The Tax Court found, in the case of Petersen v. Commissioner, 148 TC No. 22, found that participants in an ESOP that owned shares of an S corporation were related individuals for purposes of the deduction deferral rules of IRC §267(a)(2).
IRC §267 generally requires deferring a deduction by a taxpayer to a “related person” until such time as the income in includable in income of the related person. Thus, if a calendar year accrual basis taxpayer has accrued but unpaid compensation in existence at December 31 payable to a cash basis related person, no deduction will be allowed until the following year when the cash basis related person, having received payment, includes that amount in income.
For S corporations, every shareholder, no matter how small their interest in the corporation, is a related party. As the Tax Court notes:
I.R.C. sec. 267(e) provides that, for purposes of applying subsec. (a)(2), an S corporation and “any person who owns (directly or indirectly) any of the stock of such corporation” shall be “treated as persons specified in a paragraph of subsection (b).” I.R.C. sec. 267(e) thus deems S corporations and their shareholders to be “related persons” regardless of how much or how little stock each shareholder individually owns. I.R.C. sec. 267(c), which provides rules for constructive ownership of stock, provides that stock owned by a “trust” is deemed constructively owned by the beneficiaries of the trust.
In this case, some or all of the corporation’s stock for the years in question were owned by an employee stock ownership plan (ESOP) trust. The IRS contended that, for purposes of IRC §267, an ESOP trust should be treated as a trust, and the participants in the ESOP treated as beneficiaries of the trust. Since the corporation reported it income on the accrual basis, the IRS sought to disallow a deduction for any accrued compensation at year end payable to an employee who was a participant in the ESOP.
The amounts in question are described by the Court as follows:
Petersen generally paid its employees every second Friday. At year-end 2009 and 2010 Petersen had accrued but unpaid wage expenses of $1,059,767 and $825,185, respectively. These amounts were paid to its employees by January 31 of the following year. Approximately 89% of these amounts was attributable to employees who participated in the ESOP.
Petersen’s employees accrued vacation time as they worked. They were required to use this accrued vacation time during the year accrued or during the next calendar year. At year-end 2009 and 2010 Petersen had accrued but unpaid vacation pay expenses of $473,744 and $503,896, respectively. These amounts were paid to its employees by December 31 of the following year. Roughly 94.5% of these amounts was attributable to employees who participated in the ESOP.
The taxpayers first argued that IRC §318, which provides for the constructive ownership of stock, should apply in this case and, under IRC §318, participants in an ESOP are not deemed to constructively own stock held by the ESOP. But the Court found that IRC §318 did not apply.
The opinion notes:
Section 318 is one of several Code provisions that set forth rules for constructive ownership of stock. By its terms, however, it applies only “[f]or purposes of those provisions of this subchapter to which the rules contained in this section are expressly made applicable.” Sec. 318(a).
Section 318 does not apply here for two reasons. First, section 318 is in subchapter C, whereas section 267 is in subchapter B, of title 26, subtitle A, chapter 1. Thus, section 267 is not a “provision[ ] of this subchapter” within the meaning of section 318(a). Second, the rules of section 318 are not “expressly made applicable” by section 267. Quite the contrary: Section 267(c) provides its own rules for constructive ownership of stock, demonstrating Congress’ intent that these latter rules should apply. Cf. In re S. Beach Sec., Inc., 606 F.3d 366, 375 (7th Cir. 2010) (Posner, J.) (ruling that the attribution rules of section 318 “don’t apply to section 269; for section 318 applies only when expressly made applicable * * *, and it hasn’t been made expressly applicable to section 269, which anyway is not in subchapter C”).
Next, they advance a somewhat odd argument—that since they have over $5 million in revenue, IRC §448 requires the corporation to report on the accrual basis. Thus, they argue, §267 cannot required them to report on the cash basis. The Court (and likely many readers) found a number of flaws in the logic.
As the opinion continues:
Section 448 applies only to C corporations, tax shelters, and partnerships with a C corporation as a partner. See sec. 448(a). In any event, section 267(a) does not deny Petersen use of the accrual method generally; it simply defers deductions for a limited universe of expenses payable to related cash basis parties.
The taxpayers argue that the treatment the IRS seeks to impose is contrary to U.S. GAAP. But the Court points out that GAAP compliance isn’t relevant to tax matters. As the Court notes:
As has often been noted, however, tax accounting differs in many respects from GAAP financial accounting. See, e.g., United States v. Hughes Props., Inc., 476 U.S. 593, 603 (1986); Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979) (disallowing writedown of excess inventory for tax purposes even though it conformed to GAAP); Hamilton Indus., Inc. v. Commissioner, 97 T.C. 120, 128 (1991). Especially is that so where (as here) a Code provision explicitly requires a treatment that differs from GAAP. Petersen has no greater claim than any other accrual basis taxpayer to exemption from the operation of section 267.
Having dealt with those objections, the Court moves on to consider if the ESOP is a trust for purposes of IRC §267 and, if so, does that mean the participants will be treated as shareholders for purposes of disallowing the deduction.
The Court notes that under IRC §267 the reference is merely to a “trust” with no additional definition or restriction. The opinion notes that IRC §318, the section the Court has already ruled does not apply, also treats trust as “related” for purposes of attribution, but §318(a)(2)(B)(i) specifically excludes from attribution a “an employees’ trust described in Section 401(a) which is exempt from tax under IRC §501(a).” This, the Court holds, “shows that Congress knew how to limit the scope of the term “trust” when it intended to do so” and it notably did not do so with regard to IRC §267.
The Court then looks at the documents used to establish the ESOP, one of which is labeled a trust. The Court notes that the ESOP trust has language that is consistent with that expected to be found in a trust. As the Court finds:
These provisions show that the entity holding the Petersen stock for the benefit of the ESOP participants was a “trust” in the ordinary sense of that word. The regulations describe a trust as an arrangement “whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries.” Sec. 301.7701-4(a), Proced. & Admin. Regs. “Generally speaking, an arrangement will be treated as a trust * * * if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries.” Ibid.8
The arrangement involved here closely resembles an ordinary trust whereby a settlor (here, the company) establishes a trust for the benefit of specified beneficiaries (the ESOP participants), contributes property to the trust (Petersen stock and cash), and designates a trustee to hold the property for the beneficiaries and act in their best interest. The ESOP trust easily qualifies as a “trust” under the regulatory definition and the common law definitions appearing in the case law.
The Court goes on to note that if the assets are not held by a trust, the ESOP could not qualify under ERISA. The Court notes that there is a difference between the ESOP agreement (the plan) and the trust that holds the ESOP assets—while the former is not a trust, the latter is—and the latter holds the stock.
The Court notes that conceivably the failure to exclude employee benefit plan trusts from §267 might be an oversight by Congress, as ESOPs were not eligible shareholders when Congress revised §267. But, the Court states, it is bound by what Congress has written into the law. Presumably if Congress now finds it made an error, Congress will enact legislation to solve the problem.
Because of this the opinion concludes:
Section 267(c)(1) thus deems the Petersen stock held by the trust to be owned by the trust’s beneficiaries, viz., the Petersen employees who participated in the ESOP. As a result the ESOP participants and the company are deemed “related persons” for purposes of section 267(b). See sec. 267(e)(1)(B)(ii). Section 267(a) accordingly operates to defer Petersen’s deductions for the accrued but unpaid payroll expenses to the year in which such pay was received by the ESOP participants and includible in their gross income.