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GT Alert

California's Controversial New 'Anti-Tax Shelter' Law Increases Penalties, the Statute of Limitations and Applies Retroactively

October 2003
By Barbara T. Kaplan and Stephen A. Mihaly, Greenberg Traurig

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On October 2, 2003, the Governor of California signed the “Anti-Tax Shelter & Tax Avoidance Initiative,” Senate Bill 614 and Assembly Bill 1601. This law is intended to detect “abusive transactions” which the California Franchise Tax Board (“FTB”) will challenge and to impose a chilling effect on the marketing of tax shelter products. The law is broadly drafted and encompasses disclosure of many ordinary business transactions that will require the FTB to sift through the disclosures to identify the type of questionable transactions the legislation was intended for. We expect that most of the transactions that will have to be disclosed will not cross over the line of allowability and will not merit enforcement. Although some transactions may be a close call and will have to be assessed on a case-by-case basis, taxpayers with “listed” transactions (those which have been identified in published guidance as abusive) face the greatest exposure to the increased penalties just enacted.

Barbara T. Kaplan
"This law is intended to combat perceived abusive tax shelters and is based largely on proposed Federal tax legislation that has not yet been enacted."

The California law is based largely on proposed Federal tax legislation that has not yet been enacted but with a number of unique and highly controversial differences which are described below. The law applies generally to California taxpayers, as well as any tax shelter organized in California, doing business in California, deriving income from California, or if at least one of the investors is a California taxpayer. The law is generally applicable to any penalty assessed on or after January 1, 2004 for any open tax year. All other changes generally apply on and after January 1, 2004. Because the new law is both broad in scope and retroactive in effect, it is sure to face challenge in the courts.

The most significant provisions of the California anti-tax shelter law are:

  • A significant increase in penalties for tax shelters entered into after February 28, 2000. Note the retroactive effect of the penalty provisions, which is different from the proposed federal legislation providing for increased penalties but only for transactions entered into on a prospective basis.
  • A doubling of the statute of limitations for “abusive” transactions from four (4) years to eight (8) years for tax returns filed after January 1, 2000 (i.e., 1999 tax returns and thereafter).
  • To ameliorate the impact of the penalty enhancements and statute of limitations extension, the new law offers a short amnesty program, the Voluntary Compliance Initiative (VCI), which allows eligible taxpayers to avoid all of the substantially increased penalties if, between January 1 and April 15, 2004, they disclose abusive tax avoidance transactions for taxable years before 2003, waive any appeal and pay the tax and interest due. A modified program also is available allowing an appeal of the tax consequences of the transaction which waives all penalties other than the accuracy-related penalty as in effect before this enactment. The VCI program is similar to a federal disclosure initiative that expired in April 2002. Although the federal initiative was availed of by a relatively small number of taxpayers (under 1700), the Internal Revenue Service (“IRS”) has proclaimed it a success in exposing the names of previously unknown tax shelter promoters and abusive transactions. Because of differences between the federal program, which was more liberal than that which California has enacted, it is uncertain how successful California’s voluntary disclosure program will be. It will probably be most attractive to taxpayers with listed transactions.

Recommendation. Because the new legislation will affect some prior transactions and the VCI will only be offered for a short period of time, taxpayers with possibly abusive tax shelter transactions should consider consulting a knowledgeable tax practitioner as soon as possible in order to determine their potential exposure and the best strategy for dealing with the new law.

  • A suspension of interest and time-sensitive penalties on tax deficiencies is enacted which begins 18 months after a timely filed return and ends 15 days after the FTB provides notice of the taxpayer’s liability and the basis for it. No suspension is permitted, however, if the FTB notice is sent before the 18-month period runs or if the taxpayer has taxable income in excess of $200,000 and has been contacted by the FTB regarding the use of a potentially abusive tax shelter. The suspension provision applies to taxable years ending after October 10, 1999.
  • The law extends the protections of attorney-client confidentiality to state tax advice given by certified public accountants and certain other persons. This statutory amendment is modeled on the federal equivalent and, like the federal statute, exempts criminal tax matters and tax shelters. It also expires on January 1, 2005 unless reenacted. It applies to communications made on or after September 13, 2000.

