Former Tyco International Ltd. Chairman Dennis Kozlowski really knew how to take advantage of tax laws. Now, however, others won't be able to follow in his footsteps. The Internal Revenue Service has closed a major loophole that will prevent many executives from sheltering certain types of income from taxation.
Mr. Kozlowski reportedly used a technique that allowed him to defer income taxes for between 15 and 30 years by transferring company stock options to family partnerships. It is believed that Mr. Kozlowski deferred as much as $208 million in income using this sheltering technique.
Under new rules issued this week, sheltering income in family partnerships such as those used by Mr. Kozlowski is now considered to be a "listed transaction," meaning taxpayers will have to disclose such activity and open themselves to scrutiny from the IRS and possible litigation.
"As a practical matter, most clients will not buy a listed transaction because they know they are buying litigation," said Deloitte & Touche director Laura Peebles.
According to the Treasury Department, CEOs have been using the shelter opportunity to exercise stock options, then transfer the options to a family partnership in return for a 20- or 30-year unsecured loan. The CEO gets the use of the money without paying tax currently, while the partnership can invest the money. Tax on the securities gain is deferred until a specified date in the future when the partnership agrees to pay gain over to the CEO.
"Executives cannot defer income taxes on stock option exercise by purporting to sell their stock options to a family member or family limited partnership," said Pam Olson, U.S. Treasury's assistant secretary for tax policy, describing the new ruling.