IRS Updates Transaction-Specific FAQs on Settlement Initiative

A.1 No. Notice 2003-54 states that the transaction described in that notice and the transactions described in Notice 2002-50 and Notice 2002-65 are substantially similar transactions. Announcement 2005-80 states that the transaction described in Notice 2003-54 is eligible for settlement under the initiative but that the transactions described in Notice 2002-50 and Notice 2002-65 are not eligible for settlement under the initiative. Thus, a taxpayer who participated in a transaction described in Notice 2002-50 or Notice 2002-65 is not eligible to resolve the treatment of that transaction under the Announcement 2005-80 settlement initiative. Furthermore, if a taxpayer participated in a transaction that is substantially similar to the transaction described in Notice 2003-54 yet the transaction does not involve an investment made in a common trust fund, the Service will not treat the transaction as one described in Notice 2003-54 for purposes of Announcement 2005-80. See Section 3.4.

Q.2 What are the fees and costs in a Notice 2003-54 transaction that the taxpayer may deduct?

A.2 Typical fees and costs in a Notice 2003-54 transaction include fees paid to promoters and trustees, loan origination fees, fees for tax opinions, and finder's fees.

Q.3 What additional documents and information will the Service request from the taxpayer when resolving transactions described in Notice 2003-54?

A.3 In addition to the documents and information required by the Form 13750, taxpayers resolving transactions described in Notice 2003-54 can expect the Service to request the following documents and information:

• All returns of the taxpayer (Forms 1040), the grantor trust that invested in the common trust fund (Forms 1041), and any pass-through entities (Forms 1120S or 1065) between the grantor trust and the taxpayer, for all years affected by the transaction, and all amended returns for those years; and

• A statement explaining how the investment in the common trust fund was or will be closed out, along with a schedule listing the amount and date of all distributions made by the common trust fund directly or indirectly to the taxpayer.

5. Notice 2003-81 (Tax Avoidance Using Offsetting Foreign Currency Option Contracts)

Q.1 How are transactions described in Notice 2003-81 resolved under Section 4.A of Announcement 2005-80?

A.1 For purposes of settlement, taxpayers must concede the aggregate loss claimed on their return. In the typical case, the Service will disallow the gains and losses from all the foreign currency contracts reported on either Schedule D or Form 4797. This approach results in the full disallowance of the purported tax benefits claimed.

Q.2 In completing Schedule A of Form 13750, who are the "Other parties to the transaction," as requested in item 5?

A.2 For Notice 2003-81 transactions, the other parties include the exempt organization that received the foreign currency contracts or any other consideration in connection with the foreign currency transaction. At a minimum, the taxpayer should include the name, address, and phone number of the exempt organization.

Q.3 What additional documents can an investor in a Notice 2003-81 transaction expect the Service to request?

A.3 In addition to providing supporting documents for transaction costs, the Service will request Notice 2003-81 investors to provide additional information regarding the exempt organization. This will include the Assignment Agreement, all correspondence exchanged with the exempt organization, the date and amount of the payment, and copies of any cancelled checks to, or for the benefit of, either the exempt organization or the promoter.

6. Notice 99-59 (Tax Avoidance Using Distributions of Encumbered Property)

Q.1 What is a Notice 99-59 transaction?

A.1 A Notice 99-59 transaction can take a variety of forms, all of which involve the use of distributions of encumbered property for the purpose of either generating large capital losses or excluding a distribution of property from income. A typical arrangement involves a taxpayer acting through a partnership to contribute cash to a foreign corporation formed for the purpose of carrying out the transaction, in exchange for the common stock of that corporation. Another party contributes additional capital to the corporation in exchange for the preferred stock of that corporation. The foreign corporation then acquires additional capital by borrowing from a bank and grants the bank a security interest in securities acquired by the foreign corporation that have a value equal to the amount of the borrowing. Thereafter, the foreign corporation distributes the encumbered securities to the partnership that holds its common stock. The foreign corporation nonetheless remains primarily liable for such debts, and in fact eventually pays off these debts with its other assets. The effect of the distribution, however, combined with fees and other transaction costs incurred at the corporate level, is to reduce the remaining value of the corporate stock to zero or a de minimis amount, due to its liabilities being approximately equal to its assets. After a deemed disposition of the corporate stock, the partnership claims a tax loss equal to the difference between its original basis, and the purported low fair market value of the common stock.

Q.2 What are some transactions that are substantially similar to the one described in Q&A 1?

A.2 As indicated above, taxpayers have cast these transactions in a variety of forms.

