Tax Court addresses related party rules as applied for S corporation employees participating in an ESOP

In Petersen v. Commissioner, 148 T.C. No. 22 (June 13, 2017), the Tax Court addressed the application of Section 267(a)(2) to an S corporation that maintains an employee stock ownership plan (ESOP).

Section 267(a)(2) defers deductions for expenses paid by a taxpayer to a related person until the payments are includible in the related person’s gross income. The court held that employees who participate in an S corporation’s ESOP are related persons for this purpose. As a result, the S corporation cannot take a deduction for compensation items, such as bonus payments until the tax year in which the employee includes the compensation in income, even if the S corporation is on an accrual basis of accounting and could otherwise take the deduction in an earlier tax year, the court ruled.

It is important to note that for employees who do not participate in the ESOP, an S corporation should take deductions in accordance with its method of accounting without regard to Section 267(a)(2).   

Eddie Adkins
Partner, Washington National Tax Office
T +1 202 521 1565

Jeffrey Martin

Senior Manager, Washington National Tax Office
T +1 202 521 1526

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