For the first time, the U.S. Tax Court has ruled that participants and beneficiaries of an employee stock ownership plan (ESOP) and its S corporation shareholders are related persons under Internal Revenue Code Section 267. As a result, the Tax Court has disallowed an S corporation's deduction of the unpaid portion of its payroll expenses for employees who participated in the S corporation's ESOP.
The petitioners were shareholders of Petersen, Inc., an S corporation. Petersen had established an ESOP in 2001 for the benefit of its employees, and by 2009 had transferred 20.4 percent of the S corporation stock to the related ESOP trust. The remaining stock was owned by the petitioners.
In 2009 and 2010, Petersen accrued payroll expenses for employees, but a portion of these expenses remained unpaid as of the end of each year. The majority of these accrued but unpaid expenses were attributable to employees who participated in the ESOP. Petersen used the accrual method of accounting. Generally, an accrual basis taxpayer may deduct ordinary and necessary business expenses in the year when all events have occurred that establish the fact of the liability, the amount of the liability is set, and economic performance has occurred with respect to the liability, even if such amounts have not actually been paid. Thus, on its 2009 and 2010 returns Petersen claimed deductions for the accrued but unpaid payroll expenses described above. Petitioners on their individual returns claimed flow-through deductions equal to their pro rata shares of these accrued but unpaid expenses.
However, under Section 267, if a taxpayer makes a deductible payment to a “related person,” that payment is not allowable as a deduction to the payor until it is includible in the gross income of the payee. Thus, if Petersen and its employees were “related persons,” Section 267 would require Petersen to defer the deduction for these accrued but unpaid expenses until the year the expenses were paid and the amounts were includible in the employees' income.
Ultimately, the Tax Court determined that Petersen and its employees were “related persons.” Under Section 267, an S corporation and “any person who owns (directly or indirectly) any of the stock of such corporation” are treated as “related persons.” Section 267 provides (in relevant part) that “[s]tock owned, directly or indirectly, by or for a … trust shall be considered as being owned proportionately by … its…beneficiaries.” The Tax Court determined that the entity holding S corporation stock for the benefit of the ESOP participants was a “trust” within the meaning of Section 267.
Accordingly, the stock held by the ESOP trust was deemed constructively owned by the beneficiaries of the trust, specifically, the Petersen employees who participated in the ESOP. As a result, the ESOP participants and S corporation were related persons for purposes of Section 267, and Petersen’s deductions for the accrued but unpaid payroll expenses should have been deferred until the year in which such pay was received by the ESOP employees and includible in their gross income.This decision makes it clear that sponsors of S corporation ESOPs using the accrual method need to be careful regarding the timing of their tax deductions for payroll.