10th Circuit: ESOP participants are related persons for deduction timing rules

Tax Hot Topics newsletterThe 10th Circuit Court of Appeals held in Petersen v. Commissioner (Nos. 17-9003 and 17-9004) that participants in an employee stock ownership plan (ESOP) were related parties for purposes of the deduction timing rules under Section 267, affirming an earlier 2017 decision by the U.S. Tax Court.

In Petersen v. Commissioner, 148 T.C. No. 22, the Tax Court addressed the application of Section 267(a)(2) to an S corporation that maintains an ESOP. The S corporation was an accrual-basis taxpayer and its ESOP participant employees were cash-basis taxpayers. Section 267(a)(2) restricts the timing of deductibility when an accrued expense is to be paid to a cash-basis taxpayer that is “related to” the taxpayer. Such expenses cannot be deducted until the amount is included in the related taxpayer’s gross income.

The Tax Court held that employees who participate in the S corporation’s ESOP and the S corporation are related persons for this purpose. Thus, the expenses paid by the S corporation to the participants that were accrued but unpaid as of the end of the taxable year (e.g., accrued but unpaid wages, and vacation carryovers) are not deductible until the tax year in which the participants include 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. Although not specifically addressed by the court, it would appear that any such expenses paid to employees of the S corporation who do not participate in the ESOP generally should be deductible in accordance with the S corporation’s method of accounting without regard to Section 267(a)(2).

On appeal, the 10th Circuit further examined whether an ESOP was considered a trust subject to the Section 267 rules. Under Section 267(e), related persons include S corporations and any persons who own any stock directly or indirectly in such entities. Further, Section 267(c)(1) provides that any stock owned directly or indirectly by a trust shall be considered owned proportionately by its beneficiaries. Although Section 267 does not define the term “trust”, the 10th Circuit relied on common trust law and legislative guidance under the Employee Retirement Income Security Act (ERISA) in reaching its decision that an ESOP is a trust within the meaning of Section 267.

Jeff Martin
Washington National Tax Office
T +1 202 521 1526

Keith Mong
Managing Director
Washington National Tax Office
T +1 202 521 1554

James Sanchez
Senior Associate
Washington National Tax Office
T +1 202 861 4107

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