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Transaction-Specific Frequently Asked Questions (Additional Items Posted 1/18/06)

Announcement 2005-80 Settlement Initiative
1. Notice 2002-21 (Tax Avoidance Using Inflated Basis)
2. Notice 2001-16 (Intermediary Transactions Tax Shelter)
3. Notice 2003-55 (Accounting for Lease Strips and Other Stripping Transactions…)
4. Notice 2003-54 (Common Trust Fund Straddle Tax Shelters)
5. Notice 2003-81 (Tax Avoidance Using Offsetting Foreign Currency Option Contracts)
6. Notice 99-59 (Tax Avoidance Using Distributions of Encumbered Property)
7. Rev. Rul. 2004-98 (“Reimbursements” for parking expenses…)
8. Rev. Rul. 2004-20 and Rev. Rul. 2004-21 (Pension plan fails to satisfy…)
9. Notice 2004-8 (Abusive Roth IRA Transactions)
10. Rev. Rul. 2004-4 (Transactions that involve…employee stock ownership plan (ESOP)…)
11. Notice 2003-77 (Transfers to Trusts…)
12. Notice 2003-24 (Tax Problems Raised by Certain Trust Arrangements…)
13. Rev. Rul. 2003-6 (Certain arrangements involving the transfer of ESOPs…)
14. Rev. Rul 2002-3/2002-80 (“Reimbursements” of employees for salary reduction…)
15. Notice 2000-60 (Stock Compensation Corporate Tax Shelter)
16. Rev. Rul. 2000-12 (Certain transactions involving acquisition of two debt instruments…)
17. Notice 95-34 (Tax Problems Raised by Certain Trust Arrangements…)
18. Treas. Reg. § 1.643(a)-8 (Certain Distributions by Charitable Remainder Trusts)
19. Certain abusive charitable contributions and conservation easements…
20. Certain abusive charitable contributions of patents…
21. Management S Corporation ESOP Transactions…

 

4. Notice 2003-54 (Common Trust Fund Straddle Tax Shelters)

Q.1  If a taxpayer participated in a transaction that is described in Notice 2002-50 or Notice 2002-65, can the taxpayer participate in the settlement initiative in Announcement 2005-80?

A.1  No.  Notice 2003-54 states that the transaction described in that notice and the transactions described in Notice 2002-50 and Notice 2002-65 are substantially similar transactions.  Announcement 2005-80 states that the transaction described in Notice 2003-54 is eligible for settlement under the initiative but that the transactions described in Notice 2002-50 and Notice 2002-65 are not eligible for settlement under the initiative.  Thus, a taxpayer who participated in a transaction described in Notice 2002-50 or Notice 2002-65 is not eligible to resolve the treatment of that transaction under the Announcement 2005-80 settlement initiative.  Furthermore, if a taxpayer participated in a transaction that is substantially similar to the transaction described in Notice 2003-54 yet the transaction does not involve an investment made in a common trust fund, the Service will not treat the transaction as one described in Notice 2003-54 for purposes of Announcement 2005-80.  See Section 3.4.


Q.2  What are the fees and costs in a Notice 2003-54 transaction that the taxpayer may deduct?

A.2  Typical fees and costs in a Notice 2003-54 transaction include fees paid to promoters and trustees, loan origination fees, fees for tax opinions, and finder’s fees.


Q.3  What additional documents and information will the Service request from the taxpayer when resolving transactions described in Notice 2003-54?

A.3  In addition to the documents and information required by the Form 13750, taxpayers resolving transactions described in Notice 2003-54 can expect the Service to request the following documents and information:

• All returns of the taxpayer (Forms 1040), the grantor trust that invested in the common trust fund (Forms 1041), and any pass-through entities (Forms 1120S or 1065) between the grantor trust and the taxpayer, for all years affected by the transaction, and all amended returns for those years; and

• A statement explaining how the investment in the common trust fund was or will be closed out, along with a schedule listing the amount and date of all distributions made by the common trust fund directly or indirectly to the taxpayer.

 The Service may also request other documents and information not listed above.

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5.  Notice 2003-81 (Tax Avoidance Using Offsetting Foreign Currency Option Contracts)

Q.1  How are transactions described in Notice 2003-81 resolved under Section 4.A of Announcement 2005-80?

A.1  For purposes of settlement, taxpayers must concede the aggregate loss claimed on their return.  In the typical case, the Service will disallow the gains and losses from all the foreign currency contracts reported on either Schedule D or Form 4797.  This approach results in the full disallowance of the purported tax benefits claimed.

Q.2  In completing Schedule A of Form 13750, who are the “Other parties to the transaction,” as requested in item 5?

A.2  For Notice 2003-81 transactions, the other parties include the exempt organization that received the foreign currency contracts or any other consideration in connection with the foreign currency transaction.  At a minimum, the taxpayer should include the name, address, and phone number of the exempt organization.
 

Q.3  What additional documents can an investor in a Notice 2003-81 transaction expect the Service to request?

A.3  In addition to providing supporting documents for transaction costs, the Service will request Notice 2003-81 investors to provide additional information regarding the exempt organization.  This will include the Assignment Agreement, all correspondence exchanged with the exempt organization, the date and amount of the payment, and copies of any cancelled checks to, or for the benefit of, either the exempt organization or the promoter.

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6.  Notice 99-59 (Tax Avoidance Using Distributions of Encumbered Property)

Q.1  What is a Notice 99-59 transaction?

A.1  A Notice 99-59 transaction can take a variety of forms, all of which involve the use of distributions of encumbered property for the purpose of either generating large capital losses or excluding a distribution of property from income.  A typical arrangement involves a taxpayer acting through a partnership to contribute cash to a foreign corporation formed for the purpose of carrying out the transaction, in exchange for the common stock of that corporation.  Another party contributes additional capital to the corporation in exchange for the preferred stock of that corporation.  The foreign corporation then acquires additional capital by borrowing from a bank and grants the bank a security interest in securities acquired by the foreign corporation that have a value equal to the amount of the borrowing.  Thereafter, the foreign corporation distributes the encumbered securities to the partnership that holds its common stock.  The foreign corporation nonetheless remains primarily liable for such debts, and in fact eventually pays off these debts with its other assets.  The effect of the distribution, however, combined with fees and other transaction costs incurred at the corporate level, is to reduce the remaining value of the corporate stock to zero or a de minimis amount, due to its liabilities being approximately equal to its assets.  After a deemed disposition of the corporate stock, the partnership claims a tax loss equal to the difference between its original basis, and the purported low fair market value of the common stock.


Q.2  What are some transactions that are substantially similar to the one described in Q&A 1?

A.2  As indicated above, taxpayers have cast these transactions in a variety of forms.  Indeed, Notice 99-59 expressly provided that the scenario described in the notice is merely one of a variety of forms covered by the notice.  In one such form, taxpayers do not form a partnership, but instead form a new corporation, and are shareholders of such corporation.  In another form, taxpayers use a pre-existing corporation which already has earnings and profits.  Rather than distribute cash to its shareholders, the pre-existing corporation borrows money, purchases assets such as Treasury Bills, encumbers the assets with the borrowing, and distributes the "encumbered" assets to its shareholders.  The pre-existing corporation remains primarily liable for the debt and eventually pays off the debt with its other assets.  The common factor is that these transactions involve the distribution of encumbered property, and the assertion that the fair market value of that property is reduced by the amount of the encumbrance.


Q.3  On what basis will the Service disallow the claimed tax benefits of this transaction?

A.3  The loss claimed, or the income excluded, from this transaction does not reflect the actual economic consequences of the transaction.  Instead, the claimed tax benefits are the result of a series of contrived steps, and do not reflect actual losses or reductions in income.  Additional legal theories may be appropriate based on the particular facts of each case.  For a complete discussion of the Service’s position, see Notice 99-59, 1999-2 C.B. 761.


Q.4  What are the appropriate adjustments for Notice 99-59 cases resolved under the Announcement 2005-80 settlement initiative?

