A CRITIQUE OF CURRENT STATE TAX SHELTER LAWS 1. by Marilyn A. Wethekam

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1 A CRITIQUE OF CURRENT STATE TAX SHELTER LAWS 1 by Marilyn A. Wethekam I. Introduction Over and over again Courts have said there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant. 2 Honorable Learned Hand Corporate business transactions may result in a reduction of federal, international and/or state income taxes. In some instances it may be the primary purpose of the transaction or merely a favorable by-product of the transaction. All business planning projects, restructuring projects and/or basic business transactions require attention to both substance and detail and should be analyzed from both a business operation and financial perspective. The tax consequences also must be considered in the analysis. In analyzing the project one must consider not only the federal tax doctrines that have been used to evaluate tax-orientated transactions but also the application of those doctrines by the state taxing authorities. In addition to analyzing a project in light of the federal tax doctrines and the various state interpretations of those doctrines, one must also take into consideration the recently enacted tax shelter regimes and amnesty programs. This 1 Marilyn Wethekam is a partner in the Chicago law firm of Horwood Marcus & Berk Chartered. She practices exclusively in the area of state tax. The author would like to thank Heather A. Wallack for her invaluable assistance in writing this article. 2 Comm r v. Newman, 159 F.2d 848, (2d Cir. 1947) (Hand, J., dissenting).

2 analysis is not only required for future projects, but due to the recent statutory and financial accounting rule changes, must also be applied to existing business transactions. The challenge is, as evidenced by several recent court decisions, that at the state tax level there is no uniform application of the federal doctrines or general tax policy with respect to what will be considered an unacceptable transaction. While the structuring of tax transactions to reduce or minimize tax liabilities is not a new concept, in the late 1990s, there was a perception that there was a substantial increase in the number of abusive tax shelters. 3 The federal government and IRS began cracking down on such transactions. In 2003, the IRS joined forces with several states to combat the perceived increase in abusive tax shelters, and memoranda of understanding between the IRS and individual states were executed. 4 Generally, the goal of this federal/state partnership was to increase the efficiency with which the federal and state governments tackled abusive tax shelter schemes, primarily through increased exchanges of information and coordination, as well as participation in joint public outreach programs. 5 3 There are a number of reasons for the recent proliferation of abusive tax shelters. Tax analysts generally believe that the increase was due in large part to the substantial stock market-related capital gains that were occurring during the late 1990s, as well as other large income gains on the corporate side. In response, there developed an increasingly sophisticated [abusive tax shelter] industry that relies on complex tax and income optimization modeling and legal and financial structures to offer tax-avoidance schemes. In addition, some factors leading to the increase in ATS activity resulted from institutional changes and other considerations associated with the tax collection agencies. These institutional factors included: (1) a decline in the rate of federal tax agency compliance and auditing activities due to budgetary limitations and a shift of resources to taxpayer services, (2) the lack of meaningful disclosure requirements, and (3) an absence of sizeable penalties on ATS promoters and investors who are caught, relative to the magnitude of tax savings achievable. California Legislative Analyst s Office, Abusive Tax Shelters: Impact of Recent California Legislation, (January 27, 2006). 4 News Release, Internal Revenue Service, IRS and States Announce Partnership to Target Abusive Tax Avoidance Transactions, IR , (Sept. 16, 2003). 5 Id. 2

3 This article will review the federal tax doctrines that have been utilized when evaluating business transactions. As these doctrines are the foundation for various states judicial challenges. The article will also address recently enacted federal tax shelter laws and regulations, and examine select state statutes that have incorporated the federal laws and regulations in whole or in part. II. Federal Tax Doctrines The federal courts have developed four basic doctrines to apply when evaluating a business transaction. For federal tax purposes, a transaction will be evaluated by applying the business purpose, step transaction, sham transaction, and/or economic substance doctrines. There remains a question as to whether there are four separate doctrines or merely the doctrines are subsets of each other. A. The Business Purpose Doctrine The business purpose doctrine originated in the United States Supreme Court decision in Gregory v. Helvering. 6 In analyzing a tax-free reorganization, the Court emphasized that, the whole undertaking, though conducted according to the terms of subdivision (B) [Revenue Act of 1928, section 112], was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else. 7 Therefore, although the transaction met the strict letter of the law the Court held that the transaction was not a tax-free corporate reorganization. In fact, the transaction had no business or corporate purpose. The Court s holding in Gregory v. Helvering has been subsequently interpreted to mean that the literal compliance with a statute is insufficient U.S. 465 (1935). 7 Id. at

4 In order to fit within a specific provision of the statute a transaction must comply with both the letter of the statutory section and also have a business purpose. When drafting the Internal Revenue Code of 1954, Congress responded to the Gregory v. Helvering 8 holding and included in a business purpose requirement a number of Internal Revenue Code (IRC) provisions. While the initial IRC provisions related to stock redemptions, dispositions of preferred stock that was received as dividends, corporate spin-offs, foreign personal holding companies and partnership income, the IRC provisions requiring business purpose have increased from those provisions found in the original 1954 IRC. Business purpose is now required for acquisitions made to evade or avoid income tax; 9 dispositions of preferred stock as dividends; 10 tax-free incorporations; 11 corporate spin-offs; 12 assumptions of liabilities in connection with taxfree incorporations or reorganizations; 13 conveyance of property to foreign corporations; 14 tax-free reorganizations; 15 and formation of partnerships. 16 Initially, the courts applied the business purpose doctrine to transactions between corporations and their sole shareholders. The application has been extended to transactions involving corporate distributions, interest deductions, sales/leasebacks transactions and forgiveness of debt. In these instances the analysis has shifted from examining the corporate form to examining the taxpayer s motives. 8 Id. 9 I.R.C. 269 (2006). 10 I.R.C. 306 (2006). It is important to note, however, that in January 2006, the IRS indicated that this category of significant book/tax differences is going to be removed from IRS Reg. Section I.R.C. 351 (2006). 12 I.R.C. 355 (2006). 13 I.R.C. 357 (2006). 14 I.R.C. 367 (2006). 15 I.R.C. 368 (2006). 16 I.R.C. 701 (2006). 4

