Section 4.12 of Revenue Procedure 2016-51 provides that the Self-Correction Program (SCP) and Voluntary Correction Program (VCP) under the Employee Plans Compliance Resolution System (EPCRS) will not be available if: (a) either the plan or plan sponsor has been a party to an abusive tax avoidance transaction and (b) the failure being corrected is directly or indirectly related to the abusive tax avoidance transaction. For purposes of SCP and VCP, an abusive tax avoidance transaction means any listed transaction under § 1.6011-4(b)(2) and any other transaction identified as an abusive transaction in the IRS web site entitled “EP Abusive Tax Transactions.”
The same section also provides that if either the plan or plan sponsor has been a party to an abusive tax avoidance transaction, then the availability of the Audit Closing Agreement Program and SCP for a plan that is Under Examination (as defined in section 5.03), is impacted. For this purpose, an abusive tax avoidance transaction includes not only any listed transaction under § 1.6011-4(b)(2) and any other transaction identified as an abusive transaction in the IRS web site entitled “EP Abusive Tax Transactions,” but also any other transaction that the Service determines was designed to facilitate the impermissible avoidance of tax.
To facilitate the administration of this provision of the revenue procedure, listed transactions and other transactions identified in this web site as abusive are set forth below.
I. The following transactions have been identified by the Internal Revenue Service as
S Corporation ESOP Abuse of Delayed Effective Date for Section 409(p)
Revenue Ruling 2003-6, 2003-3 I.R.B. 286. The Treasury Department and the IRS issued Revenue Ruling 2003-6 to identify certain transactions in which promoters attempted to avoid the effective date of section 409(p) of the Internal Revenue Code by the use of ESOPs formed before the application of that provision. The ruling designates these, and substantially similar, transactions as "listed transactions" for purposes of the tax shelter regulations, including the disclosure requirements.
IRC section 409(p) of the Code requires that an employee stock ownership plan (ESOP) holding employer securities consisting of stock in an S corporation provide that no portion of the assets of the plan attributable to such employer securities may, during a nonallocation year, accrue for the benefit of any disqualified person. IRC section 409(p) is intended to limit the establishment of ESOPs by S corporations to those that provide broad-based employee coverage and that benefit rank-and-file employees, as well as highly compensated employees and historical owners.
In general, these provisions apply to S corporation ESOPs established after March 14, 2001. S corporation ESOPs established on or before March 14, 2001 must have complied with the law by December 31, 2004. Promoters marketed arrangements involving ESOPs that hold employer securities in an S corporation for the purpose of claiming eligibility for the delayed effective date of IRC section 409(p).
This ruling describes an S corporation ESOP that is not eligible for the delayed effective date under IRC section 409(p) and thus is subject to the nonallocation rules of IRC section 409(p). Any taxpayer who is a disqualified person with respect to the S corporation ESOP is treated as receiving a deemed distribution of stock allocated to the taxpayer’s account and income with respect to that account. In addition, excise taxes under IRC section 4979A apply to any nonallocation year.
See Rev. Rul. 2003-6 for further information.
S Corporation ESOP Abuses: Certain Business Structures Held to Violate Code Section 409(p)
Revenue Ruling 2004-4, 2004-6 I.R.B. 414. The Treasury Department and the IRS issued Revenue Ruling 2004-4 to identify certain business structures in which taxpayers attempted to use interests in qualified S corporation subsidiaries (QSUBs) to avoid the application of section 409(p) of the Internal Revenue Code.
An employee stock ownership plan, or ESOP, is a type of retirement plan that invests primarily in employer stock. Congress has allowed an S corporation to be owned by an ESOP, but only if the ESOP gives rank-and-file employees a meaningful stake in the S corporation. When an ESOP owns an S corporation, the profits of that corporation generally are not taxed until the ESOP makes distributions to the company’s employees when they retire or leave the job. This is an important tax break which allows the company to reinvest profits on a tax-deferred basis, for the ultimate benefit of employees who are ESOP participants. The business structures described in the ruling have the effect of moving the business profits of the S corporation away from the ESOP, so that rank-and-file employees do not benefit from the arrangement. For example, options in the QSUB stock may be used to drain value out of the ESOP for the benefit of the S corporation’s former owners or key employees.
The ruling treats the interests in the related entity, such as stock options, as synthetic equity under the rules of section 409(p) and the final regulations. Accordingly, the holders of those interests could be subject to deemed distributions under the rules of section 409(p) and excise taxes may apply.
