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 transactionthe executive stock option scheme. Executives (often facilitated by their corporate employers) transferred stock options to family 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 corporations 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 below and 2 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.

From Natalie Bell Takacs, CPA, MT, Cohen & Company, Ltd., Cleveland, OH