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.