A.4  The claimed benefits of this transaction depend on the corporation acquiring, encumbering, and then distributing securities, and then later using other, unencumbered assets to pay off the debt.  The parties never intended the “encumbered” securities to truly secure the underlying liability, and that other assets have been set aside for the purpose of paying that liability.  Because of this, the distribution of “encumbered” securities should be treated as a distribution of unencumbered securities, and treated according to the provisions of IRC Section 301(c).  Because the distributing corporation is often a new entity, the taxpayer’s basis in corporate stock will ordinarily be reduced by the fair market value of the distributed securities, pursuant to IRC Section 301(c)(2), with a corresponding reduction in the taxpayer’s capital loss upon the deemed disposition of company stock.  In some of these cases, however, a portion of the distribution will constitute a dividend as defined in IRC Section 316.  In such instances, some or all of the distribution is a dividend to the taxpayer, and should be included in gross income pursuant to IRC Section 301(c)(1) at the time of the distribution.

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7.  Rev. Rul. 2004-98 (“Reimbursements” for parking expenses…)

Q.1  Is the employer required to file Form W-2c, Corrected Wage and Tax Statement, to resolve a transaction described in Rev. Rul. 2004-98, Rev. Rul. 2002-3, or Rev. Rul. 2002-80 under the Announcement 2005-80 settlement initiative?

A.1  Yes.  The employer is required to file a Form W-2c for each affected employee for each affected tax year.  In accordance with the Form 906 Closing Agreement, the employer will report the increased wages in Box 3 for social security wages and Box 5 for Medicare wages.  Form W-2c, Box 1, should not include the increased wages.  The employer is responsible for payment of federal income tax withholding, FICA tax and FUTA tax owed pursuant to the Form 906.  Filing the Form W-2c in the manner described will reflect increased wages for social security and Medicare benefit purposes, but will not require employees to amend their Forms 1040, U.S. Individual Income Tax Returns.  The Service will not assess additional income taxes against employees of the employer as a result of the Form W-2c.  The employer will file each original Form W-2c (along with transmittal Form W-3c) with the Social Security Administration, and will furnish copies of the W-2c to the employee and to the revenue agent prior to finalizing the Form 906 Closing Agreement. 


Q.2  What suggested language may an employer use to notify an employee of the purpose of the Form W-2c provided to the employee?

A.2  The following suggested language may be provided to the employee with a copy of the Form W-2c:

You are receiving a copy of Form W-2c, Corrected Wage and Tax Statement, that reflects a correction and increase in social security wages and Medicare wages reported to the Social Security Administration.  The corrected wages are reported in Box 3 for social security wages and Box 5 for Medicare wages.  The Form W-2c does not include any increase to your federal income tax wages reported in Box 1.  The Form W-2c is for informational purposes only relating to social security and Medicare wages; it does not require any action by you.  You are not required to file an amended Form 1040, U.S. Individual Income Tax Return based on receipt of this Form W-2c. 


Q.3  What is the applicable rate the employer must pay for income tax withholding?

A.3  The employer will pay federal income tax withholding at a rate of 15% of the increased wages.  The employer will pay FICA taxes and FUTA taxes at the statutory rates with the Form 906 Closing Agreement.


Q.4  Will the federal income tax withholding, FICA tax, and FUTA tax adjustments for increased wages be subject to interest-free adjustments under IRC Section 6205?

A.4  For income tax withholding and FICA tax adjustments, the answer is yes, but for FUTA tax adjustments, the answer is no.  Federal income tax withholding and FICA tax adjustments will be treated as interest-free adjustments under IRC Section 6205.  Under IRC Section 6205, federal income tax withholding and FICA tax liabilities may be satisfied without statutory interest if the additional tax is paid by the due date of the Form 941, Employer’s Quarterly Tax Return, for the period during which the error was ascertained.  The error will be considered ascertained on the date the Form 906 Closing Agreement is signed.  FUTA taxes and penalties are subject to the normal interest rules. 


Q.5  Will the employer be required to terminate the plan to participate in the settlement agreement?

A.5  Yes.  The employer must terminate the plan or arrangement described in Announcement 2005-80, or the part of the plan or arrangement that is described in the announcement.  The employer must provide the IRS agent a corporate resolution, plan amendment or similar binding document that reflects termination of the plan or arrangement and includes the effective date of the termination and the date the document is executed by the employer.  This must be done before the Form 906 is finalized.


Q.6  Are public employers and other tax-exempt employers eligible to participate in the settlement initiative?

A.6  Yes.  The settlement initiative is available to all employers who may have filed an incorrect Form 941, Employer’s Quarterly Federal Tax Return, due to participation in the transactions described in Rev. Rul. 2002-3, Rev. Rul. 2002-80, or Rev. Rul. 2004-98.  The specific amount of additional FICA tax will be based on the statutory provisions applicable to these taxpayers.  Public and other tax-exempt employers, however, are exempt from FUTA tax.

 

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8. Rev. Rul. 2004-20 and Rev. Rul. 2004-21 (Pension plan fails to satisfy…)

Q.1  Announcement 2005-80 states that transactions described in Situation 1 and Situation 2 of Rev. Rul. 2004-20, 2004-1 C.B. 546, are eligible to be settled under the settlement initiative.  What are these Situations?

A.1  Rev. Rul. 2004-20 addresses issues arising from the use of life insurance contracts and annuity contracts to fund certain pension plans.  In Situation 1, an employer maintains a defined benefit plan that is funded solely with life insurance contracts and annuity contracts.  The plan is intended to be a IRC Section 412(i) plan, but the amounts that will be accumulated for a participant under the contracts will provide for benefits at normal retirement age in excess of the participant’s benefits at normal retirement age under the terms of the plan.  Rev. Rul. 2004-20 holds that such a plan cannot be a IRC Section 412(i) plan. 

In Situation 2 an employer’s pension plan provides a death benefit to a participant that meets the definition of an incidental death benefit under the regulations.  The assets of the plan include life insurance contracts on the life of the participant with a face amount in excess of that participant’s death benefit.  The revenue ruling holds with respect to Situation 2 that the employer contributions that are used to purchase the excess coverage are not fully deductible when contributed.  Instead, these contributions may be deductible in future years.  The revenue ruling also identifies Situation 2 as a listed transaction (except where the face amount exceeds the death benefit by not more than $100,000).


Q.2  Announcement 2005-80 states that transactions described in Rev. Rul. 2004-21, 2004-1 C.B. 544, are also eligible to be settled under this initiative.  What are these transactions?

A.2  In Rev. Rul. 2004-21 an employer maintains a retirement plan that is intended to be qualified under section 401(a).  The plan provides an incidental death benefit and holds a life insurance contract on the life of each participant to fund that benefit.  Before distributions to a participant begin under the plan, each participant is given the opportunity to purchase the applicable contract for its cash surrender value.  The value of the rights to purchase the contracts is different for the highly compensated employees (HCEs) and the nonhighly compensated employees (NHCEs). This may occur, for example, where the features of the contracts are different for the highly compensated employees (HCEs) and the nonhighly compensated employees (NHCEs).  Because the rights of the NHCEs to purchase the contracts are of inherently lesser value than the rights of the HCEs, Rev. Rul. 2004-21 holds that a plan holding such contracts under these circumstances fails to satisfy the nondiscrimination requirements of section 401(a)(4). 


Q.3  What settlement terms will a taxpayer be expected to agree to with respect to these transactions if the taxpayer elects to participate in the Announcement 2005-80 settlement initiative?

A.3  In general, the Service will disallow all deductions for any contributions to the plan for all open years.  The plan must distribute the insurance contracts to the plan participants and the plan must be terminated.  At the time of the distribution, the employer will be permitted to deduct the lesser of (1) the amount of the contributions for which deductions were previously disallowed, or (2) the amount included in income by the participant upon the distribution of the contract.  An accuracy-related penalty of 5% will generally be imposed on any underpayment attributable to the transactions.  See Section 4.E of the announcement and Q&As 4.2 through 4.4 and 4.20 through 4.21 of the general FAQs for exceptions to the penalty.


Q.4  How will the plan participants be affected?

A.4  Under the settlement initiative, the fair market value of the distributed contracts must be included in the applicable participant’s income with the sum of the premiums paid on the contracts being treated as the fair market value for this purpose. The distribution to the participant will be treated as a distribution from a nonqualified plan for purposes of IRC Sections 72 and 402.  Thus, for example, participants cannot roll over distributions of the contracts to another retirement plan or to an IRA.  The Service will not execute a closing agreement for this transaction pursuant to this settlement initiative unless both the employer and the plan participant elect to participate in the settlement agreement.


