Since 1998, the S corporation ESOP has become one of the most popular forms of

Transcription

1 Since 1998, the S corporation ESOP has become one of the most popular forms of ESOPs in the United States. Hundreds of S corporations have become 100% owned by ESOPs since 2001 because of the favorable tax consequences associated with this ownership structure (i.e., little or no corporate and/or shareholder level taxes). Given the proliferation of this form of employee ownership through ESOPs, the Internal Revenue Service (IRS) has been very active each year since 1998 in providing continuing guidance regarding S corporation ESOPs. With such beneficial tax treatment also comes the potential for abuse. This abuse resulted in the creation of the most significant and complex legislation related to S corporation ESOPs, the anti-abuse provisions under Section 409(p) of the Internal Revenue Code of 1986, as amended (Code), which became law on June 7, This appendix reflects a comprehensive compilation of almost all of the regulatory developments in this respect since 1998, including the temporary regulations relating to Section 409(p) of the Code that the IRS issued in late Stay tuned, because the IRS will continue to regulate S corporation ESOPs to prevent abuse and provide guidance with respect to this unique and growing form of employee ownership. On January 8, 1999, the Internal Revenue Service (IRS) issued final regulations (T.D. 8806) that permit an S corporation ESOP to be amended to eliminate participants right to elect benefit distributions in the form of company stock without violating the protected benefit rules under Section 411(d)(6) of the Code permitted under Code Section 409(h)(2), as amended by the Taxpayer Relief Act of 1997 ( TRA 97 ). The proposed regulations (issued by the IRS on September 4, 1998) had provided that the ESOP must be amended to eliminate a distribution in shares of employer securities by the last day of the first plan year commencing after December 31, The ESOP Association submitted a comment to the IRS raising a concern regarding the limitation on the time period to make the amendment. The IRS acknowledged this comment and clarified that the remedial amendment period cutoff date (the last day of the first plan year

2 commencing after December 31, 1998) applies only to retroactive amendments to conform the ESOP plan document to the operation of the plan. The IRS further clarified that an ESOP may be amended to eliminate in-kind company stock distributions (after the termination of this remedial amendment period) if an ESOP company subsequently elects to be taxed as an S corporation under Code Section The IRS s position permitting a subsequent amendment is consistent with prior Regulation Section 1.411(d)-4(d)(1)(ii), which permits an ESOP to be amended to eliminate in-kind distributions if the company becomes substantially employee-owned in accordance with Section 409(h)(2) of the Code. In Private Letter Ruling (PLR) (July 2, 1999), the IRS issued significant guidance with respect to S corporation ESOPs. The PLR addresses the use of earnings (dividends or S corporation distributions) on shares of company stock owned by an ESOP sponsored by an S corporation to make payments on an ESOP loan. The IRS ruled that although it is permissible to use earnings on unallocated shares (i.e., suspense account shares) to make payments on an ESOP loan, the use of earnings on allocated shares of company stock to make such payments would result in a prohibited transaction under Section 4975(c)(1) of the Code because it would fail to satisfy the ESOP loan exemption under Section 4975(d)(3) of the Code. The IRS based its reasoning on Treasury Regulation Section (b)(5), which provides that a person entitled to payment under an ESOP loan does not have the right to assets of the ESOP other than (1) the collateral given for the loan, (2) contributions made to the ESOP for purposes of making loan payments, and (3) earnings attributable to the collateral and the investment of such contributions. The IRS reasoned that because shares of company stock that have been released from the ESOP s suspense account are not available as collateral, the earnings on such shares are not earnings attributable to collateral on the ESOP loan and, accordingly, are not available to make payments on the ESOP loan. Use of ESOP assets other than those permitted under the regulation would result in a prohibited transaction under Section 4975(c)(1) of the Code. Section 404(k)(5)(B) of the Code permits a C corporation ESOP (unlike an S corporation ESOP) to use cash dividends on both unallocated and allocated shares to make payments on an ESOP loan. Also significant is the fact that the IRS ruled that the S corporation distributions attributable to the unallocated shares of company stock may be used to make payments on the ESOP loan to the extent that such distributions are from either accumulated earnings and profits or from the S corporation s accumulated adjustments account. The IRS has now issued several more PLRs coming to the same conclusion as PLR In PLR (Sept. 8, 1999), the IRS ruled for a second time regarding the use of earnings (dividends or S corporation distributions) on shares of company stock owned by 2

3 an ESOP sponsored by an S corporation to make payments on an ESOP loan. The IRS ruled that it is permissible to use earnings on unallocated shares in the ESOP s suspense account to make payments on an ESOP loan to the extent that such earnings are from either accumulated earnings and profits or from the S corporation s accumulated adjustments account. In this PLR, the IRS did not address the use of earnings on allocated shares of company stock. In PLR (July 2, 1999), the IRS ruled that the use of earnings on allocated shares of company stock to make such payments would result in a prohibited transaction under Code Section 4975(c)(1) because it would fail to satisfy the ESOP loan exemption under Code Section 4975(d)(3). In PLR (Sept. 27, 1999), the IRS denied a company s request to reelect S corporation status within five years of having terminated such status in order to permit the company s ESOP to purchase company stock from a shareholder in a tax-deferred sale under Section 1042 of the Code. The company was an S corporation with two shareholders. Five days before the shareholders sale of more than 50% of their stock to the company s ESOP, the company revoked its S election and became a C corporation. Following the sale of stock to the ESOP, the shareholders elected under Code Section 1042 to defer the gain on the sale. Thereafter, the company filed a request with the IRS to reelect S status. Shareholders who sell their company stock to an ESOP that is maintained by an S corporation do not qualify for the nonrecognition of gain provisions of Code Section These nonrecognition provisions are available only with respect to a sale of company stock to an ESOP that is maintained by a C corporation. Code Section 1362(g) provides that a company that terminates its S election is not eligible to reelect S status for a five-year period unless the IRS consents to the reelection. Treasury Regulation Section (a) provides that the IRS may permit a company to make a new S election before the five-year period expires if the company establishes that, under the relevant facts and circumstances, the IRS should consent to the new election. Under the regulations, the fact that more than 50% of the stock in the corporation is owned by persons who did not own any stock in the corporation on the date of the termination tends to establish that consent should be granted. PLR presents a situation in which the ESOP acquired more than 50% of the company s stock after the termination of the company s S election. Under these facts, more than 50% of the company s stock was owned by a person (i.e., the ESOP) that did not own any stock on the date of the termination. Generally, this would suffice for the IRS to grant the request to make a new S election. Nevertheless, in this PLR, after acknowledging its authority under the statute and the regulations to consent to a new S election, the IRS ruled that to allow the company to terminate its S election, have its shareholders immediately engage in a Code Section 1042 transaction, and then subsequently reelect S status before the expiration of the five-year waiting period would contravene the applicable statutes and be contrary to Congressional intent. 3

