Many routine transactions occur between related parties, including the payment or accrual of interest on indebtedness, license fees, salary or benefits to employees and/or shareholders, and trade invoices. The Tax Court recently found that accrued but unpaid payroll expenses owed to an employee stock ownership plan (ESOP) trust formed for the benefit of an S corp’s employees were not deductible by the S corp until the ESOP’s beneficiaries took the amounts into gross income.1
'Related Party' – Section 267
Section 267(a)(2) of the Internal Revenue Code provides that, with respect to accrued but unpaid expenses that would otherwise be deductible under the payer’s method of accounting, if the accrued expense is owed to a “related party” defined under section 267(b), then the payer cannot take the deduction into account until it is taken into income by the recipient of the payment. Section 267(b) lists 13 relationships that are treated as related parties under these rules.2 For parties in these relationships, amounts accrued by a purported payer cannot be deducted until the recipient of the payment includes the payment into its gross income.
Section 267(e)(1)(B)(ii) provides a special rule for determining the related-party status of an S corp and its shareholders with respect to payments of expenses between the parties under section 267(a)(2). It treats as related parties an S corp and “any person who owns (directly or indirectly) any of the stock of such corporation.” Thus, when determining the timing of a deduction with respect to accrued but unpaid amounts, S corps and their shareholders are treated as related parties under section 267 regardless of the amount of S corp stock owned by the shareholder. As a result, this rule defers a deduction until the recipient of the payment takes the amount into gross income.
Peterson – ESOP Shareholder Is Related to the S Corp Under Section 267(c)(1)
In Peterson, the S corp established an ESOP for the benefit of its employees and contributed S corp stock and cash to the ESOP. The S corp deducted amounts accrued for payroll expenses for employees who participated in the ESOP. Because the S corp deducted the full amounts of the accrued payroll expenses, the deductions passed through to the S corp shareholders (who also participated in the ESOP as beneficiaries), and the shareholders claimed these deductions on their tax returns.
However, some of the accrued amounts were not paid by the S corp by the close of the tax year. The IRS denied the deductions by the S corp shareholders because the accrued but unpaid expenses were with respect to a “related party” and, thus, could not be deducted by the S corp shareholders until the ESOP beneficiaries (the purported recipients of the payments) took the payments into gross income.
The S corp shareholders advanced three arguments for deductibility of the accrued payroll expenses. The first argument was that section 318, and not section 267, is the appropriate provision to determine related-party status between an S corp and its shareholders, and in particular with an ESOP shareholder and an S corp. Under section 318(a)(3)(B)(i), an exception is provided for an ESOP by stating that the stock held by the ESOP is not treated as owned by the trust. The Tax Court sympathized with the taxpayer’s view that the exception under section 318 might also be appropriate for related-party treatment under section 267 on policy grounds. However, the Tax Court did not believe that it could apply the apparent policy underlying the exception in section 318 to trusts subject to section 267 without a congressional change to section 267. As a result, the Tax Court found that section 318 only applies to Sub C provisions, and only where “expressly made applicable.”3
The second argument advanced by the taxpayers was that section 448 required the S corp to report its income and deductions on an accrual basis because its annual receipts exceed $5 million annually. The Tax Court noted that section 448(a) applies only to C corps, certain tax shelters and partnerships with a C corp as a partner. In the present case, the Tax Court concluded that section 267 allows accrual method reporting except with respect to related parties that are on the cash method. As a result, the accrued and unpaid payroll expenses owed to the ESOP must be taken into account only when the recipients take the amounts into gross income, but the S corp is free to use the accrual method for all other items subject to accrual.
The third argument was that the deduction deferral required by the IRS for accrued but unpaid payroll expenses to the ESOP is inconsistent with the taxpayer’s GAAP accounting treatment. The Tax Court, however, stated that “tax accounting differs in many respects from GAAP financial accounting,” and concluded that “Peterson has no greater claim than any other accrual basis taxpayer to exemption from the operation of Section 267.”
Because the Tax Court rejected all three of the taxpayer’s arguments, the ESOP trust was treated as related to the S corp for purposes of section 267(c)(1). Consequently, the taxpayer’s deduction was denied.
This recent Tax Court decision provides a reminder that related-party provisions must be reviewed in each case when there are payments or accruals of payments between parties that are not third-party unrelated persons or entities. In this type of fact pattern, a threshold determination must be made as to the status of the relevant taxpayers as “related” for tax purposes. As can be observed from the Tax Court’s discussion, several provisions of the Code address related-party rules, and each has its own applicability. For example, related-party rules are important to determinations and applications of sections 108, 263, 269, 351, 368, 382, 707, 1361 and 1563, just to name a few.
As a second level of inquiry, in each case, a taxpayer must determine if there are any exceptions to its particular related-party transaction or if there are events that can be treated as integrated to create a related-party transaction, even if there is time between the transaction and the related-party status, i.e., section 108(e)(4) (special rules for debt acquired by a related party). Taxpayers should carefully review these rules when addressing the tax consequences of transactions between parties that could be viewed as “related” by the IRS.
2 The relationships listed in section 267(b) include:
- Members of a family (brothers, sisters, spouse, ancestors and lineal descendants)
- An individual and a corporation when the individual owns (directly or indirectly) more than 50 percent value of the corporation’s stock
- Two corporations that are members of the same group (as defined in section 1563, replacing 50 percent with 80 percent)
- A grantor and a fiduciary of any trust
- Fiduciaries of multiple trusts if the grantor is the same for the trusts
- A fiduciary of a trust and the trust beneficiaries
- A fiduciary of a trust and the beneficiary of another trust if the same person is the grantor of both trusts
- A fiduciary of a trust and a corporation when more than 50 percent value of the corporation’s stock is owned (directly or indirectly) by the trust or the grantor of the trust
- A person and certain 501 corporations when the corporation is controlled (directly or indirectly) by the person or members of their family
- A corporation and a partnership if the same persons own more than 50 percent of the stock of the corporation and more than 50 percent of the capital interest or profits interest in the partnership
- An S corp and another S corp if the same persons own more than 50 percent of the value of the stock of each S corp
- An S corp and a C corp if the same persons own more than 50 percent of the value of the stock of each corporation
- Except for sale or exchange pursuant to a pecuniary bequest, an executor of an estate and the beneficiary of the estate.