IRS Notice 2004-23: S Corp Listed Transaction Rules

The Internal Revenue Service (IRS) issued Notice 2004-30 to stop a specific tax shelter involving S corporations. This guidance identifies the arrangement as a “listed transaction,” signaling that the IRS views it as an improper method of tax avoidance. This classification imposes strict reporting duties on participants and carries the risk of significant penalties.

The Targeted S Corporation Transaction

The transaction targeted by IRS Notice 2004-30 involves a multi-step arrangement designed to artificially reduce an S corporation’s taxable income. It begins with the S corporation authorizing and issuing non-voting stock, along with warrants to acquire additional shares, which are distributed proportionally to the existing shareholders.

Following the issuance, the shareholders make a purported donation or sale of the non-voting stock to a “tax-indifferent party.” This party is an entity not subject to U.S. federal income tax on the S corporation’s income, such as a tax-exempt organization or a foreign person. While the tax-indifferent party becomes the legal owner of the non-voting shares, the original shareholders retain the warrants. These warrants give them the right to repurchase the non-voting stock at a later date for a nominal price, ensuring they never lose economic control.

The core of the tax avoidance strategy unfolds when the S corporation allocates a substantial portion of its income to the block of non-voting stock held by the tax-indifferent party. Simultaneously, the S corporation claims large, non-economic deductions associated with the warrants held by the original shareholders. The combination of allocating income to a non-taxable entity and creating artificial deductions for the taxable shareholders effectively erases the tax liability on the corporation’s profits.

The IRS contends this structure lacks economic substance and is designed solely to defer or eliminate taxes. For example, an S corporation earning $1 million might allocate 90% of that income, or $900,000, to the non-voting stock held by a tax-exempt charity. The original shareholders, who retain control through their voting stock and warrants, would only be allocated $100,000 of income. The IRS views this as an abusive manipulation of S corporation and tax-exempt entity rules.

Implications of a Listed Transaction

The “listed” designation serves as a public warning that the IRS will challenge the tax benefits claimed from these transactions. Unlike other reportable transactions that may have legitimate business purposes, a listed transaction is presumed to be improper. This classification removes ambiguity about the IRS’s position and subjects a taxpayer’s return to a higher level of scrutiny, increasing the risk of an audit.

Required Disclosure Filings

Taxpayers who participate in the S corporation transaction described in Notice 2004-30 must disclose their involvement to the IRS. This disclosure is made using Form 8886, Reportable Transaction Disclosure Statement, which must be filed for each tax year of participation and attached to the income tax return. A separate copy must also be mailed to the IRS Office of Tax Shelter Analysis (OTSA).

On Form 8886, the filer must provide a detailed description of the arrangement, identify the expected tax benefits, and name all other participants. This includes the tax-indifferent party that received the non-voting stock.

Material advisors, such as accountants or lawyers who promote or help implement the transaction for a fee, have their own disclosure duties. These advisors are generally required to file Form 8918, Material Advisor Disclosure Statement. They must also maintain a list of all clients who participated in the transaction, which must be made available to the IRS upon request.

Penalties for Non-Compliance

Failing to comply with the disclosure requirements for a listed transaction carries financial consequences. The rules are strict, and the penalties can be applied even if the underlying tax position is ultimately determined to be valid.

For taxpayers, the penalty for failing to properly file Form 8886 for a listed transaction is significant. Under Internal Revenue Code § 6707A, the penalty is 75% of the decrease in tax shown on the return as a result of the transaction, with a maximum of $200,000 for individuals and other entities.

Material advisors face substantial penalties for their failure to comply. An advisor who does not file an accurate Form 8918 for a listed transaction is subject to a penalty under § 6707, which can be the greater of $200,000 or 50% of the gross income the advisor derived from the activity. Advisors who fail to maintain or furnish their investor list when requested by the IRS face a penalty under § 6708 of $10,000 for each day of non-compliance after a 20-day grace period.