4 It should be noted that the IRS made the additional statement (which extends beyond the scope of the company s request) to the effect that the company would also be prohibited from becoming a qualified subchapter S subsidiary ( QSSS ) under Code Section 1361(b)(3) during the same five-year period. Generally, if a former S corporation (the target ) is acquired by an S corporation acquiror, the target would become an S corporation (or may elect to be a QSSS) if the acquiror is not considered a successor corporation. This additional statement in PLR should serve as a caution for any ESOP-owned corporation that is acquired by an S corporation during the five-year waiting period. In PLR (Oct. 20, 1999), the IRS ruled that company stock will constitute qualified securities under Section 1042(c)(1) of the Code and that the selling shareholders holding period for purposes of Section 1042(b)(4) of the Code will include the period during which the company was an S corporation. Under the facts of this PLR, the company is an S corporation that proposes to establish an ESOP and then terminate its S election. After termination of the company s S election, the company s sole shareholder intends to sell company stock to the ESOP in a transaction intended to qualify for nonrecognition treatment under Section 1042 of the Code. (The company was originally a C corporation when the shareholder obtained his stock.) For a transaction to qualify for nonrecognition treatment under Section 1042 of the Code (in addition to satisfying other requirements), the company stock sold to an ESOP must be issued by a domestic C corporation, and the selling shareholder must have a holding period with respect to such stock of at least three years. In this PLR, the IRS ruled that the selling shareholder s holding period with respect to his stock includes the period during which the S election was in effect and that the stock will constitute qualified securities under Section 1042(c)(1) of the Code once the S election is terminated. An IRS PLR should simplify the distribution procedures for ESOPs sponsored by subchapter S corporations. An administrative problem faced by S corporation ESOPs is the general ESOP requirement that benefits for participants must be distributable in the form of company stock. If a participant who becomes entitled to a distribution from the ESOP (e.g., due to retirement, death, disability, or other termination of employment) elects to take a distribution in the form of company stock and also elects to have the distribution transferred directly to an individual retirement arrangement (IRA) under Section 401(a)(31) of the Code, then the IRA would become the owner of the S corporation s stock. That could be a problem because IRAs are not permitted to be S corporation shareholders, and ownership of even a single share of an S corporation s stock by an impermissible holder results in automatic involuntary termination of S corporation status. 4

5 Section 409(h)(2) of the Code provides some protection against this occurrence by permitting the stock distributed by an S corporation ESOP trust to be subject to a requirement that it immediately be resold to the ESOP company. Even an immediate sale by the IRA, however, would still result in the IRA s ownership of the distributed S corporation stock for a theoretical instant in time, which some have feared would result in an involuntary termination of S corporation status. The ruling request sought prospective relief from this result for future ESOP distributions of S corporation stock, based on the following three grounds: 1. The IRS has granted dozens of other requests to disregard momentary ownership of S corporation stock when the momentary owner is a corporation or a partnership and, therefore, should reach the same result when the momentary owner is an IRA. 2. Treas. Reg (a)(2)(ii) provides that a shareholder who disposes of stock in an S corporation is treated as the shareholder for the day of the disposition. Logically, this would appear to mean that the ESOP trust is treated as the shareholder for the day on which the stock is transferred to the IRA. If the IRA sells the stock back to the company or the ESOP trust on the same day, then the company or the ESOP trust is treated as the owner of the stock on the next day. Because there is no day on which the IRA is treated as the owner of the stock under this regulation, it should not be treated as ever having owned the stock for purposes of involuntarily terminating the corporation s S status. 3. The administrative burden of the alternatives available to the company if the ESOP trust could not continue its practice of making stock distributions, subject to a right of immediate repurchase, was quite substantial. After taking a tentative position adverse to granting the request, representatives of the IRS met with representatives of the company and received some additional information. Shortly thereafter, the IRS granted a favorable ruling, stating that the Company s status as an S corporation will not terminate if the ESOP (trust) makes distributions of Company stock, and one or more participants elects to make a direct rollover to an IRA, provided that the stock is immediately repurchased by Company. The company s procedure is to have the participant, or his or her IRA custodian, sign an irrevocable stock transfer form before receiving the distribution. Although a stock certificate is prepared, it never leaves the company s premises and is retired the same day. By monitoring the timing of stock distributions, the company ensures that it will never have more than 75 shareholders (including momentary shareholders) on any given day. The ruling does not indicate its rationale but merely recites the facts and states the conclusion. Based on discussions with the IRS representatives, it is surmised that the IRS was not moved by the analysis under Treas. Reg (a)(2)(ii), which could be regarded as proving too much because it would justify ownership for less than a day by any otherwise impermissible S corporation shareholder. What seems to have made more of a difference was the argument that the administrative burden resulting from forcing participants to do indirect rollovers (in which the stock is distributed to the participant, who has to sell it back to the company and then reinvest the sale proceeds in an IRA within 60 days) was substantial. Because this burden was so substantial and because the IRS 5