Other key provisions of the new law are:

Reliance on Tax Opinions. The law eliminates as reasonable cause to avoid a penalty a taxpayer’s reliance on a tax opinion if the opinion is given with respect to a “potentially abusive tax shelter” transaction and the tax adviser who gave the opinion was or is a “material advisor,” is compensated by a material advisor, or has a contingent fee arrangement based on realizing tax benefits. A “material advisor” includes anyone who provided any material assistance or advice in organizing, promoting, selling, implementing or carrying out the transaction and who received a minimum fee of $250,000 in representing corporate clients or $50,000 in representing all others.

This change is made even more radical in that it has retroactive effect because it applies to any penalty imposed after January 1, 2004 with respect to transactions entered into after February 28, 2000. The retroactive application of this provision to nullify a taxpayer’s prior reliance on a tax opinion is bound to be challenged as being invalid.

Disclosure Requirements. Taxpayers who engaged in “reportable transactions” will have to disclose such transactions to the FTB. There are six (6) types of “reportable transactions” which follow the reportable transactions defined in existing IRS regulations. They are: (1) listed transactions, (2) loss transactions, (3) short holding period transactions, (4) transactions with tax loss protection, (5) confidential transactions, and (6) transactions with a significant book-tax difference. However, as previously stated, many, if not most, reportable transactions are not abusive. Reportable transactions other than listed transactions have to be disclosed for tax years beginning on January 1, 2003. Only listed transactions are subject to retroactive disclosure for transactions entered into after Febraury 28, 2000.

Penalty for Failure to Disclose Reportable Transaction. The penalty for failure to disclose a reportable transaction is $15,000 for high net worth individuals and for large entities. A “high net worth individual” is a person with a net worth in excess of $2 million, and a “large entity” is one with gross receipts in excess of $10 million. If the transaction was or becomes a “listed transaction”, the penalty for failure to disclose is $30,000 and applies if the investment occurred after February 28, 2000 and before January 1, 2004. If the transaction is not a listed transaction, the penalty will only apply to taxable years beginning on or after January 1, 2003.

Penalty for Failure to Maintain Investor Lists. Under the law, any seller, organizer or material advisor of a potentially abusive tax shelter entered into after February 28, 2000 must keep a list of all investors in the tax shelter in the form and manner prescribed by the FTB. If a potentially abusive tax shelter becomes a “listed transaction” at any time, then the seller, organizer or material advisor must automatically submit to the FTB all investor lists for any listed transaction entered into after February 28, 2000 by the later of: (a) 60 days after entering the transaction, (b) 60 days after the transaction becomes listed, or (c) April 30, 2004. A material advisor who fails to provide an investor list within 20 days of a request from the FTB will be subject to a $20,000 per day penalty. However, the listing penalty will not apply to licensed attorneys for transactions entered into prior to January 1, 2004 if the attorney is a material advisor solely due to the practice of law; i.e. not as a promoter or developer of the transaction.

Penalty for Failure to Register Tax Shelter. Promoters and organizers of “listed transactions” that are entered into after February 28, 2000 and which become listed at any time are required to register the tax shelter with the FTB. Registration must be completed by the later of: (a) 60 days after entering into the transaction, (b) 60 days after the transaction becomes listed or (c) April 30, 2004. However, if the tax shelter was offered for sale between February 28, 2000 and January 1, 2004, and it is listed on or before January 1, 2004, it must be registered by April 30, 2004. The penalty on an organizer, promoter or material advisor for failure to register a listed transaction is the greater of a) $100,000 or b) 50% of the gross income that the organizer or material advisor received from the listed transaction. This is a strict liability penalty with no reasonable cause exception. The penalty for failure to register all other types of reportable transactions is $15,000. This penalty may be rescinded if certain circumstances are met.