Q.5  Will an employer have to pay an excise tax under IRC Section 4972 with respect to the deductions that are disallowed?

A.5  No.  The IRC Section 4972 excise tax applies to contributions with respect to qualified plans.  Because the plan is treated as a nonqualified plan, the IRC Section 4972 tax will not apply.


Q.6  If an employer believes that at least one situation, but not all three situations, are present, will the settlement terms be adjusted to reflect this?

A.6  No.  The settlement terms may not be altered.  An employer can decide not to elect the initiative and have their case processed through the traditional examination procedures.  However, Announcement 2005-80 will no longer be available and all applicable adjustments and taxes will be proposed.  For example, unless the plan is disqualified for an applicable tax year, the excise tax under IRC Section 4972 will apply to any deductions that are disallowed.


Q.7  How do the settlement terms apply to a C corporation?

A.7  As described in Q&As 4 and 5, deductions for contributions to the plan are disallowed for all open taxable years.  The plan must be terminated and the insurance contracts distributed to the individual participants.  The participants will include an amount in income in the year of distribution equal to the sum of all the premiums paid on the insurance contracts they receive as a distribution.  If all years are open years, the C corporation may take a deduction for the amounts included in the participants’ income.  The C corporation and the individual participants must enter into closing agreements with the Service that reflect these terms.


Q.8  How are the settlement terms for a C corporation affected if some of the taxable years are barred by the statute of limitations on assessment?

A.8  As described above, the contributions deducted in the open years are disallowed.  The sum of the premiums paid for all years on the contracts that are distributed to the participant (including the premiums paid in closed years) are included in the income of each participant.  However, the amount allowed as a deduction for the C corporation in the year the contracts are distributed is the amount included in participants’ income reduced by the amounts deducted in the closed years.


Q.9  If a plan was a top-heavy plan under IRC Section 416 and maintained an auxiliary fund as described in Q&A M-17 of Treas. Reg. § 1.416-1, how are the settlement terms affected?

A.9  The amounts contributed to an auxiliary fund are treated as premiums for purposes of the settlement initiative.  Thus, contributions to the auxiliary fund for open taxable years are disallowed, amounts from the auxiliary fund that are paid to non-key employees are included in the income of the employees, and the C corporation receives a corresponding deduction.


Q.10  How does the settlement initiative apply to a self-employed individual?

A.10  Because amounts that are disallowed for a self-employed individual are shown on the individual’s income tax return, the settlement terms apply differently to a self-employed individual.  The deductions are still disallowed for open years and thus result in an increase in taxable income to the self-employed individual in open years.  The plan is terminated and the contracts distributed.  In the case of contracts distributed to a self-employed individual, the amount included in income is the sum of the premiums paid for the contracts reduced by the amounts added to taxable income with respect to the contracts for the open years.  Thus, in the year of distribution, no deduction is allowed with respect to the distribution of the contracts to the self-employed individual (or his or her spouse) but a deduction is allowed with respect to the sum of the premiums paid to other employees.


Q.11  How does the settlement initiative apply to a partnership or S corporation?

A.11  The settlement terms that apply to a partnership or S Corporation are similar to those that apply to a self-employed individual.  Thus, the amounts disallowed with respect to the plan for the open years result in an increase in the taxable income of the partners of the partnership or shareholders in the S corporation in the manner any disallowance would normally be allocated under an examination.  With respect to the contracts distributed to partners or shareholders, the amounts included in income are the sum of the premiums paid reduced by the amounts added to taxable income with respect to the contracts in the earlier taxable years.


Q.12  Is the settlement initiative available if no Form 5500 was filed with respect to a plan (for example because only the owner participated in the plan and the insurance contracts were valued at less than $100,000)?

A.12  Yes.  The mere fact that the Form 5500 was not filed with respect to the plan will not prevent a taxpayer from participating in the settlement initiative. 

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9. Notice 2004-8 (Abusive Roth IRA Transactions)

Q.1  What simplifying assumptions will be used to resolve the Notice 2004-8 transaction?

A.1  For the limited purpose of resolving the Notice 2004-8 transaction under Announcement 2005-80, various simplifying assumptions will be used to determine the amount of tax that must be paid.  The following simplifying assumptions are for cases in which the Roth IRA does not predate the Notice 2004-8 transaction, did not receive any rollover contributions from another Roth IRA or conversion contributions, and did not make any distributions that were rolled over to another Roth IRA.  Thus, all assets must be disgorged from the Roth IRA and are not eligible for rollover treatment.  Appropriate adjustments will be made in those cases involving pre-existing Roth IRAs, rollover contributions from another Roth IRA, conversion contributions, or distributions that were rolled over to another Roth IRA.

All contributions to the Roth IRA will be treated as made on June 30, 2003.

All distributions from the Roth IRA will treated as made on December 31, 2004, except that actual distribution dates will be used for determining fair market value and for the allocation between contributions and earnings described below.  The fair market value of Roth IRA Corporation stock distributed from the Roth IRA is equal to the greater of (1) the fair market value of the assets of the Roth IRA Corporation reduced by the Roth IRA Corporation’s liabilities, if any, or (2) three times the taxable income of the Roth IRA Corporation for the taxable year ending in 2004.

The total amount distributed will be allocated between contributions and earnings as follows:  the contributions consist of the amount(s) distributed, discounted to June 30, 2003, at a 7% annual rate (i.e., by assuming that the contributions generated earnings at that rate).  The difference constitutes earnings.  For example, if all assets are distributed on March 31, 2006, and there were no prior distributions, there will be 2.75 years of discounting so that 83% of the amount distributed will be treated as having been contributed on June 30, 2003, and the remaining 17% will be treated as earnings.

Additional simplifying assumptions are built into Q&A-2 through -4, below.


Q.2  What is the appropriate income tax adjustment?
 
A.2  The fair market value of all assets distributed (including prior distributions), reduced by actual cash contributions made by the Roth IRA owner to that Roth IRA and by any amounts already included in gross income on account of prior distributions, must be included in the Roth IRA owner's gross income as ordinary income for the 2004 taxable year.


Q.3  Will the Roth IRA owner be subject to the 10 percent additional tax on early distributions under IRC Section 72(t)?

A.3  Yes, unless one of the exceptions set forth in IRC Section 72(t)(2) is available.  If no exception is available, the additional tax is applied in 2004 to the earnings portion (as determined above) of the total amount distributed.


Q.4  How is the IRC Section 4973 excise tax on excess contributions to the Roth IRA calculated? 

A.4  The excess contributions to the Roth IRA consist of the contribution portion (as determined above) of the total amount distributed, reduced by $3,000.  The excise tax for 2003 is 6 percent of the excess contributions.  There is no excise tax for 2004 or later years because all amounts (including the excess contributions) are treated as distributed on December 31, 2004.


Q.5  What is an example of these tax calculations?

A.5  Assume that the Roth IRA distributes all assets to the Roth IRA owner on March 31, 2006.  The assets, including the Roth IRA Corporation, have a fair market value on that date of $200,000, and there were no prior distributions.  Assume further that the owner contributed $2,000 cash in 2002 and made no other cash contributions to the Roth IRA.  Allocating the total distribution between contributions and earnings as described in Q&A-1 above, the contributions are $166,000 (83% of $200,000) and the earnings are $34,000 (17% of $200,000).  Therefore –
• $198,000 ($200,000 - $2,000) is included in the Roth IRA owner's gross income as ordinary income in 2004. 
• The 10 percent additional tax of IRC Section 72(t) is applied to the $34,000 earnings unless one of the exceptions in IRC Section 72(t)(2) is available. 
• The 6 percent excise tax under IRC Section 4973 is applied to $163,000 excess contributions ($166,000 - $3,000).

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10. Revenue Ruling 2004-4 (Transactions that involve…employee stock ownership plan (ESOP)…)

Q.1 Announcement 2005-80 states that listed transactions under Rev. Rul. 2004-4, 2004-1 C.B. 414, are eligible for settlement under the initiative. What abuse was involved in that revenue ruling?

