephen, valuing the 66,234 shares held by the ESOT at $1 each, or $66,234.

The IRS subsequently determined that the ESOP failed to qualify under Code Sec. 401(a) as a qualified retirement plan due to both operational and form failures. The IRS determined that the operational failures included: (1) allowing ineligible individuals to participate in the plan, (2) accepting contributions in excess of the limitations imposed by Code Sec. 401(a)(16) and Code Sec. 415(c)(1), and (3) failing to have an independent appraiser value employer securities as required by Code Sec. 401(a)(28)(C). The IRS determined that the plan failed to qualify in form because it did not conform to certain statutory and regulatory requirements, and because the S corporation did not adopt timely amendments. The S corporation sought a declaratory judgment from the Tax Court that the ESOP was a qualified retirement plan under Code Sec. 401(a).

Tax Court's Analysis

The Tax Court held that the IRS did not abuse its discretion in determining that the ESOP was not a qualified retirement plan under Code Sec. 401(a) for 2007 and all subsequent plan years.

The Tax Court found that it was impossible for Ed to have attained a year of service when he became a plan participant in February of 2007 because the S corporation was incorporated in March of 2006. The court further found that Ed did not perform services for the S corporation that met the 1,000 hours of service requirement. The court noted that while the ESOP agreement defined an hour of service as each hour for which an employee was paid for the performance of duties, the S corporation did not report as deductions either officer compensation or salaries and wages for 2007 and provided no evidence that it compensated Ed for any duties performed for the S corporation. Therefore, Ed failed both prongs of the test for eligibility, and his admission as a plan participant in 2007 created an operational failure. Additionally, the court found that the ESOT accepted a rollover contribution from Amy in 2008, but the S corporation did not report Amy as a participant until 2009, creating another operational failure.

The Tax Court further held that, because the S corporation contributed property with an alleged value of $23,000 to the ESOT, it exceeded the contribution limits under Code Sec. 401(a)(16) and Code Sec. 415(c), which limit ESOP contributions to the lesser of $40,000 or 100 percent of the participant's compensation. The court found that because Ed performed no duties for the S corporation, his contribution limit for 2007 was zero.

The Tax Court also held that Stephen was not an independent appraiser as required under Code Sec. 401(a)(28)(C). The court determined that, as Ed's father, Stephen constructively owned all of the S corporation's stock under Code Sec. 267(c)(1), and found that he was therefore a related person and not an independent appraiser. The court rejected the assertion that Stephen had been found an independent appraiser in a previous Tax Court case, Val Lanes Recreation Ctr. Corp. v. Comm'r, T.C. Memo. 2018-92. The court said that Stephen had no familial relationship with the primary beneficiary of the ESOP in that case and, in that case, the court found that signed appraisals were submitted.

Finally, the Tax Court found that the ESOP had form failures because it never amended the ESOP agreement to comport with subsequent changes to the requirements under Code Sec. 401(a). The court noted that the IRS requested the plan documents and all amendments on at least three occasions in 2010, 2011, and 2012, but never received them.

For a discussion of ESOPs and S corporations, see Parker Tax ¶33,560.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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