New Interest-Based Penalty. The law creates a new penalty which doubles the amount of interest on a deficiency attributable to a potentially abusive tax shelter. The interest-based penalty applies to all notices of proposed assessments mailed after the effective date of the Act and is in addition to all other applicable penalties. Thus, this penalty has full retroactive effect. It remains to be seen if it will withstand judicial scrutiny.

Amended Substantial Understatement Penalty. The law reduces the threshold for application of the 20% substantial understatement penalty. The penalty applies to an understatement of tax that exceeds the lesser of (1) 10% of the correct tax or (2) $5 million.

Penalty for Lack of Economic Substance. The law creates a new 40% strict liability penalty for understatements of tax attributable to “non-economic substance” transactions. The term “lack of economic substance” includes the disallowance of a loss, deduction or credit attributable to a transaction or arrangement that lacks economic substance, including a transaction or arrangement in which an entity is disregarded as lacking economic substance or if a taxpayer lacks a valid non-tax California business purpose for entering the transaction. The law avoids codifying the term “economic substance” so its meaning remains subject to judicial interpretation in each factual context presented to the FTB and in the courts. If a transaction that lacks economic substance is adequately disclosed, the penalty is 20% instead of 40%. The penalty cannot be added to the 20% substantial understatement penalty. The penalty for lack of economic substance applies to all open years so that taxpayers whose prior-year transactions are found to lack economic substance will be subject to the 40% penalty if they do not disclose the transaction prior to being contacted by the FTB.

Amended Tax Return Preparer Penalty. The law retroactively changes the standards and increases penalties on tax return preparers who understate a taxpayer’s liability. Under the new law for potentially abusive tax shelters, the tax return preparer, in preparing a tax return, must have “a reasonable belief that the tax treatment…was more likely than not” the proper treatment (i.e., a more than 50% chance of prevailing). The penalty amount is $1,000 or $5,000 depending on various circumstances. It applies with respect to all open years for which a penalty is assessed after January 1, 2004.

Increased Promoter Penalty. The law increases the existing penalty imposed on promoters of tax shelters if the promoter knew or should have known that any statements made with respect to the tax consequences of a potentially abusive tax shelter were false or fraudulent. The penalty is increased from $1,000 to 50% of the promoter’s gross income from the transaction. The penalty applies to deficiencies assessed after January 1, 2004, and consequently applies to all open tax years.

Options and Recommendations

Taxpayers in the next few months will need to consider with their tax advisors whether to accept the VCI offer in order to avoid or minimize the penalty exposure. This determination will depend partly on whether the taxpayer entered into transactions after February 28, 2000, and whether such transactions are listed or expected to become listed.

If it is anticipated that the IRS or FTB will identify the taxpayer’s transaction as a listed transaction, the taxpayer will have to weigh the following considerations: (a) assessing the possibility of prevailing on the merits of the transaction or reaching a favorable settlement with the FTB and IRS; (b) conceding the position and paying the tax and interest to minimize penalties under the VCI offer; and (c) assessing the risk of losing on the merits and having to pay the increased penalties. The taxpayer will also have to take into consideration the eight (8) year statute of limitations effective for returns filed after January 1, 2000, as there is a risk that a taxpayer’s tax return may be audited in this time frame.

Greenberg Traurig can assist taxpayers in evaluating the audit, disclosure, litigation and penalty risks of a taxpayers’ transactions, and can represent and defend taxpayers before the California’s Franchise Tax Board and the Internal Revenue Service.


© 2003 Greenberg Traurig

Additional Information:

For more information, please review our Tax Practice description, or feel free to contact one of our attorneys.

This GT ALERT is issued for general purposes only and is not intended to be construed or used as legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs. The Firm’s responsive approach to client service often cuts across legal subject matter, applying the right experience and resources to provide cost-effective solutions.