Taxing Lessons Case Summaries

Case — Income From an Employee Stock Ownership Plan

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TL Case Summ


How much of taxpayer’s vested accrued benefit in an Employee Stock Ownership Plan must be included in income when the plan is retroactively disqualified?


Taxpayer Says: Only the 2004 increase in the disqualified ESOP is taxable income.

Internal Revenue Service Says: The entire balance of the disqualified ESOP is taxable income.


From Internal Revenue Code Section 402(b)(4)(A): Provides in pertinent part: [A] highly compensated employee shall * * * include in gross income for the taxable year with or within which the taxable year of the trust ends an amount equal to the vested accrued benefit of such employee (other than the employee’s investment in the contract) as of the close of such taxable year of the trust.


An employee stock ownership plan, known as an ESOP, is a benefit plan that invests in the stock of the employer. A company (the employer) sets up a trust fund with shares of stock, or cash to buy shares of stock, and you, as an employee, benefit by having a portion of the shares allocated to you based on your income or years of service, or some combination of those. In order to receive your shares in an ESOP, you have to be “vested”, which means you have to meet certain requirements, such as five years of employment.

One of the tax benefits of an ESOP is that you, as an employee, pay no tax on the contributions to the ESOP. Instead, you’re taxed when your account is distributed. You can choose to pay income tax on the distribution, with the accumulated gain in your account taxed at capital gain rates, or you can roll over the distribution into an IRA to delay the tax.

In this case, the taxpayer, a plastic surgeon, established an ESOP in which he was the sole participant, and in which he was also fully vested. The IRS issued a determination letter accepting the ESOP as an exempt trust.

From 2000 (the year the ESOP was established) through 2004, the taxpayer made multiple contributions to the ESOP, and filed the required tax returns. At the end of 2004, when the balance in the account was $2.4 million, the taxpayer closed the ESOP and rolled the total amount into his individual retirement account.

After the ESOP was closed, the IRS audited it, determined it violated tax-exempt requirements, and revoked its status as a qualified plan retroactively to the initial year. (A prior tax court case found the IRS could retroactively revoke an already-closed plan; see Yarish Consulting, TC Memo. 2010-174.)

Because the ESOP was disqualified from inception, the IRS says the account balance was taxable income to the taxpayer in 2004, when distributed. Both parties agree the statute of limitations had run out for all years except 2004 (the year in question), and that section 402(b)(4)(A) applies (see above). The dispute arises over the meaning of the parenthetical phrase “(other than the employee’s investment in the contract)” in that section.

The taxpayer says he only needs to include part of the $2.4 million on his 2004 income tax return–specifically, the portion attributable to the increase in his account during 2004. He believes the fact that the ESOP was never a qualified plan means the rest of the account balance was includible in income as it vested in prior years (2000 to 2003), which are closed due to the statute of limitations. He says at the time of the distribution in 2004, the prior-year amount was therefore part of his “investment in the contract”, and was not taxable in 2004.

The IRS says an “employee’s investment in the contract” equals the portion of the benefit that has previously been taxed to the employee, and that no portion of the $2.4 million was previously taxed. Therefore, the entire amount must be included in income in 2004.


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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit and

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Sorry, wrong answer :(
Right answer!
For the IRS. We hold that section 402(b)(4)(A) is one of several exceptions to the principle that income is only includible in income for the year the “accession to wealth” occurs. The court understands congressional intent in using the disputed parenthetical phrase in that section was to exclude that portion of the vested accrued benefit from taxation that had previously been taxed to the employee so as to avoid double taxation of it. We therefore hold that under section 402(b)(4)(A) the vested accrued benefit of a highly compensated employee must be included in income to the extent it has not been previously taxed to the employee. The account balance has not been previously taxed. Thus, we agree with the IRS.