A.1 Rev. Rul. 2004-4 describes three situations in which the ownership structure of an S corporation is designed to allow one or more taxpayers, each operating a business for his or her own benefit, to take advantage of the tax-exempt status of the S corporation that results from the ownership of its stock by an employee stock ownership plan (ESOP). In each situation, the taxpayer segregated the profits of his or her business, accumulated them in a qualified subchapter S subsidiary (QSub), and retained the right to at least 50 percent of the business through the right to acquire shares in the QSub. Thus, the ESOP was the owner of the business in form only and the ESOP was not providing benefits to the rank-and-file employees. Rev. Rul. 2004-4 holds that the taxpayers are treated as holding “synthetic equity” for purposes of IRC Section 409(p).

Q.2 What is IRC Section 409(p) and what does it provide?

A.2 In 2001, Congress added IRC Section 409(p) to address concerns about ownership structures involving S corporations and ESOPs that concentrate the benefits of the ESOP in a small number of persons. In general, this section imposes income and excise taxes when there are prohibited allocations under an S corporation ESOP in a nonallocation year. The rules under IRC Section 409(p) are complex. For more information on the application of IRC Section 409(p), click on the following links for the text of Temporary regulations published on July 21, 2003 and December 17, 2004.

Q.2(a) What is a nonallocation year?

A.2(a) A nonallocation year occurs when the ownership of the S corporation is so concentrated that disqualified persons own or are deemed to own at least 50 percent of the S corporation shares. Disqualified persons are persons who own, or who are deemed to own, at least 10 percent of the S corporation stock held by the ESOP (or 20 percent with family members). See Treas. Reg. § 1.409(p)-1T(c) and (d)). In determining whether there has been a nonallocation year, including whether someone is a disqualified person, "synthetic equity" is taken into account.

Q.3 What is a “synthetic equity”?

A.3 Synthetic equity is defined in IRC Section 409(p)(6)(C) and Treas. Reg. § 1.409(p) -1T(f) to include any stock option, warrant, restricted stock, deferred issuance stock right, stock appreciation right payable in stock, or similar interest or right that gives the holder the right to acquire or receive stock of the S corporation in the future. Synthetic equity can also include the right to acquire stock in an entity related to the S corporation, such as a QSub. It may also include other items such as nonqualified deferred compensation. For further information on the definition of synthetic equity, see Treas. Reg. § 1.409(p) -1T(f)).

Q.4 What settlement terms apply to this transaction?

A.4 For every year that is a nonallocation year and in which an individual with a right to acquire a QSub of the S corporation is a disqualified person, Rev. Rul. 2004-4 treats the individual’s interest in the QSub as synthetic equity during a nonallocation year and thus subject to the excise tax under IRC Section 4979A. If any disqualified person is a participant in the ESOP and there are prohibited allocations to any disqualified person (within the meaning of IRC Section 409(p)) during any nonallocation years, the S corporation will be subject to the excise taxes imposed by IRC Section 4979A on prohibited allocations and the disqualified person will be subject to the deemed distribution rules of IRC Section 409(p)(2).

Q.4(a) What income tax consequences apply under this settlement initiative?

A.4(a) Individual participants, trusts and corporations involved in this transaction may be liable for income tax on prohibited allocations. The trust may also be liable for tax on unrelated business income.

Q.4(b) What are the excise tax consequences of this settlement?

A.4(b) If any year is a nonallocation year, the S corporation will be subject to the IRC Section 4979A(a) excise tax on prohibited allocations under IRC Section 409(p) attributable to synthetic equity held by a disqualified person in a nonallocation year, and in certain cases on the occurrence of the ESOP's first nonallocation year under IRC Section 4979A(e)(2)(C).

Q.5 Will the plan cease to be an ESOP under the terms of the settlement?

A.5 In appropriate circumstances, the plan may cease to be an ESOP, which will carry with it certain tax consequences, e.g., the distributive share of income on S corporation shares held by the ESOP will be unrelated business taxable income to the plan trust.

Q.6 Will the ESOP cease to be a qualified plan under the settlement agreement?

A.6 In the appropriate case, the Service may determine that the plan is not, or has ceased to be, qualified under IRC Section 401(a), resulting in termination of the S corporation election and other tax consequences. Other tax benefits claimed by any taxpayer involved in the business structure may have to be conceded in this situation. See Rev. Rul. 2004-4.

Q.7 How will distributions from the ESOP be treated under the settlement?

A.7 As described in Q&A-6, if the ESOP ceases to be qualified, any distributions from the ESOP that were made after the plan ceased to be qualified and that were rolled over to another retirement plan must be distributed from the other retirement plan as an amount not eligible for rollover. If the rollover was to an individual retirement account (IRA), the individual may be subject to the IRC Section 4973 excise tax on excess contributions to an IRA.

Q.8 Will the S corporation be required to distribute the interest in the QSubs as part of the settlement?

A.8 In connection with this resolution, the S corporation may be required to distribute the interest in the QSubs. The S corporation may also be required to terminate the plan as a condition of resolving the transaction.

Q.9 What should a taxpayer do if the taxpayer wants to correct a situation relating to an ESOP that does not involve a transaction covered by this settlement initiative?

A.9 If the transaction is related to the ESOP, but is not covered in Announcement 2005-80, the taxpayer may wish to consider the other customary procedures applicable to retirement plans.

Q.10 If the taxpayer had already taken steps to unwind the transaction before the settlement initiative described in Announcement 2005-80 was issued, does the taxpayer need to elect to participate in the settlement initiative?

A.10 The taxpayer must file a Form 13750, Election to Participate in Announcement 2005-80 Settlement Initiative, to participate. Although the taxpayer may have already taken some steps to unwind the transaction, participation in this settlement initiative will be the best way to ensure that all tax matters (including additions to tax, interest and penalties) pertaining to the transaction are conclusively resolved.

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12. Notice 2003-24 (Tax Problems Raised by Certain Trust Arrangements…)

Q-1  If the taxpayer is the only employee covered by an insurance policy under the plan that the employer joined, are both the taxpayer and the employer required to elect to participate in the Announcement 2005-80 settlement initiative?

A-1  Yes.


Q-2  If several employees are covered under the employer’s plan, are all the employees required to elect to participate in the settlement initiative?

A-2  No.  The Service generally expects that all of an employer’s covered employees will elect to resolve issues associated with an employer’s plan under this initiative.  However, the failure of some employees to participate will not automatically preclude settlement by otherwise eligible electing parties.  For example, settlement will generally not require the participation of an employee who has no direct or indirect ownership interest in the employer and received only minimal benefits such as coverage under term life insurance policies.  Also, if an employer is a partnership or an S corporation with more than one shareholder and only some of the partners or shareholders elect to participate, the Service may in its discretion settle with those that do elect. 


Q-3  May a taxpayer participate in the initiative if the plan administrator refuses to make the distribution of assets as described in the notice. 

A-3  Yes.  While the Service expects that in most cases, all plan assets will be distributed to participants as described in the initiative, the Service will consider alternative arrangements to effectuate the purposes of the initiative if electing participants can establish that they are unable to meet the distribution requirement because of circumstances beyond their control.  Thus, if both the individual and corporate taxpayers elect to participate, and otherwise comply with all terms of the initiative, including the production of complete documentation regarding the plan, the Service will enter into a closing agreement consistent with the initiative’s requirements.


Q-4  Under the settlement initiative life insurance contracts are to be valued at the sum of premiums paid.  What additional documentation will the Service request to establish the sum of premiums paid?

A-4  The Service will generally request two or more of the following documents to assist in establishing the sum of the premiums paid with respect to each covered employee:

a.  copies of statements from the insurance company showing premiums paid;
b.  copies of the cancelled checks used to buy the insurance;
c.  copies of all corporate income tax returns on which deductions were claimed for premium payments;
d.  a letter from the insurance company stating the dates and amounts of premium payments.


Q-5  Are there methods, other than the method described in the initiative, by which insurance contracts can be valued?

A-5  No.  The valuation method set forth in Announcement 2005-80 is the exclusive valuation method to be used for purposes of this initiative.  The initiative is designed to reduce the burden on both taxpayers and the Service.  The terms of the initiative must be accepted in their entirety; taxpayers will not be permitted to select terms. 


