Paul L. Caron

Sunday, January 19, 2014

WSJ: Can S Corps Use ESOPs to Wipe Out Current Income?

ESOPWall 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.

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No one should try this -- you will be taxed severely and your company probably shut down. I am the founder of the National Center for Employee Ownership, so this is a subject I know a lot about.

Back in the 1990's, when S corporations were allowed to have ESOPs, and the ESOP would not have to pay taxes on its share of ownership (because the employees would pay taxes when they leave the plan, so taxing up front and then when the get their distrinition would violate the double taxation rule of S corporations), a number of all-too-clever (but none-too-ethical) lawyers came up with a variety of ways to try to use this law to circumvent its real purpose, which was to encourage the broad distribution of the ownership of wealth through ESOPs.

The scams took many forms, but the essential goal was to find a way to make it appear that employees would really be the beneficiaries even though they were, at best, getting nominal amounts while the real profits and tax savings were funneled to one or a few people. The ESOP community asked the IRS and Congress to prohibit these transactions. Congress passed rules effective in 2004 that accomplished that quite successfully. Meanwhile, the IRS created regulations that used prohibited a number of specific arrangements but also braodly said that plan structures intended to benefit just a few people were listed transactions. Violations of either the law or the listed transaction rules lead to severe tax penalties.The kind of structure described here would not be possible after 2004 and no one has tried to do it because if you violate that law, the tax penalties amount to the large majority of the value of your business.

In this transaction, the ESOP is the nominal 100% owner but really is just a 5% owner considering the dilution. That kind of structure should not be accepted by any ESOP fiducairy for any reason as this plan is clearly violative of the core Employee Retirement Income Security Act requirement that ESOPs (which are governed by ERISA) are required to be "for the exclusive benefit of plan participants." This clearly is not one.

Posted by: Corey Rosen, National Center for Employee Ownership | Jan 20, 2014 10:38:01 AM