California’s Controversial New “Anti-Tax Shelter” Law Increases Penalties,
the Statute of Limitations, Applies Retroactively and Its Limited Amnesty
Runs Out on April 15, 2004
By Barbara T. Kaplan, Greenberg
Traurig, New York Office
View or download the PDF version of this Alert
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” 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. Thus,
the California Franchise Tax Board (the “FTB”) will have to sift through
the disclosures to identify the type of questionable transactions for which
the legislation was intended. 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 increased penalties just enacted.
|"This law is intended to detect
'abusive transactions' and to impose a chilling effect on the marketing
of tax shelter products."
The California law is based largely on proposed Federal tax legislation
but with a number of unique and highly controversial differences, which
are described below. The law applies generally to California taxpayers,
as well as to 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 generally applies to any penalty assessed
on or after January 1, 2004 for any open tax year. 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
Increased Penalties. A significant increase in penalties for “reportable
transactions” entered into on or after January 1, 2003 and transactions
entered into after February 28, 2000 and before January 1, 2004, where the
transaction becomes “listed” at any time. 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.
Statute of Limitations. A doubling of the statute of limitations
for “abusive” transactions from four years to eight years for tax returns
filed after January 1, 2000 (i.e., 1999 tax returns and later).
Amnesty Program. California is offering a brief amnesty program,
known as the Voluntary Compliance Initiative (the “VCI”), which allows eligible
taxpayers to avoid all of the substantially increased penalties if, between
January 1, 2004 and April 15, 2004, they (i) disclose abusive
tax avoidance transactions for taxable years before 2003, (ii) waive any
appeal, and (iii) pay the tax and interest due. Taxpayers are also given
the option to participate in the VCI, reserving their right to appeal the
tax consequences. Under this modified program, all penalties, with the exception
of the accuracy-related penalty as in effect before this enactment, are
waived. The VCI is similar to a Federal disclosure initiative that expired
in April, 2002. The Federal program, however, was more liberal than the
California program. Although the Federal initiative was availed of by a
relatively small number of taxpayers (under 1,700), the Internal Revenue
Service (the “IRS”) has proclaimed it a success in exposing the names of
previously unknown tax shelter promoters and abusive transactions. According
to the FTB, as of January 7, 2004, the VCI program has already generated
more than $30 million. The VCI program will probably be most attractive
to taxpayers who participated in listed transactions.
Because the new legislation will affect some prior transactions and the
VCI will expire on April 15, 2004, 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.
Interest Suspension. A suspension of interest and time-sensitive
penalties on tax deficiencies 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. The suspension provision applies
to taxable years ending after October 10, 1999. No suspension is permitted,
however, if the FTB notice is sent before the 18-month period runs or if
the taxpayer has been contacted by the FTB after January 1, 2004 regarding
the use of a potentially abusive tax shelter and the taxpayer has taxable
income in excess of $200,000 (determined as of the date the FTB sends the
Attorney-Client Confidentiality. The protections of attorney-client
confidentiality extend to state tax advice given by certified public accountants
and certain other persons. This statutory amendment is modeled on the Federal
statute; both statutes exempt communications relating to criminal tax matters
and tax shelters. The amendment is effective for communications made on
or after January 1, 2001 and expires on January 1, 2005, unless reenacted.
Other key provisions of the new law are:
Reliance on Tax Opinions. The new 20% understatement penalty does
not apply if (i) the taxpayer discloses the transaction; (ii) there is or
was substantial authority for the claimed tax treatment; and (iii) the taxpayer
reasonably believed that the claimed tax treatment was more likely than
not the proper treatment. Under the new law (effective for tax years beginning
on or after January 1, 2003), a taxpayer may no longer rely on an opinion
of a tax advisor to establish reasonable belief if 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. The retroactive
application of this provision to nullify a taxpayer’s prior reliance on
a tax opinion is bound to be challenged.
Disclosure Requirements. Taxpayers who engaged in “reportable
transactions” will have to disclose such transactions to the FTB. There
are six types of “reportable transactions,” as 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 or after January 1, 2003.