Q-6  If the plan sponsor terminated the arrangement and the employer “rolled over” to another plan, is the initiative still available?

A-6  Yes.  Under the initiative, premium amounts paid under the first plan are taxable to the employee in the year of the “rollover” or, if that is later than 2004, in 2004.  Participation in the second plan must also be terminated in accordance with the initiative.  Thus, premium amounts paid under the second plan are taxable to the employee in 2004 (or earlier, if the second plan terminated before 2004).


Q-7  Under the initiative “all distributions are included in employees’ income when received, except to the extent of amounts actually included in prior years.”  What additional information can a taxpayer expect the Service to request for this purpose?

A-7  The Service will generally ask for a copy of each income tax return on which such distributions were reported together with an explanation explaining the reported amounts.    


Q-8  If the employer’s plan is still in effect and the taxpayer participates in the initiative but does not receive a distribution until 2006, is the taxpayer still required to report the distribution in as income in 2004?

A-8  Yes. 


Q-9  How does a taxpayer include distributions in income for the 2004 tax year?

A-9  After the taxpayer elects to participate in the initiative, the Service will prepare the required paperwork to accomplish this adjustment.


Q-10  Why should a taxpayer participate in the initiative if a taxpayer was in a plan that terminated in 2003 or 2004, and at that time received and reported a distribution?

A-10  In many cases the amounts reported upon plan terminations do not properly reflect the value of the property distributed.  The Service is aware of a number of such situations and will conduct examinations as necessary.  The initiative offers electing taxpayers a simple and cost effective approach to resolving such cases.

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13. Revenue Ruling 2003-6 (Certain arrangements involving the transfer of ESOPs…)

 Q.1 Announcement 2005-80 states that listed transactions under Rev. Rul. 2003-6, 2003-1 C.B. 286, are eligible for settlement under the initiative. What abuse was involved in that revenue ruling?

A.1 Rev. Rul. 2003-6 concerns certain arrangements where employee stock ownership plans (ESOPs) holding employer securities in an S corporation were being used for the purpose of improperly claiming eligibility for the delayed effective date of IRC Section 409(p). These arrangements are referred to as “S corporation ESOPs.”

Q.2 What is IRC Section 409(p) and what does it provide?

A.2 In 2001, Congress added IRC Section 409(p) to address concerns about ownership structures involving S corporations and ESOPs that concentrate the benefits of the ESOP in a small number of persons. In general, this section imposes income and excise taxes when there are prohibited allocations under an S corporation ESOP in a nonallocation year. The rules under IRC Section 409(p) are complex. For more information on the application of IRC Section 409(p), click on the following links for the text of temporary regulations published on July 21, 2003 and December 17, 2004.

Q.2(a) What is a nonallocation year?

A.2(a) A nonallocation year occurs when the ownership of the S corporation is so concentrated that disqualified persons own or are deemed to own at least 50 percent of the S corporation shares. Disqualified persons are persons who own, or who are deemed to own, at least 10 percent of S corporation stock held by the ESOP (or 20 percent with family members). For further information, see Treas. Reg. § 1.409(p)-1T(c) and (d). In determining whether a nonallocation year has occurred, including whether someone is a disqualified person, "synthetic equity" is taken into account. Q.3 What is “synthetic equity”? A.3 Synthetic equity is defined in IRC Section 409(p)(6)(C) and Treas. Reg. § 1.409(p)-1T(f) to include any stock option, warrant, restricted stock, deferred issuance stock right, stock appreciation right payable in stock, or similar interest or right that gives the holder the right to acquire or receive stock of the S corporation in the future. Synthetic equity can also include the right to acquire stock in an entity related to the S corporation, such as a qualified subchapter S subsidiary (a QSub). It may also include other items such as nonqualified deferred compensation. For further information on the definition of synthetic equity, see Treas. Reg. § 1.409(p)-1T(f).

Q.4 What was the delayed effective date of IRC Section 409(p)?

A.4 For S corporation ESOPs in existence on March 14, 2001, IRC Section 409(p) was effective for plan years beginning after December 31, 2004. This delayed effective date allowed existing S corporations that maintained ESOPs at the time of enactment to come into compliance with IRC Section 409(p). However, IRC Section 409(p) was effective for plan years ending after March 14, 2001, for an ESOP that is established after that date, or if the corporation's S election was not in effect on that date.

Q.5 How was this effective date provision being abused?

A.5 On or before March 14, 2001, some tax advisors arranged for the establishment of a number of S corporations that had no substantial assets or business and formed an ESOP for each of these corporations. The employees of these advisors were allegedly eligible to participate under the terms of each of the ESOPs, but there was no reasonable expectation that these employees would accrue more than insubstantial benefits under the plans. After March 14, 2001, these S corporations and the associated ESOPs were marketed to various taxpayers and these taxpayers restructured their businesses so that the S corporation received income from those businesses. These taxpayers then claimed that the provisions of IRC Section 409(p) did not apply to them because they were eligible for the delayed effective date discussed above.

Q.6 What does Rev. Rul. 2003-6 hold?

A.6 The revenue ruling holds that, for purposes of the effective date of IRC Section 409(p), an ESOP described in this situation is not established until it is adopted by an employer to enable its employees to participate in more than an insubstantial manner in the ownership of the employer's business and to provide employees with more than insubstantial benefits. Since this occurs after March 14, 2001, the ESOP is not eligible for the delayed effective date under IRC Section 409(p). The ruling also holds that transactions that are the same as, or substantially similar to, the transaction described in the revenue ruling are listed transactions.

Q.7 What settlement terms will apply to this transaction?

A.7 Because the ESOP was established after March 14, 2001, it will be subject to IRC Section 409(p) effective for plan years ending after that date. Thus, if the ESOP fails IRC Section 409(p) for any plan year, the S corporation will be subject to the 50 percent excise tax imposed by IRC Section 4979A and any disqualified persons will be currently taxable on deemed distributions under IRC Section 409(p)(2).

Q.7(a) What are the income tax consequences that apply to this settlement?

A.7(a) Individuals who received prohibited allocations in a nonallocation year will be taxable on such allocations. The plan will be liable for unrelated business income tax on its share of the S corporation's income. (See Q&A-7).

Q.7(b) What are the excise tax consequences of this settlement?

A.7(b) If any year is a nonallocation year, the S corporation will be subject to the IRC Section 4979A(a) excise tax on prohibited allocations under IRC Section 409(p) attributable to synthetic equity held by a disqualified person in a nonallocation year, and in certain cases on the occurrence of the ESOP's first nonallocation year under IRC Section 4979A(e)(2)(C).

Q.8 Will the plan cease to be an ESOP under the terms of the settlement?

A.8 In appropriate circumstances, the plan may cease to be an ESOP, which will carry with it certain tax consequences, e.g., the distributive share of income on S corporation shares held by the ESOP will be unrelated business taxable income to the plan trust.

Q.9 Will the ESOP cease to be a qualified plan under the settlement agreement?

A.9 In the appropriate case, the Service may determine that the plan is not, or has ceased to be, qualified under IRC Section 401(a), resulting in termination of the S corporation election and other tax consequences. Other tax benefits claimed by any taxpayer involved in the business structure may have to be conceded in this situation.

Q.10 How will distributions from the ESOP be treated?

A.10 Any distributions from the ESOP that were made after the plan ceased to be qualified and that were rolled over to another retirement plan must be distributed from the other retirement plan as an amount not eligible for rollover. If the rollover was to an IRA, the individual may be subject to the excise tax under IRC Section 4973 for an excess contribution to an IRA.

Q.11 What should a taxpayer do if the taxpayer wants to correct a situation relating to an ESOP that does not involve a transaction covered by this settlement initiative?

A.11 If the transaction is related to the ESOP, but is not covered in Announcement 2005-80, the taxpayer may wish to consider the other customary procedures applicable to retirement plans.

Q.12 If the taxpayer had already taken steps to unwind the transaction before the settlement initiative described in Announcement 2005-80 was issued, does the taxpayer need to elect to participate in the settlement initiative?

