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Notice 2004-30
Part III - Administrative, Procedural, and Miscellaneous
S Corporation Tax Shelter
Notice 2004-30
The Internal Revenue Service and the Treasury Department are aware of a type
of transaction, described below, in which S corporation shareholders attempt
to transfer the incidence of taxation on S corporation income by purportedly
donating S corporation nonvoting stock to an exempt organization, while retaining
the economic benefits associated with that stock. This notice alerts taxpayers
and their representatives that these transactions are tax avoidance transactions
and identifies these transactions, and substantially similar transactions,
as listed transactions for purposes of § 1.6011-4(b)(2) of the Income
Tax Regulations and §§ 301.6111-2(b)(2) and 301.6112-1(b)(2) of the
Procedure and Administration Regulations. This notice also alerts parties involved
with these transactions to certain responsibilities that may arise from their
involvement with these transactions.
FACTS
In a typical transaction, an S corporation, its shareholders, and an organization
exempt from tax under § 501(a) and described in either § 501(c)(3)
or § 401(a) of the Internal Revenue Code (such as a tax-qualified retirement
plan maintained by a state or local government) (the exempt party) undertake
the following steps. An S corporation issues, pro rata to each of its shareholders
(the original shareholders), nonvoting stock and warrants that are exercisable
into nonvoting stock. For example, the S corporation issues nonvoting stock
in a ratio of 9 shares for every share of voting stock and warrants in a
ratio of 10 warrants for every share of nonvoting stock. Thus, if the S corporation
has 1,000 shares of voting stock outstanding, the S corporation would issue
9,000 shares of nonvoting stock and warrants exercisable into 90,000 shares
of nonvoting stock to the original shareholders. The warrants may be exercised
at any time over a period of years. The strike price on the warrants is set
at a price that is at least equal to 90 percent of the purported fair market
value of the newly issued nonvoting stock on the date the warrants are granted.
For this purpose, the fair market value of the nonvoting stock is claimed
to be substantially reduced because of the existence of the warrants.
Shortly after the issuance of the nonvoting stock and the warrants, the original
shareholders donate the nonvoting stock to the exempt party. The parties to
the transaction claim that, after the donation of the nonvoting stock, the
exempt party owns 90 percent of the stock of the S corporation. The parties
further claim that any taxable income allocated on the nonvoting stock to the
exempt party is not subject to tax on unrelated business income (UBIT) under §§ 511
through 514 (or the exempt party has offsetting UBIT net operating losses).
The original shareholders might also claim a charitable contribution deduction
under § 170 for the donation of the nonvoting stock to the exempt party.
In some variations of this transaction, the S corporation may issue nonvoting
stock directly to the exempt party.
Pursuant to one or more agreements (typically redemption agreements, rights
of first refusal, put agreements, or pledge agreements) entered into as part
of the transaction, the exempt party can require the S corporation or the original
shareholders to purchase the exempt party’s nonvoting stock for an amount
equal to the fair market value of the stock as of the date the shares are presented
for repurchase. In some cases, the S corporation or the original shareholders
guarantee that the exempt party will receive the fair market value of the nonvoting
stock as of the date the stock was given to the exempt party if that amount
is greater than the fair market value on the repurchase date.
Because they own 100 percent of the voting stock of the S corporation, the
original shareholders have the power to determine the amount and timing of
any distributions made with respect to the voting and nonvoting stock. The
original shareholders exercise that power to cause the S corporation to limit
or suspend distributions to its shareholders while the exempt party purportedly
owns the nonvoting stock. For tax purposes, however, during that period, 90
percent of the S corporation’s income is allocated to the exempt party
and 10 percent of the S corporation’s income is allocated to the original
shareholders. The transaction is structured for the original shareholders to
exercise the warrants and dilute the shares of nonvoting stock held by the
exempt party, or for the S corporation or the original shareholders to purchase
the nonvoting stock from the exempt party at a value that is substantially
reduced by reason of the existence of the warrants. In either event, the exempt
party will receive a share of the total economic benefit of stock ownership
that is substantially lower than the share of the S corporation income allocated
to the exempt party.
DISCUSSION
The transaction described in this notice is designed to artificially shift
the incidence of taxation on S corporation income away from taxable shareholders
to the exempt party. In this manner, the original shareholders attempt to avoid
paying income tax on most of the S corporation’s income over a period
of time.
The Service intends to challenge the purported tax benefits from this transaction
based on the application of various theories, including judicial doctrines
such as substance over form. Under appropriate facts and circumstances, the
Service also may argue that the existence of the warrants results in a violation
of the single class of stock requirement of § 1361(b)(1)(D), thus terminating
the corporation’s status as an S corporation. See, e.g., §§ 1.1361-1(l)(4)(ii)
and (iii).
Transactions that are the same as, or substantially similar to, the transaction
described in this notice are identified as “listed transactions” for
purposes of §§ 1.6011 4(b)(2), 301.6111-2(b)(2), and 301.6112-1(b)(2)
effective April 1, 2004, the date this notice was released to the public. Independent
of their classification as listed transactions, transactions that are the same
as, or substantially similar to, the transaction described in this notice may
already be subject to the disclosure requirements of § 6011 (§ 1.6011-4),
the tax shelter registration requirements of § 6111 (§ 301.6111-1T
and § 301.6111-2), or the list maintenance requirements of § 6112
(§ 301.6112-1). Under the authority of §1.6011 4(c)(3)(i)(A), the
exempt party in the listed transaction described in this notice will also be
treated as a participant in the transaction (whether or not otherwise a participant).
The exempt party will be treated as participating in the transaction for the
taxable year of the purported donation, the taxable year of the reacquisition,
and all intervening taxable years. Pending further review and possible additional
guidance, this notice does not apply to any investment in employer securities,
as defined in § 409(l), by an employee stock ownership plan subject to
the requirements of § 409(p).
Persons who are required to register these tax shelters under § 6111
but have failed to do so may be subject to the penalty under § 6707(a).
Persons who are required to maintain lists of investors under § 6112 but
have failed to do so (or who fail to provide those lists when requested by
the Service) may be subject to the penalty under § 6708(a). In addition,
the Service may impose penalties on parties involved in these transactions
or substantially similar transactions, including the accuracy-related penalty
under § 6662.
The Service and the Treasury Department recognize that some taxpayers may have
filed tax returns taking the position that they were entitled to the purported
tax benefits of the type of transaction described in this notice. These taxpayers
should take appropriate corrective action and ensure that their transactions
are disclosed properly.
The principal author of this notice is Tara P. Volungis of the Office of Associate
Chief Counsel (Passthroughs & Special Industries). For further information
regarding this notice contact Ms. Volungis at (202) 622-3070 (not a toll-free
call).