The Tax Court recently issued an opinion on an issue of significance to companies that are S corporations for federal tax purposes, that use some form of accrual method of accounting, and that have, or are thinking of adopting, an Employee Stock Ownership Plan (ESOP). The case is Petersen v. Commissioner, Docket Nos. 15184-14, 15185-14, 148 T.C. No. 22 (June 13, 2017). It also affects any C corporations with an ESOP that may be considering an S election.
The key question in Petersen was whether Petersen, Inc., an S corporation which generally used an accrual method of accounting for tax purposes, would be barred from passing through to its shareholders deductions in one year for accrued wages and benefits outstanding at year end but not expected to be paid until the following year or later, to the extent the compensation or benefits belonged to employees who were ESOP participants? This issue has been awaiting resolution for a decade, since the IRS identified it as an audit priority in 2007, but this appears to be the first Tax Court ruling to address it.
The Tax Court had little trouble agreeing with the IRS that the question was simple under the language of the Code. Section 267(a)(2) delays deduction of expenses by an accrual basis corporation if paid to a cash-basis related party. Section 267(b) as modified by subsection (e) treats any shareholder of an S corporation as a related party. And Section 267(c) says that for purposes of determining who is a shareholder, shares owned by a trust are attributed proportionately to the trust’s beneficiaries. As with every ESOP, the Petersen, Inc. ESOP had a trust that held the ESOP’s shares for the benefit of its participants. Therefore, for Section 267 purposes, each individual ESOP participant would be considered a shareholder of the company, and therefore a related party. Any accrued compensation to an ESOP participant would not be deductible until actually paid and included in the recipient’s income.
A final decision has not yet been issued in the case, and it may well be appealed to the U.S. Court of Appeals for the 10th Circuit. However, the Tax Court’s opinion and rationale will not be easy to reverse.
The issue had a huge impact on the S corporation’s shareholders. At the end of the year at issue, the company had over $1 million of accrued but unpaid wages to be paid with the next paycheck, and another $500,000 of accrued vacation pay that would be used within the next year. The company appears not to have had deferred compensation or performance bonuses accrued, but those items would have been included as well. The IRS assessed nearly $500,000 in tax, plus penalties and interest.
Any S corporation that is accrual basis and has an ESOP needs to assess the impact this decision will have on its tax accounting and its shareholders’ tax liability. Furthermore, any accrual basis S corporation thinking of adopting an ESOP and any C corporation with an ESOP considering an S election should consider the potential for a significant adverse tax consequence from the action. (S Corporations that are 100% owned by an ESOP do not have adverse consequences from this ruling, although they may have to change their tax reporting.) However, if they are not already under audit for this issue, taxpayers can take advantage of Section 481 to spread the cost of compliance with the IRS position approved by the Tax Court over four years, rather than paying it all in the first year.