About 1700 business and retirement plan sponsors will be receiving something in the mail from IRS this season–and it won’t be a holiday greeting. The IRS announced yesterday that it has recently issued letters to certain businesses and retirement plan sponsors (1) alerting them of a change in the law effective January 1, 2005 applicable to S corporation ESOPs and (2) warning them of the consequences of participating in abusive schemes involving ESOPs and S corporations. The letters are being mailed to S corporation ESOPs reporting 10 or fewer participants. (You can read the letter here.)
The change in the law has to do with section 409(p) of the Internal Revenue Code, enacted by Congress in 2001, to address concerns about ownership structures involving S corporations and ESOPs that concentrate the benefits of the ESOP in a small number of persons. The section imposes income and excise taxes on prohibited allocations made by an S corporation ESOP in a “nonallocation year.” A “nonallocation year” is deemed to occur under the provision when the ownership of the S corporation is so concentrated that disqualified persons own or are deemed to own at least 50 percent of the S corporation shares. Disqualified persons are persons who own at least 10% of S corporation stock held by the ESOP (or 20% with family members). For S corporation ESOPs in existence on March 14, 2001, section 409(p) is effective for plan years beginning after December 31, 2004.
On December 16, 2004, the IRS announced the issuance of section 409(p) regulations, replacing proposed and temporary regulations that were issued in 2003 and addressing a wide variety of issues under section 409(p), including such issues as the definitions of a prohibited accrual or allocation, a disqualified person and a non-allocation year. The regulations generally go into effect for plan years beginning on or after January 1, 2005, subject to several special effective date rules. A public hearing on the regulations is scheduled for April 20, 2005.
The IRS also has a special website set up and dedicated to “S Corporation ESOP Guidance” which you can visit here and which includes a section entitled “What you should do if you are involved with an abusive ESOP.” What’s the advice* being given? The IRS says to consult your tax advisor immediately, and if you are unfortunate enough to have one of these arrangements that are deemed “abusive” under IRS rules, the IRS advises that you should immediately file an amended return for all open years affected by the arrangement.
And there’s more bad news for those who have entered into these types of arrangements–the IRS makes it clear in their “holiday” letter that EPCRS (the “Employee Plans Compliance Resolution System“) is not available for businesses and taxpayers wishing to unravel such arrangements.
Update: Roth CPA.com has more here.