ESOP Failed to Cover Employees of Related Corporation, Plan Disqualified

Qualified retirement plan provision in the IRC generally give controlling owner-employees a trade-off—they can benefit under the plan, but only to the extent that an appropriate benefit is offered to the “rank and file.” Not surprisingly, some owners, attempting to maximize their benefit and avoid the cost of funding for other individuals, have attempted to establish structures to “isolate” the rank and file outside of the organization whose employees are covered by the program while still obtaining their services. And, similarly not surprisingly, the law has provisions meant to address such structures.

This type of arrangement was challenged by the IRS in the case of Paza Staffing Services v. Commissioner, Docket No. 6881-12R and is the subject of an unpublished order and decision published on August 17, 2017.   The plan in question was an employee stock ownership plan (ESOP) established by a corporation controlled by Dr. Zapolanski.

The structure the taxpayer used is described in the order as follows:

On November 18, 1998, Dr. Zapolanski acquired all 10,000 shares in Paza from its initial incorporator. A little over a week later, Zapolanski signed a resolution, as the sole director of Paza, establishing the ESOP and appointing himself trustee. Zapolanski then transferred the Paza stock to the ESOP in exchange for a $10,000 note (the stock itself being the collateral). This made the ESOP Paza's sole shareholder. Zapolanski was the ESOP's sole participant for the year at issue.

On December 1, 1998, Zapolanski, in his capacity as Paza's president, signed a contract with another company named Golden Gate to lease employees. Zapolanski is also the president, secretary, and sole owner of Golden Gate. He received a $83,000 salary from Paza during the 1999 tax and plan year.

So we have two entities, with only Paza having an ESOP plan in place. The order describes more details of Paza’s plan:

The ESOP’s plan documents stated that employees employed on December 31, 1998 were immediately eligible participants in the ESOP, but employees hired in 1999 and after had to log one year — a consecutive 12-month period where the employee accrued 1000 hours of service — before they would be eligible. For the plan year ending in December 1999, Paza made a $12,450 cash contribution to the ESOP and it accrued to the benefit of the plan’s sole shareholder — Zapolanski. This released the Paza stock from encumbrance — from there it was allocated to Zapolanski’s ESOP account. ESOPs are classified as tax-exempt entities under I.R.C. § 501(a) — meaning the stock released to Zapolanski’s account was tax exempt. By 1999, the Paza stock was valued at $333,000.

In 1999 five Golden Gate employees would meet the one-year requirement—if they were required to be included in the plan. Nevertheless, only Dr. Zapolanski was a participant in the plan.

The IRS argued that the plan failed to meet the coverage requirements found in IRC §§401(a)(3) and 410(b). Under those provisions, a plan will not qualify if it fails to cover at least 70 percent of the non-highly compensated employees of the employer since 100 percent of the highly compensated employees were covered.

Dr. Zapolanski is highly compensated based on the tests found at IRC §414(q). The salary limit for 1998 was $80,000 and, even if his salary had reduced below that level, Dr. Zapolanski indirect held more than 5 percent of the stock in Paza since he had assigned to his ESOP account 100 percent of the outstanding stock of Paza. But since Dr. Zapolanski was the only employee of Paza you might think there should be no issue.

That would be true except Congress has addressed structures that attempt to use related entities to isolate the favored employees (including owners) so that only the favored employees will be participating in the plan. IRC §414(b) provides that, in applying the coverage tests, that all employees of all corporations that are part of a controlled group must be treated as employees of a single entity. A controlled group is defined in §1563(a).

The order continues noting:

There are many types of controlled groups under I.R.C. § 1563, but only one matters here. Paza and Golden Gate are a controlled group if five or fewer individuals own:

“. . . at least 80 percent of the total value of shares of all classes of stock, of each corporation,”

and “more than 50 percent of the total combined voting power . . .”

I.R.C. §§ 1563(a)(2) and (f)(5).

As was noted early, Dr. Zapolanski effectively held 100 percent of the stock of Paza since all the stock is held by the ESOP, and all the stock in ESOP is assigned to Dr. Zapolanski. This causes him to run afoul of the constructive ownership rules for determining a controlled group found at IRC §1563(e)(3)(A). That provides that any stock held by a trust shall be deemed to be constructively owned by any beneficiary who has a 5 percent or greater actuarial interest in the stock, to the extent of that interest.

But the ESOP is a qualified plan filing a Form 5500 and not a trust filing a Form 1041, so why does this apply some might wonder?  It applies because a qualified plan is a trust—just a tax exempt one. But this rule isn’t limited to just taxable trusts that file a Form 1041.

Once that stock is treated as Dr. Zapolanski, he is treated as owning 100 percent of the total value of shares of stock of each corporation and 100 percent of the total combined voting power. This makes Paza and Golden Gate a controlled group, so the failure to cover at least 4 of the 5 Golden Gate employees under the plan is a violation of §401.

And what is the consequence of the violation?  In this case the IRS went for the plan “death penalty” and argued that the plan was disqualified for 1999 and all subsequent plan years.

The consequences of this disqualification are dire for Dr. Zapolanski. First, the value of Dr. Zapolanksi’s accrued account balance is treated as immediately taxable to Dr. Zapolanski. Similarly, the income of the trust for all future years is not shielded from tax either, so any future contributions to the program will no longer be plan contributions, but rather indirect distributions to Dr. Zapolanski.