TAX SHELTERS

Bob BlumHanson Bridgett Marcus Vlahos & Rudy LLP

San Francisco, CAOctober, 2007

For Discussion

• IRS’ concern

• Applicable Code sections

• Shelter defined

• Excise taxes on managers + entities

• Details re the tax

• What you can do for protection

IRS’ CONCERN

From the Commissioner

“I cannot overstate the seriousness of the involvement of tax-exempt and government entities as accomodation parties to abusive transactions.”

Commissioner Everson, 6/22/04, statement before the Senate Finance Committee

Example – Roth IRAs

• IRA owner (O) also owns a sole proprietorship business (B)

• IRA sets up a wholly owned corp (C)

• O sells assets of B to C for less than FMV

• IRS: treats as payment to O, a contrib to the IRA and a contrib by IRA to C

• Notice 2004 – 9

• A “listed transaction”

Example – SILO

• Lender (L) loans $ to X• X uses $ to purchase property from FP

which leases it back with optn to purchase• FP transfers $ to L in its capacity as

“payment undertaker”• L is obligated to use this $ to make lease

payments to X• X instructs L to apply those lease

payments to satisfy X’s debt to L

Example – SILO (2)

• IRS: X cannot deduct depreciation or interest on the loan

• “Treasury Press Release on Abusive ‘SILO’ Arrangements”, 2/11/05

• IRS problem: failure to convey tax ownership and absence of genuine debt.– Circularity of funds– Self cancelling nature of rights and obligations– No substance to transaction

S Corp - Notice 2004-30

• S corp issues nonvoting stock (9:1 nonv to v)• 10:1 warrants to buy nonv also issued• Nonvoting stock is contrib’d to qualified plan;

90% of income is allocated to nonv stock. little income is distributed

• Income on nonv is treated as not UBTI• Warrants are exercised; economic benefit to

qual plan is much lower than S corp income allocated to it

General Issue

• Income is shifted to exempt from taxable; deductions or losses shifted to taxable

• Qualified plans have engaged in these transactions, as have other exempts

More Reading

• Notice 2001-16 – intermediary transactions

• Coordinated Issue – Intermediary Transaction Tax Shelters (12/19/02) UIL 9300.16.00

• Rev. Rul. 2002-69 – LILO transactions• “TE/GE Abusive Tax Shelters”, ACT

5/20/03• Notice 2005-13 – leasing with defeasance

Section 4965

• Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA)

• P.L. 109-222, sec. 516(a)(1)

• Added new section 4965 imposing excise taxes on tax exempts and on their managers in connection with shelters

CODE SECTIONS

Governing Sections

• 4965 + prop 53.4965 [72 Fed Reg No. 129 (7/6/07)]

• 6707A• 6011 + 1.6011-4 [72 Fed Reg No. 149 (8/3/07)] +

54.6011-1T• 6011(g) + 301.6011(g)-1• 6033 + 1.6033-5T• 6071 + 53.6071-1T• 6652(c)(3)

General Scheme

• 4965 imposes excise taxes on entities and managers that are parties to shelters– up to 100% of net income or 75% of proceeds– $20,000 per manager per action

• 6707A defines the tax shelters targeted– 6707A refers to 6011; definition in regs

• 6033 reqs reporting & 6652 sets penalties• 6011(g) reqs disclosure to tx exempts• 6071 sets return requirements

Dual Requirements?

• 6011 and 1.6011-4 separately require disclosure and reporting of shelters

• 6707A sets high penalties for failure to disclose per 1.6011-4– as much as $200,000 per transaction

• Notice 2004-30 clearly requires that a qualified plan disclose under 6011– IR 2044-44 (first time IRS has designated an exempt

entity as a “participant” for shelter reporting per 6011)

SHELTERS

4965 And Shelters

• 4965 imposes an excise tax on tax shelter transactions to which tax exempt entities are parties

• “Prohibited tax shelter transactions”– A subset of all tax shelter transactions– 4965(e) and 53.4965-3

Prohibited Tax Shelters4965(e)

• Listed transactions– including substantially similar transactions– including subsequently listed transactions– this tax picks up transactions after they occur

• Confidential transactions

• Transactions with contractual protection

• If 6011 applies, the shelter universe is larger, for reporting & not for the excise tax

Listed Transactions4965(e)

• 4965(e)(1)(A) to 6707A to 6011 to 1.6011-4(b)(2) and prop 53.4965-3

• See Notice 2004-67 (10/12/04) (which is not up to date, however)

• http://www.irs.gov/retirement/article/0,,id=118821,00.html for EP abusive transactions

EP Listed Transactions• 401(k) accelerated deductions• S corp ESOP abuse of delayed eff date• Coll bargd welfare funds – 419A(f)(5)• Trusts that do not qualify for 419 exemptn• Abusive Roth IRA transactions• Deductions for excess life insur’ce – 412(i)• Segregation of ESOP-owned S corp profits to

cut out rank&file• Plus “business” transactions that use qual plan

as an intermediary to shift deductions or income

“Substantially Similar”

• “[A]ny 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.” 1.6011-4(c)(4)

• An opinion from counsel on the tax effects is irrelevant. Id.

• Substantially similar “must be broadly construed in favor of disclosure”. Id.

“Substantially Similar” Examples

• Transaction based on offsetting options transferred to partnership can be “SS” to– use of short sales, futures, derivatives, or any

other offsetting obligations to inflate basis in a partnership. 1.6011-4(c)(4)

• Use of intermediary to buy stock to facilitate an asset sale can be “SS” to– any transaction that uses intermediaries to

prevent recognition of gain. Id.

