ESOP Style Over Substance Loses in Tax Court

“These transactions lacked economic substance and economic purpose and were entered into for the primary purpose of obtaining tax benefits.”

In Weekend Warrior Trailers, Inc., et al. v. Commissioner, T.C. Memo 2011-105 (May 19, 2011), the U.S. Tax Court addressed a tax deficiency resulting from a fancy corporate two-step that included the creation and demise of an ESOP within a 3-year time period.
In 1988, Mark Warmoth started a company.

In 1995, he incorporated it as a C-corp and named it Weekend Warrior.

On January 1, 2003, Weekend Warrior elected S corporation status. From 1995 through 2009, Mr. Warmoth was the only shareholder of Weekend Warrior.

On Nov. 14, 2002, Mr. Warmoth incorporated Leading Edge and received all 10,000 of Leading Edge’s shares of stock. According to the Tax Court, Mr. Warmoth was suppose to pay $20,000 for the shares but failed to do so. Leading Edge also elected S corporation status. Mr. Warmoth was the only member of Leading Edge’s board of directors, its CEO and President. Leading Edge and Weekend Warrior shared the same address and phone number.

Effective Dec. 15, 2002, Leading Edge established a deferred compensation (NQDC) plan to benefit Mr. Warmoth. The Board, which consisted solely of Mr. Warmoth, was to decided annually which employees were entitled to participate in the NQDC plan.

On Dec. 28, 2002, Leading Edge adopted an ESOP and a 401(k) plan, effective Dec. 1, 2002, with Mr. Warmoth and one other person as trustees. On Dec. 18, 2002, Mr. Warmoth sold 9,990 shares of Leading Edge stock to the ESOP for $1.50 per share, leaving Mr. Warmoth with the remaining 10 shares of Leading Edge stock. The plan executed a promissory note to Mr. Warmoth for the shares for $14,985.

Also on Dec. 28, 2002, Weekend Warrior and Leading Edge entered into an agreement signed by Mr. Warmoth on behalf of both companies. Leading Edge agreed to provide design, personnel and management services to Weekend Warrior. In exchange, Weekend Warrior paid Leading Edge an initial payment of $4,175,000 plus agreed to make monthly payments to Leading Edge based upon Weekend Warriors’ gross sales with Leading Edge guaranteed a minimum monthly payment. As part of the personnel agreement, in 2003 Weekend Warrior transferred all of their employees to Leading Edge, and Leading Edge leased those employees back to Weekend Warrior at a mutually-agreed to rate.

On June 1, 2004, Leading Edge executed a stock repurchase agreement and acquired all 9,990 shares of its stock from the ESOP for $150,000. The Tax Court states that the reason for this transaction was the change to Code section 409(p) which made the ESOP unattractive. After the stock repurchase, Mr. Warmoth again became Leading Edge’s sole shareholder.

After Dec. 31, 2004, Leading Edge became inactive and, according to the Tax Court, the ESOP was terminated and converted into a profit-sharing plan.

The IRS challenged the deductions Weekend Warrior paid to Leading Edge for design and management fees for 2002, 2003 and 2004. The IRS did not challenge the amounts paid between the two companies for personnel services.

The IRS argued that Leading Edge should be disregarded for Federal income tax purposes because it lacked a legitimate business purpose and economic substance and was formed solely for the purpose of obtaining tax benefits. Mr. Warmoth argued that there were several potentially legitimate reasons for incorporating Leading Edge, including the desire to motivate the rank-and-file employees by establishing an ESOP. The Tax Court rejected that reason, stating that viewing the ESOP through the lens of the deferred compensation plan that solely benefited Mr. Warmoth cast doubt that the benefits to rank-and-file employees were more than minimal.

The Tax Court did find that, even though Leading Edge was not formed for a valid business purpose, it engaged in sufficient business activity to be respected as a separate entity for tax purposes. Some of that sufficient business activity included providing personnel services to Weekend Warrior, maintaining investment and bank accounts, paying its employees by check, adopting a retirement plan, keeping books and records, engaging a professional to appraise its stock and following corporate formalities.
Even though the Tax Court found that Leading Edge was a separate entity for tax purposes, the Tax Court agreed with the IRS, in part, finding that the management fees were not necessary or reasonable, and therefore were not deductible under Code section 162.

The IRS also challenged the sale of Leading Edge stock to the ESOP, stating that it lacked a business purpose because the true purpose of establishing the ESOP was not to provide an incentive for the employees due to the short lifespan of the plan and the fact that as soon as the changes to Code section 409 made the ESOP arrangement less appealing from a tax standpoint, the retirement plan’s shares were redeemed and the company’s founder once again became Leading Edge’s sole shareholder. Because the IRS first asserted this issue on brief, the Tax Court declines to consider whether the sale of Leading Edge stock to the retirement plan lacked a business purpose.

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