Wall Street Journal Tax Report: A Novel Way to Skirt Taxes: Can Two Business Owners Wipe Out Current Income Taxes on Their Company's Profits?, by Laura Saunders:
Will two North Carolina business owners succeed with a tax-avoidance technique—one that billionaire Sam Zell once tried—and wipe out current income taxes on their company's profits?
That question is currently being weighed in U.S. Tax Court. ... The court ruled in favor of the business owners on a key motion in December, and this year it could decide the rest of the case, which is known as Larry E. Austin et al. v. Commissioner.
Experts are watching closely. The company in question is an "S corporation," a popular structure for closely held firms. It gives business owners the protections of a corporation, such as limited liability, but allows profits to bypass corporate-level income tax.
Instead, S-corporation earnings pass directly through to the owners, who are taxed on their personal returns. To qualify, the firms can't have more than 100 shareholders and must meet other requirements as well.
More than 4 million S-corporation returns are filed annually; firms that have used the structure include Tribune Co., formerly run by Mr. Zell, and Bloomberg LP, the financial-services company founded by former New York Mayor Michael Bloomberg. So tax-saving strategies available to S corporations attract notice.
"If the court allows this technique, many closely held companies will be able to avoid even their one layer of tax on the company's earnings," says Robert Willens, an independent tax analyst in New York, who adds that the maneuver would be "easy to implement." ...
Larry Austin and Arthur Kechijian lived in North Carolina and had a business dealing in distressed debt, according to the December decision. In 1998, they reorganized their business into an S corporation, with ownership divided so that each would own 47.5% of the stock. An Employee Stock Ownership Plan, or ESOP, held the other 5%. ...
When the two partners turned their business into an S corporation, they also executed employment agreements worded in such a way that the partners, for tax purposes, wouldn't own the stock for several years. In the interim, the ESOP did. And unlike with other pension arrangements, the law doesn't tax ESOPs that own shares of S corporations.
As a result, experts say, most or all of the profits from the business could be allocated to the ESOP for tax purposes, with no tax due on those profits until participants in the plan made withdrawals down the road.