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Law Office's Tax Avoidance Strategy Backfires

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By Casey C. Sullivan, Esq. on September 22, 2015 3:13 PM

For a while, the Law Office of John H. Eggertsen had a good thing going. In 1998, Eggertsen, a Michigan attorney, bought up "J & R's Little Harvest" for $500. He changed the name, reorganized the corporation, and created a stock ownership plan. Due to Eggertsen's clever tax maneuvering, Eggertsen and the Law Offices avoided paying taxes on income for years.

And it was all perfectly legal -- until it wasn't. In 2001, Congress released its mistake, closed the loophole Eggertsen was taking advantage of and gave companies four years to come into compliance. Eggertsen didn't and that failing ended up costing him dearly in a recent Sixth Circuit case.

Eggertsen's Tax Avoidance Loophole

After he purchased Little Harvest, Eggertsen changed the name to what the Sixth Circuit describes as the "less quaint" name of "Law Office of John H. Eggertsen." He also reorganized the company as an S corporation for federal tax purposes and created an employee owned stock ownership plan (ESOP) -- a form of retirement plan that owns securities of the employing company. Eggertsen then transferred his stock to the plan. The ESOP then owned all the company's shares and Eggertsen remained as its only beneficiary.

Why jump through all those hoops? S corps pay no corporate taxes; their income is taxed only when it passes to shareholders, who pay taxes on it as income. S corp ESOPs paid no taxes at the plan level. ESOP beneficiaries pay taxes only when their stock is distributed, such as at retirement. Essentially, Eggertsen had created a system where no taxes would be paid on the Law Office income until his retirement.

Failure to Correct

All of that was legal, at least for little while. But in 2001, Congress discovered that such setups allowed S corp income to be totally exempt from current taxation. They changed the law so that ESOPs must benefit rank-and-file employees, not just the company's owners. ESOP's were required to have broad-based employee ownership or face a 50 percent excise tax.

Eggertsen thought he had complied with the new rules, transferring his stock to a non-ESOP account when the new regulations came into effect in 2006. He never filed a return for the excise tax. In 2008, he was audited and, in 2011, the IRS issued a deficiency notice for $200,750 or half of the Law Office stock in the ESOP in 2005.

Under the new rules, the 50 percent excise tax is owed when there is a nonallocation year and a "specified set of persons" owns more than half the stock -- that is, if the ownership of the S corp had not been spread among enough individual. Eggertsen had failed to spread ownership of the S corp stock among a wide-range of employees, as Congress demanded.

No Cover in the Statute of Limitations

You might notice that the IRS found Eggertsen deficient in 2011, for not paying a tax in 2005. As the Sixth Circuit notes, the IRS Commissioner "took his time" in coming after Eggertsen. Indeed, the tax court originally found the deficiency barred by the IRS's three year statute of limitations

Unfortunately for Eggertsen, the tax court quickly changed its mind and the Sixth Circuit agreed with the change. The three year statute of limitations only applies to returns that were actually filed, both courts found. Since Eggertsen never filed an excise return, or other returns that would have tipped the IRS off to his tax liabilities, no statute of limitations applied and 50 percent of the ESOP stock was owed to Uncle Sam.

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