By Anthony Diosdi
Some time ago, California enacted some unique penalties for taxpayers who are considered to have participated in abusive “sham transactions” or tax shelters. One of the penalties is an interest based penalty. The other penalty is a so-called noneconomic substance transaction (“NEST”) penalty. These penalties are significant and can be combined in cases where the Franchise Tax Board (“FTB”) has determined an individual has participated in a sham tax shelter.Once these penalties are assessed, they are not easily removed or abated.
Federal and State Law Differences Regarding the Assessment of Tax Shelter Penalties
Like the Internal Revenue Service (“IRS”), the FTB has taken a tough stand against taxpayers claiming tax deductions on certain transactions classified as sham transactions. Both federal and state law imposes harsh penalties against individuals who participate in tax shelters. Although California’s tax shelter legislation was patterned after federal law, there are some notable differences. One of which is the period of time an assessment can be made by the FTB against a taxpayer. Another difference is the significant civil penalties that may be assessed by the FTB which do not have any federal counterparts.
For federal income tax purposes, the IRS generally must make an assessment within three years of the filing of a tax return. For California state income tax purposes, the FTB generally must make an assessment within four years of the filing of a tax return. A six year statute of limitations will apply for both federal and California purposes if there has been a substantial omission of income from a tax return. The statute of limitations on assessments by the IRS and FTB is unlimited if a taxpayer filed a false or fraudulent tax return with the intent to evade tax or willfully attempt to defeat a tax. Under California law only, the FTB has eight years to make an assessment against a taxpayer from the date a tax return has been filed if a taxpayer entered into an abusive tax avoidance transaction. See Revenue & Taxation Code Section 19755.
Both the IRS and FTB have numerous penalties that may be assessed against a taxpayer for failing to timely pay an income tax liability. There are two penalties found in California law which do not have any federal counterparts. These two penalties are: 1) the interest based penalty and 2) the NEST penalty.
The FTB imposes an interest based penalty if it is determined that a taxpayer has a deficiency that is the result of an abusive tax shelter. The penalty is equal to 100 percent of the interest payable from the date of a prescribed payment. The only way a taxpayer can avoid this penalty is to file amended tax returns before an assessment is made for an abusive tax shelter.
The second penalty is the NEST penalty. This imposes a 40 percent penalty (reduced to 20 percent if there was adequate disclosure on a tax return) on noneconomic substance understatements on a tax return. See Revenue & Taxation Code Section 19774. A transaction is treated as lacking economic substance if a taxpayer does not have a valid nontax business purpose for entering into a transaction resulting in a tax deduction. The penalty is imposed on such a transaction after computing the difference between the taxable income with and without the shelter benefit. It should be noted that the penalty may even apply where there is no tax liability after the reversal of any shelter benefits. For example, where tax credits or a net operating loss carryforward or carryback eliminates a tax liability, a 40 percent penalty may still be imposed.
The applicable legislation provides that “Only the Chief Counsel of the Franchise Tax Board may compromise all or any portion of that penalty.” See Revenue & Taxation Code Section 19774(d)(1).
Micro-Captive Insurance Transactions
California taxpayers who engaged in certain micro-captive insurance transactions may be subject to the interest penalty, NEST, and other penalties. Once upon a time, there was a type of insurance company known as a micro-captive insurance company. The use of micro-captive insurance companies was a very effective vehicle for transferring wealth out of an operating business so that wealth was not trapped and exposed to higher taxation by the IRS. By paying premiums to micro-captive insurance companies, wealth was effectively transferred out of the operating business and into the captive. The premiums of the policies were paid with pre-tax dollars by the business. Because micro-captive insurance companies had the benefit of being able to accrue reserves tax-free and other tax advantages available only to insurance companies, micro-captive insurance companies offered huge tax benefits. For example, Internal Revenue Code Section 831(b) permitted micro-captive insurance companies to claim up to $2.2 million tax-free per year.
Unfortunately, micro-captive insurance companies were abused by a number of tax advisors who believed they could be used primarily for tax avoidance. The IRS has begun to aggressively audit owners of captive insurance companies. Through audits, the IRS typically disallows any business deductions related to policies issued by micro-captive insurance companies. The IRS has also imputed taxable income to captive insurance company owners and has assessed significant penalties against owners of captive insurance companies. The IRS is also currently aggressively litigating captive insurance company cases in court. With that said, not all micro-captive insurance companies are used for illegal tax avoidance. The Internal Revenue Code allows for the use of micro-captive insurance companies. The problem is the taxation of micro-captive insurance companies is something that is poorly understood by many attorneys. This often results in the misuse of micro-captive insurance companies for tax evasion rather than risk minimization, the very reason captive insurance companies were established to promote.
Syndicated Conservation Easement Transaction
California taxpayers that claimed deductions in connection with a syndicated conservative easement transaction may also be subject to the 100 percent interest, NEST, and other penalties. Over the years, charitable contributions of conservation easements have allowed taxpayers to obtain a federal tax deduction for the purpose of conserving land for public use, public enjoyment, or to preserve historic building structures. For tax purposes, a conservation easement creates a discounted value for the property encumbered by the easement which generates a valuable charitable deduction.
To claim a deduction for a conservation easement, the donation of the easement has to be made to a qualified charitable organization. Treasury Regulation Section 1.170A-14(c)(1) states that the qualified organization must “have a commitment to protect the conservation purpose of the donation, and have the resources to enforce the restrictions.” The contribution must also be exclusively for conservation purposes. Conservation purposes under Internal Revenue Code Section 170(h)(4)(A) are 1) preserving land for outdoor recreational use by, or education of, the general public; 2) protecting relatively natural habitats of fish, wildlife, or plants; 3) preserving open space for scenic enjoyment of the general public or under a governmental conservation policy yielding significant public benefit; and 4) preserving a historically important land area or a certified historic structure.
