An ESOP Fable

Several years back there was a nifty tax-planning technique calling for the use of an ESOP as a shareholder or partner in an S corporation or partnership/LLC. You will remember that an ESOP is a qualified retirement plan and pays no taxes. To the extent that the ESOP is top-heavy - meaning that the key employees of the sponsoring employer own the majority of ESOP – this is quite the nifty tax technique. Leverage the ESOP and make the bank payments deductible as retirement contributions. These payments reduce the sponsor’s taxable income. Combine this with an ESOP on the receiving end – an entity which does not pay tax – and you have fields of tax gold.

Of course, someone has to push this to the limit and get slapped down.

Enter the law firm Renkemeyer, Campell & Weaver, LLP. These guys are based in Kansas and have a tax year ending April 30. For year 4/30/04 the firm had three attorney/shareholders and an S corporation as the fourth shareholder. The S corporation was owned by an ESOP.

The profit percentages were 30-30-30-10, with the S having the 10%.

The revenues were approximately 33-33-33-1, with the S having the 1%.

Oh, you can see this coming, you say?

Well, the law firm allocated approximately 88% of its income to the S corporation for year 4/30/04. You have probably already guessed that the only – or least predominant – participants in the ESOP were the three attorneys.

The IRS examined the year and said “you have to be kidding.” A tax CPA would phrase that to say that the transaction does “not reflect economic reality.” Accordingly, the IRS reallocated the law firm's net business income to its partners on the basis of their respective profit and loss interests.

The attorneys disagreed, and the case went to the Tax Court. The court held that the law firm failed to show that its special allocation (of income to the S corporation) was proper. The firm could (theoretically) have won the argument with the IRS, but it had to present some cogent economic argument for shifting almost 90% of its income to an entity which did virtually nothing. It did not. The court moved income from a tax-exempt entity (the S/ESOP) to the three individual partners. This resulted in individual income taxes. In addition, the income represented self-employment earnings to the three partners, which meant that they also owed self-employment taxes.

They pushed too far.