ESOP Participants Treated as Related Persons for Deduction Deferral Purposes Under Section 267(a)(2)

Section 267(a)(2) contains a matching rule which requires that deductions resulting from items of expense and interest may not be taken in an earlier taxable year from the one in which the payee includes such item is gross income if the payor and payee are “related persons” within the meaning of Section 267(b).  Accordingly, whether taxpayers constitute related persons is often of the utmost importance in timing deductions that are otherwise subject to the Section 267(a)(2) matching rule.  In Petersen[1], the Tax Court, in a case of first impression, held that an S corporation (the “Corporation”) and its employees who were participants in the Corporation’s employee stock ownership plan (“ESOP”) were related persons under Section 267(b), and as such, the Corporation could not deduct unpaid payroll expenses until they were received and includible in such employees’ gross income under the rules of Section 267(a)(2).


The Taxpayers were shareholders of the Corporation which elected S Corporation status in 1989 and used the accrual method of accounting. In August of 2001, the Corporation formed an ESOP for the benefit of its employees and transferred cash and stock of the Corporation to the ESOP Trust (the “Trust”). During 2009 and the first nine months of 2010, the Trust owned 20.4% of the Corporation and the Taxpayers owned the remaining outstanding shares of stock of the Corporation. On October 1, 2010, the Trust acquired all of the shares owned by the Taxpayers and became the Corporation’s sole shareholder.

At year-end 2009 and 2010, the years in issue, the Corporation had accrued but unpaid wage expenses of $1,059,776 and $825,185, respectively. These amounts were paid to its employees by January 31 of the following year. Approximately 89% of these amounts were attributable to employees who participated in the ESOP. The Corporation’s employees also accrued vacation time as they worked. The employees were required to use this accrued vacation time during the year accrued or during the next calendar year. At year-end 2009 and 2010, the Corporation had accrued but unpaid vacation pay expenses of $473,744 and $503,896, respectively. These amounts were paid to its employees by December 31 of the following year. Approximately 94.5% of these amounts were attributable to employees who participated in the ESOP. On its income tax returns for 2009 and 2010, the Corporation claimed deductions for, among other things, the accrued but unpaid payroll expenses discussed above. In turn, the Taxpayers, on their individual returns, claimed passthrough deductions equal to their prorata shares of the accrued but unpaid payroll expenses.

In its audit of the Corporation’s 2009 and 2010 Forms 1120S, the IRS disallowed deductions for the accrued but unpaid payroll expenses to the extent they were attributable to employees who participated in the ESOP pursuant to the provisions of Section 267(a)(2). The IRS found that because the ESOP participants were beneficiaries of the Trust, which owned stock of the Corporation, they constructively owned the stock of the Corporation held by the Trust under Section 267(c), resulting in the ESOP participants and the S Corporation being “related persons” for purposes of Sections 267(b) and 267(a)(2).

What are the Related Party Rules of Section 267(a)(2) for Tax Deductions?

Generally, an accrual basis taxpayer may deduct ordinary and necessary business expenses in the year when all events have occurred that establish the fact of the liability, the amount of the liability is set, and economic performance has occurred with respect to the liability.[2] However, Section 267(a)(2) provides that if a taxpayer makes a deductible payment to a “related person,” such payment is not allowable as a deduction to said taxpayer until it is includible in the gross income of the payee. The Corporation was an accrual basis taxpayer during 2009 and 2010, and the ESOP participants used the cash method of accounting during 2009 and 2010. The parties agreed that the accrued payroll expenses were ordinary and necessary to the Corporation’s business and that the requirements of Section 461 were met. Consequently, the sole issue for determination was whether the Corporation and the ESOP participants were related persons within the meaning of Section 267(b).

Section 267(e) provides that in the case of any amount paid or incurred by an S corporation, the corporation and “any person who owns (directly or indirectly) any of the stock of such corporation” are deemed to be “related persons” for purposes of Section 267(b). In turn, Section 267(c)(1), which sets forth the rules for constructive ownership of stock under Section 267, provides that “stock owned, directly or indirectly, by or for a…trust shall be considered as being owned proportionately by…its…beneficiaries.”

