California has once again tried to create a legislative fix for tax shelters in the form of Senate Bill 86 (SB 86) which was recently passed and signed into law by Governor Jerry Brown. The carrot in the legislation is the Voluntary Compliance Initiative 2 (“VCI 2”). The VCI 2 is an opportunity for taxpayers who may have underreported their California income tax liabilities, through the use of abusive tax avoidance transactions (“ATAT”) or offshore financial arrangements, to: (i) amend their tax returns for 2010 and prior tax years; and (ii) obtain a waiver of most penalties.
The legislation defines ATATs: (i) as a tax shelter, reportable and listed transactions and a “gross misstatement,” as those transactions are defined under federal law; and (ii) any transaction for which the Franchise Tax Board has asserted the noneconomic substance penalty (“NEST”). The amount of the NEST penalty is equal to 40% of the tax generated from the underlying transaction.
It’s important to recognize the FTB’s definition of an ATAT is much broader than the IRS’s. The NEST penalty applies to any transaction that the FTB determines lacks economic substance and if the taxpayer does not have a valid nontax California business purpose for entering into the transaction. For example, certain estate planning and income tax deferral transactions have been determined to be ATATs by the State of California while the IRS does not find them to be reportable, listed or lacking in economic substance. Lastly, the NEST penalty cannot be appealed to the Board of Equalization like other California income tax and penalties.
The stick in Senate Bill 86 includes extending the statute of limitations period for the FTB to mail a notice of proposed assessment related to an ATAT from 8 years to 12 years. This will allow the FTB’s go after a taxpayer for transactions that happened over 12 years from the date the return on which the transaction should have been reported was due.
To participate in the VCI 2, a taxpayer should first consult with a tax attorney or other tax professional and then file a Participation Agreement with amended returns. A taxpayer must file an amended tax return and Participation Agreement between August 1, 2011 and October 31, 2011. The VCI 2 even applies to taxpayers that are already under FTB or IRS examination and to matters that are currently under administrative protest, appeal or in U.S. Tax Court.
Participating in VCI 2 will require a taxpayer to report underreported tax liabilities and interest but without the added cost of penalties and possible litigation. In addition, a taxpayer will be protected from criminal liability for the tax years in which the taxpayer voluntarily complies, unless a criminal complaint has already been filed or the taxpayer is already under criminal investigation.
The penalties avoided by participating in VCI 2 include:
- The 40% Noneconomic Substance Transaction penalty;
- The 20% Accuracy Related penalty;
- The 50% or 100% of the interest due on the unpaid tax penalty; and
- The 75% of the underpayment Fraud penalty.
VCI 2 is attractive to both the State of California and some taxpayers; however, it is not for everyone. Cash staved California hopes to generate revenue without spending the resources to chase down taxpayers. Taxpayers can reverse a questionable transaction without being hit with devastating penalties. If a taxpayer believes the taxpayer may have participated in a transaction that could be construed as an ATAT, then the taxpayer should consult with an experienced tax attorney in California as soon as possible to analyze the merits of participating in the VCI 2.
