The "Nuts and Bolts" of Complying with the Tax Shelter Regulations

The IRS recently released two Notices describing transactions that have been added to the category of listed transactions for purposes of the Tax Shelter rules. These Notices describe transactions involving partnership arrangements where the partnership and its partners (domestic and foreign entities) belong to the same affiliated group, and the tax consequences of S corporation stock ownership by a tax-exempt entity.

Executive Overview

The "Nuts and Bolts" of Complying with the Tax Shelter Regulations The focus by Congress, the Treasury Department, and the Internal Revenue Service on Corporate Tax Shelters has become intense. The types of transactions that may ultimately be considered corporate tax shelters are constantly changing. Thus, in addition to understanding what types of transactions may subject them to the tax shelter disclosure rules, companies need to know whether they are in compliance with disclosure, the registration obligations, and the list maintenance obligations. This article summarizes the three key requirements that are imposed by the tax shelter regulations and offers a "check-list" that may be useful in determining whether a company is tax shelter compliant for both current and past activities.

The Internal Revenue Service ("IRS") and Treasury Department ("Treasury") issued final tax shelter regulations in February 2003. These regulations have, almost overnight, changed the way corporations view the risks associated with corporate transactions. The regulations impose (1) disclosure obligations on taxpayers who participate in reportable transactions, (2) registration obligations on promoters of confidential tax shelters, and (3) list maintenance obligations on organizers and sellers of potentially abusive tax shelters. Since the regulations were finalized in 2003, IRS and Treasury have continued to issue additional guidance on tax shelters, particularly with respect to reportable transactions. These new disclosure obligations may have significant implications particularly because the category of reportable transactions continues to expand. Thus, companies will need to continuously monitor both past and present transactions to ensure that reportable transactions have been identified and properly disclosed, and furthermore that registration and list maintenance obligations, if applicable, are satisfied.

For companies that are faced with some or all of the tax shelter obligations, the following three steps may be useful in determining what they need to do to become compliant with the final tax shelter regulations.

The first step in determining compliance with the tax shelter disclosure regulations is to determine whether any of the transactions your company has entered into in recent years constitute reportable transactions. There are six categories of reportable transactions: (1) Listed transactions, (2) Confidential transactions, (3) Transactions with contractual protection, (4) Loss transactions, (5) Transactions with a significant book-tax difference, and (6) Transactions involving a brief asset holding period. Particular attention should be paid to listed transactions because the IRS and Treasury continue to expand the list of listed transactions. Listed transactions are transactions that the IRS has determined to be tax avoidance transactions through published guidance. As of April 1, 2004, the IRS had identified over 30 listed transactions. The two most recent listed transactions were identified in Notice 2004-30 (S Corporation Tax Shelter) and Notice 2004-31 (Intercompany Financing Using Guaranteed Payment), which are both discussed in this article.

If your company has participated in a reportable transaction, the second step is to review the disclosure obligations. Reportable transactions must be disclosed on Form 8886 – Reportable Transaction Disclosure Statement. Disclosure must be made for each taxable year that your company participates in a reportable transaction, meaning it is important to know what, if any, reportable transactions have been entered into on an annual basis. Companies must also retain a copy of all documents and all other records related to the transaction that may be subject to disclosure. Examples include marketing materials related to the transaction; written analyses used in decision-making related to the transaction; correspondence and agreements between the taxpayer and any advisor, lender, or other party to the reportable transaction that relate to the transaction; documents discussing, referring to, or demonstrating the purported or claimed tax benefits arising from the reportable transaction; and documents, if any, referring to the business purposes for the reportable transaction.

Moreover, with respect to listed transactions, if a transaction becomes a listed transaction after a company has filed its tax return, the regulations still require that the transaction be disclosed. For this purpose, disclosure is rather broad, and includes transactions that are the same as or substantially similar to listed transactions. As described in the final regulations, the term "substantially similar" is also broad and includes any transaction that is expected to obtain the same or similar types of tax consequences and that is either factually similar or based on the same or similar tax strategy. In particular, this means that companies should periodically revisit their transactional history to ensure that they have identified both actual listed transactions and transactions that are substantially similar, as transactions that are substantially similar are generally subject to the same disclosure obligations to which actual listed transactions are subject.

Regulations Impose Additional Obligations For certain companies, particularly those that are in the business of selling financial instruments to investors, lending to facilitate corporate acquisitions or professional service firms that advise on corporate transactions, compliance with the final tax shelter regulations may extend beyond disclosure. Thus, this third step may apply only to certain types of companies, including professional advisory firms, banks, and financial institutions. Specifically, if a company is considered (1) a promoter or material advisor of a confidential tax shelter or (2) an organizer or seller of an abusive tax shelter, it may be subject to both the registration and list maintenance obligations, respectively.

Briefly, a confidential corporate tax shelter is any transaction (i.e., listed transactions, other tax-structured transactions), the significant purpose of which is the avoidance of federal income tax, that is offered to a participant under conditions of confidentiality, and for which the promoter receives aggregate fees in excess of $100,000. The person required to register the confidential corporate tax shelter (i.e., the promoter or another party to the transaction) must file Form 8264 – Application for Registration of a Tax Shelter for either a single tax shelter or an aggregated tax shelter.