IRS’s Argument: Trust as defined within Section 267(e)

The IRS simply argued that the Trust constituted a “trust” within the meaning of Section 267(e) (1) with the result that the beneficiaries of the Trust, which included the Taxpayers, were deemed to have owned their proportionate shares of the Corporation’s stock held by the Trust. As such, the court found Section 267(a)(2) applicable so as to require the Corporation’s deductions for accrued but unpaid payroll expenses to be deferred until such amounts were received by the employees and includable in their gross income (pursuant to the cash method of accounting).

Taxpayers’ Arguments: Section 318 vs. Section 267

The Taxpayers first set forth three threshold arguments. First, the Taxpayers contended that Section 318, rather than Section 267, provides the applicable rules of constructive ownership of stock in their situation. The Tax Court found that Section 318 did not apply for two reasons. First, Section 318 is contained within subchapter C, and by its own terms applies only “for purposes of those provisions of this subchapter to which the rules contained in this section are expressly made applicable.” Section 267 is contained in subchapter B of the Code, and as such, Section 267 is not a provision of subchapter C within the meaning of Section 318(a). Second, the Court found that the rules of Section 318 are not “expressly made applicable,” by Section 267, and that to the contrary, Section 267(c) provides its own rules for constructive ownership of stock, demonstrating Congress’ intent that the rules of Section 267, rather than the rules of 318, should apply to the instant situation. The Taxpayers also cited Boise Cascade Corp.[3] to support the conclusion that the related party rules of Section 318 should apply rather than related party rules of Section 267. The Tax Court found that the Taxpayer’s reliance on Boise Cascade Corp. was misplaced, as the operative code provision in that case was Section 302, which is clearly part of subchapter C, to which the rules of Section 318 are expressly made applicable. In the instant case, the operative code provision is Section 267, and as pointed out by the court, Section 267 is not a part of subchapter C and the rules of Section 318 therefore are not (expressly or otherwise) applicable to it.

Next, the Taxpayers argued that because the Corporation’s gross receipts exceeded $5,000,000 annually, Section 448 required the Corporation to be on the accrual basis of accounting. As correctly pointed out by the Tax Court, the Taxpayer’s contention is incorrect as Section 448 applies only to C corporations, tax shelters and partnerships with a C corporation as a partner. Additionally, the Court found that in any event, Section 267(a) does not deny corporations use of the accrual method generally, it simply defers the deductions for a limited universe of expenses payable to related cash basis parties.

The Taxpayers also argued that the IRS’s position violated generally accepted accounting principles (“GAAP”) by denying a current deduction for properly accrued payroll costs. The Tax Court found this argument to have no weight as many cases have noted that tax accounting differs in many respects from GAAP financial accounting.[4]

What constitutes a “trust” for purposes of Section 267?

After dismissing the Taxpayer’s three “threshold” arguments, the Court focused on the primary issue of the case of whether the Trust should be considered a trust within the meaning of Section 267(c)(1) and whether the ESOP participants were beneficiaries of a trust within the meaning of Section 267(c)(1).

The court began by finding that the term “trust” is not defined in Section 267(c)(1) or elsewhere in Section 267. The Tax Court also pointed out that the legislative history is also silent concerning the universe of entities that Congress intended this term to encompass. The Court then went on to find that the word “trust” appears in Section 267(c)(1) as part of a series that also includes “corporation,” “partnership,” and “estate.” The Court found that each of these words appears to be used in a broad and generic sense without limitation or qualification. The court pointed out that in this respect, Section 267 differs in a significant way from Section 318, which prescribes constructive ownership rules for certain provision of subchapter C, as Section 318(a)(2)(B)(i) mandates attribution to beneficiaries of stock owned “by or for a trust (other than an employees’ trust described in Section 401(a) which is exempt from the tax under Section 501(a)).” The court found this critical as it showed that Congress knew how to limit the scope of the term “trust” when it intended to do so, and it expressed no such intent either in Section 267 itself or in the legislative history accompanying the enactment of Section 267 or any amendments thereto.

