The plan, reportedly marketed by one national accounting firm as "SC2" through a telemarketing center, had several steps:
- Issue warrants to S corporation shareholders pro-rata - say, 1000 warrants per each share. The single owner of a 100-share S corporation would receive 100,000 warrants to buy one additional share.
- make a class of non-voting shares - for example, turn 99 out of 100 shares non-voting shares.
- Donate the non-voting shares to charity - but not the associated warrants.
- Allocate 99% of the earnings to charity for a few years. This would work best with interest, dividend and capital gain income, which is non-taxable to charities.
- The owner of the one voting share then exercises his warrants, suddenly owning 100,001 shares to the charity's 99 nonvoting shares.
- Redeem the charity's 99 shares.
If it works as designed, most of the income isn't taxed because it is allocable to charity, yet the warrants enable the "donor" to reclaim almost all of the income eventually. Because the charity has no vote, it gets no say in the corporation.
Notice 2004-30 says:
The Service intends to challenge the purported tax benefits from this transaction based on the application of various theories, including judicial doctrines such as substance over form. Under appropriate facts and circumstances, the Service also may argue that the existence of the warrants results in a violation of the single class of stock requirement of § 1361(b)(1)(D), thus terminating the corporation's status as an S corporation.
The notice makes such arrangements a "listed transaction." Failure to fully disclose such a transaction subjects taxpayers to penalties.
Employee stock ownership plans owning S corporation shares are not subject to Notice 2004-30.
The items included in the Tax Update Blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation.
Joe Kristan writes the Tax Update items, and any opinions expressed or implied are not necessarily shared by anyone else at Roth & Company, P.C. Address questions or comments on Tax Updates to