A recent Tax Court case, Petersen v. Commissioner of Internal Revenue, confirmed that an S corporation owned by an employee stock ownership plan (ESOP) can not deduct accrued wages due to employees who were participants in the ESOP until the wages are paid. In general, businesses using the accrual method of accounting may not deduct an otherwise deductible accrued liability, including wages, to a related cash method taxpayer.
In Petersen, the court analyzed the applicability of the Section 267 related-party definitions to determine if the accrued wages owed to ESOP participants were deductible in the year in which they were accrued or in the subsequent year when the wages were paid. Under Section 267, an S corporation and any person who owns, directly or indirectly, any stock in the S corporation are considered related parties. The court’s analysis focused on whether the ownership of the S corporation by the ESOP constituted indirect ownership of the stock by the employees who were participants in the ESOP.
To make its determination, the court focused on whether the ESOP was a trust. Classification as a trust was central to the analysis, as beneficiaries of a trust are deemed to own their proportionate share of stock held by the trust. The court concluded the ESOP was a trust for purposes of Section 267, and, as a result, the ESOP participants were treated as indirect owners of the S-corporation stock. Once the ESOP participants were treated as indirect owners of the S-corp, the wages accrued to them were not deductible until paid in the subsequent year.