6 representatives agreed that no tax policy purpose would be served by terminating the company s S corporation status under these circumstances, the company s counsel argued that the IRS should expand on its line of rulings to the effect that corporations and partnerships can be momentary owners of S corporation stock, which often arise in cases where a corporation is to be created and spun off from its parent (which, as a corporation or partnership itself, is an impermissible owner for the instant in time between the creation of the corporation to be spun off and the actual spin-off). The ruling does differ qualitatively from the previous PLRs that deal with corporation and partnership momentary ownership, however, because each of these prior PLRs involved only a single discrete event, while this PLR gives the company carte blanche for an unlimited number of future direct rollovers of stock from the ESOP trust to an IRA. Note that this is a PLR, not a published revenue ruling; therefore, no taxpayer other than the company to which it was addressed is entitled to rely on it. It is likely that any other ESOP S corporation that applied for a similar PLR would receive one and that the position of the IRS National Office is that S corporations should not suffer loss of their S corporation status due to momentary ownership of their stock by an IRA under these circumstances. In Revenue Procedure (Feb. 20, 2003), the IRS once again addressed the momentary distribution of company stock to an IRA. The trustee or custodian of an IRA is not a permissible S corporation stockholder (see Code Sections 1361(b) and 1361(c)(6)), and an election to be treated as an S corporation normally is terminated when a person or entity that is not a permissible S corporation stockholder becomes a stockholder of the S corporation (see Code Section 1362(d)(2)). The IRS has previously determined, however, that under certain circumstances it is consistent with the purposes of, and policies underlying, ESOPs to enable an ESOP trust to distribute S corporation stock to the IRA of an ESOP participant without terminating the corporation s S election. For example, in two IRS PLRs, PLR (June 27, 2002) and PLR (Feb. 28, 2001), the IRS ruled that an ESOP-owned S corporation s status as an S corporation will not terminate if an ESOP participant elects to make a direct rollover of S corporation stock from the ESOP trust to the participant s IRA, provided that the distributed stock is immediately repurchased by the S corporation under certain procedures. Accordingly, Revenue Procedure provides that the IRS will accept the position that a distribution of S corporation stock to a participant s IRA does not affect the corporation s election to be taxed as an S corporation if the following requirements are satisfied: 1. The ESOP participant elects to have S corporation stock distributed by the ESOP trust to the participant s IRA in a direct rollover (i.e., the ESOP trust distributes the S corporation stock directly to the trustee or custodian of the participant s IRA); 2. The terms of the ESOP require that the S corporation repurchase its stock immediately upon the ESOP trust s distribution of the stock to an IRA; 6

7 3. The S corporation actually repurchases the S corporation stock contemporaneously with, and effective on the same day as, the distribution to the IRA; and 4. No income, loss, deduction, or credit attributable to the distributed S corporation stock is allocated to the participant s IRA. One has to question whether the IRS may extend the application of Revenue Procedure in other circumstances. For example, in an estate planning context, would the transitory holding of S corporation stock by a charitable remainder unitrust or a limited liability company cause the S corporation to lose its status as such? Internal Revenue Service Expands Scope of Individual Retirement Account (IRA) Rollover Exception for S Corporations In Rev. Proc , dated February 17, 2004, the IRS published guidance that expands on its prior position that an ESOP participant may roll over to an IRA a distribution of company stock without terminating the employer s S corporation election. Under the direct rollover rules of Section 401(a)(31) of the Code, a participant who is entitled to receive a distribution of shares of company stock from an ESOP trust has the right to direct the ESOP trustee to roll over those shares directly to an IRA. Because an IRA is not an eligible shareholder of an S corporation, a direct rollover election by an ESOP participant could terminate the S election and cause the employer to become a C corporation. In Rev. Proc , C.B. 599, the IRS agreed that the S election would not be terminated under these circumstances if the terms of the ESOP require that the IRA immediately sell the shares of company stock back to the employer, the employer in fact purchases the shares from the IRA on the same day and the IRA is not treated as having received any share of the S corporation s income. Section 409(h)(2)(B) of the Code permits the employer to assign to the ESOP trust its rights to buy back the participant s shares of company stock. The new guidance, Rev. Proc , supersedes Rev. Proc by restating the initial IRS position and by expanding the guidance to cover the situation in which the shares of company stock that are distributed by the ESOP trust are repurchased by the ESOP trust rather than the employer. Therefore, ESOPs of S corporations that distribute shares of company stock subject to immediate buyback by the ESOP trust are now safe from a claim that the distribution of company stock to the IRA disqualifies the S election so long as the ESOP follows the requirements of Rev. Proc On May 10, 2002, in Revenue Procedure , the IRS confirmed that Section 1378 of the Code and of the applicable U.S. Treasury Regulations provide that the taxable year of an S corporation must be a permitted year. A permitted year for this purpose means (1) the required taxable year (i.e., a taxable year ending on December 31); (2) a taxable year elected under Code Section 444; (3) a 52 week taxable year ending with reference to the required taxable year or a taxable year elected under Code Section 444; or (4) any other accounting period for which the corporation establishes a business purpose 7

8 to the satisfaction of the Commissioner. There are a large number of ESOP plan sponsors that are fiscal year S corporations (i.e., with a taxable year ending on a date other than December 31) where the ESOP owns a majority, but not all, of the capital stock of the corporation. It now appears that these corporations may not use the exception on the back of the existing Form 2553 that permits the corporation to retain the taxable year of its sole owner (i.e., the ESOP). There appears to be no grandfather provision under Revenue Procedure It also appears that all of these corporations must now change their fiscal years to the calendar year unless they petition the IRS and receive approval to retain their fiscal years. Apparently the only grandfather provision with respect to Revenue Procedure applies to companies that have received approval of a fiscal year by means other than automatic approval. Many ESOP-owned S corporations retained their fiscal year when they elected S corporation status through the automatic process. According to one member of the ESOP community who has spoken with an individual at the IRS who was responsible for drafting Revenue Procedure , this is consistent with what the IRS intended when it published this revenue procedure. Section 5.03 of Revenue Procedure also specifically states that it applies to a corporation that retains its fiscal year at the time that it makes the S corporation election. The IRS apparently also has informally indicated that it would not consider the size of the non-esop ownership to be relevant in any petition by an S corporation to retain a fiscal year other than a calendar year. It is possible that the IRS will allow the additional tax due to the doubling up of income in a single year as a result of being required to switch from a fiscal year to a calendar year under Revenue Procedure to be spread over a number of years, but there does not seem to be any hope of changing the basic rule provided under Revenue Procedure In Revenue Ruling (February 20, 2003), the IRS addressed whether an ESOP is required to adjust the basis in the capital stock held by the ESOP trust for a pro rata share of an S corporation s items under Section 1367(a) of the Code. This ruling also addressed whether, upon distribution of S corporation capital stock by an ESOP trust to a participant, the stock s net unrealized appreciation under Section 402(e)(4) of the Code is determined using the ESOP trust s adjusted basis in the stock. As background, the IRS provided the following information in Revenue Ruling : 1. An S corporation stockholder is required to increase its basis in its S corporation stock for its pro rata share of the corporation s items of income and gain (Code Section 1367(a)(1)) and decrease its basis in such stock (but not below zero) for its pro rata share of the corporation s items of loss and deductions (Code Section 1367(a)(2)); and 8

