Franchise Tax Board

Frequently Asked Questions: Abusive Tax Shelters & Transactions

General Information

Fiscal Impact to California

Compliance Strategies

Audit Information

Penalties

Practices and Procedures

General Information

What is an abusive tax scheme?

Generally, an abusive tax scheme has no business purpose other than reducing taxes and is promoted with:

  • The promise of tax benefits.
  • Predictable tax losses or tax consequences.
  • No related economic loss experienced with respect to the taxpayer's income or assets.

Who invests in abusive tax schemes?

Individuals and business entities with large, constant streams of income or with substantial gains from one-time events may invest in abusive tax schemes.

Why did abusive tax schemes become so common?

Abusive tax schemes multiplied in the 1990's for various reasons:

  • Taxpayers had large capital gains or other income subject to income tax.
  • Internal Revenue Service compliance activity decreased.
  • Promoters increased the marketing of abusive tax schemes as 'legally defensible' ways to minimize tax burdens.
  • Penalties for participating in abusive tax schemes were too small to have a deterrent effect.
  • There was no efficient disclosure and reporting system for abusive tax schemes.

Fiscal Impact to California

How many tax dollars are lost in California due to abusive tax schemes?

We estimate California lost between $2.4 and $4 billion in tax revenue over the last four years.

Who really pays for the tax dollars lost due to abusive tax schemes?

To the extent that government expenses are static and investments in abusive tax schemes reduce the tax burden of one segment of the public, the real cost of abusive tax schemes is borne by taxpayers who correctly file their returns and pay their fair share of taxes.

How many cases has the Franchise Tax Board identified with abusive tax schemes and what is the associated revenue?

We have identified over 380 taxpayers investing in abusive tax schemes. We expect that number to grow as we dedicate more resources to this area. By partnering with the Internal Revenue Service, we avoid duplicating audit activity and optimize the number of taxpayers examined. We estimate the potential revenue from those 380 cases at $1 billion. Unfortunately, California will not collect the tax revenues for several years because the audits and administrative appeal process take a number of years to resolve.

Compliance Strategies

What is the Franchise Tax Board doing to address this problem?

We:

  1. Exchange information with the Internal Revenue Service related to audit activity and leads identifying abusive tax schemes.
  2. Participate in several federal/state taskforce teams.
  3. Increase our audit focus on these cases.
  4. Refer cases to FTB's Criminal Investigations if there is potential criminal activity.
  5. Work with the Legislature to create new tools to combat abusive tax schemes, to provide avenues for taxpayers to come back into compliance, and to provide clarity for taxpayers considering abusive tax avoidance investments. These tools include: a. A state voluntary compliance initiative.
    b. Stiffer penalties for participating in or marketing abusive tax avoidance transactions.
    c. An extended statute of limitations (8 years) for issuing a deficiency.
  6. Consider non-legislative remedies to combat abusive tax schemes and provide methods promoting self-compliance. These remedies include reviewing the rules and procedures associated with: a. Accuracy related penalties.
    b. Claims for refund.
    c. Following federal determinations.

  7. Follow the Internal Revenue Service compliance initiatives to the extent allowed by California law.
  8. Publicize our audit activity and our working relationship with the Internal Revenue Service.
  9. Educate both tax practitioners and taxpayers to the pitfalls of investing in abusive tax schemes.

What is the Internal Revenue Service doing to address abusive tax schemes?

The Internal Revenue Service describes their efforts to address these abusive tax schemes in depth on their websites at:
http://www.irs.gov/businesses/corporations/article/0,,id=97384,00.html
http://www.irs.gov/individuals/content/0,,id=97749,00.html

What are the Franchise Tax Board and the Internal Revenue Service doing jointly to address abusive tax schemes?

Franchise Tax Board and the Internal Revenue Service Small Business and Self-Employed Division signed a Memorandum of Understanding (MOU) on 09/16/2003. The MOU will streamline the exchange of knowledge and information between the two agencies and avoid duplication of effort. The MOU will allow us to share names of those participating in abusive tax schemes, training materials, and other related information. Benefits of the MOU include:

  1. Avoiding duplicate audits of the same taxpayer.
  2. Providing a united compliance front to taxpayers and their representatives.
  3. Enabling both agencies to identify, examine, and bring more taxpayers into compliance.
  4. Maximizing federal and state resources by working together, including the development of legal arguments and strategies.
  5. Allowing consistent treatment of taxpayers' transactions by both agencies.
  6. Sharing more information about the numerous tax schemes.
  7. Sharing leads, tax returns and other audit information early in the audit cycle rather than waiting until the examination is completed.
  8. Coordinating training, marketing efforts, and educational materials.
  9. Enhancing the Franchise Tax Board's ability to reduce the outflow of critical California revenues.