The ruling generally designates these types of transactions, and substantially similar transactions, as "listed transactions" for purposes of the tax shelter regulations, including the disclosure requirements. Specifically, the ruling states that the following (and any substantially similar transactions) are “listed transactions:" Any transaction in which (i) at least 50 percent of the outstanding shares of an S corporation are employer securities held by an ESOP, (ii) the profits of the S corporation generated by the business activities of a specific individual are accumulated and held for the benefit of that individual in a QSUB or similar entity (such as a limited liability company), (iii) these profits are not paid to the individual as compensation within 2½ months after the end of the year in which earned, and (iv) the individual has rights to acquire shares of stock (or similar interests) of the QSUB or similar entity representing 50 percent or more of the fair market value of the stock of such QSUB or similar entity. For this purpose, the rights of an individual are determined after taking into account the attribution rules of section 409(p). These arrangements are identified as “listed transactions” with respect to the S corporation and each individual who is a disqualified person under the revenue ruling.
See Rev. Rul. 2004-4 for further details.
Death Benefits From Insurance Exceeding Terms of the Plan In Order to Claim Large Tax Deductions
Revenue Ruling 2004-20, 2004-10 I.R.B. 546. Situation 2 of this revenue ruling addresses qualified plans that buy excessive life insurance (i.e., insurance contracts where the death benefits exceed the death benefits provided to the employee’s beneficiaries under the terms of the plan, with the balance of the proceeds reverting to the plan as a return on investment). The revenue ruling holds that the premium for the excess death benefit is not deductible when contributed, but is carried over to be treated as a contribution in future years. These arrangements are listed transactions for tax-shelter disclosure purposes if the employer has deducted amounts used to pay premiums on a life insurance contract for a participant with a death benefit under the contract that exceeds the participant’s death benefit under the plan by more than $100,000.
Abuse of Roth Accounts
Notice 2004-8, 2004-4, I.R.B. 333 applies to certain abuses involving indirect contributions to Roth IRAs. The notice addresses situations in which value is shifted into an individual’s Roth IRA through transactions involving businesses, such as a corporation or sole proprietorship, owned by the individual. For example, a business owned by the individual might sell its receivables for less than fair value to a shell corporation owned by the individual’s Roth IRA. In effect, this is a disguised contribution to the Roth IRA and is treated as such. The notice states that the IRS also may assert that these are “prohibited transactions” under the Code rules that disqualify the IRA or impose an excise tax on transactions between the IRA and certain disqualified persons. The notice specifically states that the following (and any substantially similar transactions) are “listed transactions:" Any arrangements in which an individual, related persons described in section 267(b) or 707(b), or a business controlled by such individual or related persons, engage in one or more transactions with a corporation, including contributions of property to such corporation, substantially all of whose stock is owned by one or more Roth IRAs maintained for the benefit of the individual, related persons described in section 267(b)(1), or both. The transactions are listed transactions with respect to the individuals for whom the Roth IRAs are maintained, the business (if not a sole proprietorship) that is a party to the transaction, and the corporation substantially all of whose stock is owned by the Roth IRAs. The notice also includes additional guidance on substantially similar transactions.
S Corporation Tax Shelter
Notice 2004-30, 2004-17 I.R.B. 828 addresses a type of transaction in which S corporation shareholders attempt to transfer the incidence of taxation on S corporation income by purportedly donating S corporation nonvoting stock to a tax-exempt organization, while retaining the economic benefits associated with that stock.
In a typical transaction, an S corporation, its shareholders, and a tax-qualified retirement plan maintained by a state or local government (or other organization exempt from tax under section 501(a) and described in either section 501(c)(3) or 401(a) of the Internal Revenue Code) (the exempt party) undertake steps that include the S corporation issuing, 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 value of the nonvoting stock, with that fair market value claimed to be substantially reduced because of the existence of the warrants.
Shortly thereafter, 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 sections 511 through 514 (or the exempt party has offsetting UBIT net operating losses). Pursuant to one or more agreements entered into as part of the transaction (repurchase agreements), 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. 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. Because of the repurchase agreements, 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.
Substantially Similar Transactions
Note that, as stated in each of the notices and revenue rulings described above, a listed transaction includes not only the transaction described in the published guidance, but also any substantially similar transaction. Thus, for example, a transaction that is otherwise described in Rev. Rul. 2004-8 (abuse of Roth accounts) is a listed transaction regardless of whether the abuse is in an IRA or in a designated Roth account in a qualified plan or section 403(b) contract.
