The IRS challenges some tax positions by asserting that the transactions lack economic substance. This can allow the government to unwind or ignore transactions that comply with our tax laws if there is no legitimate business purpose for the transactions other than tax savings. There is a growing body of court cases that helps define economic substance. In Austin v. Commissioner, T.C. Memo. 2017-69, the court considered economic substance in the context of an S corp ESOP.
The S Corp ESOP
An employee stock ownership plan (“ESOP”) is a type of retirement plan whereby the business offers an ownership interest to its employees. ESOPs are not subject to Federal income taxes, so income they receive is generally not taxable.
Unlike C corps, S corps do not pay Federal income tax on distributions to their shareholders. To the extent the ESOP owns the business, there are no Federal income taxes imposed on the distributions from the S corp to the ESOP. This is true even if the ESOP owns 100% of the S corp.
The Restricted Stock Strategy
The restricted property rules generally say that property received in connection with the performance of services is not taxable until the restriction is lifted. This usually relates to restricted stock that does not vest until some event and/or date in the future.
If the S corp is owned by shareholders whose stock is restricted, the distribution rules say that the stock is not considered to be issued. So any income attributable to the unissued stock is taxed to those who have vested or unrestricted shares.
Many taxpayers took advantage of these rules by having the original business shareholders hold only restricted stock while having just the ESOP holding unrestricted or vested shares. This allows the Federal income tax on the business profits to essentially be deferred until the restriction on the stock goes away. This brings us to the Austin case.
The Austin Case
The two taxpayers in Austin were shareholders in an S corp that was partially owned by an ESOP. They entered into restricted stock and employment agreements that said that their stock would be forfeited if they did not remain employed with the business for five years. Both shareholders remained employed by the business beyond the restricted stock vesting date.
At the five year period, the taxpayers entered into agreements to surrender their stock and agreements to immediately repurchase their stock. The repurchase agreements obligated the taxpayers to pay for their stock via promissory notes that would be paid over a number of years.
The Court’s Analysis of Economic Substance
Despite the IRS’s arguments, the court concluded that the S corp ESOP strategy had economic substance. The court based this decision on the fact that the arrangement was specifically envisioned by Congress and widely-known and that the taxpayers could have actually forefited their stock if they did not stay employed with the business until the date the stock vested. The court focused on the fact that the taxpayers were not related and that they seemingly had no reason to not act in their own financial interests.
With respect to the agreements to surrender their stock and agreements to immediately repurchase their stock, the court concluded that these transactions did not have economic substance. The court noted that the stock option rules require a “snapshot valuation” immediately upon vesting and that this amount has to be included as compensation in the taxpayer’s income. The court also focused on the taxpayers inability to come up with a non-tax reason for entering into these transactions. The taxpayers only offered that the transactions allowed the S corp to avoid paying Federal employment taxes. Last, the court noted that there was no realistic possibility that the taxpayers could profit from the transactions.
So the takeaway from the case is that transactions that appear to be sanctioned by Congress and widely known and used can have economic substance even though one of the primary reasons for entering into the transactions are the tax benefits. Another takeaway is that avoiding a different type of Federal tax, namely employment taxes, may not be a sufficient business purpose to have economic substance.