In addition, a taxpayer who invested in a transaction after February 28,
2000 and before January 1, 2004, where the transaction becomes a listed
transaction at any time, is required to disclose the transaction.
Confidential Transactions. The IRS regulations used to define a confidential
transaction as a transaction sold on the express or implied understanding
or agreement that the taxpayer not disclose the advisor’s tax strategies.
This definition of a confidential transaction was criticized as being
overly broad. Accordingly, effective for transactions entered into
after December 29, 2003, the IRS amended the definition of a confidential
transaction. In particular, a confidential transaction is now defined
as a transaction offered under conditions of confidentiality and for which
the taxpayer has paid an advisor a “minimum fee.” A transaction is considered
offered to a taxpayer under conditions of confidentiality if the advisor
who is paid the minimum fee limits disclosure of the tax strategy/structure.
A transaction is still treated as confidential where the conditions of
confidentiality are not legally binding. In addition, a transaction that
is proprietary or exclusive is not confidential if there is no limit on
the disclosure of the tax treatment. The “minimum fee” is $250,000 if
the taxpayer is a corporation, and $50,000 for all other taxpayers.
Failure to Disclose Penalty. 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 increased to $30,000. This penalty
applies for tax years beginning on or after January 1, 2003. The penalty
also applies to a taxpayer who invested in a transaction after February
28, 2000 and before January 1, 2004, where the transaction becomes a listed
transaction at any time.
100% Interest-Based Penalty. A new penalty 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 on or after January 1, 2004 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 Accuracy-Related Penalty. In the case of a C corporation
that has been contacted by the FTB regarding the use of a potentially abusive
tax shelter, the law reduces the threshold for application of the 20% accuracy-related
penalty. In particular, this penalty applies to an understatement of tax
that exceeds the lesser of (i) 10% of the correct tax or (ii) $5
million. This penalty cannot be added to the non-economic substance penalty
or the new 20% understatement penalty.
Non-Economic Substance Penalty. The law creates a new 40% 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 into the transaction. The
law avoids codifying the term “economic substance” so its meaning remains
subject to interpretation in each factual context presented to the FTB and
the courts. If a transaction that lacks economic substance is adequately
disclosed, the penalty is decreased to 20%. The penalty cannot be added
to the new 20% understatement penalty or the accuracy-related penalty. The
non-economic substance penalty 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.
The following penalties apply to promoters, organizers, material advisors
and/or tax preparers:
Penalty for Failure to Maintain Investor Lists. 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: (i) 60 days after entering into the transaction, (ii) 60
days after the transaction becomes listed, or (iii) 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 a developer of the
Penalty for Failure to Register Tax Shelter. Promoters and organizers
of 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: (i) 60 days
after entering into the transaction, (ii) 60 days after the transaction
becomes listed or (iii) 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 imposed on an organizer, promoter or material advisor
for failure to register a listed transaction is the greater of (i)
$100,000 or (ii) 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.
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 on or after January 1, 2004,
and consequently applies to all open tax years.
Tax Return Preparer Penalty (Amended). The law retroactively changes
the standards and increases penalties for 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. The penalty applies with
respect to all open years for which a penalty is assessed on or after January
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 are expected to become listed.
If it is anticipated that the IRS or the FTB will identify the taxpayer’s
transaction as a listed transaction, the taxpayer will have to weigh the
following considerations: (i) assessing the possibility of prevailing on
the merits of the transaction or reaching a favorable settlement with the
FTB and the IRS; (ii) conceding the position and paying the tax and interest
to minimize penalties under the VCI offer; and (iii) 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 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 during 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 California’s Franchise Tax Board and the Internal
© 2004 Greenberg Traurig
For more information, please review our Tax Practice description, or
feel free to contact one of our attorneys.
This GT ALERT is issued for informational purposes only and is not intended
to be construed or used as general legal advice. Greenberg Traurig attorneys
provide practical, result-oriented strategies and solutions tailored to
meet our clients’ individual legal needs.