Collateralized Debt Obligations (CDOs)

A collateralized debt obligation (CDO) is a debt instrument, other than a REMIC regular interest, that is secured by a pool of mortgages or other evidence of debt and that has principal payments that are subject to acceleration. (Note: While REMIC regular interests are collateralized debt obligations, they have unique rules that do not apply to CDOs issued before 1987.) CDOs, also known as pay-through bonds, are commonly divided into different classes (also called tranches).

CDOs can be secured by a pool of mortgages, automobile loans, equipment leases, or credit card receivables.

For more information about the qualifications and the tax treatment that apply to an issuer of a CDO, see section 1272(a)(6) of the Internal Revenue Code and the regulations under that section.

The OID, market discount, and income-reporting rules that apply to bonds and other debt instruments, as described earlier in this chapter under Discount on Debt Instruments, also apply to a CDO.

You must include interest income from your CDO in your gross income under your regular method of accounting. Also include any OID accrued on your CDO during the tax year.

Generally, you report your income from a CDO on line 8a, Form 1040. For more information about reporting these amounts on your return, see How To Report Interest Income, earlier.

Forms 1099-INT and 1099-OID.   You should receive a copy of Form 1099-INT or Form 1099-OID. You will also receive a written statement by March 17, 2003, that provides additional information. The statement should contain enough information about the CDO to enable you to figure your accrual of market discount or amortizable bond premium.

Form 1099-INT shows the amount of interest income paid to you for the period you held the CDO.

Form 1099-OID shows the amount of OID accrued to you and the interest, if any, paid to you for the period you held the CDO. You should not need to make any adjustments to the amounts reported even if you held the CDO for only a part of the calendar year. However, if you bought the CDO at a premium or acquisition premium, see Refiguring OID shown on Form 1099-OID under Original Issue Discount (OID), earlier.

If you did not receive a Form 1099, see You may not get a Form 1099 under REMICs, earlier.

FASITs

A financial asset securitization investment trust (FASIT) is an entity that securitizes debt obligations such as credit card receivables, home equity loans, and automobile loans.

A regular interest in a FASIT is treated as a debt instrument. The rules described under Collaterized Debt Obligations (CDOs), earlier, apply to a regular interest in a FASIT, except that a holder of a regular interest in a FASIT must use an accrual method of accounting to report OID and interest income.

For more information about FASITs, see sections 860H through 860L of the Internal Revenue Code.

S Corporations

In general, an S corporation does not pay a tax on its income. Instead, its income and expenses are passed through to the shareholders, who then report these items on their own income tax returns.

If you are an S corporation shareholder, your share of the corporation's current year income or loss and other tax items are taxed to you whether or not you receive any amount. Generally, those items increase or decrease the basis of your S corporation stock as appropriate. For more information on basis adjustments for S corporation stock, see Stocks and Bonds under Basis of Investment Property in chapter 4.

Generally, S corporation distributions, except dividend distributions, are considered a return of capital and reduce your basis in the stock of the corporation. The part of any distribution that is more than your basis is treated as a gain from the sale or exchange of property. The corporation's distributions may be in the form of cash or property.

S corporation distributions are not treated as dividends except in certain cases in which the corporation has accumulated earnings and profits from years before it became an S corporation.

Reporting S corporation income, deductions, and credits.   The S corporation should send you a copy of Schedule K-1 (Form 1120S) showing your share of the S corporation's income, credits, and deductions for the tax year. You must report your distributive share of the S corporation's income, gain, loss, deductions, or credits on the appropriate lines and schedules of your Form 1040.

For more information about your treatment of S corporation tax items, see Shareholder's Instructions for Schedule K-1 (Form 1120S).

Limit on losses and deductions.   The deduction for your share of losses and deductions shown on Schedule K-1 (Form 1120S) is limited to the adjusted basis of your stock and any debt the corporation owes you. Any loss or deduction not allowed because of this limit is carried over and treated as a loss or deduction in the next tax year.

Passive activity losses.   Rules apply that limit losses from passive activities. Your copy of Schedule K-1 and its instructions will explain the limits and tell you where on your return to report your share of S corporation items from passive activities.

Form 8582.   If you have a passive activity loss from an S corporation, you must complete Form 8582, Passive Activity Loss Limitations, to figure the amount of the allowable loss to enter on your return. See Publication 925 for more information.

Investment Clubs

An investment club is formed when a group of friends, neighbors, business associates, or others pool their money to invest in stock or other securities. The club may or may not have a written agreement, a charter, or bylaws.

