The Treasury Department and the IRS have issued temporary and proposed regulations to shut down abusive arrangements involving certain employee stock ownership plans (ESOPs) holding stock in S corporations. The regulations, issued under section 409(p), will go into effect in 90 days for certain S corporation ESOPs.

Congress enacted section 409(p) as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 to prevent the owners of an S corporation from using an ESOP to shelter business income from tax. Stockholders in an S corporation normally pay tax currently on the S corporation's income, but an ESOP is exempt from tax. Section 409(p) requires that an ESOP owning stock in an S corporation must provide meaningful benefits to a broad group of rank-and-file employees of the S corporation.

Treasury and the IRS have become aware of arrangements marketed to avoid section 409(p). These arrangements include giving former owners of the S corporation deferred compensation from a management company related to the S corporation or special rights to acquire assets of the S corporation. The new regulations make clear that the deferred compensation and the special rights will be treated as “synthetic equity” - typically resulting in both income and excise taxes to the former owners of the S corporation.

Assistant Secretary for Tax Policy Pamela Olson said, “With section 409(p), Congress made clear that S corporation ESOPs should be used for rank-and-file employees to benefit from company ownership, and not as a tax shelter for a small group of former owners and executives. These regulations are a first step in targeting arrangements that abuse the S corporation ESOP rules. They are not the final step - we expect to continue to work with the ESOP community to develop guidance addressing other arrangements that attempt to skirt the rules.”

The temporary regulations are effective in 2005 for S corporation ESOPs that were in existence on March 14, 2001. For other S corporation ESOPs, these regulations are effective for taxable years ending after the date that is 90 days after publication of the regulations.