A.12 The taxpayer must file a Form 13750, Election to Participate in Announcement 2005-80 Settlement Initiative, to participate. Although the taxpayer may have already taken some steps to unwind the transaction, participation in this settlement initiative will be the best way to ensure all tax matters (including additions to tax, interest and penalties) pertaining to the transaction are conclusively resolved.

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14.  Rev. Rul. 2002-3/2002-80 (“Reimbursements” of employees for salary reduction…)

Q.1  Is the employer required to file Form W-2c, Corrected Wage and Tax Statement, to resolve a transaction described in Rev. Rul. 2004-98, Rev. Rul. 2002-3, or Rev. Rul. 2002-80 under the Announcement 2005-80 settlement initiative?

A.1  Yes.  The employer is required to file a Form W-2c for each affected employee for each affected tax year.  In accordance with the Form 906 Closing Agreement, the employer will report the increased wages in Box 3 for social security wages and Box 5 for Medicare wages.  Form W-2c, Box 1, should not include the increased wages.  The employer is responsible for payment of federal income tax withholding, FICA tax and FUTA tax owed pursuant to the Form 906.  Filing the Form W-2c in the manner described will reflect increased wages for social security and Medicare benefit purposes, but will not require employees to amend their Forms 1040, U.S. Individual Income Tax Returns.  The Service will not assess additional income taxes against employees of the employer as a result of the Form W-2c.  The employer will file each original Form W-2c (along with transmittal Form W-3c) with the Social Security Administration, and will furnish copies of the W-2c to the employee and to the revenue agent prior to finalizing the Form 906 Closing Agreement. 


Q.2  What suggested language may an employer use to notify an employee of the purpose of the Form W-2c provided to the employee?

A.2  The following suggested language may be provided to the employee with a copy of the Form W-2c:

You are receiving a copy of Form W-2c, Corrected Wage and Tax Statement, that reflects a correction and increase in social security wages and Medicare wages reported to the Social Security Administration.  The corrected wages are reported in Box 3 for social security wages and Box 5 for Medicare wages.  The Form W-2c does not include any increase to your federal income tax wages reported in Box 1.  The Form W-2c is for informational purposes only relating to social security and Medicare wages; it does not require any action by you.  You are not required to file an amended Form 1040, U.S. Individual Income Tax Return based on receipt of this Form W-2c. 


Q.3  What is the applicable rate the employer must pay for income tax withholding?

A.3  The employer will pay federal income tax withholding at a rate of 15% of the increased wages.  The employer will pay FICA taxes and FUTA taxes at the statutory rates with the Form 906 Closing Agreement.


Q.4  Will the federal income tax withholding, FICA tax, and FUTA tax adjustments for increased wages be subject to interest-free adjustments under IRC Section 6205?

A.4  For income tax withholding and FICA tax adjustments, the answer is yes, but for FUTA tax adjustments, the answer is no.  Federal income tax withholding and FICA tax adjustments will be treated as interest-free adjustments under IRC Section 6205.  Under IRC Section 6205, federal income tax withholding and FICA tax liabilities may be satisfied without statutory interest if the additional tax is paid by the due date of the Form 941, Employer’s Quarterly Tax Return, for the period during which the error was ascertained.  The error will be considered ascertained on the date the Form 906 Closing Agreement is signed.  FUTA taxes and penalties are subject to the normal interest rules. 


Q.5  Will the employer be required to terminate the plan to participate in the settlement agreement?

A.5  Yes.  The employer must terminate the plan or arrangement described in Announcement 2005-80, or the part of the plan or arrangement that is described in the announcement.  The employer must provide the IRS agent a corporate resolution, plan amendment or similar binding document that reflects termination of the plan or arrangement and includes the effective date of the termination and the date the document is executed by the employer.  This must be done before the Form 906 is finalized.


Q.6  Are public employers and other tax-exempt employers eligible to participate in the settlement initiative?

A.6  Yes.  The settlement initiative is available to all employers who may have filed an incorrect Form 941, Employer’s Quarterly Federal Tax Return, due to participation in the transactions described in Rev. Rul. 2002-3, Rev. Rul. 2002-80, or Rev. Rul. 2004-98.  The specific amount of additional FICA tax will be based on the statutory provisions applicable to these taxpayers.  Public and other tax-exempt employers, however, are exempt from FUTA tax.

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17.  Notice 95-34 (Tax Problems Raised by Certain Trust Arrangements…)

Q-1  If the taxpayer is the only employee covered by an insurance policy under the plan that the employer joined, are both the taxpayer and the employer required to elect to participate in the Announcement 2005-80 settlement initiative?

A-1  Yes.


Q-2  If several employees are covered under the employer’s plan, are all the employees required to elect to participate in the settlement initiative?

A-2  No.  The Service generally expects that all of an employer’s covered employees will elect to resolve issues associated with an employer’s plan under this initiative.  However, the failure of some employees to participate will not automatically preclude settlement by otherwise eligible electing parties.  For example, settlement will generally not require the participation of an employee who has no direct or indirect ownership interest in the employer and received only minimal benefits such as coverage under term life insurance policies.  Also, if an employer is a partnership or an S corporation with more than one shareholder and only some of the partners or shareholders elect to participate, the Service may in its discretion settle with those that do elect. 


Q-3  May a taxpayer participate in the initiative if the plan administrator refuses to make the distribution of assets as described in the notice. 

A-3  Yes.  While the Service expects that in most cases, all plan assets will be distributed to participants as described in the initiative, the Service will consider alternative arrangements to effectuate the purposes of the initiative if electing participants can establish that they are unable to meet the distribution requirement because of circumstances beyond their control.  Thus, if both the individual and corporate taxpayers elect to participate, and otherwise comply with all terms of the initiative, including the production of complete documentation regarding the plan, the Service will enter into a closing agreement consistent with the initiative’s requirements.


Q-4  Under the settlement initiative life insurance contracts are to be valued at the sum of premiums paid.  What additional documentation will the Service request to establish the sum of premiums paid?

A-4  The Service will generally request two or more of the following documents to assist in establishing the sum of the premiums paid with respect to each covered employee:

a.  copies of statements from the insurance company showing premiums paid;
b.  copies of the cancelled checks used to buy the insurance;
c.  copies of all corporate income tax returns on which deductions were claimed for premium payments;
d.  a letter from the insurance company stating the dates and amounts of premium payments.


Q-5  Are there methods, other than the method described in the initiative, by which insurance contracts can be valued?

A-5  No.  The valuation method set forth in Announcement 2005-80 is the exclusive valuation method to be used for purposes of this initiative.  The initiative is designed to reduce the burden on both taxpayers and the Service.  The terms of the initiative must be accepted in their entirety; taxpayers will not be permitted to select terms. 


Q-6  If the plan sponsor terminated the arrangement and the employer “rolled over” to another plan, is the initiative still available?

A-6  Yes.  Under the initiative, premium amounts paid under the first plan are taxable to the employee in the year of the “rollover” or, if that is later than 2004, in 2004.  Participation in the second plan must also be terminated in accordance with the initiative.  Thus, premium amounts paid under the second plan are taxable to the employee in 2004 (or earlier, if the second plan terminated before 2004).


Q-7  Under the initiative “all distributions are included in employees’ income when received, except to the extent of amounts actually included in prior years.”  What additional information can a taxpayer expect the Service to request for this purpose?

A-7  The Service will generally ask for a copy of each income tax return on which such distributions were reported together with an explanation explaining the reported amounts.    


Q-8  If the employer’s plan is still in effect and the taxpayer participates in the initiative but does not receive a distribution until 2006, is the taxpayer still required to report the distribution in as income in 2004?

A-8  Yes. 


Q-9  How does a taxpayer include distributions in income for the 2004 tax year?

A-9  After the taxpayer elects to participate in the initiative, the Service will prepare the required paperwork to accomplish this adjustment.


Q-10  Why should a taxpayer participate in the initiative if a taxpayer was in a plan that terminated in 2003 or 2004, and at that time received and reported a distribution?

A-10  In many cases the amounts reported upon plan terminations do not properly reflect the value of the property distributed.  The Service is aware of a number of such situations and will conduct examinations as necessary.  The initiative offers electing taxpayers a simple and cost effective approach to resolving such cases.

