GT Alert

Arizona’s Voluntary Compliance Initiative Imposes a Short Deadline on Taxpayers Involved in Abusive Tax Avoidance Transactions

February 2005

  View or download the PDF version of this Alert.

On February 14, 2005, Arizona joined the list of states who are actively pursuing taxpayers involved in listed tax shelter transactions. Arizona’s Voluntary Compliance Initiative (VCI) is an effort by the Arizona Department of Revenue (ADR) to encourage taxpayers who are involved in abusive tax shelter arrangements to voluntarily disclose these transactions to the ADR. VCI enables Arizona taxpayers to disclose their involvement in any IRS “listed transaction” on a penalty-free basis for tax years before December 31, 2003. The period for taxpayers to participate in the VCI program began on February 14, 2005 and will end on April 1, 2005. Participants must pay the taxes and interest due to the ADR by May 13, 2005. Though the VCI deadlines are extremely short and fall during the height of tax-filing season, affected Arizona taxpayers should strongly consider participating in the VCI.

The Arizona VCI was modeled after the Connecticut Abusive Tax Shelter Compliance Initiative (CATSCI), which was in effect from June 16, 2004 through July 31, 2004. The CATSCI was a successful state program that also allowed Connecticut taxpayers to voluntarily disclose their participation in IRS listed transactions to the Connecticut Department of Revenue in exchange for a waiver of any civil or criminal penalties. The CATSCI was a huge success, earning several million dollars for Connecticut, and Arizona piggybacked its own VCI program onto Connecticut’s with hopes of achieving similar revenue for Arizona.

All Arizona taxpayers involved in any IRS “listed transaction,” whether still in audit status, having previously settled other issues for the same tax year or still undetected, can participate in Arizona’s VCI. Listed transactions are tax shelters which are designated by the IRS as tax avoidance transactions. (For more information regarding listed transactions, visit http://www.irs.gov/businesses/corporations/article/0,,id=120633,00.html). Typical listed transactions use offshore or abusive trusts, employee leasing arrangements, home-based businesses, employment taxes, many levels of pass-through entities which are designed to artificially create losses or derivative financial products and complicated structures to inflate basis..

Taxpayers who wish to participate in the VCI must notify the ADR of their election by sending Form AZ-VCI, Election to Participate in the Arizona Tax Shelter Voluntary Compliance Initiative on or before April 1, 2005. Participating Arizona taxpayers must attach the original Federal return and all schedules, any Federal amended return and relevant schedules, and any original or amended Arizona returns to the Form AZ-VCI. Taxpayers who agree to participate in the VCI must (1) concede 100% of the claimed artificial losses or concede the entire gain mitigation strategy used to shelter income, (2) pay all additional tax and interest due, and (3) comply with any ADR Tax Shelter Unit request for additional information. Any Arizona taxpayer, non-resident taxpayer with Arizona source income, or corporation doing business in Arizona that knowingly or unknowingly participated in a listed transaction is eligible to apply. Any affected Arizona taxpayer who is currently under state or Federal audit is also entitled to apply. Married Arizona taxpayers may participate in the VCI either jointly or on an individual basis.

Taxpayers who are eligible to participate in the VCI, but choose not to, could face serious repercussions, including penalties of up to 75%, interest and possible criminal prosecution when warranted. However, a taxpayer can eliminate this exposure by taking advantage of the VCI.

Many states, such as Arizona and California have information sharing agreements with the Internal Revenue Service. Any taxpayer involved in a listed transaction with the Internal Revenue Service will likely see his tax information shared with the ADR as a result of an IRS investigation or audit. Arizona expects to send some 2,000 notices this month to Arizona taxpayers due to their identified participation in a listed transaction. These taxpayers could face serious penalty consequences and potential criminal prosecution for their failure to take advantage of the Arizona VCI.

As an added incentive to entice shelter participants to apply, the VCI has the ability to waive (in addition to the forgiveness of 100% of the penalties) some of the interest due. Moreover, the VCI can, but is not required to, allow some taxpayers some deductions that would otherwise not be allowable on an audit. These settlement incentives are executed by closing agreement after a taxpayer has completed the Form AZ-VCI. Though the waiver on interest or the additional deductions are not an entitlement as a matter of course, the ADR has stated that it will consider these options on a case-by-case basis. After receiving all related documentation and information, the ADR will prepare and mail the Arizona taxpayer a closing agreement detailing the fact that the taxpayer may not appeal any issue that the settlement relates to nor dispute the amounts paid under the VCI agreement.

Taxpayers who cannot pay the full tax liability due by the May 13, 2005 deadline have the option to enter into an installment agreement. Installment agreements are not awarded automatically by the ADR. The taxpayer must request an installment agreement when he or she files his Form AZ-VCI by the April 1, 2005 deadline. The payment terms and amounts of an installment agreement will be decided by the ADR on a case-by-case basis.

Some taxpayers have faced difficulty in determining the amount of tax due to the state of Arizona from participation in the VCI. For example, many shelter participants have filed no Federal tax return, though the VCI requires an original Federal tax return to be submitted with the taxpayer’s VCI application. In such cases, the taxpayer may submit a pro-forma Federal tax return. Likewise, the IRS is seeing an increase in expedited requests by Arizona taxpayers for information regarding their Federal accounts. While the IRS understands the short deadlines under the VCI, the IRS may not be able to honor all requests by the timeline. The ADR recommends taxpayers estimate the tax deficiency they may have due in this instance. The ADR has stated that it will honor the penalty waiver on the entire amount estimated by the taxpayer who wishes to participate in the VCI program. If the taxpayer estimates a lower amount than is ultimately due to the IRS, the VCI penalty waiver will only apply to the amount the taxpayer offers as a tax deficiency. Thus, taxpayers should not estimate their liabilities too conservatively.

The Arizona VCI program comes on the heels of California’s newest Tax Amnesty program, effective February 1, 2005 through March 31, 2005, which applies to all taxpayers, not just shelter participants. The VCI is one of many state-imposed programs targeted at taxpayers who participate in abusive tax avoidance transactions.

Arizona has stated that taxpayers who are eligible to apply, but don’t, will receive “no leniency” from the ADR in a future audit. With the increased information sharing agreements between state taxing agencies and the IRS, it would seem all eligible Arizona taxpayers should promptly and seriously consider taking advantage of the VCI to avoid substantial civil and criminal penalties.

This Alert was written by G. Michelle Ferreira, Harry J. Friedman and Barbara T. Kaplan. Please contact Ms. Ferreira at (650) 328-8500, Mr. Friedman at (602) 445-8000, Ms. Kaplan at (212) 801-9200 or your Greenberg Traurig liaison if you have any questions regarding the subject matter of this Alert.

© 2005 Greenberg Traurig

Additional Information:

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

• Tax Practice Area
• Tax Attorneys