Part 1 of a 2-part series

Introduction

On the heels of the Enron, Worldcom and accounting firm tax scandals, California's FTB is poised to "score" tax revenues with little effort. On October 2, 2003, California enacted a Voluntary Compliance Initiative (VCI) patterned after the Federal VIC. Apparently, California hopes that taxpayers ensnared in the ongoing federal tax shelter crackdown will voluntarily confess their activities to California - and fatten its tax-starved coffers. .

Broad in scope and retroactive in effect, VCI applies to California taxpayers, any tax shelter organized in California and doing business in and/or receiving income from California, or where at least one investor is a California taxpayer.

The retroactive aspect of penalties for California differs markedly from federal penalty provisions. In California there are increased penalties for "reportable transactions" entered into on or after January 1, 2003, and for transactions entered into after February 28, 2000 and before January 1, 2004, that become "listed" by IRS as a tax avoidance scheme at any time.

FTB claims the VCI program has already produced more than $30 million in tax revenues. The program will probably attract taxpayers who participated in publicly branded listed transactions. However, FTB lacks experienced personnel and the financial resources to invest in untangling complex and highly-technical tax shelters; thus, threats aside, there is probably not much FTB will be doing independent of IRS to crackdown on California taxpayers.

In addition, unlike the national scope of federal tax laws, there could be territorial and other impediments to California's attempt to reach outside its borders to investigate tax shelters. Some states, notably Nevada, does not have an income tax and efforts to pursue transactions there could prove fruitless.

To qualify, taxpayers - not currently the subject of a criminal complaint or investigation in connection with an abusive tax avoidance scandal - between January 1, 2004 and April 15, 2004, must (1) disclose abusive tax avoidance transactions for taxable years before 2003; and (2) pay the tax and interest due - which could create a substantial impediment, especially if the transaction involved is not clearly abusive.

The First Plan - Waive Appeal Rights: Under VCI without appeal rights, a taxpayer is released from all penalties if he or she files an amended return and VCI application and pays the tax and interest due. Unless the taxpayer qualifies for an installment plan, taxes and interest must be paid in full. Thus, the taxpayer "gives-up" and pays the taxes and interest due, without the right to challenge the underlying nature of the tax transaction. This approach makes sense if IRS has already determined a strategy is abusive and there is not much doubt on the subject.

The Second Plan - VCI with Appeal Rights: The second plan allows a taxpayer to participate in the VCI while reserving his or her right to appeal the tax consequences. Under this alternative, all penalties are waived, except for the accuracy-related penalty which is increased to 20%-40%. Of course, taxpayers must first pay the taxes and interest owed - and then claim a refund. FTB may not bring criminal charges against any taxpayer for transactions included in the VCI. Thus, taxpayers may challenge the underlying tax transaction, but if they lose, they could owe accuracy-related penalties.

FTB has placed the burden on taxpayers to determine whether an investment or transaction meets the definition of an abusive transaction eligible for VCI. Clearly, transactions listed by IRS and California as abusive will fall within VCI, but FTB claims that if taxpayers choose to "confess their sins" as to other arrangements, it is more than happy to take their money in exchange for amnesty.

Of course, taxpayers battling IRS on a questionable tax-shelter or tax-motivated transaction may decide not to "admit" to California that the transaction was abusive. FTB claims that it will follow any federal determinations. So unless taxpayers discover a way to disclose under California law without causing a damaging admission for federal purposes, those with ongoing federal audits or investigations should probably steer clear of California's VCI.

Reliance on Tax Opinions

There is a new 20% understatement penalty that applies to tax-motivated transactions, however, the penalty will not apply if:

(1) the taxpayer discloses the transaction;

(2) there is or was substantial authority for the claimed tax treatment; and

(3) the taxpayer reasonably believed that the claimed tax treatment was more likely than not the proper treatment.

From January 1, 2003 onward, 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 (read: "huckster" or "huckster's accomplice"), 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.

Comment: Good. Abusive tax-shelter promoters and their lackeys are a scourge to the tax and accounting profession. There is little, if any intellectual honesty or integrity in what they do; they "hawk" their programs by distorting the law or ignoring it, and blatantly disregard the serious financial consequences facing their clients ("victims"), some of whom face financial ruin when the scheme is ultimately disallowed. Once in court, the track record of these high-priced scam artists is abysmal.

Taxpayers must disclose all "reportable transactions" to FTB. As defined in existing IRS regulations, reportable transactions include the typical list of suspects.

(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.

Although many reportable transactions may not be abusive, they still must be reported. Reportable transactions, other than listed transactions, must be disclosed for tax years beginning on or after January 1, 2003. Investment transactions entered into after February 28, 2000 and before January 1, 2004, that become listed at any time, must be disclosed. Thus taxpayers and their advisors need to closely monitor IRS announcements regarding newly-listed transactions.

Another type of reportable transaction involves deals shrouded in secrecy. IRS amended the definition of a "confidential transaction" for investments or arrangements entered into after December 29, 2003. A confidential transaction is now defined as a transaction offered under conditions of confidentiality for which the taxpayer has paid an advisor a "minimum fee;" and where the advisor so paid limits disclosure of the tax strategy. The conditions of confidentiality need not be legally binding. 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 for a corporation, and $50,000 for all other taxpayers.

Comment: This is another tell-tale sign of a tax-scam. These deals are confidential because the promoter does not want the victim to obtain an independent opinion regarding its validity. The concept that a tax-planning strategy is some type of confidential product or contains trade secrets is appalling. If a tax professional cannot withstand the scrutiny of his or her colleagues, they have no business practicing in the profession. Tax transactions must be disclosed on tax returns so the transaction is never confidential to IRS - the most important audience. Of course, the promoters know this and attempt to bury the transaction under a mountain of paperwork, thus the abusive tax shelter gambit is really just a game of "hide the ball."

©2004 Robert L. Sommers, attorney-at-law, all rights reserved

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