II. The following transactions, though not identified as listed transactions, have been identified by the IRS as an abusive transaction:
In these arrangements, taxpayers attempt to exclude the income of an operating business through the use of a combination of an S corporation and employee stock ownership plan (ESOP). In a typical case, the owner of an operating business creates an S corporation and causes the two entities to enter into an agreement under which the operating business pays a fee to the S corporation in exchange for management or other services. In addition, the S corporation (which provides management services and is alternately referred to as the management company) adopts an ESOP that is treated as the sole shareholder of the management company and in which the beneficial owner is the sole participant in the ESOP.
Taxpayers have argued that under this arrangement the operating company may deduct its payments to the S corporation for management services and the income of the S corporation is passed through to the ESOP. They further contend that because the ESOP is a tax-exempt entity, the income is not subject to tax until distributed from the plan. The Service has determined, however, that in many of these arrangements the ESOP fails to satisfy the requirements of the Code for a valid ESOP. When an ESOP is not qualified under these circumstances, the management S corporation may be taxable as a C corporation and any highly compensated ESOP participant may be taxable on the value of his account balance.
See information at the web site above for further information.
Final Regulations that were issued in 2006 set a standard for determining whether the principal purpose of the ownership structure of an S corporation involving synthetic equity constitutes an avoidance or evasion of section 409(p). Under this standard, whether the principal purpose of the ownership structure of an S corporation involving synthetic equity constitutes an avoidance or evasion of section 409(p) is determined by taking into account all the surrounding facts and circumstances, including all features of the ownership of the S corporation’s outstanding stock and related obligations (including synthetic equity), any shareholders who are taxable entities, and the cash distributions made to shareholders, to determine whether, to the extent of the ESOP’s stock ownership, the ESOP receives the economic benefits of ownership in the S corporation that occur during the period that stock of the S corporation is owned by the ESOP. Among the factors indicating that the ESOP receives these economic benefits include shareholder voting rights, the right to receive distributions made to shareholders, and the right to benefit from the profits earned by the S corporation, including the extent to which actual distributions of profits are made from the S corporation to the ESOP and the extent to which the ESOP’s ownership interest in undistributed profits and future profits is subject to dilution as a result of synthetic equity, for example, the ESOP's ownership interest is not subject to dilution if the total amount of synthetic equity is a relatively small portion of the total number of shares and deemed-owned shares of the S corporation.
The 2006 Final Regulations also identify certain specific transactions involving segregated profits as constituting an avoidance or evasion of section 409(p). Taking into account the standard described in the preceding paragraph, the principal purpose of the ownership structure of an S corporation constitutes an avoidance or evasion of section 409(p) in any case in which -
(i) The profits of the S corporation generated by the business activities of a specific individual or individuals are not provided to the ESOP, but are instead substantially accumulated and held for the benefit of that individual or individuals on a tax-deferred basis within an entity related to the S corporation, such as a partnership, trust, or corporation (such as in a subsidiary that is a disregarded entity), or any other method that has the same effect of segregating profits for the benefit of such individual or individuals (such as nonqualified deferred compensation);
(ii) The individual or individuals for whom profits are segregated have rights to acquire 50 percent or more of those profits directly or indirectly (for example, by purchase of the subsidiary); and
(iii) A nonallocation year under section 409(p) would occur if section 409(p) were separately applied with respect to either the separate entity or whatever method has the effect of segregating profits of the individual or individuals, treating such entity as a separate S corporation owned by an ESOP (or in the case of any other method of segregation of profits by treating those profits as the only assets of a separate S corporation owned by an ESOP).
Plans with high premiums for life insurance and/or annuity contracts that if continued would (absent surrender charges) exceed the amount needed to provide the benefits set forth in the plan. See Rev. Rul. 2004-20, 2004-10 I.R.B. 546, Situation 1. (Note that some of these arrangements may also be springing cash value arrangements.)
Springing Cash Value Insurance Contract
Any life insurance contract transferred from an employer or a tax-qualified plan to an employee must be taxed at its full fair market value. Some firms have promoted an arrangement where an employer establishes a qualified plan under which the contributions made to the plan are used to purchase a specially designed life insurance contract.
The insurance contract is designed so that the cash surrender value is temporarily depressed, so that it is significantly below the premiums paid. The contract is distributed or sold to the employee for the amount of the current cash surrender value during the period the cash surrender value is depressed; however, the contract is structured so that the cash surrender value increases significantly after it is transferred to the employee. Other designs may involve narrow exchange rights or other non-guaranteed elements that produce a higher value than the cash surrender value.
These special policies are made available to highly compensated employees and the policies made available to nonhighly compensated employees are not of inherently equal or greater value. See Revenue Ruling 2004-21, 2004-10 I.R.B. 544 and Revenue Procedure 2005-25, 2005-17 I.R.B. 962 for more detail.