Sherwin Williams Plan Wasn’t Tax Shelter: California Board

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By Laura Mahoney

Sherwin Williams Co. wasn’t engaged in a tax shelter when it pre-funded its employee stock purchase plan contributions in 2003 and 2004 to insulate employees from threats to the stock price, the California State Board of Equalization said ( In re The Sherwin Williams Co. , Cal. Board of Equalization, No 785285, hearing 2/22/17 ).

It was a win for the company, but the five-member elected board left open the amount of tax deduction the company can take for the transactions. The California Franchise Tax Board (FTB) must provide its own valuation of the stock in question before the SBOE will decide what the value, and therefore the tax deductions tied to that value, should be.

The SBOE said the FTB must complete an appraisal and allow Sherwin Williams to review it before the case comes for a final vote in about 90 days. At the two-hour oral hearing Feb. 22, board members also encouraged the FTB and the company to settle the case.

Pick an Appraisal

Sherwin Williams provided two appraisals setting the value of the stock—one at the time of the transactions and another as part of a closing agreement with the Internal Revenue Service that covered one of the years at issue in the California case.

“There were a couple of appraisals. Pick one, do your own, but let’s get a number, let’s let the parties determine if they can reach a settlement somehow with the number,” SBOE member Diane Harkey (R) said. “If they can’t we’ll be back here again.”

The case stems from leveraged employee stock ownership plan (ESOP) transactions in 2001 and 2003 in which Sherwin Williams loaned the ESOP $250 million and $350 million, respectively, to buy convertible preferred stock in the plan. The stock was a special class created for the transactions and wasn’t available for purchase by anyone else.

Sherwin Williams forgave the loan and interest or made contributions to the ESOP so the ESOP could make payments on the loan from the company. As the loan was paid down, the ESOP released stock held in a suspense account and converted it to common stock in the company or redeemed it for cash using a formula that set the stock’s value. That value was then allocated to employee accounts in either common stock or cash.

The formula setting the value is what remains at issue in the case.

Deductions Claimed

The company received a tax deduction for the contributions it made to the ESOP. In the 2003 tax year, it claimed deductions of $59 million for principal repayments and $18 million for dividends to the ESOP. In 2004, the company claimed deductions of $69 million for principal repayments and $8.9 million for dividend payments.

The FTB issued assessments of $308,532 for 2003 and $307,177 for 2004, along with about $61,000 in penalties, claiming that the transactions lacked economic substance.

Linda E. Carlisle, an attorney with Miller & Chevalier Chartered in Washington, D.C., told the board the non-tax business purpose of the transactions was to show employees that the company was committed to funding retirement benefits during a risky time. Sherwin Williams was facing multiple lawsuits related to manufacture and sale of lead paint and was vulnerable to hostile takeover attempts.

“Most importantly, no matter what happened to the company, there would be a base value to that stock so it could always be converted into a substantial block of common stock if the company, and I’ll use the term, went to hell in a handbasket,” Carlisle told the board.

Circular Cash Flow

In its briefings and in oral arguments before the board, the FTB said the case hinged on the conversion formula that set the stock’s value. Leveraged ESOP transactions aren’t necessarily shelters but this one was, the FTB said.

“This all comes down to one thing: a conversion formula that always strips value from the original purchase price while ensuring that the large artificial tax deduction stays in place,” Ian Foster, attorney for the FTB, told the board.

Of the $650 million the ESOP paid in the transactions, only $330 million was allocated to employee accounts. The rest was all circular cash flow that provided an artificial tax deduction, the FTB said.

The FTB argued the conversion formula setting the value guaranteed that the ESOP would never realize those values for the employees in their holdings. Employees weren’t aware that the valuation formula stripped value from the amount the ESOP was paying, and it is unclear how the transactions could have helped the company retain employees when they didn’t know.

Legitimate Purpose

Board members agreed with Sherwin Williams that the transactions had a legitimate business purpose and weren’t a tax shelter. They directed the FTB to come up with an appraisal or accept those provided by Sherwin Williams to set the value of the stock, and voted unanimously to continue the case to a future hearing.

Carlisle said the FTB has refused its offers to settle the case and its requests to provide its own valuation in the years leading up to the oral hearing before the board.

“From the beginning, we have said in protest and throughout discussions and the many briefings that this is a valuation issue,” Carlisle said. “The economic substance of this transaction is without doubt.”

Closing Agreement

Board members also asked the FTB to explain when the case comes back why it isn’t following the closing agreement between the IRS and Sherwin Williams for 2004, in which the IRS chose not to disallow most of the deductions and to assess an accuracy-related penalty as it had proposed after audit. The IRS closing agreement didn’t cover 2003, the other year at issue for SBOE.

In addition to the IRS closing agreement, the company also reached a settlement with the Department of Labor in 2013 tied to the transactions in which it paid $80 million to current and former ESOP participants.

In response to questions from board members, Carlisle called the DOL matter a “nuisance settlement” in which the company didn’t admit wrongdoing. It also wasn’t a tax matter but involved the Employee Retirement Income Security Act, and shouldn’t weigh in the SBOE’s decision, she said.

The FTB argued the DOL settlement supported its case because the department concluded the intent of the transactions wasn’t to help employees.

To contact the reporter on this story: Laura Mahoney in Sacramento, Calif. at

To contact the editor responsible for this story: Ryan C. Tuck at

For More Information

A summary of the case prepared by SBOE staff is at

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