The US Internal Revenue Service ("IRS") has unveiled a settlement initiative for executives and companies that participated in what it defin...

The US Internal Revenue Service ("IRS") has unveiled a settlement initiative for executives and companies that participated in what it defines as an abusive tax-avoidance transaction.

Generally, it consisted of the transfer of stock options or restricted stock of listed companies by their executives to an entity controlled by his or her family ("the Transaction"). Announcement 2005-19 stated that executives, companies and the "family" limited partnerships or trusts that engaged in these Transactions have until May 23, 2005, to notify the IRS of their intent to participate in this settlement initiative ("Settlement") and fix their tax, interest and penalty liability. The IRS has identified but not named 42 corporations and a larger number of executives. Approximately $700 million of unreported income is involved these Transactions.

The History
In 2003 the IRS issued a Notice (Notice 2003-47) describing 30 specific transactions that it determined of a tax-avoidant nature; the Settlement applies to the Transaction described below.

It is offered as a resolution choice other than litigation. The Settlement should be a desirable choice for participants in a Transaction because it could half the penalty portion of the tax that they would otherwise pay. It is desirable for the US Treasury in that it increases its recovery of lost tax revenue due to the sheltering nature of the Transactions.

The Transaction
First, the Transaction involves a public company granting one or more of its executives’ compensatory options or restricted stock, that had not yet vested, ("the Securities"). Second, the executives sell the Securities to a partnership or trust ("Related Entity") where the executives and their family members are the ultimate beneficiaries. From the IRS's point of view, these Related Entities were often created solely to receive the Securities and to avoid taxes. Generally, the Related Entities used unsecured promissory notes with a 30-year balloon payment, or an annuity, as consideration.

The Transaction attracted executives because it deferred taxes on their compensation for up to 30 years. However, the timing meant that the corporation could not take a deduction during this time. Eventually, the Related Entity exercised the options (or the vested stock), fixed its basis in the shares, and any subsequent sale would be subject to capital gains rates. Also, as an ultimate beneficiary or owner of the Related Entity, the executive had access to the funds that had in effect been reclassified and no longer compensatory. Thus earned income (taxed at the highest rates) was minimized and deferred.

Settlement Terms
An executive and Related Entity must participate in the Settlement jointly. Where the Related Entity is taxed on a pass-through basis, e.g. a partnership, all members must participate as well. An executive and a corporation can enter into the Settlement mutually exclusive of the other. However, this would result in less favorable terms for both parties. Even more burdensome, if a corporation participates in a Settlement, it must apply with all respect to all of the executives that participated in the Transaction.

The Settlement is open to executives, Related Entities and corporations where the Securities were transferred before 2 July 2003 so long as there is not a court proceeding regarding the Transaction. The Settlement is consummated by a closing agreement amongst all the parties, which will set out the various liabilities that are being discharged through the Settlement process. To notify the IRS of their intent to participate, a person must send a notice of election on or before 23 May 2005. Payments of interest, penalties and taxes should be submitted with the signed closing agreement sent to the IRS in accord with terms of the Settlement.

Executive
An executive must recognize compensation income equal to the difference in the fair market value of the Securities (i.e. underlying stock on exercise or shares at vesting) when the Related Entity disposed of the stock, and any amounts paid (i) as an exercise price by the Related Entity and (ii) for the option by the executive. Income recognition must occur in the tax year that the Related Entity disposed of the stock.

If the stock has yet to be disposed (but the Securities have vested or been exercised), then recognition occurs in the executive's tax year that includes 31 December 2004. If the executive has received consideration for the sale to the Related Entity, then it too must be recognized as compensation in the tax years that the payments were received. Executives must pay their FICA tax (Federal Insurance Contributions Act, similar to NICs in the UK) on the compensation income.

Additionally, gain must be recognized to the extent that the amount paid for the Securities by the Related Entity exceeds the amount the executive recognizes as compensation when calculated as described above. Like the UK system, the US provides different regimes and rates for the tax on compensation and the tax on gains of property.

This gain must be recognized by the Executive in the tax year in which the Related Entity disposes of the Securities. If they still hold the Securities, then recognition of this gain must be included in the tax year including 31 December 2004. Regarding the promissory note that the executive received as deferred consideration for the sale of the Securities, the executive must recognize interest income of the liability when interest is either paid or accrued.

The executive must pay a ten per cent penalty on the increase in the executive's tax liability resulting from the Settlement. The executive may amortize or deduct costs paid related to the transaction including promoter fees.

On no account may an executive recognize a loss as a result of the Settlement.