Indeed, Notice 99-59 expressly provided that the scenario described in the notice is merely one of a variety of forms covered by the notice. In one such form, taxpayers do not form a partnership, but instead form a new corporation, and are shareholders of such corporation. In another form, taxpayers use a pre-existing corporation which already has earnings and profits. Rather than distribute cash to its shareholders, the pre-existing corporation borrows money, purchases assets such as Treasury Bills, encumbers the assets with the borrowing, and distributes the "encumbered" assets to its shareholders. The pre-existing corporation remains primarily liable for the debt and eventually pays off the debt with its other assets. The common factor is that these transactions involve the distribution of encumbered property, and the assertion that the fair market value of that property is reduced by the amount of the encumbrance.

Q.3 On what basis will the Service disallow the claimed tax benefits of this transaction?

A.3 The loss claimed, or the income excluded, from this transaction does not reflect the actual economic consequences of the transaction. Instead, the claimed tax benefits are the result of a series of contrived steps, and do not reflect actual losses or reductions in income. Additional legal theories may be appropriate based on the particular facts of each case. For a complete discussion of the Service's position, see Notice 99-59, 1999-2 C.B. 761.

Q.4 What are the appropriate adjustments for Notice 99-59 cases resolved under the Announcement 2005-80 settlement initiative?

A.4 The claimed benefits of this transaction depend on the corporation acquiring, encumbering, and then distributing securities, and then later using other, unencumbered assets to pay off the debt. The parties never intended the "encumbered" securities to truly secure the underlying liability, and that other assets have been set aside for the purpose of paying that liability. Because of this, the distribution of "encumbered" securities should be treated as a distribution of unencumbered securities, and treated according to the provisions of IRC Section 301(c). Because the distributing corporation is often a new entity, the taxpayer's basis in corporate stock will ordinarily be reduced by the fair market value of the distributed securities, pursuant to IRC Section 301(c)(2), with a corresponding reduction in the taxpayer's capital loss upon the deemed disposition of company stock. In some of these cases, however, a portion of the distribution will constitute a dividend as defined in IRC Section 316. In such instances, some or all of the distribution is a dividend to the taxpayer, and should be included in gross income pursuant to IRC Section 301(c)(1) at the time of the distribution.

9. Notice 2004-8 (Abusive Roth IRA Transactions)

Q.1 What simplifying assumptions will be used to resolve the Notice 2004-8 transaction?

A.1 For the limited purpose of resolving the Notice 2004-8 transaction under Announcement 2005-80, various simplifying assumptions will be used to determine the amount of tax that must be paid. The following simplifying assumptions are for cases in which the Roth IRA does not predate the Notice 2004-8 transaction, did not receive any rollover contributions from another Roth IRA or conversion contributions, and did not make any distributions that were rolled over to another Roth IRA. Thus, all assets must be disgorged from the Roth IRA and are not eligible for rollover treatment. Appropriate adjustments will be made in those cases involving pre-existing Roth IRAs, rollover contributions from another Roth IRA, conversion contributions, or distributions that were rolled over to another Roth IRA.

All contributions to the Roth IRA will be treated as made on June 30, 2003.

All distributions from the Roth IRA will treated as made on December 31, 2004, except that actual distribution dates will be used for determining fair market value and for the allocation between contributions and earnings described below. The fair market value of Roth IRA Corporation stock distributed from the Roth IRA is equal to the greater of (1) the fair market value of the assets of the Roth IRA Corporation reduced by the Roth IRA Corporation's liabilities, if any, or (2) three times the taxable income of the Roth IRA Corporation for the taxable year ending in 2004.

The total amount distributed will be allocated between contributions and earnings as follows: the contributions consist of the amount(s) distributed, discounted to June 30, 2003, at a 7% annual rate (i.e., by assuming that the contributions generated earnings at that rate). The difference constitutes earnings. For example, if all assets are distributed on March 31, 2006, and there were no prior distributions, there will be 2.75 years of discounting so that 83% of the amount distributed will be treated as having been contributed on June 30, 2003, and the remaining 17% will be treated as earnings.

Additional simplifying assumptions are built into Q&A-2 through -4, below.

Q.2 What is the appropriate income tax adjustment?

A.2 The fair market value of all assets distributed (including prior distributions), reduced by actual cash contributions made by the Roth IRA owner to that Roth IRA and by any amounts already included in gross income on account of prior distributions, must be included in the Roth IRA owner's gross income as ordinary income for the 2004 taxable year.

Q.3 Will the Roth IRA owner be subject to the 10 percent additional tax on early distributions under IRC Section 72(t)?