Usually the group operates informally with members pledging to pay a regular amount into the club monthly. Some clubs have a committee that gathers information on securities, selects the most promising securities, and recommends that the club invest in them. Other clubs rotate these responsibilities among all their members. Most clubs require all members to vote for or against all investments, sales, trades, and other transactions.

Identifying number.   Each club must have an employer identification number (EIN) to use when filing its return. The club's EIN also may have to be given to the payer of dividends or other income from investments recorded in the club's name. To obtain an EIN, first get Form SS-4, Application for Employer Identification Number, from the Internal Revenue Service or your nearest Social Security Administration office. See chapter 5 of this publication for more information about how to get this form.

Investments in name of member.   When an investment is recorded in the name of one club member, this member must give his or her social security number (SSN) to the payer of investment income. (When an investment is held in the names of two or more club members, the SSN of only one member must be given to the payer.) This member is considered as the record owner for the actual owner, the investment club. This member is a nominee and must file an information return with the IRS. For example, the nominee member must file Form 1099-DIV for dividend income, showing the club as the owner of the dividend, his or her SSN, and the EIN of the club.

Tax treatment of the club.   Generally, an investment club is treated as a partnership for federal tax purposes unless it chooses otherwise. In some situations, however, it is taxed as a corporation or a trust.

Clubs formed before 1997.   Before 1997, the rules for determining how an investment club is treated were different from those explained in the following discussions. An investment club that existed before 1997 is treated for later years the same way it was treated before 1997, unless it chooses to be treated a different way under the new rules. To make that choice, the club must file Form 8832, Entity Classification Election.

Club as a Partnership

If your club is not taxed as a corporation or a trust, it will be treated as a partnership.

Club files Form 1065.   If your investment club is treated as a partnership, it must file Form 1065. However, as a partner in the club, you must report on your individual return your share of the club's income, gains, losses, deductions, and credits for the club's tax year. (Its tax year generally must be the same tax year as that of the partners owning a majority interest.) You must report these items whether or not you actually receive any distribution from the partnership.

You should receive a copy of Schedule K-1 (Form 1065), Partner's Share of Income, Credits, Deductions, etc., from the partnership. The amounts shown on Schedule K-1 are your share of the partnership's income, deductions, and credits. Report each amount on the appropriate lines and schedules of your income tax return.

The club's expenses for producing or collecting income, for managing investment property, or for determining any tax are listed separately on Schedule K-1. Each individual partner who itemizes deductions on Schedule A (Form 1040) can deduct his or her share of those expenses. The expenses are listed on line 22 of Schedule A along with other miscellaneous deductions subject to the 2% limit. See chapter 3 for more information on the 2% limit.

For more information about reporting your income from a partnership, see the Schedule K-1 instructions. Also see Publication 541, Partnerships.

Passive activity losses.   Rules apply that limit losses from passive activities. Your copy of Schedule K-1 (Form 1065) and its instructions will tell you where on your return to report your share of partnership items from passive activities. If you have a passive activity loss from a partnership, you must complete Form 8582 to figure the amount of the allowable loss to enter on your tax return.

No social security coverage for investment club earnings.   If an investment club partnership's activities are limited to investing in savings certificates, stock, or securities, and collecting interest or dividends for its members' accounts, a member's share of income is not earnings from self-employment. You cannot voluntarily pay the self-employment tax to increase your social security coverage and ultimate benefits.

Club as a Corporation

An investment club formed after 1996 is taxed as a corporation if:

1. It is formed under a federal or state law that refers to it as incorporated or as a corporation, body corporate, or body politic,
2. It is formed under a state law that refers to it as a joint-stock company or joint-stock association, or
3. It chooses to be taxed as a corporation.

Choosing to be taxed as a corporation.   To choose to be taxed as a corporation, the club cannot be a trust (see Club as a Trust, later) or otherwise subject to special treatment under the tax law. The club must file Form 8832 to make the choice.

Club files Form 1120.   If your club is taxed as a corporation, it must file Form 1120 (or Form 1120-A). In that case, you do not report any of its income or expenses on your individual return. All ordinary income and expenses and capital gains and losses must be reported on the Form 1120 (or Form 1120-A). Any distribution the club makes that qualifies as a dividend must be reported on Form 1099-DIV if total distributions to the shareholder are $10 or more for the year.

You must report any distributions that you receive from the club on your individual return. You should receive a copy of Form 1099-DIV from the club showing the distributions you received.