The court then examined the documents relating to the ESOP and pointed out the multiple times references were made to the amounts contributed to the ESOP being held by a “trustee” who acts in accordance with the terms of a “trust” instrument. The court found that these provisions demonstrated that the entity holding the Corporation’s stock for the benefit of ESOP participants was a “trust” in the ordinary sense of the word. The regulations describe a trust as an arrangement “whereby trustee’s take title to property for the purposes of protecting or conserving it for the beneficiaries.”[5] Further, the regulations provide that an arrangement will be treated as a trust if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries.[6] The court continued that the Trust easily qualified as a “trust” under the regulatory definition and the common law definitions appearing in the case law, and that the entire statutory scheme upon which the ESOP arrangement rests presumes that the stock held for the benefit of the ESOP participants will be owned by a “trust.” The Tax Court then went on to reject arguments made by the Taxpayers that the ESOP documents did not show that the Corporation intended to create a trust, and that an ESOP, as a matter of law, could not be a “trust” within the meaning of Section 267(c)(1).

Consequently, the Tax Court concluded that the Trust constituted a trust within the meaning of Section 267(c)(1), and that the ESOP participants were therefore “related persons” for purposes of Section 267(b). Accordingly, Section 267(a)(2) operated to defer the Corporation’s deductions for the accrued but unpaid payroll expenses to the year in which the pay was received by the ESOP participants and includable in their gross income.

Section 6662 Accuracy Related Penalty

Under Section 6662, a 20% penalty is imposed on the portion of any underpayment of tax attributable to “negligence or disregard of rules and regulations” or “any substantial understatement of income tax.” Negligence includes “any failure to make a reasonable attempt to comply” with the Internal Revenue laws. An understatement of income tax is “substantial” if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return. However, no penalties are imposed with respect to any portion of an understatement if a taxpayer acted with “reasonable cause” and “in good faith” with respect thereto.

The Tax Court concluded that the Taxpayers did make a good faith effort to assess their tax liabilities properly and therefore were not liable for any accuracy-related penalty. Specifically, the Tax Court pointed out that it had previously declined to impose a penalty where it appeared that the issue was not one previously considered by the court and the statutory language was not entirely clear.[7] Consequently, because the Taxpayers acted reasonably and in good faith with respect to the understatements for the years at issue, the court found that they were not liable for any accuracy-related penalties under Section 6662.


In this decision, the Tax Court noted that the Taxpayers’ underlying complaint was that Congress did not exclude tax-exempt employee trusts from the constructive ownership rules of Section 267(c), as it explicitly did from the constructive ownership rules of Section 318(a). The Court surmised that conceivably this was a drafting oversight because when Congress enacted Section 267(e) to address the treatment of S corporations and their shareholders, ESOPs were not eligible to be S corporation shareholders. However, the Tax Court found that they were bound by the laws that Congress enacted and certainly were not at liberty to revise Section 267(c) to craft an exemption that Congress did not see fit to create. It will be interesting to see whether in response to this case, there is a push to have Congress amend Section 267(c)(1) to exempt employee stock ownership trusts the same as they are excluded from the definition of the term “trust” under the constructive ownership rules of Section 318.

About the Author:
Stephen R. Looney is the chair of the Tax department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is a member of the Board of Trustees of the Southern Federal Tax Institute, as well as former Chair of the S Corporations Committee of the American Bar Association’s Tax Section. He is Board Certified in Tax Law by the Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at

[1] Petersen v. Comm’r, 148 T.C. No. 22 (2017).
[2] Section 461; Reg. Section 1.446-1(c)(1)(ii)(A).
[3] Boise Cascade Corp. v. U.S., 329 F.3d 751 (9th Cir. 2003).
[4] See e.g., U.S. v. Hughes Props., Inc., 476 U.S. 593 (1986); Thor Power Tool Co. v. Comm’r, 439 U.S. 522 (1979); and Hamilton Indus., Inc. v. Comm’r, 97 T.C. 120 (1991).
[5] Reg. Section 301.7701-4(a).
[6] Id.
[7] See Hitchins v. Comm’r, 103 T.C. 711 (1994).