Subsequently Listed

• 4965 applies to transactions “entered into before, on or after” the effective date.– Prop 53.4965-9(a)– Prop 53.4965-6(d) re subsequently listed

transactions– There is relief from the “knows or should

know” tax for pre-enactment deals

Confidential Transactions1.6011-4(b)(3)

• Tax advisor limits disclosure of– tax treatment of transaction– tax structure of transaction– AND the limit protects the confidentiality of that

advisor’s tax strategies– Irrelevant whether limit is legally binding– OK to say it is proprietary if advisor “confirms” that

there is no disclosure limit

• Plus minimum fee paid to advisor who limits disclosure

Confidential Transactions (2)

• Minimum fee is– $250,000 per transaction for corp txprs– $50,000 for all other transactions

• Combine all fees for a tax strategy– strategy, advice, implementation, returns– in cash or in kind including services– indirect fees as referral fees or fee sharing– Qstn: fee to own lawyer if “confidential

attorney client privilege”?

Confidential Transactions (3)

• Is it a confidential transaction if the transaction is patented, it can be disclosed, but anyone who uses it must pay royalties?

• Is it a confidential transaction if the transaction can be disclosed but the party who discloses must pay, e.g., $250,000 to the advisor for each disclosure?

Contractual Protection 1.6011-4(b)(4)

• Taxpayer has right to refund (all or part) of fees paid if all or part of intended tax effects not achieved

• Or, fees are contingent on realizing the tax effects intended

• Only re fees paid to a person who “makes or provides a statement” to the txpr “as to the potential tax consequences”

Contractual Protection (2)

• Exceptions– OK to have right to terminate “upon the

happening of an event affecting the taxation” of a party. [Qstn: like a deficiency notice?]

– OK if the statement re tax effect is after transaction is entered into and reported on a return and the person has not previously received fees re the transaction

Contractual Protection (3)

• Questions– If the taxpayer gets an indemnification re the

taxes, is it contractual protection if the indemnification is not tied to the fees paid?

– Is it worse for the taxpayer to get an indemnification or should it just rely on common law for damages if the transaction fails?

– What if the indemnification is for more than fees?

PARTY TO A TRANSACTION

Only A Problem If Is A “Party”4965(a); Prop 53.4965-4

• Exempt facilitates a prohibited tax shelter transaction bec of its tax status– Party: Notice 2004-30 re S Corp– Non-Party: partnership investment; status of

exempt investor is irrelevant to other partners

• Enters into a listed transaction AND there is a reduction of liability for employment, excise, or UBTI taxes

Examples

• Roth IRA “abuse”

• 401(k) accelerated deductions

• Excess deductions using 412(i)

• And others

• In each case, the transaction was “facilitated” by the benefit plan/IRA

• So IRS has a new weapon – an excise tax

EXCISE TAX

2 Taxes: Entity + ManagerProp 53.4965-5, -7

• NO entity tax for benefit plans except for– VEBAs– 115 trusts (?)– “Integral part” trusts (?)

• Manager tax– Tax is $20,000 per relevant manager– Not split among managers; not joint and

several– Self directed – participant can be “manager”

Manager TaxProp 53.4965-7(b)

• $20,000 if – approved or caused the exempt entity to

become a party to a prohibited shelter and– knew or had reason to know it was prohibited

ManagerProp 53.4965-5(b)

• A benefit plan manager is the person “who approves or otherwise causes” the entity to be a part to the shelter

• For self directed plans, the participant is the manager– If there are limited choices, the person who

selects the choices is a manager and the participant is not

Manager Who “Approves”

• Has the authority to commit the plan– individually or as part of a collective body– everyone who votes for has exercised

authority; who abstains or votes against has not

Knows or Has Reason to KnowProp 53.4965-6(b)

• Has knowledge of enough facts that “would lead a reasonable person” to conclude. . .

• A “reasonable person . . . would conclude” that was a prohibited shelter

• Facts include: prior disclosure, extraordinary transaction, exceptional return, significant size for the entity; good faith reliance on written opinion; transaction later listed

Manager Tax - Questions

• More work for the lawyers?

• Will “substantially similar” be a key issue?

• Can the employer or plan indemnify the manager against this tax? – No tax at the entity level even if the

transaction was intentional?

Entity Tax – VEBA Prop 53.4965-7(a)

• Rate, in general– Highest UBTI rate on net income from deal, or– 75% of proceeds from the deal

• If knew or had reason to know– 100% of net income from deal, or– 75% of proceeds

• Annual tax– Applies to pre-enactment deals– Applies to later listed transactions

Transition Due Date

• Form 4720 for 4965 entity tax due on or before 10/4/07 will be timely if filed and tax paid by that date– 53.60781-1T

• Form 5330 for 4965 plan manager tax due on or before 10/4/07 will be timely if filed and tax paid by that date– 54.6011-1T

NEW REPORTING

Form 88861.6033-5T

• Every tax exempt entity including plans• Report

– Is a party to a prohibited tax shelter transactn– Identity of every other party to the transactn

that is known to the exempt entity– Single disclosure for each transaction– Due 5/15 of year after listed or affects taxes– November 5, 2007 due date if entered into

after 5/17/06 and before 1/1/07

PROTECTION

Possible Actions

• Contract limits on investment managers

• Investment policy limits

• Rep & warranties re shelter status

• Ability to terminate investment– Guaranteed buyout price? Liq. damages?

• Plan lawyer’s legal opinion

• Regular watch of “listed transactions”

Important Uncertainties

• Double jeopardy – 6011 and 6707A + 4965?

• Any contractual protection

• “Substantially similar”

• Constant flow of new “listed” transactions

• Patent protection