The US Inland Revenue Service has unveiled a settlement initiative for executives and companies that participated in what it defines as an a...

The US Inland Revenue Service has unveiled a settlement initiative for executives and companies that participated in what it defines as an abusive tax avoidance transaction involving the transfer of stock options or restricted stock to family controlled entities at a discount ("the Transaction").

Executives and corporates who engaged in these Transactions have until May 23, 2005, to accept an IRS settlement offer to resolve their tax liability. 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.

In 2003 the IRS issued a "Notice" (Notice 2003-47) describing the many specific transactions that it determined of a tax avoidant nature; the settlement initiative applies to the Transaction described below. It is offered as a resolution choice other than litigation because it eases the IRS's administrative burden and a participant's tax and penalty burden.

First, the Transaction involves an executive of a public company being granted options as compensation.

Second, the executive sells the stock options to a family controlled partnership, often created for receiving the options, and to the IRS's point of view, avoiding taxes. Consideration for the sale was an unsecured promissory note with a 30-year balloon payment, the tax objective being deferring taxes on the compensation for up to 30 years.

Also, the timing meant that the corporation could not take a deduction during this time. The partnership exercised the options, fixed its basis in the shares, and any subsequent sale would be subject to capital gains rates. Thus earned income (taxed at the highest rates) was minimized and deferred.

From a corporate governance perspective, the corporation was denied a deduction that it should have had and carried the cost of setting up the Transaction, both of which arguably to the detriment of shareholders.

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 IRS has identified 42 corporations, many more executives and unreported income of more than $700 million involved in such arrangements.

The companies in question will not face any penalties, and to their benefit have a choice of years in which to claim the deduction. Both parties will be able to deduct their transaction costs if going through the settlement process. However, the IRS will recommend that any company's use of the shelter be examined by its audit committee.