If an employee stock ownership plan (ESOP) owns an S corporation’s stock, that S corporation may not deduct any accrued expenses for any ESOP participant, including retirement plan contributions based on accrued compensation. Under IRC Section 267(a)(2), a taxpayer, including an S corporation, may only deduct an expense in the same tax year that the payment is reported as income by a related party. Under IRC Section 267(e)(1)(B)(ii), a related party includes any person who directly or indirectly owns any of that S corporation’s stock. Therefore, if an ESOP holds an S corporation’s stock, that ESOP’s participants indirectly own stock in the S Corporation. These participants do not include accrued compensation in their income until the year in which they receive it and, therefore, the S corporation cannot deduct any compensation (including any bonus or vacation pay) accrued to these participants. The S corporation also can’t deduct any plan contributions for these participants that are based on accrued compensation.