9 2. An ESOP participant generally is taxed on amounts distributed to the participant (Code Section 402(a)). An ESOP participant is not taxed on any net unrealized appreciation (i.e., the excess of the fair market value of the distributed company stock over the ESOP s cost or other basis in such stock) attributable to employer securities that are distributed to the ESOP participant (Code Section 402(e)(4)(B)). Based upon this background, the IRS concluded in Revenue Ruling that an ESOP trust must adjust its basis in S corporation stock for its pro rata share of the corporation s items of income, gain, loss, and deduction, and that such adjusted basis must then be used to determine the net unrealized appreciation of such company stock when it is distributed to an ESOP participant. Accordingly, an ESOP trust must increase its basis in S corporation stock by its pro rata share of the corporation s income and thereby reduce the net unrealized appreciation in such stock that is otherwise exempt from tax when the stock is distributed to an ESOP participant. In 2001, the IRS began to target abusive arrangements whereby an S corporation was used to pass corporate income to a tax-exempt ESOP with the only participants in the ESOP being the owner/employees of the business. As a consequence, the IRS amended the Code to add Section 409(p) which limits the tax benefits of S corporation ESOPs unless the ESOP provides meaningful benefits to rank-and-file employees. (See H.R. Rep , pt. 1, at 100, and H.R. Conf. Rep , at 274 [2001].) In general, Section 409(p) of the Code imposes income and excise taxes when there are prohibited allocations under an S corporation ESOP in a nonallocation year. A nonallocation year occurs when the ownership of the S corporation is so concentrated that disqualified persons own or are deemed to own at least 50% of the S corporation s capital stock. Disqualified persons are persons who (1) have deemed-owned shares constituting more than 10% of all deemed-owned shares of the corporation s stock, or (2) are members of a family that in the aggregate own more than 20% of the deemed-owned shares of the corporation.). In July of 2003, the IRS published guidance on Section 409(p) in the form of temporary regulations. More recently, in December of 2004 the IRS and Treasury issued additional Temporary regulations providing guidance concerning the application of section 409(p) to S corporation ESOPs. Both the 2003 and the 2004 regulations are discussed below. On July 21, 2003, the U.S. Treasury and the IRS published temporary regulations (which also serve as proposed regulations) providing guidance regarding the S corporation ESOP anti-abuse provisions of Section 409(p) of the Code. The regulations include some positive clarifications of Section 409(p) of the Code. More importantly, however, the regulations also expand the definition of synthetic equity in a manner that could result in an employer violation of Section 409(p) of the Code that is not expressly provided for in the statute. 9

10 With the 1997 Tax Act, Congress amended Section 512(e) of the Code to allow ESOPs to become eligible S corporation shareholders without being required to pay an unrelated business income tax (UBIT) on the ESOP s share of the S corporation income. In reaction to several aggressive S corporation ESOP tax structures, Congress acted appropriately and enacted Section 409(p) of the Code as part of the Economic Growth and Tax Relief Reconciliation Act of 2001, as amended (EGTRRA), with the intention of limiting the S corporation ESOP tax benefit to corporations that provide for broad-based employee ownership. Despite the enactment of Section 409(p) of the Code, the IRS is concerned that aggressive S corporation ESOP structures continue to be promoted by some advisors. The principal offender was a structure referred to as an S corporation ESOP management company. Although an ESOP can be properly and legally structured as part of a management company, the IRS describes in the preamble to the regulations an S corporation ESOP management structure that it considers to be in violation of Section 409(p) of the Code. The structure that the IRS is concerned about is basically as follows: The owners of a profitable business establish a management company created as an S corporation that is owned 100% by an ESOP. The owners of the profitable business, as well as the other employees of such business, become employees of the management company, which then contracts with the profitable business to provide management operations for a management fee. The management company then adopts a generous nonqualified deferred compensation plan for certain key employees, including, significantly, the shareholders of the profitable company. This arrangement is designed to permit the profitable company to deduct the fee paid to the management company as an ordinary and necessary business expense (thereby reducing its taxable income to a relatively nominal sum), so that the management company can then use the fee to fund the nonqualified deferred compensation plan(s) for its employees (i.e., the principal shareholders of the previously profitable company). The money set aside to fund the nonqualified deferred compensation plan(s) is not deductible by the management company; however, by virtue of the management company being an S corporation that is wholly owned by an ESOP, it incurs no federal income tax (and quite possibly no state income tax) on its taxable income, and, accordingly, is not adversely affected by the loss of this current deduction. Although all of the management company employees participate in the ESOP, the benefits they will receive are limited because a substantial portion of the profits from the business operations, which should normally inure to the sole shareholder (the ESOP), will instead remain with the profitable business or be funneled into the nonqualified deferred compensation arrangement for the owners of the originally profitable business. The temporary regulations are intended to address this type of S corporation ESOP management company structure. The solution under the regulations, however, goes well beyond this isolated fact pattern. 10

11 Section 409(p) of the Code is a complicated statute. This section provides a brief refresher on the basic rules. The statute provides that no portion of the ESOP s assets attributable to (or allocable in lieu of) S corporation company stock may, during a nonallocation year, accrue or be allocated for the benefit of any disqualified person. A disqualified person is a person who (1) has deemed-owned shares constituting more than 10% of all deemed-owned shares of the corporation s stock, or (2) is a member of a family that in the aggregate owns more than 20% of the deemed-owned shares of the corporation. Deemed-owned shares are shares allocated to the participant s stock account in the ESOP and the participant s proportion of the shares of any unallocated accounts such as a loan suspense account, assuming that all unallocated shares become allocated in the same proportion as the most recent annual stock allocation under the ESOP. The share equivalent of any synthetic equity is also treated as deemed-owned shares. Shares held outright, however, are not deemedowned shares. Once the disqualified persons have been identified, the next step is to determine how much stock they own in the aggregate and whether, based on that ownership, there is a nonallocation year. If disqualified persons own at least 50% of the total number of shares of the S corporation at any time during an ESOP s plan year, then that plan year is treated as a nonallocation year. For purposes of determining whether a nonallocation year has occurred, stock that is held outright by a disqualified person does count. Finally, if the ESOP has a nonallocation year, severe penalties (both to the S corporation and to the disqualified person) are imposed on amounts allocated to disqualified persons and on synthetic equity held by disqualified persons. The stated objectives of the temporary regulations are to clarify (1) who a disqualified person is and (2) when a nonallocation year occurs. What constitutes synthetic equity and how synthetic equity is counted are critical issues for the determination of both a disqualified person and a nonallocation year. The statute defines synthetic equity as any stock option, warrant, restricted stock, or similar right that gives the holder the right to acquire or receive stock of the S corporation in the future. Synthetic equity also includes stock appreciation rights, phantom stock units, or other similar rights to a future cash payment based on the value of such stock or appreciation in such value. The temporary regulations substantially expand the definition of synthetic equity to include all nonqualified deferred compensation. Any right to receive compensation for services performed for the S corporation (or certain related entities) that is deferred beyond 2½ months after the year in which the services are performed is considered synthetic equity. To determine the synthetic equity equivalent of the nonqualified deferred compensation, the temporary regulations provide that the present value of the deferred compensation is converted into a number of shares of stock in the corporation based on 11

