IRS Notice 2006-96: Transaction of Interest Explained
Gain insight into IRS Notice 2006-96, which identifies an S corp basis-shifting arrangement and explains the resulting tax treatment and participant reporting duties.
IRS Notice 2004-30 identifies a specific transaction involving S corporations as a “listed transaction,” warning taxpayers that the claimed tax benefits will be challenged. This designation aims to deter the use of arrangements designed to artificially shift the tax burden of S corporation income away from the business’s true economic owners. The notice clarifies the transaction’s structure, its tax consequences, and the disclosure obligations for participants.
The Targeted Listed Transaction
The transaction identified by the IRS involves a set of steps designed to improperly shift income. It begins with the establishment of an S corporation by its primary shareholders. A key element is the involvement of a “tax-indifferent party,” which is a tax-exempt organization or a foreign person not subject to U.S. tax on the S corporation’s income.
The arrangement proceeds with the S corporation issuing both voting and non-voting stock. The original shareholders retain the voting stock, thereby keeping full control over the S corporation’s operations and financial decisions. A significant majority of the non-voting stock, often 90% or more, is then transferred to the tax-indifferent party through a purported donation.
This transfer is structured to give the appearance that most of the S corporation’s income should be allocated to the tax-indifferent shareholder. Following this allocation, the S corporation directs most of its income to the non-voting shares held by the tax-indifferent party. The original shareholders, holding the voting stock, allocate only a small portion of the income to themselves, minimizing their personal tax bills.
The final step involves the original shareholders reacquiring the economic benefits of the income allocated to the tax-indifferent party. This is often accomplished by having the S corporation redeem the non-voting stock from the tax-indifferent party for a fraction of its purported value. It can also be done by making payments to the party that are characterized as something other than distributions of profits.
Tax Consequences of the Transaction
The IRS will challenge the claimed tax benefits on several grounds, arguing they are not permissible. The primary argument is that the transaction lacks economic substance, a doctrine that allows the IRS to disregard transactions with no meaningful purpose beyond a tax benefit. Because the original shareholders retain complete control and ultimately receive the income’s economic benefits, the stock transfer is seen as a sham.
The IRS will reallocate the S corporation’s income from the tax-indifferent party back to the original shareholders. This means the shareholders will be held liable for the income tax on all the profits they attempted to shift. The person who earns and controls the income is the one who must pay tax on it.
Furthermore, the IRS will disallow any artificial stock basis increase. A shareholder’s basis in S corporation stock increases by their share of the corporation’s taxed income. Since the income is reallocated to the original shareholders, they have no legitimate basis for an increase related to income they did not initially report. Consequently, any tax loss claimed upon the sale of their stock that results from this inflated basis will be denied.
Disclosure Requirements for Participants
Due to its designation as a “listed transaction,” any taxpayer participating in this S corporation arrangement faces mandatory disclosure obligations. Participants must file Form 8886, Reportable Transaction Disclosure Statement, to inform the IRS of their involvement.
The Form 8886 must be filed for each taxable year of participation, and a copy must be attached to the taxpayer’s income tax return. When filing for the first time, a separate copy must also be sent to the IRS Office of Tax Shelter Analysis (OTSA) at: Internal Revenue Service, OTSA Mail Stop 4915, 1973 Rulon White Blvd., Ogden, UT 84201.
On Form 8886, the taxpayer must identify the transaction by its notice number, 2004-30. The filer must also describe the transaction’s structure and report the expected tax benefits, such as the amount of income shifted and the artificial loss generated.
Penalties for Non-Compliance
Failure to comply with disclosure requirements carries financial penalties that are applied independently of any tax owed from the transaction itself. The penalty is for the failure to report, making it a distinct liability.
The penalty for failing to disclose a listed transaction for natural persons is 75% of the decrease in tax shown on the return as a result of the transaction. This has a minimum penalty of $5,000 and a maximum of $100,000. For all other entities, including corporations, the maximum penalty increases to $200,000.
The legal landscape for these penalties is evolving due to court decisions challenging how the IRS identifies listed transactions through notices. The IRS has indicated it will no longer defend certain penalties arising from these designations, creating a complex situation for affected taxpayers. Failing to file Form 8886 can also extend the statute of limitations for the tax return on which the transaction should have been disclosed. This gives the IRS more time to conduct an audit and assess additional tax, interest, and penalties connected to the transaction.