Employee Benefits/Tax-IRS Says That An S Corporation Cannot Deduct Accrued Expenses for ESOP Participants

In its most recent Employee Plans News, the IRS says that if an Employee Stock Ownership Plan (an “ESOP”) owns an S corporation’s stock, that S corporation may not deduct the accrued compensation of an ESOP participant, including retirement plan contributions based on accrued compensation.

The reasoning is as follows. Under section 267(a)(2) of the Internal Revenue Code (the “Code”), a taxpayer, including an S corporation, may only deduct an expense pertaining to a related pary in the same tax year that the payment is reported as income by that party. Under section 267(e)(1)(B)(ii) of the Code, a related party includes any person who directly or indirectly owns any of that S corporation’s stock. Therefore, if an ESOP holds an S corporation’s stock, that ESOP’s participants indirectly own stock in the S Corporation and are related parties. These participants do not include accrued compensation in their income until the year in which they receive it and, therefore, the S corporation cannot deduct any compensation (including any bonus or vacation pay) accrued to these participants. The S corporation also can’t deduct any plan contributions for these participants that are based on accrued compensation.