Abusive Transactions That Affect Availability of Programs under EPCRS


Section 4.12 of Rev. Proc. 2019-19 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 (ATAT), and

(b) the failure being corrected is directly or indirectly related to the ATAT.

For purposes of SCP and VCP, an ATAT means any listed transaction under Section 1.6011-4(b)(2) and any other transaction identified as an abusive transaction on the EP Abusive Tax Transactions page.

Under Section 5.08, if either the plan or plan sponsor has been a party to an ATAT, the Audit Closing Agreement Program and SCP may be unavailable for a plan that is under examination. For this purpose, an ATAT includes any listed transaction discussed above as well as any other transaction the IRS determines was designed to evade tax.

To help administer this section of the revenue procedure, the listed transactions referenced above are discussed in detail below.

I. The following transactions have been identified by the IRS as "listed transactions."

S Corporation ESOP Abuse of Delayed Effective Date for Section 409(p)

The Treasury Department and the IRS issued Rev. Rul. 2003-6 PDF to identify transactions in which promoters attempted to avoid the effective date of section 409(p) of the Internal Revenue Code (IRC) by using Employee Stock Ownership Plans (ESOPs) formed before section 409(p) applied. The ruling designates these, and substantially similar, transactions as "listed transactions" for purposes of the tax shelter regulations.

IRC section 409(p) of the Code provides that no portion of the assets of the plan attributable to employer S corporation stock may accrue for the benefit of any disqualified person during a nonallocation year. The purpose of IRC section 409(p) is to limit the establishment of ESOPs by S corporations to those that provide broad-based employee coverage and 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 ESOPs arrangements that held S corporation employer securities to be eligible for the delayed effective date of section 409(p).

This ruling describes an S corporation ESOP that is not eligible for the delayed effective date under section 409(p) and is subject to the nonallocation rules of 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)

The Treasury Department and the IRS issued Rev. Rul. 2004-4 PDF to identify business structures in which taxpayers tried to use qualified S corporation subsidiaries (QSUBs) to avoid section 409(p).

An 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 generally are not taxed until the ESOP makes distributions to the company's employees when they retire or terminate. This is an important tax break that allows the company to reinvest profits on a tax-deferred basis for the ultimate benefit of the employees. 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 designates these types of transactions, and substantially similar transactions, as "listed transactions" for purposes of the tax shelter regulations. Specifically, the ruling states, "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.

Large Tax Deductions Claimed from Insurance Death Benefits that Exceed Terms of the Plan

Situation 2 of Rev. Rul. 2004-20 PDF 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 excess going back 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 should be treated as a contribution in future years. These arrangements are listed transactions if the employer has deducted the 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  PDF applies to abuses involving indirect contributions to Roth IRAs. The notice addresses situations where value is shifted into an individual's Roth IRA through transactions involving businesses 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. This is a disguised contribution to the Roth IRA and is treated as such. The notice states that the IRS may also 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, "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 PDF addresses a type of transaction in which shareholders try to transfer the income tax owed by an S corporation to a tax-exempt organization by donating the nonvoting S corporation stock while keeping the economic benefits attached to the stock.

In a typical transaction, an S corporation, its shareholders, and a qualified retirement plan maintained by a state or local government (or other exempt organization under section 501(a)) take steps to issue non-voting stock and warrants equally to each of its shareholders (the original shareholders). 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 of the warrants is at least equal to 90 percent of the claimed value of the nonvoting stock, with that fair market value (FMV) substantially reduced due to the existence of the warrants.

Later, the original shareholders donate the nonvoting stock to the exempt organization (EO). The parties claim that, after the donation of the nonvoting stock, the EO 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 EO is not subject to tax on unrelated business income (UBIT) under sections 511 through 514 (or the EO has offsetting UBIT net operating losses). Pursuant to one or more repurchase agreements entered into as part of the transaction, the EO can require the S corporation or the original shareholders to purchase the EO's nonvoting stock for an amount equal to the FMV of the stock as of the date the shares are repurchased. 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 shareholders while the EO owns the nonvoting stock. However, during that period, 90 percent of the S corporation's income is allocated to the EO for tax purposes. Because of the repurchase agreements, the EO will receive a share of the total economic benefit of stock ownership that is much lower than the share of the S corporation income allocated to the EO.

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 described in Rev. Rul. 2004-8 (abuse of Roth accounts) is a listed transaction whether the abuse is in an individual IRA or a designated Roth account held 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 abusive transactions:

Management Company S Corporation ESOPs

In these arrangements, taxpayers attempt to exclude the income of an operating business through the use of an S corporation and an ESOP. In a typical case, the owner of a business creates an S corporation and the two entities enter into an agreement by which the operating business pays a fee to the S corporation for management fees or other services. In addition, the S corporation (which provides management services and is referred to as the management company) adopts an ESOP which is the sole shareholder of the management company. 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 argue that because the ESOP is a tax-exempt entity, the income is not subject to tax until distributed from the plan. However, the IRS has determined that in many of these arrangements, the ESOP fails to satisfy the requirements of the IRC to be 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 taxed on the value of his account balance.

See information at the web site above for further information.

S Corporation ESOPs Where a Principal Purpose is Avoidance or Evasion of Section 409(p)

Final Regulations PDF 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 represents an avoidance or evasion of section 409(p). In determining the principal purpose of the S corporation, consider all facts and circumstances, including:

  • all aspects of the ownership of the S corporation's outstanding stock and related obligations (including synthetic equity),
  • cash distributions made to shareholders that are taxable entities, to determine if the ESOP receives the economic benefits of ownership in the S corporation that occur while the ESOP owns the S corporation. Factors that indicate 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. This benefit includes the extent to which actual distributions of profits are made to the ESOP and the extent to which the ESOP's ownership interest in undistributed profits and future profits is diluted due to synthetic equity. For example, the ESOP's ownership interest is not subject to dilution if the total amount of synthetic equity is only a small portion of the total number of shares and deemed-owned shares of the S corporation.

The 2006 Final Regulations also identify specific transactions that segregate profits in the S corporation and represent an avoidance or evasion of section 409(p). Using the same standard discussed above, the principal purpose of the ownership structure of an S corporation represents an avoidance or evasion of section 409(p) when:

(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).

Abusive Section 412(i) Plans

Plans with high premiums for life insurance and/or annuity contracts that would (absent surrender charges) exceed the amount needed to provide the benefits set forth in the plan are abusive. See Rev. Rul. 2004-20 PDF, Situation 1. (Note that some of these arrangements may also be springing cash value arrangements.)

Springing Cash Value Insurance Contract

If a life insurance contract is transferred from an employer or a tax-qualified plan to an employee, it must be taxed at its full fair market value. Some firms have promoted an arrangement where an employer establishes a qualified plan and the contributions made to the plan are used to purchase a specially designed life insurance contract.

The cash surrender value (CSV) of the insurance contract 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 CSV while the CSV is depressed; however, the CSV of the contract 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 CSV.

These special policies are offered to highly compensated employees, while the policies offered to nonhighly compensated employees are not of equal or greater value. See Revenue Ruling 2004-21 PDF and Revenue Procedure 2005-25 PDF for more details.