Coordinated issue paper on S Corps.

On May 9, 2005, the Service issued a coordinated issue paper (CIP), "Notice 2002-65" Tax Shelter, intended to assist its examiners in implementing Notice 2002-65, which addressed transactions in which taxpayers claim immediate losses while deferring offsetting gains from an S corporation investment.

A transaction typically subject to the notice includes a number of precisely arranged actions intended to result in a deductible noneconomic loss for the S investor; the transactions are generally marketed by promoters charging a fee of 5% of the capital losses and 6% of the ordinary losses. Promoters may also reap management fees from the S corporation established to execute the tax strategy.

Subjects covered: The new CIP addresses various issues for transactions covered by Notice 2002-65:

* The circumstances under which S corporations and their investors should be denied losses under Sec. 165.

* Whether covered transactions should be recharacterized under Sec. 988's foreign-currency transaction anti-abuse regulations.

* Whether the deduction of legal and promoter fees assessed in relation to disallowed tax practices should be allowable.

* Whether promoters should be treated as shareholders, thus voiding the S election and S corporation tax treatment.

* When accuracy-related penalties listed in the notice should apply.

The CIP also examines legal theories and judicial histories for each issue and suggests actions that examiners could take when reviewing taxpayers involved in transactions covered by Notice 2002-65.

Loss disallowance: The CIP provides several scenarios for disallowing losses:

* Examiners should apply Sec. 165's "primary profit motive" language and limit deductions to losses incurred in a trade or business or in transactions entered into for profit that are not connected with a trade or business.

* Transactions subject to Sec. 269 should be disallowed when an investor purchases control of an S corporation for the principle purpose of avoiding income tax.

Penalties: The CIP also outlines when to apply Sec. 6662, which imposes accuracy-related penalties on certain taxpayers. Penalties can total as much as 40% of a gross valuation misstatement.

Loss of S status: The CIP also discussed cases in which purported S shareholders are actually transaction promoters. In such cases, the corporation might lose its S status. Gains and losses would then be netted for a minimal gain or loss and would not flow through to shareholders.

Other consequences: According to the CIP, transactions involving S corporations that are a "substantially meaningless series of steps that manipulate tax rules to artificially create tax losses for the investor" in an S corporation, should be disallowed.

While taxpayers are generally entitled to deduct ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business under Sec. 162, those incurred for a transaction designed solely to provide tax benefits for participants would not be deductible.

Caveat: The IRS develops CIPs to identify, coordinate and resolve complex and significant industry-wide tax issues. The papers provide guidance to its field examiners to ensure uniform application of the tax laws. While CIPs are not official agency pronouncements, they do set forth the Service's current thinking about the issues discussed.