EP Abusive Tax Transactions

 

The IRS is engaged in extensive efforts to curb abusive tax shelter schemes and transactions. The Tax Exempt and Government Entities Division of the IRS, including the office of Employee Plans, participates in this IRS-wide effort by devoting substantial resources to the identification, analysis, and examination of abusive tax shelter schemes and promotions.

Listed Transactions - Background

The IRS finalized regulations on abusive tax shelters. The regulations provide that a taxpayer must disclose certain transactions, known as "listed transactions," by filing a disclosure statement (Form 8886 PDF and instructions PDF) with its tax return. Form 8886-T PDF and instructions PDF should be used by tax-exempt entities in disclosing this information. The instructions include an explanation of the penalties if there is a failure to disclose a reportable transaction.

A "listed transaction" is a transaction that is the same as, or substantially similar to, one that the IRS has determined to be a tax avoidance transaction and identified by IRS notice or other form of published guidance. The parties who participate in listed transactions may be required to disclose the transaction as required by the regulations, register the transaction with the IRS, or maintain lists of investors in the transactions and provide the list to the IRS on request.

Additionally, these types of transaction affect the plan’s ability to correct errors using the Employee Plans Compliance Resolution System, as discussed below.

Employee Plans Listed or Abusive Transactions

The IRS had identified the following transactions involving employee benefit plans as listed transactions or abusive transactions:

Deductions for Excess Life Insurance in a Section 412(i) or Other Defined Benefit Plan

 In February 2004, the Treasury Department and the IRS issued guidance to shut down abuses involving the use of certain specially-designed life insurance policies in retirement plans. Generally, these special policies are made available only to highly compensated employees.

The guidance items address situations where these special policies, often used in conjunction with Section 412(i) plans, are used to artificially increase the deductible contributions to retirement plans while greatly reducing the amount taxable when the policies are distributed to the plan participant.

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.

The other related items of guidance are:

  • Rev. Proc. 2005-25, 2005-17 I.R.B. 962 PDF
    This procedure modifies and supersedes Rev. Proc. 2004-16 PDF for purposes of determining fair market value of a life insurance contract, an endowment contract, etc. 
  • Revenue Ruling 2004-21 PDF providing that the right to purchase insurance contracts from a retirement plan must be available to all of the participants in the plan in a nondiscriminatory manner.
  • Press Release
    IR-2004-21 - Treasury and IRS Shut Down Abusive Life Insurance Policies in Retirement Plans. (02/13/2004)
  • Employee Plans News PDF: A Summer 2007 article discussing the requirements for retroactive funding standard account calculations.

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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.

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S Corporation ESOP Abuses: Certain Business Structures Held to Violate Code Section 409(p)

The Treasury Department and the IRS issued Revenue Ruling 2004-4 to identify certain business structures which will be treated by the IRS as avoiding or evading section 409(p) of the Internal Revenue Code. The ruling designates transactions in which profits are set aside in a Q-Sub or similar entity such as an LLC, as "listed transactions" for purposes of the tax shelter regulations, including the disclosure requirements.

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 ruling shuts down transactions that move business profits of the S Corporation away from the ESOP, so that rank-and-file employees do not benefit from the arrangement.  For example, the ruling prohibits using stock options on a subsidiary 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.

Press Release
The Treasury Department and the IRS issued a ruling to shut down abusive transactions involving "S corporation ESOPs." (01/23/2004)
 

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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.
 

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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.

 

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Management Company S Corporation ESOPs

In these arrangements, taxpayers attempt to exclude the income of an operating business using 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.
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401(k) Accelerated Deductions

The IRS has identified 401(k) accelerated deductions (deductions for contributions of an employer to an employee's trust or annuity plan and compensation under a deferred payment plan) as listed transactions. The following revenue rulings discuss this issue.

Where the contributions are attributable to compensation earned by plan participants after the end of the taxable year, taxpayers have sought to deduct contributions to qualified cash or deferred arrangements (Section 401(k) plans) or matching contributions using the grace period provided by Section 404(a)(6). Section 404(a)(6) provides that plan contributions may be deemed to have been made on the last day of the preceding taxable year if made "on account of" such taxable year and if made not later than the time prescribed by law for filing the return for such taxable year (including extensions).

Revenue Ruling 90-105 PDF
This revenue ruling provides that compensation cannot be deferred and contributed to a plan as elective deferrals, and matching contributions cannot be made to a plan with respect to such elective deferrals, until the underlying compensation has been earned. This holding applies regardless of whether section 404(a)(6) deems the contributions to have been paid on the last day of the taxable year, and regardless of whether the employer uses the cash or accrual method of accounting.

