What Is Notice 2005-43 on Abusive Trust Schemes?

The Internal Revenue Service (IRS) uses guidance to alert taxpayers to improper transactions. IRS Notice 2005-43 addresses an abusive trust arrangement designed to generate artificial tax losses to offset legitimate income. The notice identifies this arrangement as a “listed transaction,” signaling the IRS views the scheme as a tax avoidance strategy. This designation triggers disclosure requirements and outlines consequences for those who use or promote the scheme, serving as a warning that the structure is not a legitimate tax planning tool.

The Abusive Trust Transaction Explained

The transaction identified in Notice 2005-43 involves a complex, multi-step process designed to create an artificial high basis in an asset, which is then sold to generate a tax loss. A promoter facilitates a series of pre-arranged steps involving multiple entities, including trusts, for a taxpayer seeking to shelter a significant gain. The process commences when the taxpayer acquires an option or some other derivative interest and contributes it to a trust, referred to as “Trust 1.” Simultaneously, a promoter or an associate acquires a similar, offsetting position and contributes it to a second trust, “Trust 2.”

Next, Trust 1 and Trust 2 engage in a transaction where they exchange their respective positions and assume each other’s obligations. The taxpayer takes the position that this exchange, coupled with assuming Trust 2’s liability, increases the basis of the asset held by Trust 1. This inflated basis is created on paper through a questionable interpretation of tax rules, as the taxpayer has not invested significant additional capital.

The asset with the artificially high basis is then transferred from Trust 1 to a separate trust, “Trust 3,” in a transfer structured to carry over the inflated basis. Shortly thereafter, Trust 3 sells the asset. Because the sale price is far below the inflated basis, a substantial tax loss is generated. The taxpayer then uses this loss on their personal income tax return to offset an original, unrelated capital gain, improperly reducing their tax liability.

Identifying Affected Parties

Notice 2005-43 establishes clear categories for individuals and entities involved in the abusive trust scheme. The first category is the “participant,” who is any taxpayer that engages in the transaction with the intent of claiming the tax benefits it purports to offer. This is the individual or business owner seeking to shelter a capital gain or other income, and their involvement is defined by using the manufactured loss on a tax return.

The notice also defines “material advisors.” This group includes any person or firm that provides assistance or advice regarding the transaction and receives a minimum fee. The fee threshold is $250,000 for advice to a corporation or $50,000 for other taxpayers. Material advisors, such as promoters or attorneys, are actively involved in providing the structure, legal analysis, or implementation steps to execute the scheme.

Disclosure and Reporting Obligations

The designation as a listed transaction imposes reporting duties on all involved parties. Taxpayers who participate in the scheme must disclose their involvement to the IRS on Form 8886, “Reportable Transaction Disclosure Statement.” This form must be filed for each taxable year of participation and requires a detailed description of the transaction, the other parties involved, and the amount of the expected tax benefit.

Material advisors have their own disclosure responsibilities. They must file Form 8918, “Material Advisor Disclosure Statement,” with the IRS for each listed transaction for which they provided material aid or advice. On Form 8918, the advisor must describe the transaction and explain the tax benefits it purports to generate. This disclosure is due by the last day of the month that follows the end of the calendar quarter in which the person became a material advisor.

Material advisors must also maintain a list of all clients who participated in the transaction. This list must be kept for a specified period and furnished to the IRS upon request. The list must include information about each client, the advice provided, and the fees received.

Tax Consequences and Penalties

Engaging in the transaction described in Notice 2005-43 leads to tax and financial repercussions. The primary tax consequence is that the IRS will disregard the transaction, as the scheme lacks economic substance and has no business purpose beyond generating a tax benefit. As a result, any loss claimed from the sale of the asset will be disallowed, and any artificial basis increase will be ignored. The taxpayer’s taxable income is recalculated as if the transaction never occurred, leading to a tax deficiency.

In addition to paying the back taxes and accrued interest, taxpayers face an accuracy-related penalty on any underpayment of tax attributable to a listed transaction. This penalty is 20% of the underpayment but increases to 30% if the taxpayer did not adequately disclose the transaction.

Material advisors face penalties for non-compliance. An advisor who fails to file Form 8918 is subject to a penalty of the greater of $200,000 or 50% of the gross income the advisor derived from the activity. If the failure to disclose was intentional, the penalty increases to 75% of the gross income. An advisor who fails to maintain or furnish the required client list to the IRS upon request can be penalized $10,000 for each day of the failure.