It Maybe Too Good to be True

The Wall Street Journal ran an article on Saturday regarding the Larry E. Austin et al tax court case that was decided in December, 2013 (you will need a subscription to the online version to read the article).  This tax court case involved two families who owned a very successful distressed debt investment company.  In 1999, they elected to contribute their ownership of the business to a new S corporation with the ownership 47.5% by each individual with the remaining 5% owned by an Employee Stock Ownership Plan (ESOP).

Employers can make tax-deductible contributions to an ESOP and any earnings allocated to the ESOP grow tax-free until the funds are distributed to the participants when the reach age 59 1/2 or later.

When the two shareholders converted their interests into the new S corporation, they also executed new employment agreements.  These agreements were structured to provide, for tax purposes, that the stockholders would not own their shares for several years.  Unlike other pension arrangements, tax laws do not subject ESOPs to income taxation on their share of earnings from an S corporation.  Therefore, during the period that the two stockholders did not “technically” own the shares in the S corporation, 100% of the income was allocated to the ESOP, therefore, on an annual basis, no income tax was due on the income of the S corporation.

As you can guess, the IRS did not appreciate this and took it to tax court.  The court ruled last month in the taxpayer’s favor on the technical issue surrounding the restrictions of the employment agreement.  The IRS has appealed the case and it will be interesting to see the final resolution.  If this is upheld in favor of the taxpayer AND Congress does not change the law, this may be a very favorable method of sheltering farm income until retirement.  We shall see and will keep you posted.

Note – The US Tax Court Web Site is down for maintenance for a few days so I was unable to post a link to the court case.

Paul Neiffer, CPA