Revenue Ruling 2002-46 PDF
The transaction described in this revenue ruling is identical to the transaction in Revenue Ruling 90-105 except that (1) the plan was amended to provide for the employer's Board of Directors to set a minimum contribution for a plan year to be allocated first toward elective contributions and matching contributions and (2) the Board of Directors adopted such a resolution before the end of the employer's taxable year. This revenue ruling provides that these factual differences from Revenue Ruling 90-105 do not change the result.

Revenue Ruling 2002-73 PDF
This revenue ruling modifies Revenue Ruling 2002-46 for taxpayers electing to change method of accounting to comply with that revenue ruling.

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Certain Trust Arrangements Seeking to Qualify for Exemption from Section 419

Notice 95-34 PDF discusses tax problems raised by certain trust arrangements seeking to qualify for exemption from IRC section 419. This transaction involves the claiming of deductions under IRC sections 419 and 419A for contributions to multiple employer welfare benefit funds. In general, an employer may deduct contributions to a welfare benefit fund when paid, but only if the contributions qualify as ordinary and necessary business expenses of the employer and only to the extent allowable under IRC sections 419 and 419A. There are strict limits on the amount of tax-deductible pre-funding permitted for contributions to a welfare benefit fund.

IRC section 419A(f)(6) provides an exemption from IRC sections 419 and 419A for a welfare benefit fund that is part of a 10 or more employer plan. In general, for this exemption to apply, an employer normally cannot contribute more than 10 percent of the total contributions contributed under the plan by all employers, and the plan must not be experience rated with respect to individual employers.

Promoters have offered trust arrangements that are used to provide life insurance, disability, and severance pay benefits. The promoters enroll at least 10 employers in their multiple employer trusts and claim that all employer contributions are tax deductible when paid, relying on the 10-or-more-employer exemption from the limitations under IRC sections 419 and 419A. Often the trusts maintain separate accounting of the assets attributable to each subscribing employer’s contributions.

Notice 95-34 puts taxpayers on notice that deductions for contributions to these arrangements are disallowable for any one of several reasons (e.g., the arrangements may provide deferred compensation, the arrangements may be separate plans for each employer, the arrangements may be experience rated in form or operation, or the contributions may be nondeductible prepaid expenses).

On July 17, 2003, final regulations (T.D. 9079 PDF) relating to whether a welfare benefit fund is part of a 10 or more employer plan (as defined in section 419A(f)(6) of the Internal Revenue Code) were published in the Federal Register (68 FR 42254).

In addition, in a case decided by the Third Circuit Court of Appeals, the contributions to the plan were taxable to the owners of the corporate employers as constructive dividends (Neonatology Associates, P.A., Et Al. v. Commissioner, 299 F.3rd 221 - 3rd Cir. 2002 PDF).

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Abusive Roth IRA Transactions

The Internal Revenue Service and the Treasury Department are aware of a type of transaction that taxpayers are using to avoid the limitations on contributions to Roth IRAs. 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.

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Prohibited Tax Shelter Transaction Excise Taxes for Tax-Exempt Entities and Related Disclosure Requirements

Notice 2006-65 PDF
The Tax Increase Prevention and Reconciliation Act of 2005 ("TIPRA"), enacted on May 17, 2006, includes new excise taxes and disclosure rules that target certain potentially abusive tax shelter transactions to which a tax-exempt entity is a party. Entities that may be affected by the new provisions include, but are not limited to, charities, churches, state and local governments, Indian tribal governments, qualified pension plans, individual retirement accounts, and similar tax-favored savings arrangements. The managers of these entities, and in some cases the entities themselves, can be subject to excise taxes if the entity is a party to a prohibited tax shelter transaction.

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Substantially Similar Transactions

Note that, as stated in each of the notices and revenue rulings described above, an abusive 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.

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How Abusive Transactions Impact Availability of 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.

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Report an Abusive Transaction Involving a Retirement Plan

Employee Plans maintains the Abusive Transaction Hotline that people can use to share information (anonymously, if preferred) about abusive tax shelters and emerging issues that may be abusive in retirement plans:

  • Email: eoclass@irs.gov
  • Mail:
         Internal Revenue Service
         EP Tax Shelter Coordinator
         31 Hopkins Plaza, Room 1542
         Baltimore, Maryland  21201.

 

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Additional Resources

IRS Corporate Abusive Tax Transactions Home Page - Listed transactions, with citations of published guidance, regulations or court cases and other useful resources.

S Corporation ESOP Guidance - Guidance and other useful information to assist in understanding issues that may exist with S Corporation ESOPs.

Treasury, IRS Issue Section 409(p) Final Regulations - The Treasury Department and IRS issued final regulations under Section 409(p). That section of the tax law generally prohibits accruals or allocations under an employee stock ownership plan (ESOP) that holds stock of an S corporation where the ownership interest in the ESOP or in rights to acquire the corporation are so concentrated among 10 percent owners that they hold 50 percent or more of the interests in the corporation.