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April 02, 2004

The Treasury yesterday moved to shut down a tax shelter using S corporations to artificially pawn off taxable income to charities without really giving up the income (Notice 2004-30).

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 

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.

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