What are the Franchise Tax Board and other states doing jointly to address abusive tax schemes?

On March 4, 2004, the Franchise Tax Board and 34 other participating states ratified a Memorandum of Agreement (MOA) to share information about abusive tax schemes. Currently, 11 other states are considering participation. The MOA streamlines the exchange of knowledge and information between participating states and avoids duplication of effort. The MOA allows us to share names of those participating in abusive tax schemes, training materials, and other related information. The MOA incorporates the Federation of Tax Administrators Uniform Exchange of Information Agreement of January 1, 1993. Benefits of the MOA include:

  1. Promoting efficient use of state resources.
  2. Avoiding duplicate audits of the same taxpayer.
  3. Providing a united compliance front to taxpayers and their representatives.
  4. Enabling participating states to identify, examine, and bring more taxpayers into compliance.
  5. Maximizing state resources by working together, including the development of legal arguments and strategies.
  6. Conducting joint compliance activities to avoid duplication of efforts and to optimize the use of the states' resources.
  7. Applying consistent treatment of similar transactions.
  8. Sharing more information about specific tax schemes.
  9. Sharing leads, tax returns, and other audit information early in the audit cycle.
  10. Coordinating training, marketing efforts, and educational materials.
  11. Enhancing the Franchise Tax Board's ability to reduce the outflow of critical California revenues.

Is the Franchise Tax Board joining with Internal Revenue Service on their compliance initiatives and offering taxpayers the same benefits if they provide information or file amended returns?

We evaluate each Internal Revenue Service initiative to determine if it applies under California tax laws. We issue press releases to publicize our position and to encourage affected taxpayers to file amended federal and California returns.

Specifically, we will follow the provisions of the federal Offshore Voluntary Compliance Initiative program. California taxpayers participating in the federal program must correctly file their California amended returns by October 15, 2003 (see Press Release dated March 14, 2003). We will work with the Internal Revenue Service to exchange offshore data, subpoenas and other summons information when auditing taxpayers who chose not to participate in the federal program.

Audit Information

How does the Franchise Tax Board identify these abusive tax schemes?

We use federal and state data to identify and examine tax returns for abusive tax schemes. We also get information from informants, and Franchise Tax Board or Internal Revenue Service audit activity, that identifies other investors and abusive tax schemes.

When did the Franchise Tax Board begin identifying and auditing this new generation of abusive tax schemes?

We began identifying and auditing the new generation of abusive tax schemes in 1999.

Is the Franchise Tax Board auditing returns or waiting for the Internal Revenue Service to conduct an audit?

We audit taxpayers not under Internal Revenue Service examination. We work closely with the Internal Revenue Service to identify and develop cases that do not duplicate Internal Revenue Service audits. In addition to receiving Internal Revenue Service audit results, we share audit results with the Internal Revenue Service.

Who examines tax returns claiming abusive tax scheme losses?

Experienced audit staff examines returns claiming abusive tax scheme losses. Attorneys, tax practitioners, and promoters developed abusive tax schemes using sophisticated tax planning schemes, which intentionally abuse the tax laws’ true purpose and require intensive examinations. The Internal Revenue Service and the Franchise Tax Board also use experts including economists, financial consultants, attorneys and others to examine these abusive tax schemes.

Is the Franchise Tax Board auditing tax return preparers or promoters of abusive tax schemes?

Yes. We will pursue leads, audits and investigations of investors, tax return preparers and promoters associated with abusive tax schemes.

How long do abusive tax scheme audits take?

The length of the audit depends on the complexity of the scheme and the amount of available information. Audits may take up to two years to complete.

Penalties

Is the Franchise Tax Board assessing penalties against taxpayers on abusive tax schemes?

Yes. We assess penalties appropriate to the facts and circumstances of each case. For abusive tax schemes, we assess the accuracy related penalty unless the taxpayer shows reasonable cause existed for their position. For non-corporate taxpayers, to be excused from the accuracy related penalty, the taxpayer must have a reasonable basis for his or her reporting position or substantial authority must exist which includes a reasonable belief the tax treatment is more likely than not the proper treatment. See Treasury Regulations sections 1.6662-3 and 1.6664 and California Revenue and Taxation Code section 19164. Generally, Franchise Tax Board and Internal Revenue Service auditors have found the defenses of substantial authority or reasonable cause are not relevant. Therefore, assessment of the accuracy related penalty is frequently appropriate.

Practices and Procedures

Will the Franchise Tax Board pursue criminal investigations or civil injunctions?

Yes. We will pursue all available avenues to address abusive tax schemes.

Will the Franchise Tax Board issue subpoenas?

Yes. We will issue subpoenas as necessary to address abusive tax schemes.