CoF Advanced Legal Seminar – Tax-Shelter Transactions

Chair of the Exempt Organizations Committee of the ABA Section of Taxation LaVerne Woods discussed the topic of charities and tax shelters.  Her presentation began with a quote from IRS Commissioner Mark W. Everson at a Senate Finance Committee Hearing in 2004:

"I cannot overstate the seriousness of the involvement of tax-exempt and government entities as accommodation parties to abusive transactions."

As an example of an abusive tax shelter transaction involving an exempt organization, Woods briefly discussed SC2, a transaction designed by a major international accounting firm in which S corporation shareholders attempt to transfer the incidence of taxation on the corporation’s income to by purportedly donating nonvoting stock to an exempt organization while retaining the economic benefits associated with such stock.  If permitted, this transaction would make use of the exempt organization’s special tax status by allocating most of the corporation’s income to the exempt organization (which would not be subject to tax on such income) without actually distributing any income to the exempt organization.  The exempt organization would then sell its stock back to the corporation for a nominal price, and the distributions would be made to the remaining (taxable) shareholders who would not be subject to tax because the income had already been allocated.

In May 2006, the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) enacted new Internal Revenue Code section 4965.  Section 4965 imposes a penalty tax:

  • On a "Tax-Exempt Entity"
  • That is a "Party"
  • To a "Prohibited Tax Shelter Transaction."

A tax-exempt entity includes any entity which is described in Section 501(c) of the Internal Revenue Code.

A tax-exempt entity is a party if it facilitates a transaction by reason of its special tax status (e.g., the SC2 transaction).  It is not a party if it invests in a mutual fund that in turn invests in a prohibited tax shelter transaction.  IRS Notice 2007-18 provides interim guidance on the new tax shelter rules of exempt organizations, including the scope of the meaning of "party."

A prohibited tax shelter transaction means any "listed transaction" (specifically identified by the IRS in published guidance) and any "prohibited reportable transaction" (any confidential transaction in which the exempt organization is subject to conditions of confidentiality, and any contractual protection transaction in which a party has the right to a refund of fees if the intended tax consequences are not sustained).

Penalty taxes may be imposed on the organization equal to the highest corporate tax rate (35 percent) times the greater of (i) net income from the transaction, and (ii) 75 percent of the proceeds from the transaction.  If the organization knew or had reason to know that the transaction was a prohibited tax shelter transaction, the penalties increase to the greater of (i) 100 percent of the net income from the transaction, and (ii) 75% of the proceeds from the transaction.

Penalty taxes in the amount of $20,000 per approval may also be imposed on the "entity manager" (person with authority similar to officer/director/trustee) if such person approves or otherwise causes to enter into a prohibited tax shelter transaction and knows or had reason to know that it is such a transaction.

Woods listed four transactions to watch out for:

  1. Transactions involving foreign currency swaps;
  2. Transactions arranged by a promoter who receives a fee that requires the organization to sign a confidentiality agreement;
  3. Transactions in which a party may get its money back if the desired tax result is not achieved; and
  4. Transactions that promise an extraordinary rate of return for little risk and/or investment.