For individuals, the amount of the charitable contribution deduction from the donation of a conservation easement is limited to 50 percent of the individual’s contribution base (adjusted gross income, computed without regard to any net operating loss carryback), over the amount of all allowable charitable contributions for that year (100 percent for contributions of property by qualified farmers or ranchers).
Recently, however, developers and other promoters have begun using syndicate transactions to expand the tax deductions available from easements. Some promoters and developers have aggressively promoted syndicated easements through promotional materials to would-be investors in real estate. These promoters and developers claim investors can take advantage of charitable deductions for syndicated conservation easements. Investors are offered a substantial return in the form of charitable deduction for investments into the real estate deal. Sometimes, investors are offered the opportunity to buy one of 99 lots (just under the limit for SEC registration of an investment fund) for $36,000 and promised a return charitable deduction of $158,000 from donations of the easement. In other words, investors are offered a deal in which they buy the land for $36,000 but get a charitable deduction which may save them $60,000 in federal taxes. Make no mistake about it, these types of transactions are illegal tax shelters.
California taxpayers that participated in abusive micro-captive insurance transactions and syndicated conservation easement transactions state tax benefits on an original or amended tax return may participate in the resolution covered in FTB Notice 2023-02.
Eligible taxpayers include:
1. Taxpayers currently under examination by the FTB or under examination by the IRS.
2. Taxpayers who have received a notice of proposed assessment from the FTB with respect to a micro-captive or syndicated easement transaction.
3. Taxpayer in litigation with the IRS.
4. Taxpayers who are a direct or indirect partner in a partnership that is currently under examination by the IRS or FTB or that is in litigation with the IRS.
Eligible taxpayers have from July 10, 2023 to November 17, 2023 to submit a Notice 2023-02 closing agreement to the FTB to resolve the tax treatment of an abusive micro-captive or syndicated easement transaction, to pay all tax, interest, and reduced penalties.
Participants Who Received a Notice or notices of Proposed Assessments from the FTB
For California taxpayers who received a Notice of Proposed Assessment from the FTB adjusting the tax benefits of a micro-captive or syndicated easement transaction, the participants must pay the full amount of tax shown on the notice accrued to the date of payment with the submission of a closing agreement. If the Notice of Proposed Assessment includes a NEST penalty, the FTB’s Chief Counsel will reduce the NEST penalty to zero. If the Notice of Proposed Assessment includes an interest-based penalty, the participant will be required to pay the interest-based penalty.
Participants Who Have Received a Notice of Proposed Assessment and Who Have Resolved Their Matter in a Formal IRS Settlement Initiative
For California taxpayers who have received a Notice of Proposed Assessment and who have resolved the reporting of their tax benefits in connection with micro-captive or syndicated easement transactions pursuant to participating in a formal IRS settlement initiative for taxable years for which the participants received a Notice of Proposed Assessment from the FTB, such participants must reverse the tax benefits previously claimed on the participants’ California tax returns to the same extent the tax benefits from the micro-captive or syndicated easement transaction were reversed pursuant to the formal IRS settlement initiative for the same taxable years. Such participants will be subject to the penalty resolution discussed above.
Participants Who Have been “Contacted” by the FTB or the IRS With Respect to an Examination
For California taxpayers that has been “contacted” by the FTB or the IRS, but has not received a Notice of Proposed Assessment adjusting the tax benefit claimed by a micro-captive or syndicated easement transaction, must pay any tax resulting from the reversal of the tax benefit claimed from the transaction and pay a 20 percent accuracy-related penalty and all applicable interest. However, the FTB will not assess a NEST penalty or a 100 percent interest based penalty.
Participants Who Have Not Been Contacted With Respect to a Return Claiming a Micro-Captive or Syndicated Easement Transaction
For a California taxpayer who has not been contacted by the FTB or IRS regarding a micro-captive or syndicated easement transaction, the participant must pay any taxes associated with the reversal of the tax deduction. The FTB will not assess a 20-percent accuracy-related penalty, a NEST penalty, or the 100-percent interest based penalty.
Participants Who Have Participated in a Formal IRS Settlement Initiative With Respect to the Use of a Micro-Captive or Syndicated Easement Transaction and who Have Not Received a Notice of Proposed ASsessment from the FTB with Respect to Such Transactions
If a California taxpayer has entered into a formal IRS settlement initiative regarding the use of a micro-captive or syndicated easement, the taxpayer may participate in the settlement initiative discussed in FTB Notice 2023-02. The participant must reserve the tax benefits previously claimed in connection with the micro-captive or syndicated easement to the same extent the tax benefits were revered for federal purposes under the IRS settlement initiative. The participant in this resolution will be required to pay an accuracy-related penalty at the same rate that the participant was required to pay pursuant to participating in the formal IRS settlement initiative. The participant will not be assessed a NEST or interest based penalty.
California taxpayers who want to participate in the FTB settlement procedures discussed in FTB Notice 2023-02 will need to complete and sign a Notice 2023-02 closing agreement. The closing agreement will permanently resolve all tax, penalties, and interest associated with a participant’s participation in a micro-captive or syndicated easement transaction. The participant must submit payment in full of all taxes, interest, and penalties due under the terms of the resolution. If the participant has a financial hardship, the participant may enter into a short-term installment payment arrangement.
California taxpayers that participated in abusive micro-captive or syndicated easement transactions could be subject to significant penalties by both the IRS and FTB. FTB Notice 2023-02 offers California taxpayers that participated in abusive micro-captive or syndicated easement transactions the opportunity to significantly mitigate the state of California penalties associated with these transactions. California taxpayers that participated in micro-captive or syndicated easement transactions should consult with a qualified tax attorney regarding FTB Notice 2023-02.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.