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GT Alert

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

February 2004
By Barbara T. Kaplan, Greenberg Traurig, New York Office

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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” 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.

Barbara T. Kaplan
"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 are:

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 notice).

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 transaction.

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 1, 2004.

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 Revenue Service.


© 2004 Greenberg Traurig

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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.