The S Corporation Transaction
This abusive transaction is designed to shift income from the individual shareholder of an S corporation to an unrelated tax-exempt accommodation party that is either a municipal pension plan or a charitable organization with an unrelated business income tax net operating loss. Participants purport to donate S corporation nonvoting stock to the tax-exempt accommodation party while effectively retaining the economic benefits associated with ownership, either through stock options or repurchase rights. The purported donations generally represent 90% of the number of outstanding shares of S corporation stock. The transfer of the S corporation shares thus is designed to shift the pass-through of 90% of the S corporation taxable income from the original shareholders to the accommodation party, for purposes of deferring or avoiding taxes. The original S corporation shareholders retain voting control of the S corporation and thus retain control over the timing of corporate distributions (i.e., although the pass-through of taxable income occurs while the accommodation party holds the S corporation shares, the distribution of the underlying profit is controlled by the original S corporation shareholders). Not surprisingly, during the period that the accommodation party holds close to 90% of the outstanding shares, the S corporation distributes little or none of its profit. After a period of time, the original shareholders either cause the S corporation to repurchase the accommodation party’s nonvoting stock at an artificially low value, or else the original shareholders themselves dilute the value of the shares held by the accommodation party to a small amount by exercising warrants to purchase additional shares of nonvoting stock vastly in excess of the number of shares held by the accommodation party. In either event, the original S corporation shareholders attempt to enjoy a lengthy tax holiday while retaining control and substantially all the economic value of the S corporation, including the retained profit.
We have identified dozens of S Corporation Transactions involving the reallocation of hundreds of millions of dollars from shareholders to tax-exempt accommodation parties. Examinations are underway. We listed this transaction in Notice 2004-30, 2004-17 I.R.B. 828.