Related Entities
Corresponding to the executive’s deemed interest income, the Related Entity may be entitled to an interest expense deduction. The Related Entity may amortize or deduct costs paid related to the transaction including promoter fees. Importantly, the IRS will allow the deduction to occur in the same tax year in which the income is recognized by the executive to the extent not already taken in a previous year. Provided the Related Entity is a pass-through, this could help offset the executive's tax liability in such year.

The Related Entity's basis in the Securities, if still held, will increase for any income and gain recognized by the executive under the Settlement.

Companies
Unlike an implicated executive, companies entering into a Settlement will not face any penalties. They may take a deduction for the amount of compensation recognized by the executive(s). To their benefit, they will have a choice of tax years in which to claim the deduction for compensation paid if it has not done so. The choices are the years which include (i) 31 December 2004, (ii) the 31 December of the year in which the executive recognized compensation income, (iii) the date the Securities vest or are exercised or (iv) the sale date of the Securities between Related Entity and executive.

The language of Announcement 2005 - 19 suggests that although there may be multiple executives party to the Settlement, only one tax year may be chosen in which to claim related deductions. However, there is not an exception from its normal liability to withhold its share of FICA taxes. Even more burdensome, if the executive is not party to the Settlement, the corporation must pay:
· both its and the employee's share of FICA taxes; and
· the employee's share of income tax withholding liability on an amount that is determined to be what the executive would have had as compensation if a party to the Settlement.

This provides pressure for the company to seek out all executives implicated by the IRS that have taken part in a Transaction.

The corporation may amortize or deduct costs paid related to the Transaction including promoter fees in the same tax year it chooses to take the compensation deduction mentioned above. However, the IRS will recommend that any company's use of the shelter be examined by its audit committee.

If Securities Have not Vested or Been Exercised
If by 22 February 2005 the Securities held by the Related Entity are unvested (or the option unexercised) then the Settlement terms are slightly altered. The significant difference is the timing of recognition, which is on vesting or exercise rather than disposition of underlying property. The executive must recognize compensation income in the year in which the Security vests or is exercised by the Related Entity.

The executive is liable for FICA tax on the income during the same year. Gain on the shares will be recognized on exercise or vesting rather than in the year in which the Related Entity disposes of the property. Any deductions taken by either the executive or Related Entity, payment of the 10 per cent penalty by the executive, and increase in basis of the Securities must also be tied to the year that the Securities become vested or are exercised. However, the executive must recognize interest income on the deferred payment arrangement, and any other cash or property relating to the sale must be recognized as compensation income in the year received.

Similarly, the corporation's FICA and income withholding liability, deduction of compensation costs, and deduction of transaction costs must align with the same tax year as the one in which the executive recognizes income and gain. Thus the corporation does not get to choose the year. If the corporation participates in a Settlement, but some or all of the executives do not, again the corporation is liable for it and the executives' share of income tax withholding and FICA withholding taxes.

Not Proceeding with Settlement
In the alternate, an executive or company would likely receive a notice from the IRS stating that they owe tax on the foregone income, multiple levels of penalties, and a denial of a deduction for expenses incurred in the negotiation or litigation process. The amount they would pay if they were caught through an audit process would be approximately double. As mentioned above, corporations are penalized by the IRS if all implicated executives do not take part because the IRS will shift the non-participants' tax liabilities to the corporations.

Other Implications
These schemes were widely marketed by advisors and financial institutions during the 1990s and early 2000s and relied on historical guidance from the IRS relating to portions of the structure, but in different areas of the US tax code. The Settlement initiative stems from a Notice published in 2003 identifying about 30 transactions that the IRS and US Treasury determined were used for primarily tax-avoidance reasons and did not have an integral business purpose.
Although these transactions may be tax-abusive, they also raise questions about corporate governance and auditor independence.

These two issues are significant in the current business climate in the US created by the extensive Sarbanes-Oxley Act of 2002 ("Act"). Corporate governance is implicated because corporations involved were denied a deduction that it should have had at the ultimate expense of shareholders. Generally the corporation carried the cost of setting up the Transaction which was set up for the benefit of executives, not the corporation.

Again, the argument is that management was using the corporation to the detriment of shareholders. Often the auditor of the corporation was also the promoter of the Transaction. In this instance, conflicts of interest could arise to an extent that business ethics are questioned. The Act focuses on auditor independence and creating a regime for corporate governance, but not significantly tax issues. The IRS seems to be taking advantage of the Act's effects to make tax abuse part of the corporate governance landscape.