Coordinated issue paper on S Corps.

• Author: Laffie, Leslie S.
• Position: FROM THE IRS

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...