HCE’s entire vested benefit from disqualified ESOP taxable, not just annual increase in disqualification year


The entire amount of a highly compensated employee’s vested accrued benefit must be included in income upon the revocation of an ESOP’s tax-exempt status, and not just the annual increase in the account in the disqualification year, the U.S. Tax Court has ruled. Code Sec. 402(b)(4)(A) requires an HCE to include in income the vested accrued benefit to the extent it has not been previously taxed.


In 2000, the taxpayer, a plastic surgeon, organized an S corporation to manage his several medical practices. The S corporation sponsored an ESOP in which the taxpayer participated as an HCE. In 2004, the ESOP and the entire account balance was transferred to the taxpayer’s IRA. At that time, the taxpayer’s account balance and vested accrued benefit in the ESOP was $2.4 million. None of that amount had been taxed to the taxpayer before the 2004 plan year. The IRS retroactively disqualified the ESOP for the years 2000-2004.

The IRS determined that the ESOP did not meet the coverage requirements of Code Sec. 410(b) and that the trust under the ESOP was not exempt from taxation under Code Sec. 501(a). (The statute of limitations was closed for all years except 2004.)

The Tax Court upheld disqualification of the ESOP in Yarish Consulting, Inc. v. Commissioner. The taxpayer then argued that under Code Sec. 402, the inclusion in income should be limited to the annual increase in the disqualification year, while the IRS argued that the taxpayer’s entire vested accrued benefit should be included in income because it had never been taxed.

Investment in the contract

Code Sec. 402(b) sets forth the consequences to plan participants in the case of disqualification of the plan trust. Under Code Sec. 402(b)(4)(A), when the trust tax exemption does not apply due to a plan’s failure to meet coverage or participation requirements under Code Sec. 410(b) or 401(a)(26), an HCE must include in income an amount equal to the vested accrued benefit of such employee (other than the employee’s investment in the contract).

The taxpayer argued that the definition of “investment in the contract” found in Code Sec. 72 should apply to Code Sec. 402(b)(4)(A). The court disagreed, noting that nowhere in Code Sec. 72 or its regulations is there an indication that the definition applies outside of Code Sec. 72.

The court also rejected the taxpayer’s contention that the legal principle “in pari materia” required the court to use the Code Sec. 72 definition. Two Code sections may be considered in pari materia when they relate to the same subject matter or have the same purpose. However, the court explained, Code Secs. 72 and 402(b)(4)(A) serve different purposes. Code Sec. 72 provides rules for taxation of distributions from annuity and similar contracts. Code Sec. 402(b)(4)(A), in contrast, is intended to discourage highly compensated employees from participating in a plan that fails to satisfy coverage requirements. Thus the court agreed with the IRS that in this situation “investment in the contract” equals the portion of the vested accrued benefit that had been previously taxed to the employee. As none of the accrued benefit had been previously taxed, the taxpayer was required to include the entire amount in the disqualification year.

Source: Yarish v. Commissioner (TC).

For more information, visit http://www.wolterskluwerlb.com/rbcs.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer’s Benefits Reports.

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