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18.  Treas. Reg. § 1.643(a)-8 (Certain Distributions by Charitable Remainder Trusts)
Q.1 Can you provide an overview of this transaction?
A.1 The settlement initiative covers distributions from a charitable remainder trust (CRT) that made distributions subject to Treas. Reg. § 1.643(a)-8 for any taxable year.  The settlement initiative applies to taxpayers that received distributions from a CRT or distributive shares or distributions from a pass-through entity that received distributions directly from the CRT.  It also includes partners of pass-through entities with a CRT as a partner or member.  The Service will provide a calculation of the amounts of the taxpayer’s distributions that are attributable to transactions involving appreciated assets and taxable to the taxpayer as distributions of capital gains.  Taxpayers must concede that these amounts are taxable income to the taxpayer as distributions of capital gains.   An appropriate allowance for basis will be made.

Examples of typical transactions covered by the settlement initiative are the following:

1. Taxpayer formed a CRT and named himself or herself as noncharitable beneficiary and a qualified IRC Section 170(c) organization as the charitable beneficiary.  Taxpayer then contributed appreciated property to the CRT.  The CRT entered into a loan, or some other transaction that resulted in the CRT receiving cash, where such cash was not treated as income at the time of receipt.  The CRT made distributions at least annually to the noncharitable beneficiary.  After the last distribution to the noncharitable beneficiary, the CRT terminated and the remainder was distributed to the charitable beneficiary.  Taxpayer claimed a charitable deduction at the formation of the CRT and did not report any portion of the distributions received as capital gain.

2. Taxpayer formed a CRT named himself or herself as noncharitable beneficiary and a qualified IRC Section 170(c) organization as the charitable beneficiary.  Taxpayer and a related party formed a partnership.  Taxpayer contributed appreciated property to the partnership in exchange for a limited partner interest.  Related party made a pro rata contribution to the partnership in exchange for a general partner interest.  Taxpayer then contributed his or her limited partner interest to the CRT.  The partnership entered into a loan, or a some other transaction that resulted in the CRT receiving cash, where such cash was not treated as income at the time of receipt.  The partnership made annual cash distributions in an amount sufficient to cover the required CRT distributions.  After the last required CRT distribution to the noncharitable beneficiary, the CRT terminated and the remainder was distributed to the charitable beneficiary.  Taxpayer claimed a charitable deduction at the formation of the CRT and did not report any portion of the CRT distributions received as capital gain.


Q.2  Who is eligible to elect the settlement initiative?

A.2  A taxpayer who received distributions from a CRT or distributive shares or distributions from a pass-through entity that received distributions directly from the CRT is eligible to participate in the settlement initiative.  Certain other partners are also eligible.  See Q&A 4.  The CRT itself and any pass-through entities are not eligible to elect the settlement initiative.  Furthermore, the CRT and any TEFRA partnerships do not have to file an election for the taxpayer to be eligible.


Q.3  May a taxpayer participate in the settlement initiative even if the three-year period of limitations on assessment has expired?

A.3  Possibly.  The Service has determined that the six-year period of limitations on assessment under IRC Section 6229(c)(2) or 6501(e) may apply to those taxpayers who omitted income on their return.  If the taxpayer’s period of limitations on assessment is still open, the taxpayer may participate in the settlement initiative.  The Service will require the taxpayer to agree to extend the period of limitations on assessment, however, if it would otherwise expire within 12 months after the election is filed.


Q.4  May a partner or member, other than the CRT, in the pass-through entity participate in the settlement initiative?

A.4  Yes.  A taxpayer who is a partner or member (direct or indirect) of a pass-through entity that had a CRT as a partner is eligible to participate in the settlement initiative.  These taxpayers include general partners and those partners who purchased their partnership interest from the CRT.  General partners and those partners who purchased their interests from the CRT are eligible to participate if they did not correctly report the capital gain attributable to the partnership. 


Q.5  Does Announcement 2005-80 apply to a taxpayer who formed a CRT prior to October 19, 1999, the effective date of Treas. Reg. §1.643(a)-8?

A.5  Yes, the settlement initiative applies to all transactions involving distributions described in Treas. Reg. § 1.643(a)-8 from CRTs, regardless of when the CRT was formed and when the distributions were made.  Thus, the settlement also applies to such CRTs that made distributions before October 19, 1999.


Q.6  How are such distributions treated under the settlement initiative?

A.6  Taxpayers electing the settlement initiative must concede that the distributions are taxable as capital gains.  An appropriate allowance for basis will be made.


Q.7  Is there a different treatment for distributions received before October 19, 1999?

A.7  No.


Q.8  If a taxpayer received at least one distribution before October 19, 1999, and distributions on or after October 19, 1999, can the taxpayer elect to settle under the initiative only the distributions that were on or after October 19, 1999, and take the other open years to Appeals?

A.8  No.  A taxpayer that settles under the initiative must settle all years by conceding that the distributions are taxable as capital gains.  An appropriate allowance for basis will be made.  A taxpayer cannot settle some years under the settlement initiative and take other open year to Appeals.  See the general Q&As for Announcement 2005-80 for further discussion of this issue.


Q.9  Does a taxpayer who participates in the settlement initiative lose the charitable contribution deduction received for funding a CRT?

A.9  No.  As long as the CRT meets the requirements set forth in IRC Section 664(d) and (e), the taxpayer will not have to relinquish his or her charitable contribution deduction.


Q.10  What is the effect on the charitable contribution deduction if a taxpayer made a disclaimer, or a partial disclaimer, of his or her required final annuity distribution from a CRT?

A.10  The taxpayer is entitled to a charitable contribution deduction in the amount effectively disclaimed if the disclaimer resulted in a transfer of an undivided portion of the taxpayer’s entire interest to an organization described in IRC Section 170(c).

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19.  Certain abusive charitable contributions and conservation easements (Deductions under § 170 improperly claimed as a result of: (a) open space easements where the easement has no, or de minimis, value; (b) historic land or façade easements that have no, or de minimis, value; and (c) so-called conservation buyer transactions where the charitable organization purchases property, places an easement on it and then “sells” the property with the easement to a buyer at a price substantially less than that paid for it and the buyer also makes a charitable contribution that approximates the price differential.  See Notice 2004-41).

Q.1  How much of a taxpayer's claimed deduction for having participated in a transaction described in Notice 2004-41 will be disallowed under this initiative?

A.1  Under the initiative, the entire amount of the claimed deduction will be disallowed, including any losses related to the disposition of related state tax credits.


Q.2  If a taxpayer participates in the settlement initiative and enters into a closing agreement resolving the tax treatment of the transaction, will the settlement invalidate the easement?

A.2  Whether the conservation easement is valid depends on the state and local law governing the creation and transfer of the easement.  The validity of the easement is not affected by any closing agreement between the taxpayer and the Service.


Q.3  What additional items can a taxpayer expect the Service to request?

A.3  A taxpayer can expect the Service to request that the taxpayer provide, at a minimum, the easement document, appraisal, other written substantiation documents, proof of payment of transaction costs, and copies of returns for which the taxpayer claimed a charitable contribution deduction or carryover, as well as any other return affected by the resolution of the issue.  If a flow-through entity made the donation, the Service will request that return as well.  The Service will also request additional information regarding the exempt organization.  This will include any agreements in connection with the transaction, all correspondence exchanged with the organization, the date and amount of any payment, and copies of any checks to, or for the benefit of, either the organization or the promoter.  If the taxpayer received a state tax credit, related to the donation, that it sold or transferred, the Service may request information relating to the disposition of the tax credit and the taxpayer’s federal tax treatment of any gains or losses related to the state tax credit.

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21. Management S Corporation ESOP Transactions…

Q.1.  Announcement 2005-80 states that Management S Corporation ESOP transactions are eligible for settlement under the initiative.  What abuse was involved in those transactions?

A.1.  The Service has identified certain transactions involving S corporation management companies owned by employee stock ownership plans (ESOPs) as abusive transactions.  A taxpayer who has an arrangement similar to the one described in this Q&A is eligible to participate in this settlement initiative if the taxpayer otherwise meets the requirements of Announcement 2005-80.