A.3 Yes, unless one of the exceptions set forth in IRC Section 72(t)(2) is available. If no exception is available, the additional tax is applied in 2004 to the earnings portion (as determined above) of the total amount distributed.

Q.4 How is the IRC Section 4973 excise tax on excess contributions to the Roth IRA calculated?

A.4 The excess contributions to the Roth IRA consist of the contribution portion (as determined above) of the total amount distributed, reduced by $3,000. The excise tax for 2003 is 6 percent of the excess contributions. There is no excise tax for 2004 or later years because all amounts (including the excess contributions) are treated as distributed on December 31, 2004.

Q.5 What is an example of these tax calculations?

A.5 Assume that the Roth IRA distributes all assets to the Roth IRA owner on March 31, 2006. The assets, including the Roth IRA Corporation, have a fair market value on that date of $200,000, and there were no prior distributions. Assume further that the owner contributed $2,000 cash in 2002 and made no other cash contributions to the Roth IRA. Allocating the total distribution between contributions and earnings as described in Q&A-1 above, the contributions are $166,000 (83% of $200,000) and the earnings are $34,000 (17% of $200,000). Therefore --

• $198,000 ($200,000 - $2,000) is included in the Roth IRA owner's gross income as ordinary income in 2004.

• The 10 percent additional tax of IRC Section 72(t) is applied to the $34,000 earnings unless one of the exceptions in IRC Section 72(t)(2) is available.

• The 6 percent excise tax under IRC Section 4973 is applied to $163,000 excess contributions ($166,000 - $3,000).

Q.1 Can you provide an overview of this transaction?

A.1 The settlement initiative covers distributions from a charitable remainder trust (CRT) that made distributions subject to Treas. Reg. § 1.643(a)-8 for any taxable year. The settlement initiative applies to taxpayers that received distributions from a CRT or distributive shares or distributions from a pass-through entity that received distributions directly from the CRT. It also includes partners of pass-through entities with a CRT as a partner or member. The Service will provide a calculation of the amounts of the taxpayer's distributions that are attributable to transactions involving appreciated assets and taxable to the taxpayer as distributions of capital gains. Taxpayers must concede that these amounts are taxable income to the taxpayer as distributions of capital gains. An appropriate allowance for basis will be made.

Examples of typical transactions covered by the settlement initiative are the following:

1. Taxpayer formed a CRT and named himself or herself as noncharitable beneficiary and a qualified IRC Section 170(c) organization as the charitable beneficiary. Taxpayer then contributed appreciated property to the CRT. The CRT entered into a loan, or some other transaction that resulted in the CRT receiving cash, where such cash was not treated as income at the time of receipt. The CRT made distributions at least annually to the noncharitable beneficiary. After the last distribution to the noncharitable beneficiary, the CRT terminated and the remainder was distributed to the charitable beneficiary. Taxpayer claimed a charitable deduction at the formation of the CRT and did not report any portion of the distributions received as capital gain.

2. Taxpayer formed a CRT named himself or herself as noncharitable beneficiary and a qualified IRC Section 170(c) organization as the charitable beneficiary. Taxpayer and a related party formed a partnership. Taxpayer contributed appreciated property to the partnership in exchange for a limited partner interest. Related party made a pro rata contribution to the partnership in exchange for a general partner interest. Taxpayer then contributed his or her limited partner interest to the CRT. The partnership entered into a loan, or a some other transaction that resulted in the CRT receiving cash, where such cash was not treated as income at the time of receipt. The partnership made annual cash distributions in an amount sufficient to cover the required CRT distributions. After the last required CRT distribution to the noncharitable beneficiary, the CRT terminated and the remainder was distributed to the charitable beneficiary. Taxpayer claimed a charitable deduction at the formation of the CRT and did not report any portion of the CRT distributions received as capital gain.

Q.2 Who is eligible to elect the settlement initiative?

A.2 A taxpayer who received distributions from a CRT or distributive shares or distributions from a pass-through entity that received distributions directly from the CRT is eligible to participate in the settlement initiative. Certain other partners are also eligible. See Q&A 4. The CRT itself and any pass-through entities are not eligible to elect the settlement initiative. Furthermore, the CRT and any TEFRA partnerships do not have to file an election for the taxpayer to be eligible.

Q.3 May a taxpayer participate in the settlement initiative even if the three-year period of limitations on assessment has expired?

