ESOP Disqualified – didn’t have to be

The US Tax Court has recently concluded that an employee stock ownership plan (“ESOP”) was not qualified for plan year 2010 and subsequent plan years, and that the related trust was not exempt from income tax. The court found that the ESOP was not qualified because it violated the terms of the plan and various provisions of the Internal Revenue Code (“Code”) by allowing the transfer of vested benefits.

An ESOP is a stock bonus plan or profit sharing plan designed to invest primarily in qualifying employer securities.  Code section 401(a) sets forth the requirements which must be met in order for a plan/trust to be considered qualified and entitled to preferential tax treatment.  If a plan meets all of these requirements, then the plan is exempt from income taxation under Code section 501(a).  Failure to mtaxes2eet any one of these requirements disqualifies the plan and leads to income taxation.

A qualified plan must meet the requirements in both form and operation. A form failure occurs when a plan document does not contain language or terms which the Code requires it to contain. An operational failure occurs when: (a) a plan is not operated in accordance with the Code section 401(a) requirements; or (b) a plan fails to follow the terms set forth in the plan document.

When the IRS disqualifies a plan, all of the contributions to the plan are treated as if they were paid directly to the plan participants.  This means each of the plan participants can be treated as taxable on the amount of contributions made to his or her account and the earnings thereon.

Generally the IRS is reluctant to disqualify a plan because of the catastrophic income tax consequences on the innocent, non-highly compensated employees.  Even where the IRS disqualifies a plan, the IRS will generally not subject the plan accounts of the non-highly compensated employees to current income taxation.  But the IRS shows no such compassion for the highly-compensated employees.

In the recent Court case, a chiropractor and his wife were full-time employees of the Company.  An ESOP was set up for the benefit of the Company’s employees.  The chiropractor and his wife were, however, the only eligible employees and the ESOP’s sole participants.  Under the terms of the plan, a terminated participant was entitled to all the vested benefits in his or her account, and the plan document specifically incorporated the Code section 401(A)(13) prohibition on alienation or assignment of benefits.

The chiropractor and his wife divorced. Pursuant to the final divorce decree, each was awarded 50% of the Company’s shares of stock, ownership, and management.  The decree was silent as to the ESOP.  As reflected in the corporate documents, the wife agreed to “relinquish her retirement value in the ESOP in accordance with the divorce decree.”  The ESOP shares in the wife’s account were then reallocated to the chiropractor’s account.

The IRS found and the US Tax Court agreed that the plan was disqualified as a result of such transfer of ESOP shares. Transferring the vested shares from the wife’s account to the chiropractor’s account was a violation of the plan and the provisions of Code section 401(a)(13).  As a result, the plan was disqualified in the year the shares were transferred to the chiropractor’s account and all subsequent years.

The IRS and the Court probably dealt more strictly and harshly with the plan in this case than it might have because the only participants were the highly-compensated chiropractor and his wife.  But the IRS and the courts do not look favorably on any situations where plans do not follow their express terms or do not follow the Code section 401(a) requirements.

Call or email Jeff Senney at 937-223-1130 or if you want to talk about this case or need assistance with a retirement plan qualification matter.

AND ONE MORE THING.  I have dealt successfully with the plan disqualification issue before.  I was able to get the IRS to agree that a profit-sharing plan was not disqualified where the plan document was amended, the definition of compensation in the plan document changed, but the plan continued to operate under the old definition of compensation for a period of close to 10 years.  I based my argument on the theory of “scrivener’s error” pursuant to which Court’s have permitted irrevocable trusts to be reformed where the language in the trust was likely a drafting error and caused an unintended windfall or loss.  The IRS told me they did not agree with my argument and would never again let a plan avoid disqualification based on scrivener’s error.  But they did it in my case, and I think they would do it again given the right circumstance.

AND ANOTHER THING.  There was a way to transfer the ESOP shares as the chiropractor and his wife wanted to do without disqualifying the plan.   The Code contains provisions whereby plan assets may be transferred between divorcing spouses in accordance with a Qualified Domestic Relations Order (“QDRO”).  A QDRO is a court order that allocates plan assets between divorcing spouses and contains certain information specified in the Code.   Not that difficult to do a QDRO.  Too bad he didn’t talk to his attorney.

Call or email Jeff Senney at 937-223-1130 or if you want to talk about ANY retirement plan qualification matter.


AUTHOR: Jeff Senney

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