12 the fair market value of the S corporation shares on the determination date, which may be any date during the plan year.. The obvious objective of the regulation is to assure that the equity value of the business is shared with a broad-based group of employees rather than concentrating wealth in the hands of a few. The concern is that the application of the temporary regulations may cause a legitimate deferred compensation arrangement to result in a violation of the statute. Because the statute requires a synthetic equity calculation of the nonqualified deferred compensation on an annual basis, a company could unwittingly run afoul of Section 409(p) of the Code in a year in which its stock price suffers a decline in value. In that year, the nonqualified deferred compensation would equate to a much larger number of shares that could push the disqualified persons over the 50% limit. (Note: This issue was addressed in the temporary regulations that the IRS issued in December 2004 by permitting an ESOP to provide that the number of shares of synthetic equity treated as owned as of a specified determination date by reason of participation in a deferred compensation plan will remain constant for a period of up to three years.) The regulations clarify that all synthetic equity, including stock options or stock appreciation rights, is determined by reference to shares of S corporation stock, and the holder of the synthetic equity is treated as owning the corresponding number of shares. The regulations provide the following example: a corporation grants an employee of an S corporation an option to purchase 100 shares of the corporation s stock; the employee is the deemed owner of 100 synthetic equity shares of stock of the corporation. The conclusion of this regulatory provision is that a share of restricted stock (or a phantom stock unit) has the same synthetic equity value as a stock option (or a SAR), even though a share of restricted stock (or phantom stock unit) may be more valuable than a stock option (or SAR). The regulations also emphasize that the right to acquire interests in a related entity is deemed to be synthetic equity. An entity is considered a related entity if it is the only significant asset of the S corporation an corporation is the only significant holder of stock of the related entity. How synthetic equity is counted is critical to the determination of whether an individual is considered a disqualified person or the company has a nonallocation year. In this case, the IRS seems to apply logic to its interpretation of the statute with a beneficial result for companies that are close to a violation of the statute. The statutory provision for counting synthetic equity is relatively clear (although the language is tortuous). Section 409(p)(5) of the Code states that [i]f, without regard to this paragraph, a person is treated as a disqualified person or a year is treated as a nonallocation year, this paragraph shall not be construed to result in the person or year not being so treated. In plain English, this provision seems to say that synthetic equity is counted only if it would cause the individual to be a disqualified person or the company to have a nonallocation year. 12

13 The literal interpretation of this provision can lead to some illogical mathematical results. For example, assume ABC Company has the ownership structure illustrated in table A-1. Disqualified person test. Under the literal application of the statute, the status of each individual would be tested without regard to the other individuals synthetic equity holdings. For example, Joe s disqualified person deemed-owned share ownership percentage would calculated as follows: Joe s ESOP shares + his portion of the unallocated ESOP shares + his phantom shares Total ESOP shares + total unallocated ESOP shares + only Joe s phantom shares Based on this formula, Joe, Michael, and Colleen are each disqualified persons. By excluding all synthetic equity from the calculation (other than the synthetic equity held by the individual), the resulting ownership percentage is in excess of 100% (in this case, %). This seems to be a nonsensical result. Nonallocation year test. The purpose of the next part of the test is to determine whether the disqualified persons own 50% or more of the equity of the company. The literal interpretation of the nonallocation year provisions of the statute, however, can also lead to strange results. The statute could be interpreted to provide that for the nonallocation year test, all outstanding shares are counted; however, only the synthetic equity of the disqualified persons is counted. If this is the case, the formula for determining whether ABC Company has a nonallocation year would exclude the 25 phantom stock units held by individuals other than the disqualified persons, as follows: Joe s, Michael s, and Colleen s outright shares + Joe s, Michael s, and Colleen s ESOP shares + Joe s, Michael s, and Colleen s unallocated ESOP shares + Joe s, Michael s, and Colleen s phantom shares Total outright shares + Total ESOP shares + Total unallocated ESOP shares + Joe s, Michael s, and Colleen s phantom shares Based on this formula, ABC Company does have a nonallocation year because Joe, Michael, and Colleen (the disqualified persons) are deemed to own more than 57.79%. As shown in the Actual Equity Ownership column of table A-2, however, Joe, Michael, and Colleen actually own in the aggregate less than 50% of the equity of ABC Company. The IRS seems to acknowledge these mathematical inconsistencies in the temporary regulations and addresses them in its statement of how synthetic equity is to be counted for the purpose of the disqualified person and nonallocation year tests. The temporary regulations assure that the ownership percentage will never exceed 100% and that a nonallocation year occurs only if disqualified persons actually own at least 50% of the company s equity. This is a logical interpretation of Section 409(p) of the Code. The temporary regulations require separate tests to be performed to determine whether an individual is a disqualified person or the company has a nonallocation year. The first test considers only the deemed-owned ESOP shares (and outstanding shares in the case of the nonallocation year test). The second test includes the deemed-owned ESOP 13