A.3 Possibly. The Service has determined that the six-year period of limitations on assessment under IRC Section 6229(c)(2) or 6501(e) may apply to those taxpayers who omitted income on their return. If the taxpayer's period of limitations on assessment is still open, the taxpayer may participate in the settlement initiative. The Service will require the taxpayer to agree to extend the period of limitations on assessment, however, if it would otherwise expire within 12 months after the election is filed.

Q.4 May a partner or member, other than the CRT, in the pass-through entity participate in the settlement initiative?

A.4 Yes. A taxpayer who is a partner or member (direct or indirect) of a pass-through entity that had a CRT as a partner is eligible to participate in the settlement initiative. These taxpayers include general partners and those partners who purchased their partnership interest from the CRT. General partners and those partners who purchased their interests from the CRT are eligible to participate if they did not correctly report the capital gain attributable to the partnership.

Q.5 Does Announcement 2005-80 apply to a taxpayer who formed a CRT prior to October 19, 1999, the effective date of Treas. Reg. § 1.643(a)-8?

A.5 Yes, the settlement initiative applies to all transactions involving distributions described in Treas. Reg. § 1.643(a)-8 from CRTs, regardless of when the CRT was formed and when the distributions were made. Thus, the settlement also applies to such CRTs that made distributions before October 19, 1999.

Q.6 How are such distributions treated under the settlement initiative?

A.6 Taxpayers electing the settlement initiative must concede that the distributions are taxable as capital gains. An appropriate allowance for basis will be made.

Q.7 Is there a different treatment for distributions received before October 19, 1999?

A.7 No.

Q.8 If a taxpayer received at least one distribution before October 19, 1999, and distributions on or after October 19, 1999, can the taxpayer elect to settle under the initiative only the distributions that were on or after October 19, 1999, and take the other open years to Appeals?

A.8 No. A taxpayer that settles under the initiative must settle all years by conceding that the distributions are taxable as capital gains. An appropriate allowance for basis will be made. A taxpayer cannot settle some years under the settlement initiative and take other open year to Appeals. See the general Q&As for Announcement 2005-80 for further discussion of this issue.

Q.9 Does a taxpayer who participates in the settlement initiative lose the charitable contribution deduction received for funding a CRT?

A.9 No. As long as the CRT meets the requirements set forth in IRC Section 664(d) and (e), the taxpayer will not have to relinquish his or her charitable contribution deduction.

Q.10 What is the effect on the charitable contribution deduction if a taxpayer made a disclaimer, or a partial disclaimer, of his or her required final annuity distribution from a CRT?

A.10 The taxpayer is entitled to a charitable contribution deduction in the amount effectively disclaimed if the disclaimer resulted in a transfer of an undivided portion of the taxpayer's entire interest to an organization described in IRC Section 170(c).

19. Certain abusive charitable contributions and conservation easements (Deductions under § 170 improperly claimed as a result of: (a) open space easements where the easement has no, or de minimis, value; (b) historic land or façade easements that have no, or de minimis, value; and (c) so-called conservation buyer transactions where the charitable organization purchases property, places an easement on it and then "sells" the property with the easement to a buyer at a price substantially less than that paid for it and the buyer also makes a charitable contribution that approximates the price differential. See Notice 2004-41).

Q.1 How much of a taxpayer's claimed deduction for having participated in a transaction described in Notice 2004-41 will be disallowed under this initiative?

A.1 Under the initiative, the entire amount of the claimed deduction will be disallowed, including any losses related to the disposition of related state tax credits.

Q.2 If a taxpayer participates in the settlement initiative and enters into a closing agreement resolving the tax treatment of the transaction, will the settlement invalidate the easement?

A.2 Whether the conservation easement is valid depends on the state and local law governing the creation and transfer of the easement. The validity of the easement is not affected by any closing agreement between the taxpayer and the Service.

Q.3 What additional items can a taxpayer expect the Service to request?

A.3 A taxpayer can expect the Service to request that the taxpayer provide, at a minimum, the easement document, appraisal, other written substantiation documents, proof of payment of transaction costs, and copies of returns for which the taxpayer claimed a charitable contribution deduction or carryover, as well as any other return affected by the resolution of the issue. If a flow- through entity made the donation, the Service will request that return as well. The Service will also request additional information regarding the exempt organization.

This will include any agreements in connection with the transaction, all correspondence exchanged with the organization, the date and amount of any payment, and copies of any checks to, or for the benefit of, either the organization or the promoter. If the taxpayer received a state tax credit, related to the donation, that it sold or transferred, the Service may request information relating to the disposition of the tax credit and the taxpayer's federal tax treatment of any gains or losses related to the state tax credit.