Pension & Benefits News ESOP maintained for sole benefit of owner violated minimum coverage rules
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Thursday, March 14, 2019

ESOP maintained for sole benefit of owner violated minimum coverage rules

By Pension and Benefits Editorial Staff

An employee stock ownership plan (ESOP) that was maintained for the sole beneficiary of an owner violated the minimum coverage rules, according to the U.S. Court of Appeals in Philadelphia (CA-3), because the plan did not cover employees of the owner’s controlled group.

ESOP created for sole owner of controlled group. A physician was the president and sole owner of Golden Gate Cardiothoracic Surgery Medical Group. Golden Gate employed five people, in addition to the physician.

In 1998, the physician acquired 100 percent of the stock of Paza Staffing Services, Inc., a newly created S Corporation. The physician subsequently created an ESOP for Paza, appointed himself trustee, and sold all of his Paza stock to the ESOP.

Following the creation of the ESOP, the physician negotiated an employment contract (with himself), pursuant to which he became Paza’s only employee and thus, the sole beneficiary of the ESOP. Paza further entered into a separate agreement (again negotiated by the physician) under which it would lease employees (including the physician) to Golden Gate. With the exception of the physician, however, employees of Golden Gate did not benefit under the ESOP.

The tax benefits of the complicated arrangement became apparent in the following year. In 1999, Golden Gate had total income of $1,292,884. However, because it had paid $835,786 for the physician’s services, Golden Gate reported negative taxable income. By contrast, Paza had income of $835,786, However, because Paza was a S Corporation, the income passed through to its only shareholder--the tax-exempt ESOP.

The IRS initially approved the arrangement, determining in May 1999 that the ESOP was tax-qualified. However, in December 2011, the IRS reversed course, concluding that because Paza and Golden Gate comprised a controlled group of corporations, the failure of the ESOP to cover Golden Gate employees was a violation of the minimum coverage requirements upon which the tax-exempt status of the ESOP was conditioned. The Tax Court affirmed the IRS non-qualification letter and the physician appealed.

Application of minimum coverage requirements to employees of controlled group. Initially, the Third Circuit explained that a tax-exempt ESOP must comply with the minimum coverage requirements of Code Sec. 410(b), which requires that a plan benefit: (1) at least 70 percent of employees who are not highly compensated, or (2) a percentage of non-highly compensated employees that is at least 70 percent of the percentage of highly compensated employees benefitting under the plan. For purposes of the minimum coverage requirements, the court further advised, all employees of all corporations that are members of a controlled group are treated as a single employer.

Applying the controlled group rules, the court next noted that the physician owned all of Golden Gate, constructively owned 100 percent of Paza, and was the sole beneficiary of the ESOP, which owned all of Paza’s stock. Accordingly, Paza and Golden Gate constituted a controlled group of corporations.

As Golden Gate and Paza were a controlled group, the ESOP needed to benefit at least 70 percent of the non-highly compensated employees of Golden Gate and Paza in order to qualify for tax-exempt status. However, because the ESOP benefitted only the physician (clearly a highly compensated employee), it violated the minimum coverage requirements.

SOURCE: Paza Staffing Services, Inc. v. Commissioner of Internal Revenue (CA-3).

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