The list maintenance obligations are imposed on each organizer and seller of a potentially abusive tax shelter, which is any transaction that is required to be registered because it is a tax shelter or any transaction that has a potential for tax avoidance or tax evasion (e.g., listed transactions, transactions that a material advisor knows will become reportable transactions, and transactions that a transferor of any transferred interest knows will become listed transactions).

• Identify those transactions entered into on or after February 28, 2000 that fall within the abusive tax shelter category. Review the list maintenance obligations and determine whether your company is the entity that is required to prepare and maintain the list, or alternately, is required to be included on the list.
• For those situations in which a transaction could arguably fall within the list of reportable transactions, review the legal documentation and opinions that may be in your tax files to determine if they can be relied upon to avoid penalties and interest if the positions taken by your company are successfully challenged by the IRS (e.g., make sure an advisor other than the promoters issued the tax opinion). n

On April 1, 2004, the IRS issued Notice 2004-30 and Notice 2004-31 describing certain transactions that have been added to the classification of "listed transactions" for purposes of the tax shelter regulations. These authorities address transactions involving S corporations with a tax-exempt shareholder and partnership arrangements that involve related domestic and foreign entities. In addition to the classification of such transactions as listed transactions, the IRS indicated its intent to challenge the tax benefits arising from such transactions. Although not previously included in the category of listed transactions, the IRS noted that these described transactions, or substantially similar transactions, may already be subject to the disclosure, tax shelter registration, or the list maintenance requirements of the Code and Regulations. Nevertheless, taxpayers engaging in these types of transactions after April 1, 2004, are required to comply with the requirements of the tax shelter regulations, and taxpayers that have engaged in such transactions prior to April 1, 2004 are required to take appropriate corrective actions pursuant to Treas. Reg. § 1.6011-4(e)(2)(i). Under Treas. Reg. § 1.6011-4(e)(2)(i), a taxpayer that has engaged in any of the described transactions is required to attach a disclosure statement (only for years with open limitation periods) to any tax return it files after April 1, 2004. The transactions are described briefly below.

Notice 2004-30: The transaction described involves the shifting of tax liability from the taxable shareholders of an S corporation to a tax-exempt entity (such as a tax-qualified retirement plan or charity) that is either not subject to tax on unrelated business income tax (UBIT) or has offsetting UBIT net operating losses. As described in the Notice, the listed transaction involves an S corporation issuing voting stock and nonvoting stock and exercisable warrants pro rata to its shareholders, who subsequently donate the nonvoting stock to a tax-exempt entity. During the entire period that the tax-exempt entity "owns" the stock, it is allocated its percentage of the S corporation’s income, and the original shareholders who continue to own all of the corporation’s voting stock are allocated the remaining percentage of income from their non-voting stock. Following the allocation of the income and corresponding tax liability to the tax-exempt entity, the original shareholders exercise the warrants, and consequently dilute the nonvoting stock in a manner that reduces its value significantly. The tax-exempt entity then causes the S corporation or the original shareholders to buy back the stock at its fair market value that is significantly lower than the S corporation’s income that was allocated to it, and for which it is liable for tax. As a result, the transaction is viewed as one structured merely for the purpose of transferring a portion of the tax liability away from taxable S corporation shareholders to a tax-exempt entity without any corresponding economic benefits.

Notice 2004-31: This Notice describes a partnership arrangement between related entities where the agreement contained special allocations that were deemed to lack substantial economic effect. As described in the Notice, the listed transaction involves a domestic corporation (C1) and an affiliated foreign entity that form a partnership, which becomes a preferred stockholder in another entity (C2) that is an affiliate of the partners. The foreign entity is entitled to guaranteed payments from the partnership for the use of capital, and pursuant to the special allocations contained in the partnership agreement, is also entitled to an allocation of a small portion of the partnership’s dividend income and guaranteed payment deduction. C1 is entitled to an allocation of a substantial portion of the partnership’s dividend income and guaranteed payment deduction. Because of the 100% dividends received deduction and the large partnership guaranteed payment deduction that C1 is able to claim, it ends up with a substantial net deduction. According to the IRS, if the partnership was not formed and the foreign entity, as a direct equity investor in C2, loaned money to C2, the interest payments on the debt to the foreign entity would not be deductible under Section 163(j). By forming the partnership, the parties are able to convert the nondeductible interest payments to deductible payments that C1 is able to claim. The Notice also included a variation of the transaction, in which the foreign entity is not entitled to guaranteed payments, but guarantees the partnership’s obligation to make guaranteed payments to an unrelated partner, in addition to avoiding potential treatment as disqualified interest under Section 163(j).

Partnerships with affiliated partners that include a foreign entity should review the listed transaction rules carefully to determine their disclosure requirements if they are receiving a benefit by deducting interest that would normally be disqualified.

Copyright 2004 Gardner Carton & Douglas

This article is not intended as legal advice, which may often turn on specific facts. Readers should seek specific legal advice before acting with regard to the subjects mentioned here.