IRS to aggressively pursue executive stock option scheme participants.

In the late 1990s and early 2000s, professional service firms and financial institutions aggressively promoted an abusive tax avoidance transaction--the "executive stock option scheme." Executives (often facilitated by their corporate employers) transferred stock options to fanny limited partnerships (FLPs) and other related entities typically created for the sole purpose of receiving the options and avoiding taxes on compensation income normally taxed to the executive. The objective was to defer (for up to 30 years) taxes on the compensation; in many cases this resulted in the corporation deferring a legitimate deduction for the same compensation. In 2003, the IRS pinpointed this scheme in Notice 2003-47 as a listed transaction. To date, it has identified unreported income of more than $700 million, related to participation in transactions that are virtually the same as that described in the notice or similar to it.

In Ann. 2005-19, the Service introduced a settlement initiative aimed at encouraging executives and corporations to disclose their participation in listed transactions voluntarily. It is available for a stock option transfer made from an executive to a related person before July 2, 2003. Taxpayers involved in a court proceeding to determine the tax treatment of a transaction cannot participate.

Settlement Initiation

Although Ann. 2005-19 encouraged executives, FLPs and corporations to take part in the settlement initiative, executives (along with FLPs) could participate regardless of the corporation's participation, and vice versa. To notify the Service of their intent to participate in the settlement initiative, executives were required to submit Form 13656, Notice of Election by Executive and Related Person, to the IRS before May 24, 2005; corporations were required to submit Form 13657, Notice of Election by Corporation to Participate in Announcement 2005-19 Settlement Initiative. The Service will not extend the deadline.

Information Required

Under the elections, the parties had to disclose (under penalties of perjury) all details relevant to the transaction and to compute tax and penalties in accordance with Ann. 2005-19. In addition, corporations had to disclose the name, address and Social Security number of all their current and former officers, directors and employees that participated in the transaction. After the Service receives the necessary information, it will prepare a closing agreement under Sec. 7121 reflecting the settlement terms.

Exhibits 1, on p. 456, and 2, below, respectively, compare the tax consequences to executives and to corporations that agreed to settle, to the tax consequences the IRS expects to include when it issues Form 5701, Notice of Proposed Adjustments, to nonparticipants.

Consequences of Nonparticiation

Through various means, the Service will aggressively pursue taxpayers who failed to accept the settlement offer. This will presumably include the use of the information obtained from the elections filed by executives and corporations who participated in the settlement initiative. The IRS may also identify participants from (1) investor lists secured through promoter audits of professional firms and financial institutions, (2) "John Doe" summonses issued to promoters and (3) information document requests issued in corporate tax examinations targeting disclosures of executives' transactions. These techniques, combined with the fact that under the American Jobs Creation Act of 2004, the statute of limitations on a return with a listed transaction remains open until one year after the IRS receives information about it, make it increasingly likely that participants in a Notice 2003-47 transaction will be identified, and likely subject to less favorable assessments than would have been available to them under the IRS settlement offer.

Exhibit 1: Tax consequences to executives (Notice 2003-47)

Item           Settlement participants     Nonparticipants

Compensation   The executive generally     The executive must recognize
income         must recognize total        compensation on the date the
               compensation income equal   option was transferred to
               to the fair market value    the related person and
               of the stock covered by     recognize additional
               the stock option measured   compensation in the year
               at the exercise date,       the related person sold the
               less the exercise price.    stock (or, if the stock has
               He or she must recognize    not yet been sold, in 2004).
               this income in the tax      The compensation is equal to
               year that the related       the difference between the
               person disposed of the      stock's market value on the
               stock (or, if the stock     day the related person
               has not yet been sold,      exercised the options, over
               in 2004).                   the amount included as
                                           compensation when the option
                                           was transferred to the
                                           related person, and the
                                           exercise price.

Transaction    The Service will not        No deduction will be allowed
costs          challenge the               to the executive or the
               capitalization, deduction   related party as an expense
               or amortization of          for the transaction costs
               transaction costs paid by   paid.
               the executive or related
               person.

FICA tax       The executive must pay      The executive must pay the
               the employee's share of     employee's share of FICA
               FICA tax on the             tax on the compensation
               compensation income at      income at the time of
               exercise.                   transfer and at exercise.

Penalty        The executive must pay a    A 20% accuracy-related
               Sec. 6662 accuracy-         penalty will be assessed on
               related penalty equal to    the tax resulting from the
               10% of the amount of any    transaction.
               underpayment attributable
               to the transaction
               (unless he or she filed a
               valid disclosure under
               Ann. 2002-2).

Exhibit 2: Tax consequences to corporations (Notice 2003-47)

Item              Settlement participants       Nonparticipants

Compensation      The corporation cannot        The corporation cannot
deduction         claim a compensation          claim a compensation
                  deduction greater than the    deduction until the
                  total compensation the        year the compensation
                  executive recognized. To      is included in the
                  the extent the corporation    executive's income.
                  has not already claimed
                  such deduction, it can
                  claim it in a tax year
                  that includes any of the
                  following: (1) the date the
                  executive transferred the
                  stock option to the related
                  person, (2) the date the
                  option was exercised, (3)
                  December 31 of the year in
                  which the executive
                  recognized the compensation
                  or (4) Dec. 31, 2004.

FICA tax          The corporation must pay      Both the employer's and
                  the employer's portion of     the employee's FICA tax
                  FICA tax on the               will be assessed on
                  compensation income the       the includible stock
                  executive recognized. In      option income at the
                  addition, it must pay         time of transfer and at
                  the employee's share of       exercise. The 10%
                  FICA tax for each             failure-to-deposit
                  nonparticipating employee     penalty will also be
                  executive.                    assessed on the
                                                employee's share of
                                                FICA tax.

Withholding for   For participating             The corporation must
supplemental      executives, the corporation   pay income tax
wages             is not required to pay        withholding for
                  income tax withholding.       supplemental wages
                  For nonparticipating          at the applicable rate
                  executives, the corporation   (25%-28%, depending on
                  must pay income tax           the year) at the time
                  withholding for               of the transfer and
                  supplemental wages at the     exercise.
                  applicable rate (25%-28%,
                  depending on the year).

Transaction       The Service will not          The corporation will
costs             challenge the                 not be allowed to
                  capitalization, deduction     deduct any transaction
                  or amortization of            costs incurred on
                  transaction costs paid by     behalf of its
                  the corporation.              executives (unless it
                                                included the
                                                executives' transaction
                                                costs in their Forms
                                                W-2). A 20% accuracy-
                                                related penalty will
                                                be assessed on any
                                                resulting tax
                                                underpayment.

Penalties         No penalties will be          A 20% accuracy-related
                  imposed on the corporation    penalty will be
                  for its participation in      assessed on the tax
                  the transaction.              resulting from the
                                                failure to pay the
                                                income tax withholding
                                                and the employer's and
                                                employee's FICA tax.

                                                A 10% information
                                                reporting penalty will
                                                be assessed on the
                                                compensation income not
                                                reported on Form W-2,
                                                for disregarding the
                                                requirement to file and
                                                provide correct Forms
                                                W-2.

FROM NATALIE BELL TAKACS, CPA, MT, COHEN & COMPANY, LTD., CLEVELAND, OH