Some corporations can choose not to be taxed and have earnings taxed to the shareholders. See S Corporations, earlier.

For more information about corporations, see Publication 542, Corporations.

Club as a Trust

In a few cases, an investment club is taxed as a trust. In general, a trust is an arrangement through which trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. An arrangement is treated as a trust for tax purposes if its purpose is to vest in trustees responsibility for protecting and conserving property for beneficiaries who cannot share in that responsibility and so are not associates in a joint enterprise for the conduct of business for profit. If you need more information about trusts, see section 301.7701-4 of the regulations.

Club files Form 1041.   If your club is taxed as a trust, it must file Form 1041. You should receive a copy of Schedule K-1 (Form 1041) from the trust. Report the amounts shown on Schedule K-1 on the appropriate lines and schedules of your income tax return.

Tax Shelters

Introduction

Investments that yield tax benefits are sometimes called tax shelters. In some cases, Congress has concluded that the loss of revenue is an acceptable side effect of special tax provisions designed to encourage taxpayers to make certain types of investments. In many cases, however, losses from tax shelters produce little or no benefit to society, or the tax benefits are exaggerated beyond those intended. Those cases are called abusive tax shelters. An investment that is considered a tax shelter is subject to restrictions, including the requirement that it be registered, as discussed later, unless it is a projected income investment (defined later).

Topics

This chapter discusses:

• How to recognize an abusive tax shelter,
• Rules enacted by Congress to curb tax shelters,
• Investors' reporting requirements, and
• Penalties that may apply.

Useful Items You may want to see:

Publication

• 538   Accounting Periods and Methods
• 556   Examination of Returns, Appeal Rights, and Claims for Refund
• 561   Determining the Value of Donated Property
• 925   Passive Activity and At-Risk Rules

Form (and Instructions)

• 8271   Investor Reporting of Tax Shelter Registration Number
• 8275   Disclosure Statement
• 8275-R   Regulation Disclosure Statement

See chapter 5 for information about getting these publications and forms.

Abusive Tax Shelters

Abusive tax shelters are marketing schemes that involve artificial transactions with little or no economic reality. They often make use of unrealistic allocations, inflated appraisals, losses in connection with nonrecourse loans, mismatching of income and deductions, financing techniques that do not conform to standard commercial business practices, or the mischaracterization of the substance of the transaction. Despite appearances to the contrary, the taxpayer generally risks little.

Abusive tax shelters commonly involve package deals that are designed from the start to generate losses, deductions, or credits that will be far more than present or future investment. Or, they may promise investors from the start that future inflated appraisals will enable them, for example, to reap charitable contribution deductions based on those appraisals. (But see the appraisal requirements discussed under Curbing Abusive Tax Shelters.) They are commonly marketed in terms of the ratio of tax deductions allegedly available to each dollar invested. This ratio (or write-off) is frequently said to be several times greater than one-to-one.

Since there are many abusive tax shelters, it is not possible to list all the factors you should consider in determining whether an offering is an abusive tax shelter. However, you should ask the following questions, which might provide a clue to the abusive nature of the plan.

• Do the tax benefits far outweigh the economic benefits?
• Is this a transaction you would seriously consider, apart from the tax benefits, if you hoped to make a profit?
• Do shelter assets really exist and, if so, are they insured for less than their purchase price?
• Is there a nontax justification for the way profits and losses are allocated to partners?
• Do the facts and supporting documents make economic sense? In that connection, are there sales and resales of the tax shelter property at ever increasing prices?
• Does the investment plan involve a gimmick, device, or sham to hide the economic reality of the transaction?
• Does the promoter offer to backdate documents after the close of the year? Are you instructed to backdate checks covering your investment?
• Is your debt a real debt or are you assured by the promoter that you will never have to pay it?
• Does this transaction involve laundering United States source income through foreign corporations incorporated in a tax haven and owned by United States shareholders?

Curbing Abusive Tax Shelters

Congress has enacted a series of income tax laws designed to halt the growth of abusive tax shelters. These provisions include the following.