14 shares (and outstanding shares in the case of the nonallocation year test) and all synthetic equity in the S corporation. The inclusion of all synthetic equity in the application of the tests seems appropriate if the intent of Section 409(p) of the Code is to assure that disqualified persons have a claim on less than 50% of the equity of the company. The application of these tests based on the same ownership structure described above provides the results in table A-3. Based on the application of the tests in the regulations, Joe is the only disqualified person. Under the first test (considering only Joe s ESOP shares), Joe is not a disqualified person. After taking his phantom shares into account, however, he owns a least 10% of the equity, based on the following formula required by the regulations: Joe s ESOP shares + Joe s unallocated ESOP shares + Joe s phantom shares Total ESOP shares + total unallocated ESOP shares + total phantom shares Under this formula, Joe owns 12.84% of the deemed-owned shares. The nonallocation year test is next. Joe is the only disqualified person and his ownership percentage is less than 50%. The formula for the nonallocation year is as follows: Joe s outright shares + Joe s ESOP shares + Joe s unallocated ESOP shares + Joe s phantom shares Total outright shares + Total ESOP shares + Total unallocated ESOP shares + Total phantom shares This formula results in Joe having a 36.31% ownership interest, and no nonallocation year has occurred. Although the regulations impart reason to the application of the disqualified person and nonallocation year tests, the definition of synthetic equity in the regulations may lead to some unintended results when applying these tests. The regulations provide that a stock option (or SAR) has the same value as a share of restricted stock (or phantom stock unit), even though the restricted stock (or phantom stock unit) is more valuable. An extreme example helps to illustrate this point. Assume the ESOP owns only 10 outstanding shares of ABC Company and Joe owns 990 phantom stock units. Each of the corporation s 1,000 employees holds one stock option (or SAR) with a fair market value exercise price. Even though the stock options (or SARs) have some option value, as a practical matter Joe clearly owns over 50% of the economic value of the company. Under the new regulations, however, the stock options (or SARs) have the same unit value as the phantom stock units, and all synthetic equity is included in the denominator of the 50% nonallocation year test. As a result, Joe would hold less than 50% of the total equity, and there would be no nonallocation year. (Note: The IRS has provided additional guidance on the issue of valuation and calculation of synthetic equity in the temporary regulations issued in December 2004 described below. It is likely that the IRS will continue to publish additional guidance in this area in the future.) 14

15 The regulations are applicable for plan years ending after October 20, Please note, however, that Section 409(p) of the Code was grandfathered and is not applicable until plan years ending after December 31, 2004, for S corporation ESOPs in effect before March 14, The proposed regulations provide another grandfathering rule that provides that if any nonqualified deferred compensation is paid out by July 21, 2004, it will not be treated as synthetic equity for purposes of testing the anti-abuse provision. The vast majority of S corporation ESOPs will not have any difficulty satisfying the anti-abuse requirements of Section 409(p) of the Code; however, the proposed regulations do change the calculation and may make it more difficult even for those companies that would not otherwise be considered abusive ESOPs. Because the regulations were issued as temporary regulations, they can be relied upon immediately in accordance with the effective dates. The regulations further provide that clarifications on prohibited accruals or allocations will be addressed in subsequent regulations. Section 409(p)(7)(A) of the Code authorized the Secretary of the Treasury to prescribe such regulations as necessary to carry out the purpose of Section 409(p) of the Code. On December 16, 2004, the IRS issued additional temporary regulations regarding the anti-abuse rules for S corporation ESOPs (2004 regulations). The 2004 regulations continue in the same manner as the 2003 regulations with respect to Section 409(p) of the Code, requiring strict compliance with its provisions, and imposing substantial penalties if Section 409(p) of the Code is violated. In general, the 2004 regulations are effective for plan years beginning on or after January 1, Definition of Prohibited Allocation The first change instituted by the 2004 regulations relates to the concepts of prohibited accruals and allocations. Section 409(p) provides that an S corporation ESOP must ensure that, during a nonallocation year, no portion of the assets of the plan attributable to the S corporation shares may accrue under the ESOP, or be allocated under any qualified plan of the employer (including the ESOP), for the benefit of any disqualified person. According to the 2004 regulations, an impermissible accrual occurs if any S corporation stock owned by the ESOP trust, or any assets attributable to that stock, are held for the benefit of a disqualified person during a nonallocation year and an impermissible allocation is any allocation for a disqualified person under any tax-qualified plan of the employer that occurs during a nonallocation year to the extent that an allocation is made that, but for a provision in the ESOP to comply with Section 409(p) of the Code, would have been added to the account of the disqualified person under the ESOP and been invested in S corporation securities owned by the ESOP trust. If there is either an impermissible accrual or an impermissible allocation, then there is a prohibited allocation within the meaning of Section 409(p) of the Code. Under the 2004 regulations, the consequences of violation of Section 409(p) of the Code have not changed. The company will be subject to an excise tax equal to 50% of the amount of the prohibited allocation and the shares allocated to the accounts of the disqualified persons will be treated as having been distributed to them, and they will be subject to tax on the value of those shares. Furthermore, under the 2004 regulations, the plan would not longer satisfy the requirements of Section 4975(e)(7) of the Code and would cease to be an ESOP. Although it would remain a qualified plan, it would lose both 15

16 the prohibited-transaction exemption for any loans made to the ESOP trust under Section 4975(d)(3) of the Code and the exemption for ESOPs under Section 512(e)(3) of the Code from the unrelated business income tax. Prevention of a Nonallocation Year In the 2004 regulations, the IRS clearly states that compliance with Section 409(p) of the Code is required on a current operational basis, as well as on a plan document basis. Therefore, if S corporation shares of company stock are held in a disqualified person s account during a nonallocation year, then there is a failure to satisfy Section 409(p) of the Code, without regard to whether the terms of the ESOP prohibit such actions or require preventative action to be taken. The IRS recommends that a plan take steps before the beginning of a year in order to ensure that the year is not a nonallocation year, including, (i) reducing the amount of synthetic equity (for example, by cancellation or distribution of the synthetic equity); (ii) selling the S corporation stock held in the participant's ESOP account, so that the account is not invested in S corporation stock; (iii) distributing the S corporation stock held in the participant's account from the ESOP to the participant; or (iv) transferring the S corporation stock held for the participant under the ESOP into a separate portion of the plan that is not an ESOP or to another qualified plan sponsored by the employer. Determination of Disqualified Persons on Person-by-Person Basis Under the 2003 regulations, a person s synthetic equity shares are added to his or her deemed-owned ESOP shares to determine whether he or she is a disqualified person. This total number of shares is then compared with the total outstanding synthetic equity shares in determining whether that person is a disqualified person. The 2003 regulations were criticized for this approach in the case of options because it allowed options held by other shareholders to dilute the interests of the person being tested and prevent them from being treated as a disqualified person. These 2004 regulations change this approach by looking only at the synthetic equity of the person being tested to determine if he or she is a disqualified person. Synthetic Equity The 2004 regulations contain some changes and clarifications related to synthetic equity, including a few revisions to the definition of synthetic equity. The definition of synthetic equity was expanded to include the rights to acquire stock or assets of a related entity. The 2004 regulations also exclude nonqualified deferred compensation that was taken into account before January 1, 2005, for purposes of the Federal Insurance Compensation Act, and that was provided for before the first date on which the ESOP trust acquired any employer securities, from the definition of synthetic equity. The 2004 regulations also provide several new rules to be used to calculate the amount of synthetic equity held by a person. The first new rule related to calculation of synthetic equity relates on voting rights. If a synthetic equity right includes a right to purchase or receive shares of S corporation stock that have greater voting rights on a per-share basis than the shares of company stock held by the ESOP trust, the number of deemed-owned shares attributable to the synthetic equity then will be at least equal to the number of shares that would have the same voting rights if those shares had the same per share voting rights as the voting rights of the shares held by the ESOP trust. Second, in an attempt to address the concerns about compliance with Section 409(p) of the Code relating to administrative and planning difficulties that arise from a daily, or even annual, determination of synthetic equity shares where the number is affected both by the potential volatility of the S corporation stock value and separately by the potential volatility of the nonqualified deferred compensation, the 2004 regulations permit an ESOP to provide that the number of shares of synthetic equity treated as owned as of a specified determination date by reason of participation in a deferred compensation plan shall remain constant for a period of up to three years. Finally, the 2004 Regulations provide a new rule for cases 16

