The IRS, Section 267, and Deducting Accrued Expenses for Less Than 100% S Corporation ESOPs

ESOP Update: Deduction Disallowance Under Section 267 discusses how the Large & Mid-Size Business Division (LMSB) of the IRS, a division that "serves corporations, subchapter S corporations, and partnerships with assets greater than $10 million," issued a memorandum on September 28, 2007 (LMSB-04-0907-064) identifying an emerging issue that could affect some ESOP companies:

An "emerging issue" is defined as a tax issue that has been identified through pre-filing initiatives or surfaced in current examinations by an industry or specialty area that an LMSB Director believes that guidance to field examiners is needed. Once an emerging issue is identified, examiners are required to contact the Issue Owner or Coordinator if the issue is present in their tax case to gain insight on the issue and provide feedback on the issue to the Coordinator."

The memorandum discusses IRC Section 267 - Losses, expenses, and interest with respect to transactions between related taxpayers and advises IRS representatives to look for violations involving related persons:

"Section 267 of the Code generally disallows loss recognition on a sale or exchange of property between related persons. It also states that deductions for amounts paid to a related party can only be taken in the year in which the related party includes such amounts in its income."

The article notes that ESOP participants qualify as indirect shareholders of the S corporation and are considered related persons. This could create an issue for accrual basis companies that are less than 100% ESOP-owned:

"For companies that are accrual basis taxpayers, in order to avoid an inadvertent violation of Section 267 of the Code, it is recommended that accrued expenses be examined. Accrued expenses that are impacted could include, but are not limited to, accrued wages, accrued bonuses, and accrued vacation pay. Although the issue is equally applicable to a 100% S corporation ESOP, since the S corporation income is allocated to the ESOP that is exempt from tax, any audit adjustment required by Section 267 of the Code would have no current year impact, and therefore has the practical effect of only impacting partially owned S corporation ESOPs.