Like any other retirement plan, an employee stock ownership plan (ESOP), in order to be and remain qualified, must meet the requirements of the Code in both form and operation (Regs. Sec. 1.401-1(b)). A form failure occurs when a plan document does not contain required language or terms, and an operational failure occurs when a plan, in operation, does not meet the Sec. 401(a) requirements or fails to follow the terms of the plan document. In a qualified plan situation, the statute of limitation may close a tax year for disallowed contribution deductions, employee income inclusion, etc. However, any form or operational failure that occurred in a closed year remains a continuing failure that can still adversely affect a plan's tax-qualified status. The passage of time does not cure those errors.
Sec. 4975(e)(7) defines an ESOP as a tax-qualified retirement plan designed to invest primarily in the stock of the company that employs the plan participants. An ESOP can provide significant tax, financial, and employee motivational advantages to an employer that adopts one. Chief among these advantages is the employer's ability to use an ESOP as a way to redeem departing shareholders' shares on a tax-deductible basis and, if necessary, have the ESOP borrow money to fund the redemption. What too many taxpayers seem to miss is that an ESOP, like any tax-qualified plan, will only receive these promised benefits if the employer follows all of the statutory and regulatory requirements related to establishing and maintaining a tax-qualified plan. In other words, the plan must follow the rules.
The Tax Court, in DNA Pro Ventures, Inc. Employee Stock Ownership Plan, T.C. Memo. 2015-195, and Fleming Cardiovascular, P.A., T.C. Memo. 2015-224, reiterated that lesson in cases involving two Kansas corporations that used the same ESOP adviser.
DNA Pro Ventures
On Nov. 12, 2008, DNA Pro Ventures Inc. (DNA), a Kansas corporation, was established with a doctor and his wife serving as the initial directors and officers of the corporation. The couple were DNA's sole employees. On that same date, DNA established the DNA Pro Ventures, Inc. Employee Stock Ownership Plan (the DNA ESOP). On Dec. 31, 2008, DNA issued 1,150 shares of class B common stock with a par value of $10 per share to the ESOP trust. The trust then immediately allocated those 1,150 shares of DNA stock to the ESOP account of the doctor. During 2008, DNA paid no compensation to the couple. In 2009, DNA paid the couple nominal compensation and claimed a deduction for $1,350 for contributions to the ESOP.
The IRS selected the DNA ESOP for examination. On June 6, 2014, the IRS issued a final nonqualification letter to DNA explaining that (1) the ESOP had failed to follow the terms set forth in the plan documents and therefore was not qualified under Sec. 401(a); and (2) the ESOP trust was not exempt from tax under Sec. 501(a) for its 2008, 2009, and 2010 plan years.
The IRS asserted that DNA in 2008 failed to follow the terms of the DNA ESOP plan document in two different respects. First, the plan allocated contributions to the couple, although neither received compensation from DNA in 2008. This violated the Sec. 415 maximum contribution limit, which provides that the value of any contribution cannot exceed 100% of eligible compensation. Since the couple received no compensation, the value of the shares contributed exceeded the Sec. 415 limit as incorporated into the document. Further, the plan document required, consistent with Sec. 401(a)(28)(C), that an independent appraisal of the shares be obtained for the shares contributed to and held by the DNA ESOP. The taxpayer, however, failed to obtain an appraisal of the shares for 2008 or any subsequent plan year.
Because of the taxpayer's failure to follow any of the basic rules associated with maintaining an ESOP, the Tax Court agreed with and upheld the IRS's determination that the DNA ESOP was not a qualified plan.
In Fleming Cardiovascular, the Tax Court ruled on facts remarkably similar to those in DNA Pro Ventures. In this case, Dr. Robert Fleming formed Fleming Cardiovascular P.A. (Fleming Cardiovascular) in Wichita, Kan., on May 14, 2004. Fleming Cardiovascular then adopted the Fleming Cardiovascular, P.A. Employee Stock Ownership Plan (the Fleming ESOP) on May 28, 2004. On June 1, 2005, the IRS issued a favorable determination letter stating that the Fleming ESOP was qualified under Sec. 401(a), and as a result, the related trust was exempt from income tax under Sec. 501(a). (It should be noted that the determination letter process focuses on the form of the plan document and not on the actual plan operations.)
Fleming Cardiovascular did not have any employees from 2004 through 2009. Nonetheless, Fleming Cardiovascular issued shares of its class B common stock to the ESOP trust on two occasions—five shares on Dec. 30, 2004, and 48.06 shares on Dec. 15, 2005. The ESOP trustee allocated these shares to the participant rollover portion of Dr. Fleming's account. In this regard, Dr. Fleming had received a distribution in the amount of $408,543 from his individual retirement account in 2004. He purportedly rolled that distribution over to his ESOP participant's account, and the ESOP trust allegedly paid Fleming Cardiovascular $50 for the five shares and $409,253 for the 48.06 shares. However, the ESOP trust did not have a bank or brokerage account, and neither Dr. Fleming nor the Fleming ESOP was able to prove that $408,543 was timely rolled over to the ESOP.
The Fleming ESOP plan document required that the net worth of the ESOP trust's assets be determined as of Dec. 31 each year and that the value of employer securities held by the ESOP trust be determined by an independent appraiser. An accounting firm prepared a valuation report for the 2006 plan year, but it did not include the required certifications establishing the appraiser's independence. The same accounting firm also allegedly prepared a valuation report for the 2005 plan year, but a copy was not included in the record presented to the Tax Court. A valuation report that arguably met the independent appraiser requirements was prepared for the 2007 plan year, but valuation reports were not prepared for the 2004, 2008, 2009, or 2010 plan years.
The IRS determined that the Fleming ESOP and its related trust failed to qualify under Secs. 401(a) and 501(a), respectively, and it revoked the Fleming ESOP's qualification retroactively to its inception. The IRS based its decision on (1) its belief that the Fleming ESOP was not operated in accordance with the terms of the plan document; (2) the fact that Fleming Cardiovascular failed to make recurring and substantial employer contributions to the Fleming ESOP; and (3) the fact that because Dr. Fleming had no compensation in 2004 or 2005, the annual additions exceeded the Sec. 415 limits.
The Tax Court ruled in the IRS's favor and, in doing so, noted that any one of these violations was sufficient on its own to warrant a determination that the Fleming ESOP was not a qualified plan and that despite the taxpayer's allegations, the IRS's determination to revoke its initial qualification letter was not unreasonable, arbitrary, or capricious.
Qualified retirement plans are powerful, tax-favored wealth accumulation vehicles, and this can be particularly true for participants in a successful ESOP. However, these tax-favored benefits are granted with a clear expectation that plan sponsors will follow the tax and fiduciary rules that Congress, as well as the IRS and U.S. Department of Labor, have enacted and promulgated. Therefore, taxpayers that sponsor an ESOP or any qualified plan without a clear understanding of the rules risk having these plans fail the objective of creating tax-deferred wealth and instead result in retroactively asserted tax liabilities with all of the interest and penalties associated with those disallowed tax deductions.
Mindy Tyson Weber is a senior director, Washington National Tax, for RSM US LLP.
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