17 in which the ESOP trust does not own all of the stock of the S corporation. This rule reflects the view that the dilutive effect of synthetic equity only affects an ESOP to the extent of the ESOP s ownership interest in the S corporation. Under this rule, the number of synthetic equity shares otherwise determined is reduced ratably to the extent that shares of the S corporation are owned by a person who is not an ESOP (and who is subject to Federal income taxes). Avoidance or Evasion of Section 409(p) of the Code Finally, the 2004 regulations state the IRS goal in creating a standard to determine situations where the principal purpose of the ownership structure of an S corporation involving synthetic equity constitutes an avoidance or evasion of Section 409(p) of the Code, such as those transactions set forth in Revenue Ruling This standard allows the IRS to act promptly to issue guidance to prevent ownership structures that deny an ESOP the economic benefits of ownership In Revenue Ruling , the IRS ruled that an S corporation ESOP described in this ruling is not eligible for the delayed effective date (January 1, 1995) under Section 409(p) of the Code for the application of the anti-abuse rules that is provided under Section 656(d)(2) of EGTRRA. Therefore, an S corporation ESOP described in this ruling is subject to the nonallocation rules of Section 409(p) of the Code effective for plan years ending after March 14, Furthermore, any taxpayer who is a disqualified person with respect to the S corporation ESOP is treated as receiving a deemed distribution of the company stock allocated to the taxpayer s account and income with respect to that account. Finally, excise taxes under Section 4979A(c)(3) of the Code apply to any nonallocation year. Following is a comprehensive summary of the thought process underlying and the prohibitions of Revenue Ruling , focusing specifically on the information and the examples that the IRS provided in this ruling. The IRS and the U.S. Treasury Department have become aware through their own investigative efforts and through communications from the ESOP community that certain arrangements involving ESOPs that hold company stock in an S corporation are being used for the purpose of claiming eligibility for the delayed effective date of Section 409(p) of the Code. Revenue Ruling alerts taxpayers and their representatives that the tax benefits purportedly generated by these transactions are not allowable for federal income tax purposes. It also alerts taxpayers, their representatives, and organizers or sellers of these transactions to certain responsibilities that may arise from participating in these transactions. Revenue Ruling describes the following specific fact pattern to which its rulings apply. On or before March 14, 2001, A, a person in the business of providing ESOP consulting advice to other companies or individuals, arranges for the creation of a number of S corporations that have no substantial assets or business and forms an ESOP for each of those corporations. A takes the position that some or all of the employees of A are eligible to participate under the terms of the ESOP sponsored by each S corporation, but there is no reasonable expectation that these individuals will accrue more than insubstantial benefits under the plans or more than an insubstantial share in the ownership of the S 17

18 corporations. After March 14, 2001, A markets these S corporations and the associated ESOPs to other taxpayers, including individuals or companies. After one of the S corporations (and its ESOP) are transferred to one or more taxpayers, the taxpayers who purchase the S corporation (that includes an ESOP) restructure their businesses so that the S corporation receives income from those businesses for providing management or other services to the businesses. After the restructuring is completed, the S corporation is wholly or substantially owned by the ESOP trust. Furthermore, there are typically one or more individual taxpayers who are disqualified persons within the meaning of Section 409(p)(4)(A) of the Code (relating to prohibited allocations under an ESOP that holds stock in an S corporation) who are deemed to own in the aggregate at least 50% of the number of issued and outstanding shares of company stock of the S corporation. The IRS reviewed the following legislative history and content and regulations in reaching its restrictive conclusions regarding S corporation ESOPs that are designed in this manner. Section 4975(e)(7) of the Code provides that an ESOP is a defined contribution plan that is (1) either a stock bonus plan that is qualified or a stock bonus plan and a money purchase pension plan, both of which are qualified under Section 401(a) of the Code, and (2) designed to invest primarily in qualifying employer securities. A plan is not treated as an ESOP unless it meets the following requirements, to the extent applicable: (1) Section 409(e) (relating to participants voting rights), if the employer has a registrationtype class of securities (as defined in Section 409(e)(4)); (2) Section 409(h) (relating to participants right to receive employer securities and put options); (3) Section 409(n) (relating to securities received in transactions to which Section 1042 applies); (4) Section 409(o) (relating to participants distribution rights and payment requirements); (5) Section 409(p) (relating to prohibited allocations of employer securities in an S corporation); and (6) Section 664(g) (relating to qualified gratuitous transfers of qualified employer securities). The legislative history to the Tax Reform Act of 1976 (Public Law ) states that an ESOP is a technique of corporate finance designed to build beneficial equity ownership of shares in the employer corporation into its employees (See S. Rep at 180 and C.B. vol. 3, 218). Section (a)(2)(ii) of the Treasury Regulations provides that a qualified profitsharing plan is established and maintained by an employer to enable employees or their beneficiaries to participate in the profits of the employer s trade or business. Under Section (a)(2)(iii) of the Treasury Regulations, a stock bonus plan is a plan that provides employees or their beneficiaries benefits similar to those of a profit-sharing plan, except that benefits are distributable in the form of company stock of the employer. EGTRRA added Section 409(p) of the Code and requires that an ESOP that holds employer securities consisting of company stock in an S corporation provide that no portion of the assets of the ESOP attributable to such employer securities may, during a nonallocation year, accrue (or be allocated directly or indirectly under any plan of the employer meeting the requirements of Section 401(a) of the Code) for the benefit of any disqualified person. Indirect allocations include allocations of income on S corporation company stock held in the account of a disqualified person (H.R. Conf. Rep at 276). 18

