S Corp Owner Liable for Tax on Entire Vested Accrued Benefit in ESOP
(Parker's Federal Tax Bulletin: October 23 2012)

A special rule applies when an employees' trust, such as an S corporation employee stock ownership plan (ESOP) trust, does not qualify for exemption from tax due to the plan's failure to meet certain coverage or participation requirements. Under Code Sec. 402(b)(4)(A), a highly compensated employee that benefits from such a plan must include in income an amount equal to the employee's vested accrued benefit (other than the employee's investment in the contract). In Yarish v. Comm'r, 139 T.C. No. 11 (2012), the Tax Court was called upon to decide for the first time the meaning of that rule and whether it requires the employee to include in income only the annual increase in the vested benefit or the entire amount of the vested accrued benefit. Unfortunately for the taxpayer, the Tax Court sided with the IRS and held that the entire benefit was includible in the taxpayer's income.

Facts

Robert Yarish, a plastic surgeon, owned several medical practice entities. In 2000, he organized Yarish Consulting, Inc., an S corporation, to manage these entities. Yarish Consulting sponsored an ESOP, Yarish ESOP, and Robert participated in the ESOP. Robert was a highly compensated employee under Code Sec. 414(q) and was fully vested from the start of the Yarish ESOP until its termination. Multiple contributions were made to the Yarish ESOP during 2000 to 2004. Robert's account balance and vested accrued benefit was $2,440,000 at the end of 2004. None of that amount had been taxed to Robert and his wife before the 2004 plan year.

Robert terminated the Yarish ESOP on the last day of 2004. His entire account balance in the ESOP was transferred to an individual retirement account that same day. The IRS retroactively disqualified the Yarish ESOP through a revocation letter for the 2000 through 2004 period. The IRS determined in the revocation letter that the Yarish ESOP did not meet the requirements under Code Sec. 401(a) and was not exempt from tax under Code Sec. 501(a). In Yarish Consulting Inc. v. Comm'r, T.C. Memo. 2010-174, the Tax Court sustained that determination. With the exception of 2004, the statute of limitations period expired for all years for which the Yarish ESOP was disqualified.

Taxpayer and IRS Arguments

Robert argued that the phrase investment in the contract is defined in Code Sec. 72 and that the court should apply that meaning in interpreting Code Sec. 402(b)(4)(A). Under Code Sec. 72, employer contributions are treated as part of the investment in the contract to the extent they were previously includible in income (i.e., could have been taxed). According to Robert, all of his vested benefit from 2000 to 2003 was previously includible in income due to the disqualification of the Yarish ESOP and therefore constituted his investment in the contract for 2004. Thus, Robert contended, he was required by Code Sec. 402(b)(4)(A) to include in income for 2004 only the annual increase in his vested accrued benefit for that same year.

The IRS argued that under Code Sec. 402(b)(4)(A) an employee's investment in the contract equals the portion of the employee's vested accrued benefit that has previously been taxed to the employee. Thus, the IRS maintained that Robert had to include in income for 2004 the entire amount of his vested accrued benefit in the Yarish ESOP, given that no portion of it was previously taxed.

Tax Court Analyzes Statutory Interpretation

The Tax Court began by reviewing the plain language of Code Sec. 402(b)(4)(A) which provides, in part, that [A] highly compensated employee shall * * * include in gross income for the taxable year with or within which the taxable year of the trust ends an amount equal to the vested accrued benefit of such employee (other than the employee's investment in the contract) as of the close of such taxable year of the trust.

The center of the dispute, the court observed, was the meaning of the parenthetical (other than the employee's investment in the contract) used to modify the phrase an amount equal to the vested accrued benefit of such employee. The court noted that the disputed parenthetical was not defined in whole or part in Code Sec. 402 or in the corresponding regulations, nor was any definition supplied by a cross reference to another section in the Code. Additionally, neither the disputed parenthetical nor any of its words or phrases are terms of art, the court stated. The Tax Court found the disputed parenthetical ambiguous in that it was susceptible of at least two different meanings. It could mean that only direct contributions by the employee constitute the employee's investment in the contract. Or it could also mean that the employee's investment in the contract includes other contributions made on the employee's behalf, i.e., employer contributions.

Accordingly, the court looked to the legislative history of Code Sec. 402(b)(4)(A) as an aid in discerning its meaning. The legislative history indicated that the general purpose of Code Sec. 402(b)(4)(A) was to penalize highly compensated individuals. The conference report also shed light on the portion of a highly compensated employee's vested accrued benefit that Congress intended to tax. According to the report, the law was designed to tax highly compensated employees on the value of their vested accrued benefit attributable to employer contributions and income on any contributions to the extent such amounts had not previously been taxed to the employee.

Based on the Tax Court's reading of Code Sec. 402(b)(4)(A) in the context of the statutory scheme as a whole, the court concluded that Congress' intent in using the disputed parenthetical was to exclude that portion of the vested accrued benefit from tax that had previously been taxed to the employee so as to avoid double taxation of it. Thus, the court held that, under Code Sec. 402(b)(4)(A), the vested accrued benefit of a highly compensated employee must be included in income to the extent it was not previously taxed to the employee

Staff Editor at Parker Tax Publishing

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.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com