Podcast: Discussing and Demystifying the IRS News Release on ESOPs

Renee Lewis: I'm Renee Lewis, co-chair of the Holland & Knight ESOP Group out of our Chicago office. I'm joined today by my co-chair, David Pardys, out of the Holland & Knight Philadelphia office. We are happy to have with us Josh Odintz from the Holland & Knight Public Policy & Regulation Group from our Washington, D.C., office. As a bit of background, Josh has held high-level government positions with both the U.S. Treasury Department and the Senate Finance Committee. He also served as the chief tax counsel to the president's National Commission on Fiscal Responsibility and Reform under President Obama. We asked Josh to join us to discuss the press release issued by the IRS on August 9, which cautions plan sponsors to be alerted to compliance issues associated with ESOPs. Josh, thank you for joining us today.

Joshua Odintz: Thank you for having me, Renee.

What Does the IRS Press Release Mean?

Renee Lewis: OK. Let's jump right to it. Josh, what does it mean when the IRS issues such a press release, and how often do you see these releases?

Joshua Odintz: Yes. So the IRS issues press releases when the exam function of the IRS observes transactions that they want to inspect or do not like. And so the IRS puts taxpayers on warning that if they enter into a certain transaction that's described in a press release, it may get reviewed and audited by the IRS exam team. These are fairly common types of press releases. They can take multiple forms, like adding a transaction or type of form to the dirty dozen list of transactions the taxpayer should be on the lookout for. But this is one way of notifying the tax community and taxpayers about transactions the IRS does not like. Generally, these types of alerts reflect the field, the exam teams working up the issue and can reflect the national office or commissioner and chief counsel review. But generally they reflect the exam function of the IRS' views of a transaction.

So the IRS issues press releases when the exam function of the IRS observes transactions that they want to inspect or do not like. And so the IRS puts taxpayers on warning that if they enter into a certain transaction that's described in a press release, it may get reviewed and audited by the IRS exam team. These are fairly common types of press releases.

The ESOP Example Listed by the IRS

David Pardys: Thanks, Josh. One thing that's caught the attention of the ESOP community is that the release begins with a broad statement that the IRS wants to ensure that high-income taxpayers pay what they owe. The IRS release then focuses on a particular arrangement involving a management S corporation where taxpayers purport to convert taxable compensation into nontaxable loan proceeds through the use of an ESOP-owned S corporation. What are your thoughts on the broad statement about tax compliance and then the specific ESOP example?

Joshua Odintz: It's not unusual for the IRS to issue a statement about tax compliance. If you look at the dirty dozen transactions list or dirty dozen issues that taxpayers should be aware of as they go into tax season, the IRS does remind taxpayers and their advisers to comply with the law. So this is, I think, a boilerplate statement. But the press release describes a specific transaction that is the, on a management company S corporation ESOP, and has placed it on the abuse of tax transaction list on the IRS website. And so, look, I believe the ESOP community is aware that the IRS has long expressed an interest in the use of S corporations for abuse of ESOPs since the commissioner's TEGE Fiscal Year 2020 program letter identified ESOPs as a priority item. But without any additional indication or announcement from the IRS, it really appears that this IRS press statement is nothing new. Again, without further information from the IRS, it would appear that unless Congress acts, the IRS will continue to go after these transactions it does not like such as the management company transaction described in the press release.

Again, without further information from the IRS, it would appear that unless Congress acts, the IRS will continue to go after these transactions it does not like such as the management company transaction described in the press release.

Listed Transactions vs. Abusive Transactions

David Pardys: Thanks for pointing out the additional information on the IRS website. In addition to the description of the management company S corp ESOP, this page mainly describes listed transactions. For those of us who are not tax administration experts, can you explain what it means to be a listed transaction? And is that the same thing as an abusive transaction?

Joshua Odintz: It is quite different than an abusive transaction. So if the IRS lists a transaction, it immediately places a series of burdens and potential penalties on the table. The burdens fall on both tax advisors and then also on those that enter into these transactions. If a transaction is listed, a material tax advisor must report, within a short time frame, the transaction to the IRS and describe it with sufficient particularity for the IRS to then be able to audit that transaction. It also requires the material advisor to maintain a list of all taxpayers that have entered into that, was to that transaction. Additionally, taxpayers are required to disclose those transactions on their returns and file a separate document with the Office of Tax Shelter Analysis, which OTSA uses to audit taxpayers. And if taxpayers fail to disclose, there are penalties, including a significant penalty for material advisors of up to $10,000 a day for failure to file the required forms. Second, on the taxpayer side, there can be a strict liability penalty of 30 percent of the understatement of taxation, as due. So, listing a transaction is a very significant action by the IRS. Recently, there's litigation in the Sixth Circuit and seen in other circuits where the IRS has taken the position that it does not need to follow a period of notice and comment under the Administrative Procedures Act for purposes of listing a transaction. The Sixth Circuit in Mann v. Construction held that in fact the IRS and Treasury must go through notice and comment to list a transaction and to, in a sense, turn on the reporting and penalty provisions in the code. So in the last two listed transactions, the IRS has in fact done that. It has gone through notice and comment. Whereas in an abusive transaction, it's a transaction where the IRS has taken a position that it believes the transaction is of concern, it will get audited, but there are no additional requirements to report that transaction for the taxpayer and for the material adviser. There's no obligation to disclose that transaction to the IRS or keep a list of those transactions.

So in the last two listed transactions, the IRS has in fact done that. It has gone through notice and comment. Whereas in an abusive transaction, it's a transaction where the IRS has taken a position that it believes the transaction is of concern, it will get audited, but there are no additional requirements to report that transaction for the taxpayer and for the material adviser.

What Does the Release Mean for ESOPs?

Renee Lewis: Josh, based upon your understanding of the IRS process, should the press release be viewed as a broad investigation of ESOPs? And in addition, should the companies considering an ESOP be concerned by this press release?

Joshua Odintz: So I think those taxpayers that are entering into the transaction that is described in the press release should be concerned that if they were to undertake that transaction, the IRS will audit that transaction. Once again, this is an IRS position. It does not necessarily mean the transaction does not work, but the taxpayer should be aware they are probably picking a fight with the IRS. But if your structure is different, then no, the IRS is not picking a fight broadly with the ESOP community. It has identified a specific flavor of the transaction that it doesn't like, but it is in no way picking a fight with all ESOPs. And if it wanted to do so, it could seek to have Congress change the law. But that's not what is occurring here.

If your structure is different, then no, the IRS is not picking a fight broadly with the ESOP community. It has identified a specific flavor of the transaction that it doesn't like, but it is in no way picking a fight with all ESOPs.

Renee Lewis: Great. David and I would like to thank you for taking the time to join us today and sharing your insights, Josh. We hope those of you in the community find this helpful. If you have any questions, please do not hesitate to reach out.