19 Any prohibited allocations in a nonallocation year are treated as distributions and are currently taxable to the disqualified person. Section 409(p)(3)(A)(ii) of the Code provides that a nonallocation year means a plan year during which, at any time, disqualified persons own at least 50% of the number of shares of company stock of the S corporation. Section 409(p)(4)(A) provides, in general, that a disqualified person refers to a person for whom (1) the aggregate number of deemed-owned shares of such person and the members of such person s family is at least 20% of the number of deemed-owned shares of stock in the S corporation or (2) the number of such deemed-owned shares is at least 10% of the number of deemed-owned shares of company stock in the S corporation. This concept of shares that are deemed-owned is new to the body of ESOP law and is a broadened version of the attribution rules such as those contained in Section 318 of the Code, which previously applied and continue to apply to ESOPs in many respects. According to Section 409(p)(4)(c)(i) of the Code, a participant in an S corporation ESOP is deemed to own the shares allocated to his or her ESOP stock account and a portion of the shares that are held in the ESOP loan suspense account and have not yet been allocated to ESOP participants stock accounts. Under Section 318(a)(2)(B)(i) of the Code, the employee trust exception, these shares of company stock would not normally be counted, but this exception does not apply for purposes of the new S corporation anti-abuse rules. See Sections 409(p)(3)(B)(i)(II) and 409()(4)(D) of the Code. Under Section 409(p)(4)(C)(ii) of the Code, an ESOP participant s share of unallocated shares is the amount of such shares that would have been allocated to the participant s ESOP stock account if the unallocated shares were allocated to all ESOP participants in the same proportion as the most recent share allocation under the (ESOP). It appears that this phantom allocation process requires the unallocated shares to be allocated (and treated as deemed-owned ) in a pro rata manner based upon the shares that were allocated to ESOP participants stock accounts in the most recent allocation. If an ESOP fails to satisfy the requirements of Section 409(p) of the Code, prohibited allocations are treated as currently taxable to the disqualified persons under Section 409(p)(2) of the Code, and an excise tax equal to 50% of the allocations is imposed on the S corporation under Section 4979A(a)(3) of the Code. Section 409(p) of the Code is generally effective for plan years beginning after December 31, Pursuant to Section 656(d)(2) of EGTRRA, however, Section 409(p) of the Code is effective for plan years ending after March 14, 2001, if the ESOP that is established after that date or if the company stock held by the ESOP consists of stock in an S corporation that did not have an S election in effect on March 14, IRS Notice , Q&A 15, I.R.B. 285, provides that an S corporation does not have an election in effect on March 14, 2001, unless the S corporation actually filed a valid S election on or before that date and such election was effective with respect to such corporation on or before that date. The legislative history to Section 656 of EGTRRA, which added Section 409(p) of the Code, is very clear when it states that Section 409(p) of the Code is intended to limit the establishment of ESOPs by S corporations to those that provide broad-based employee ownership coverage and that benefit rank-and-file employees as well as highly compensated employees and historical owners. (See H.R. Rep , pt. 1, at 100, and H.R. Conf. Rep , at 274 [2001].) Furthermore, Congress has expressed concern 19

20 regarding techniques to avoid or evade the requirements of Section 409(p) of the Code. (See Section 409(p)(7)(B), which provides that the U.S. Treasury Secretary may, by regulation or other guidance of general applicability, provide that a nonallocation year occurs in any case in which the principal purpose of the ownership structure of an S corporation constitutes an avoidance or evasion of the nonallocation requirements of Section 409(p) of the Code.) In the types of transactions described in Revenue Ruling , the IRS concluded that A (the consultant who formed and marketed the corporations in the fact pattern given above) has not formed the ESOPs to provide substantial benefits, or substantial participation in the ownership of the S corporations, to the initial purported participants in the ESOPs. The initial employees of the entity forming the ESOP do not receive more than insubstantial benefits or more than insubstantial ownership interests through the ESOP. For purposes of the effective date of Section 409(p) of the Code, an ESOP is not established until it is adopted by an employer for the purpose of enabling its employees to participate in a more than insubstantial manner in the ownership of the employer s business and to provide its employees with more than insubstantial benefits under the ESOP. For the foregoing reasons, an ESOP adopted by an S corporation under the facts provided above will not be treated as having been established on or before March 14, 2001, and is not entitled to the delayed January 1, 2005, effective date for purposes of the nonallocation rules of Section 409(p) of the Code. Accordingly, because there is a nonallocation year under Section 409(p) of the Code, the disqualified persons under Section 409(p)(4)(A) are treated as receiving deemed distributions to the extent of any allocation to their account, pursuant to Section 409(p)(2)(A) of the Code. Furthermore, excise taxes under Section 4979A(a)(3) of the Code apply to any nonallocation year. The IRS also concluded in Revenue Ruling that transactions that are the same as, or substantially similar to, the transaction described above are identified as listed transactions for purposes of Section T(b)(2) of the Temporary Income Tax Regulations and Section T(b)(2) of the Temporary Procedure and Administration Regulations with respect to each disqualified person for plan years beginning before January 1, See also Temporary Income Tax Regulations Section T, A-4. Furthermore, independent of their classification as listed transactions for purposes of Sections T(b)(2) and T(b)(2), transactions that are the same as, or substantially similar to, the transaction described above may already be subject to the disclosure requirements of Section 6011 of the Code, the tax shelter registration requirements of Section 6111 of the Code, or the list maintenance requirements of Section 6112 of the Code (see Sections T; T; T; and T, A-3 and A-4). Persons who are required to satisfy the registration requirement of Section 6111 of the Code with respect to the transaction described above and who fail to do so may be subject to the penalty under Section 6707(a) of the Code. Persons who are required to satisfy the list-keeping requirement of Section 6112 of the Code with respect to the transaction and who fail to do so may be subject to the penalty under Section 6708(a) of the Code. Furthermore, the IRS may impose penalties on participants in this type of transaction or substantially similar transactions, or, as applicable, on persons who participate in the reporting of this type of transaction or substantially similar transactions, including the 20