In these transactions, taxpayers have attempted to exclude the income of an operating business through the use of a combination of an S corporation and an arrangement purported to be an ESOP, both of which are claimed to have been established before March 14, 2001.

The owner of an operating business creates (or claims to create) an S corporation (Management S Corporation) and causes the two entities to enter into an agreement under which the operating business is to pay a fee to the S corporation in exchange for management or other services.  In addition, the Management S Corporation establishes (or claims to establish) an employees' trust which is purported to be an ESOP, which is treated as the sole shareholder of the Management S Corporation, and in which the owner of the operating business is the sole participant.  Whatever actions were taken in attempting to establish the ESOP and the Management S Corporation must have been completed on or before March 14, 2001.

Taxpayers have argued that under this arrangement the operating business may deduct its fee payments (or, for an accrual taxpayer, its claimed obligation to pay fees) to the Management S Corporation and the income of the Management S Corporation is passed through to the employees' trust.  They further contend that the income from the Management S Corporation is not subject to tax because the Management S Corporation is owned by an employees' trust purported to be an ESOP and thus is not taxed until distributed.  The Service has determined, however, that many of these purported ESOPs (if actually established) are nonqualified employees' trusts described in IRC Section 402(b) of the Code because the arrangement fails to satisfy one or more requirements under the Code for being a qualified plan under IRC Section 401(a), such as the minimum coverage requirements of IRC Section 410(b).  As a result, because there is no qualified ESOP, the claimed tax benefits of the arrangement are not applicable and the nonqualified ESOP is an impermissible shareholder which terminates the Management S Corporation's S election.

Q.2.  Which parties are eligible to participate in this settlement initiative?
A.2.  All of the following parties are eligible to participate in this settlement initiative:  the operating business; its shareholders (where the operating business is an S corporation), partners or members; the Management S Corporation; the ESOP; and the participants of the ESOP. 


Q.3.  What transactions are eligible to be resolved under this settlement initiative?

A.3.  For the transaction to be eligible, any actions taken to attempt to establish the ESOP and the Management S Corporation must have been taken on or before March 14, 2001.

Q.4.  What terms must the parties agree to in order to resolve the transaction under the settlement initiative?
A.4.  The Management S Corporation must be dissolved and generally will be disregarded for federal income tax purposes and for purposes of determining the parties’ liability.  The terms of the agreement will vary, however, depending on whether cash or property payments were made by the operating business to the Management S Corporation. 


Q.5.  What settlement terms will the taxpayer be expected to agree to if no cash or property payments were made to the Management S Corporation by the operating business?

A.5.  If no cash or property payments were made to the Management S Corporation by the operating business, then the taxpayer must agree to the following settlement terms:

1.   In the first taxable year for which the period of limitations on assessment under IRC Section 6501(a) has not expired (IRC Section 6501(a) open year), the operating business must include in income the total amount of the accrued payables (attributable to management service fees) to the Management S Corporation that were deducted in all years prior to the first IRC Section 6501(a) open year;

2. In all IRC Section 6501(a) open years, the operating business must eliminate the current year deduction for management service fees accrued to the Management S Corporation.


Q.6.  What settlement terms will the taxpayer be expected to agree to if some cash or property payments were made to the Management S Corporation by the operating business?

A.6.  If some cash or property payments were made by the operating business to the Management S Corporation, then the taxpayer must agree to the following settlement terms:

1. To the extent payables were accrued by the operating business, but were never paid to the Management S Corporation, the terms described under A-5, above, apply.

2. If cash or property was paid by the operating business to the Management S Corporation in years prior to the first IRC Section 6501(a) open year, the amount of all cash or property held by the Management S Corporation or ESOP, or rolled over from the ESOP to an IRA or other qualified plan during such years, as of the first day of the first IRC Section 6501(a) open year is includible in the income of the participants in the ESOP in that first IRC Section 6501(a) open year in proportion to their interests under the ESOP or, if the documentation is insufficient to establish the proportion of their interests, in the proportion specified in the closing agreement.  For property, the amount includible is the tax adjusted basis of the property on such first day in the hands of the Management S Corporation or ESOP, as applicable.

3. If cash or property was paid by the operating business to the Management S Corporation in a IRC Section 6501(a) open year, the amount of the cash or property (including any earnings on these amounts) is includible in the income of the participants of the ESOP in the applicable year in proportion to their interests under the ESOP or, if the documentation is insufficient to establish the proportion of their interests, in the proportion specified in the closing agreement.

4. In IRC Section 6501(a) open years, all losses and deductions of the Management S Corporation or ESOP will be treated as incurred by the participants in proportion to their interests under the ESOP or, if the documentation is insufficient to establish the proportion of their interests, in the proportion specified in the closing agreement.  As such, those expenses that are personal or non-business are not deductible and expenses attributable to amounts paid to or for the benefit of a particular participant shall not be deductible by such participant.

5. For these purposes, any outstanding loans from either the Management S Corporation or the ESOP to the participants will also be included as income to the participants in proportion to their interests under the ESOP or, if the documentation is insufficient to establish the proportion of their interests, in the proportion specified in the closing agreement.  Loans made prior to the first IRC Section 6501(a) open year are includible in the first IRC Section 6501(a) open year.  Loans made in any IRC Section 6501(a) open year, including accrued interest on the loan, are includible in the applicable year.


Q.7.  What if the Management S Corporation had other income not described above? 

A.7.  If the Management S Corporation had any other income (not described in A-5 or A-6 above) in IRC Section 6501(a) open years, the amount of this income is included in the income of the participants of the ESOP in the applicable year in proportion to their interests under the ESOP or, if the documentation is insufficient to establish the proportion of their interests, in the proportion specified in the closing agreement.  Appropriate adjustments will be made to the results described above in those situations where the parties do not have the same earliest IRC Section 6501(a) open year.

Q.8.  What other settlement terms apply if a taxpayer elects to participate in the settlement initiative?
A.8.  The following additional terms apply:
-- A 5% accuracy-related penalty under IRC Section 6662 will be imposed on any underpayment of tax resulting from the transaction unless the circumstances described in sections 4.E.2 and 3 of Announcement 2005-80 apply.  See the FAQs for Announcement 2005-80 for discussion of the exceptions to the penalty.
-- The parties agree the ESOP, and any successor plan, was never a qualified plan under IRC Section 401(a).  The nonqualified trust must be terminated and its assets distributed to the ESOP participants if the trust has not already been terminated.  Assets from the nonqualified ESOP may not be rolled over to an IRA or transferred to a qualified retirement or benefits plan. 
-- A final Form 5500 must be filed for the trust.
-- Any distributions from the ESOP that were made after the plan ceased to be qualified and that were rolled over to another retirement plan must be distributed from the other retirement plan as an amount not eligible for rollover.  The individual may be subject to the excise tax under IRC Section 4973 for an excess contribution to an IRA.

Q.9.  A taxpayer’s Management S Corporation provides services to unrelated third parties as well as to the taxpayer’s operating business.  The taxpayer would like to continue to maintain the Management S Corporation.  Does the Management S Corporation have to be dissolved as part of the agreement under the settlement initiative?

A.9.  Yes, the Management S Corporation must be dissolved under state law as part of the agreement.  If the taxpayer does not dissolve the Management S Corporation, the Service will not enter into a closing agreement with the taxpayer pursuant to this initiative.


Q.10.  What should a taxpayer do if the taxpayer wants to correct a situation that relates to an ESOP but does not involve a transaction covered by this settlement initiative?

A.10.  If the transaction is related to the ESOP, but is not covered by Announcement 2005-80, the taxpayer may wish to consider the other customary procedures applicable to retirement plans.


Q.11.  If the taxpayer had already taken steps to unwind the transaction before the settlement initiative was announced, does the taxpayer still need to elect to participate in the settlement initiative?
 
A.11.  Although the taxpayer may have already taken some steps to unwind the transaction, participation in this settlement initiative will be the best way to ensure all tax matters (including additions to tax, interest and penalties) pertaining to the transaction are conclusively resolved.  To participate in the settlement initiative, the taxpayer must file a Form 13750, Election to Participate in Announcement 2005-80 Settlement Initiative.

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Page Last Reviewed or Updated: 24-Mar-2014