IRS Notice 2004-50: Abusive S Corp Charity Schemes
Explore how IRS Notice 2004-50 recharacterizes certain S corp charitable stock transfers, affecting shareholder tax liability and creating new reporting duties.
Through IRS Notice 2004-30, the Internal Revenue Service (IRS) formally identified a transaction involving S corporation stock and charitable organizations as a “listed transaction.” This classification is for arrangements the IRS has determined to be structured for tax avoidance, rather than for a legitimate business purpose. Designating a transaction as “listed” signals that the IRS views the arrangement as potentially abusive, triggering mandatory disclosure requirements for all parties involved. Taxpayers who have participated in such a transaction are put on notice that the claimed tax benefits are subject to challenge.
The Transaction Identified as Abusive
The arrangement targeted by the IRS involves a specific sequence of events designed to generate tax benefits for an S corporation shareholder. It begins when a shareholder donates a portion of their nonvoting S corporation stock to a tax-exempt organization, typically a charity. Following the donation, the shareholder claims a charitable contribution deduction on their personal income tax return, valuing the stock at its fair market value.
A central feature of this transaction is a prearranged understanding that the S corporation will redeem the donated stock from the charity for cash. The charity, being tax-exempt, does not pay tax on the proceeds from this redemption. The timing of these steps is planned to ensure the charity holds the stock for a short period, just long enough for the S corporation to allocate income to it.
The IRS views this structure as an improper shifting of income. For the period the charity holds the stock, a share of the S corporation’s income is allocated to the tax-exempt entity, shielding it from tax. This combination of a charitable deduction for the shareholder and shifting taxable income to a non-taxable entity is what the IRS deems abusive, contending the transaction lacks economic substance beyond the tax savings.
Tax Consequences and Recharacterization
When the IRS identifies participation in this listed transaction, it disregards the taxpayer’s characterization of the events and imposes its own interpretation. The agency’s primary action is to disallow the charitable contribution deduction claimed by the shareholder for the donation of the nonvoting stock. The IRS argues that the transfer and subsequent redemption were part of a single, integrated plan that lacked the requisite charitable intent.
The IRS also recharacterizes the payment made by the S corporation to the charity to redeem the stock. Instead of viewing it as a simple stock redemption, the agency treats the funds as if they were first distributed from the S corporation directly to the shareholder. This deemed distribution is taxable to the shareholder, who is then treated as having personally donated that cash to the charity.
For example, a shareholder donates S corporation stock valued at $100,000 to a charity. The S corporation then redeems the stock from the charity for $100,000. The shareholder initially claims a $100,000 charitable deduction, and the S corporation allocates income to the charity, which the shareholder avoids paying tax on. Upon audit, the IRS would disallow the stock deduction and the $100,000 paid to the charity would be treated as a taxable distribution to the shareholder, creating a significant tax bill.
Disclosure Obligations for Participants
Taxpayers who have engaged in the S corporation stock donation transaction described in Notice 2004-30 have a mandatory disclosure obligation to the IRS. Because it is a “listed transaction,” participation must be reported on Form 8886, Reportable Transaction Disclosure Statement. Filing this form is not an admission of wrongdoing but is a required procedural step.
Completing Form 8886 requires the taxpayer to provide specific details about the transaction. The filer must describe the arrangement, including all the steps from the stock donation to the subsequent redemption. The form also requires the identification of all parties involved, including the name of the S corporation, the shareholder, and the tax-exempt organization that received the stock, along with the dates of key events.
The taxpayer must quantify the amount of the charitable contribution deduction that was claimed and any other tax savings that were anticipated. Failure to file a required Form 8886 can lead to substantial penalties, which are separate from any tax liability that may result from the transaction itself. Taxpayers must attach the form to their income tax return for each year of participation.
Obligations for Material Advisors
Tax professionals who provide assistance or advice regarding listed transactions also have stringent obligations. An individual or firm can be classified as a “material advisor” if they provide material aid, assistance, or advice with respect to organizing, managing, promoting, or implementing any reportable transaction. This definition often includes accountants, lawyers, and financial planners involved in the scheme.
A material advisor connected to a listed transaction has two primary duties. The first is a disclosure requirement to the IRS. The advisor must file Form 8918, Material Advisor Disclosure Statement, with the IRS, which alerts the agency that the advisor has provided services related to a reportable transaction.
The second obligation is to maintain a comprehensive list of all clients who were advised on the specific transaction. This list must be organized and detailed, containing the names, addresses, and taxpayer identification numbers of each client. The advisor is required to furnish this list to the IRS upon written request.