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ESOT & Efficient Corporate Tax Structure


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Anyone familiar with a tax strategy using an ESOT?  Gist of the strategy is payments are made to an administrative services company (S corp) owned 100% by an ESOT.  No income tax due at the ESOT level obviously but then they say only 15% of the profits are allocated to the rank & file.  That's the part I'm struggling with as I would assume allocations would need to be based on compensation???

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I think you are leaving too much out of the question to give a good answer. 

If they are simply talking about setting up an ESOP by an S Corp and neither the company nor the trust will pay income taxes on the company's net profits that is basically true.

There is a lot that can go wrong, very BADLY wrong, with that structure and if they are planning on this they need to get people who are experts on S Corp ESOPs to help them or they could bankrupt the company with IRS fines.  

But your question is so vague and open ended we need more data to give a more specific answer.   For example you don't normally allocate profits.  You allocate a contribution or dividends/S Corp earnings payments.  

You might want to search the NCEO and/or ESOP Association websites to find educational material to help get some of the basics. 

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Agreed...I didn't have much info at the time.  Arrangement is that operating company (OC) contracts with an administrative services company (ASC) for the provision of management and administrative services.  OK so far as long as the amounts paid are reasonable for services provided, etc.  That's a whole other issue.  ASC is owned100%  by an ESOT.  Owners and other HCE's are excluded from participation in the ESOT.  ASC lends money to owner to pay premiums on a life insurance policy on the owner and owned by the owner.  Loan is secured by cash surrender value and death benefit of the policy, however the owner can cancel the policy at any time.  Down the road, at retirement or liquidity event, the loan is valued at between 10-15% of the outstanding loan balance since the owner can cancel it at any time (along with other valuation discounts) and the only thing the ASC would get is the CSV.  Since the ASC's only asset is the loan, it's value is also is also discounted at the ESOT.  Bottomline is the rank and file receive about 15% of the assets originally put into the 100% owned company.  I see all kinds of issues but the main one that jumps out at me is the fiduciary responsibility of the ESOT trustee (who is probably the business owner!).  Prudent investment to put 100% of the assets of the ESOT owned company in a loan where the only collateral is the CSV and death benefit but the DB can be cancelled at any time?  And when you know there will be a 85%+ discount down the road???

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PowerCPA, there are not enough details in your description to really evaluate it, but I have reviewed proposals with similar bottom lines. Not saying that the one you are looking at does this, but the most aggressive I have reviewed typically rely on an assumption that eventually the stock can be bought back from the ESOP (or the assets of the ESOP-owned company looted, or whatever), based on a very aggressive valuation in favor of the purchaser by an "independent" valuation form, as well as on the docility and/or ignorance of the rank and file employees, as you call them. That eventual purchaser is the person who will be performing his or her valuable services for the service corporation (and being underpaid for them while the ESOP is in existence, so that the ESOP will get the K-1); he or she is also the person who is performing those services now in another structure, and paying, in his or her view, too much income tax on his or W-2 and/or K-1. And that person is probably also going to be the ESOP "committee."

It's likely that the scheme you are evaluating has been structured carefully enough to avoid any obvious synthetic equity, but if you are responsible for advising your client on this transaction and have not read the 409(p) regs, you may want to do so. Unfortunately (or, fortunately, depending on your point of view, I guess), the IRS has not published much under its authority in Section 1.409(p)-1T(c)(3)(ii).

 

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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I do not have enough of the finer details to render much of an opinion, but from my experience, neither would you or the prospective client, simply because this is what I usually see in the promoting of very questionable wealth transfer or tax shelter schemes. The IRS has issued a few warnings over the years about what looks like similar schemes.

I suggest that you do some searching on the issue..

https://www.irs.gov/retirement-plans/ep-abusive-tax-transactions-s-corporation-esop-abuses-certain-business-structures-held-to-violate-code-section-409p

https://www.irs.gov/irb/2004-06_IRB#RR-2004-4

 

George D. Burns

Cost Reduction Strategies

Burns and Associates, Inc

www.costreductionstrategies.com(under construction)

www.employeebenefitsstrategies.com(under construction)

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  • 2 years later...

Great! All this precisely forms the tax efficiency! Tax efficiency is when an individual or a legal entity pays the lowest amount of taxes required by law. A financial solution is considered tax-efficient if the tax result is lower than that of an alternative financial structure that achieves the same goal.Tax-efficient mutual funds are taxed at a lower rate compared to other mutual funds. You can calculate your capabilities using ThePayStubs. You should seriously think about it!

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