1. Passive activity losses and credits. The passive activity loss and credit rules limit the amount of losses and credits that can be claimed from passive activities and limit the amount that can offset nonpassive income, such as certain portfolio income from investments. For more detailed information about determining and reporting income, losses, and credits from passive activities, see Publication 925.
2. Registration of tax shelters. Generally, the organizers of certain tax shelters must register the shelter with the IRS. The IRS will then assign the tax shelter a registration number. If you are an investor in a tax shelter, the seller (or the transferor) must provide you with the tax shelter registration number at the time of sale (or transfer) or within 20 days after the seller or transferor receives the number if that date is later. See Investor Reporting, later, for more information about reporting this number when filing your tax return.
3. List of tax shelter investors. Organizers and sellers of any potentially abusive tax shelter must maintain a list identifying each investor. The list must be available for inspection by the IRS, and the information required to be included on the list generally must be kept for 7 years. See Transfer of interests in a tax shelter, later, for more information.
4. Appraisals of donated property. Generally, if you donate property valued at more than $5,000 ($10,000 in the case of privately traded stock), you must get a written qualified appraisal of the property's fair market value and attach an appraisal summary to your income tax return. The appraisal must be done by a qualified appraiser who is not the taxpayer, a party to a transaction in which the taxpayer acquired the property, the donee, or an employee or related party of any of the preceding persons. (Related parties are defined under Related Party Transactions in chapter 4.) For more information about appraisals, see Publication 561.
5. Interest on penalties. If you are assessed an accuracy-related or civil fraud penalty (as discussed under Penalties, later), interest will be imposed on the amount of the penalty from the due date of the return (including any extensions) to the date you pay the penalty.
6. Accounting methods and capitalization rules. Tax shelters generally cannot use the cash method of accounting. Also, uniform capitalization rules generally apply to producing property or acquiring it for resale. Under those rules, the direct cost and part of the indirect cost of the property must be capitalized or included in inventory. For more information, see Publication 538.

Projected income investment.   Special rules apply to a projected income investment. To qualify as a projected income investment, a tax shelter must not be expected to reduce the cumulative tax liability of any investor during any year of the first 5 years ending after the date the investment was offered for sale. In addition, the assets of a projected income investment must not include or relate to more than an incidental interest in:

1. Master sound recordings,
2. Motion picture or television films,
3. Videotapes,
4. Lithograph plates,
5. Copyrights,
6. Literary, musical, or artistic compositions, or
7. Collectibles (such as works of art, rugs, antiques, metals, gems, stamps, coins, or alcoholic beverages).

Tax shelters that qualify as projected income investments are not subject to the registration rules for tax shelters, described earlier. However, the requirement to maintain a list of investors that is in effect for tax shelters also applies to any projected income investment, except for one an investor later transfers. See Transfer of interests in a tax shelter, later.

A tax shelter that previously qualified as a projected income investment may later be disqualified if, in one of its first 5 years, it reduces the cumulative tax liability of any investor. In that case, the tax shelter becomes subject to the registration rules for tax shelters, described earlier.

Pre-filing notification letter.   If you are an investor in an abusive tax shelter promotion, the IRS may send you a pre-filing notification letter if it determines that it is highly likely that there is:

1. A gross valuation overstatement, or
2. A false or fraudulent statement regarding the tax benefits to be derived from the tax shelter entity or arrangement.

This letter will advise you that, based upon a review of the promotion, it is believed that the purported tax benefits are not allowable. The letter also will advise you of the possible tax consequences if you claim the benefits on your income tax return.

You also may receive a notification letter after you file your tax return. If you have already claimed the benefits on your tax return, you will be advised that you can file an amended return. However, any penalties that apply still can be asserted.

If you claim the benefits after receiving the pre-filing notification or if you fail to amend your return, you will be notified that your tax return is being examined. Normal audit and appeal procedures will be followed during the examination, and accuracy-related, civil or criminal fraud, and other penalties will be considered and, when appropriate, asserted. For information on the examination of returns, see Publication 556.

Revenue rulings.   The IRS has published numerous revenue rulings concluding that the claimed tax benefits of various abusive tax shelters should be disallowed. A revenue ruling is the conclusion of the IRS on how the law is applied to a particular set of facts. Revenue rulings are published in the Internal Revenue Bulletin for taxpayers' guidance and information and also for use by IRS officials. So, if your return is examined and an abusive tax shelter is identified and challenged, a published revenue ruling dealing with that type of shelter, which disallows certain claimed tax shelter benefits, could serve as the basis for the examining official's challenge of the tax benefits that you claimed. In such a case, the examiner will not compromise even if you or your representative believes that you have authority for the positions taken on your tax return.

The courts have generally been unsympathetic to taxpayers involved in abusive tax shelter schemes and have ruled in favor of the IRS in the majority of the cases in which these shelters have been challenged.

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