Penalties on Exempt Entities & Managers for Prohibited Tax Shelters

Penalties on Exempt Entities & Managers for Prohibited Tax Shelters

By Andrew W. Singer, Esq.*

In addition to imposing disclosure obligations on participants in and material advisors to reportable transactions and penalties for violation of those obligations, the Code also imposes penalties in the form of excise taxes on tax-exempt entities that act as accommodation parties in prohibited tax shelter transactions (generally, reportable transactions other than loss transactions and transactions of interest) [IRC §  4965]; requires that the tax-exempt entity disclose to the IRS such prohibited tax shelter transactions in which it has acted as an accommodation party and the other parties to such transactions [IRC §  6033(a)(2)]; and requires that any participant in a prohibited tax shelter transaction that knows or has reason to know that a tax-exempt entity is an accomodation party to the transaction disclose to that tax-exempt entity that the transaction is a prohibited tax shelter transaction. [IRC §  6011(g)].

Notice 2004-30 describes the paradigm of the kind of transaction at which these provisions are aimed. First, an S corporation issues, pro rata to each of its shareholders (the "original shareholders"), nonvoting stock and stock warrants that are exercisable over a period of years into nonvoting stock. For example, the S corporation might issue nonvoting stock in a ratio of 9 shares for every share of voting stock held by each S corporation shareholder and warrants in a ratio of 10 warrants for every share of nonvoting stock. In that case, if the S corporation has 1,000 shares of voting stock outstanding, it would issue 9,000 shares of nonvoting stock and warrants exercisable into 90,000 shares of nonvoting stock to the original shareholders. 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 a tax-exempt entity. The parties to the transaction claim that, after the donation of the nonvoting stock, the tax-exempt entity 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 tax-exempt entity is not subject to tax on unrelated business income (UBIT) (or the tax-exempt entity has offsetting UBIT net operating losses). The original shareholders might also claim a charitable contribution deduction under IRC § 170 for the donation of the nonvoting stock to the tax-exempt entity. In some variations of this transaction, the S corporation may issue nonvoting stock directly to the tax-exempt entity. 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 tax-exempt entity can require the S corporation or the original shareholders to purchase the tax-exempt entity'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.

The IRS opined that the transaction in
Notice 2004-30 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." It announced that "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 IRC Section 1361(b)(1)(D), thus terminating the corporation's status as an S corporation. Finally, the IRS determined that "transactions that are the same as, or substantially similar to, the transaction described in this notice are identified as "listed transactions." That determination would make the tax-exempt entity subject to the IRC Section 4965 excise tax and the disclosure requirements under IRC Section 6033(a)(2)...

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RELATED LINKS: For more information on Tax Shelter Transactions: Penalties and Disclosure Requirements, see:

* Andrew W. Singer is a retired partner of the Washington DC firm of Covington & Burling. Mr. Singer specializes in all areas involving federal and state taxation and has extensive experience in international taxation which includes representation of the Commonwealth of Puerto Rico and the Marshall Islands in negotiating tax agreements with the US and participation in competent authority negotiations under US tax treaties. Mr. Singer served as Chairman for the Committee on Court Procedure, American Bar Association and as Chairman for the Committee on Taxation, District of Columbia Bar Association; lectured at American University, Washington College of Law, Washington, DC and George Washington University, National Law Center, Washington, DC; and has published articles in various tax journals, including articles on income taxation of bankrupt companies and individuals, litigation in US Claims Court, District Courts and Tax Court.

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