The Tax Prophet - Hot Topics March, 2004 California's Voluntary Compliance Initiative, part 2 of 2.

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Part 2 of a 2-part series.

		California's Voluntary Compliance Initiative

New Failure to Disclose Penalty		The penalty for failure to disclose a reportable transaction is $15,000 for high net worth individuals and large entities. A "high net worth" individual is one whose net worth is 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. The penalties apply to tax years beginning on or after January 1, 2003; and also apply to taxpayers who invested in a transaction after February 28, 2000 and before January 1, 2004, where the transaction becomes a listed transaction at any time.
New 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.
Amended Accuracy-Related Penalty		Where a C corporation has been contacted by FTB regarding the use of a potentially abusive tax shelter, the law reduces the threshold for application of the 20% accuracy-related penalty. This penalty applies to an understatement of tax that exceeds the lesser of (1) 10% of the correct tax or (2) $5 million. This penalty cannot be added to the non-economic substance penalty or the new 20% understatement penalty, if either one has been assessed.
New Non-Economic Substance Penalty		The new law creates a 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 business purpose for entering into the transaction. The law avoids codifying the concept of economic substance. The federal courts have long held that "economic substance over form" prevails with respect to the tax consequences of transactions. Thus, transactions lacking true economic substance, apart from the tax benefits, are disregarded for tax purposes. If a transaction lacking 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, if either one has been assessed. 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 FTB.
New Eight-Year Statute of Limitations		Taxpayers must consider the new eight year statute of limitations effective for returns filed after January 1, 2000; there is a now an audit risk lasting eight years. Also taxpayers are required to include years otherwise barred by the statute of limitations, if those returns involved "an abusive tax avoidance transaction to underreport the taxpayer's tax liability for that taxable year." However, FTB is taking the position that the taxpayer can decide which years to put in their VCI and which years they elect not to include. As a practical matter, it may be difficult for FTB to audit after the normal limitations period expires, although taxpayers should be mindful that the possibility exists.
Full Cooperation		In addition to all the other "carrots and sticks" offered by VCI, taxpayers are also required to "fully cooperate" with FTB, which apparently means that a taxpayer's defense under Plan Two (retaining appeal rights) or with respect to ongoing negotiations with IRS could be jeopardized. The law is silent with respect to "when" FTB may ask questions or "what" information it may seek. There is also no indication of "who" decides upon the issue of full cooperation. Also, the statute contains no limitations period with respect to either asking questions or assessing penalties. Taxpayers need to carefully review all possible repercussions from engaging in full cooperation under VCI. FTB is the final arbiter of whether or not the taxpayer has complied with this overly vague standard; and if the agency decides a taxpayer has been less than fully cooperative, the penalty waivers could be revoked. As a consequence, a negotiating position with IRS could be undermined if a taxpayer must admit to California that he or she participated in an abusive tax transaction.
Conclusion		If it is anticipated that IRS or FTB will identify the taxpayer's transaction as a listed transaction, the taxpayer will have to weigh the following considerations: (1) assessing the possibility of prevailing on the merits of the transaction or reaching a favorable settlement with FTB and IRS; (2) conceding the position and paying the tax and interest to minimize penalties under the VCI offer; (3) assessing the risk of losing on the merits and having to pay the increased penalties; (4) assessing the risk of the new eight-year statute of limitations on abusive transactions; and (5) the risk of complying with the "full cooperation" requirements of FTB in which a taxpayer may be asked questions about the abusive transaction at any time and, apparently, for any reason. The following is a link to a comparison chart regarding the California VCI program provided by the FTB. Note: For a list of new promoter and tax preparer penalties, see California Revenue and Taxation Code зз19166, 19173 and 19177.

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