5 The United States Supreme Court decision in Moline Properties Inc. v. Commissioner 17 remains the standard for evaluating a corporation s status as a taxable entity. The Court was asked to determine whether a corporation organized to hold real property should be taxed on the gain from the sale of the property. 18 The corporation leased the property, collected rents in its own name, defended condemnation proceedings and instituted various lawsuits. 19 Although the corporation had no books and records, maintained no bank accounts and held no other assets, 20 the Court held the corporation could not be disregarded for tax purposes. 21 In so holding the Court concluded that the doctrine of corporate entity fills a useful purpose in business life, 22 and so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity. 23 B. Step Transaction Doctrine The step transaction doctrine basically combines or collapses formally distinct and separate transactions to determine the tax treatment of a single integrated series of events. The courts have developed three tests for determining the existence of a step transaction. Those tests are the end result test, the interdependence test, and the binding commitment test. In analyzing a transaction, the courts may employ one or all of three U.S. 436 (1943). 18 Id. 19 Id. at Id. at Id. at Id. at Id. at

6 tests to determine whether each step should be treated separately or whether the completed transactions should be viewed in its entirety 24. In sum, the key to the step transaction doctrine is the notion that literal compliance with the tax statute does not secure a tax benefit. In addition, it is important to note that presence of a business purpose does not mean that a court will not apply this doctrine. For example, the United States Court of Appeals for the Tenth Circuit concluded that the existence of business purpose does not preclude the application of the step transaction doctrine. 25 C. Sham Transaction Doctrine The Honorable Learned Hand indicated that, [a] transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one chooses, to evade, taxation. Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes. 26 However, a transaction that is considered a sham will be disregarded. Generally, taxing authorities and the courts will consider two factors in determining if a transaction should be considered a sham. 27 The first factor is whether there is a demonstrated business purpose for engaging in the transaction other than tax avoidance. 28 The second factor is 24 The end result test analyzes all of the steps part of a single transaction aimed at obtaining an ultimate result. The interdependence test analyzes whether the steps are so interrelated or interdependent that each individual step would be useless unless all of the steps are completed. The binding commitment test inquires as to whether a binding commitment exists among the parties to execute all transaction steps upon the execution of the first step. 25 Associated Wholesale Grocers v. United States, 927 F.2d 1517, 1527 (10th Cir. 1991). 26 Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934). 27 Rice s Toyota World, Inc. v. Comm r of Internal Revenue, 752 F.2d 89, 91 (4th Cir. 1985). 28 Id. 6

7 whether the transaction had economic substance beyond the creation of tax benefits. 29 Courts apply these factors in different ways. Some apply this two-prong inquiry rigidly, while others treat economic substance and business purpose as more precise factors to consider in the application of [the] traditional sham analysis; that is, whether the transaction had any practical economic effects other than the creation of income tax losses. 30 The sham transaction doctrine originated in the area of sale-leaseback transactions. The United States Supreme Court in Frank Lyon Co. v. United States, 31 in reversing the Eighth Circuit, held the District Court was correct in holding that the saleleaseback transaction should be respected and should not be recast as a financing device. The Court concluded, where there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties. Expressed another way, so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes. 32 The Court in Frank Lyon Co. 33 cited seven factors used in determining the status of the subject transaction. These factors were 1) more than two parties were involved; 34 2) the buyer-lessor was primarily liable on the mortgage; 35 3) the buyer-lessor was 29 Id. 30 Sherwin-Williams Co. v. Comm r of Revenue, 778 N.E.2d 504, 516 (Mass. 2002) (quoting Sochin v. Comm r of Internal Revenue, 843 F.2d 351, 354 (9th Cir.)) U.S. 561 (1978). 32 Id. at U.S. 561 (1978). 34 Id. at Id. at

8 exposed to real and substantial risk; 36 4) the buyer-lessor s financial position was substantially affected due to the presence of long-term debt and the use of working capital; 37 5) the seller-lessee was compelled to use the sale-leaseback transaction due to regulatory constraints, namely, a non-tax business purpose existed; 38 6) the saleleaseback was a non-family, arm s length transaction; 39 and 7) the government would lose little, if any, revenue as a result of the transaction. 40 Although the sham transaction doctrine may have originated in the area of saleleasebacks, it has been given a broader application. The doctrine has been also been used when evaluating partnership transactions. 41 Recently a number of state tax administrators have cited the doctrine when challenging the viability of holding company structures. In United Parcel Service of America v. Commissioner, 42 the United States Tax Court distinguished between two types of sham transactions, namely, sham in fact and sham in substance. 43 A sham in fact is when the transaction never occurred but was merely created on paper. 44 A sham in substance is when the transaction actually occurred but lacks the substance its form represents. 45 However, the sham transaction doctrine is not solely a judicial doctrine. States are increasingly codifying and/or applying this doctrine in their efforts to combat abusive tax avoidance transactions. One example of the recent codification of the sham transaction by the states is found in understatement penalties for non-economic substance 36 Id. at Id. 38 Id. at Id. at Id. at ASA Investerings P ship v. Comm r, 201 F.3d 505, 512 (D.C. Cir. 2000) T.C.M. (CCH) 262, n29 (1999), rev d, 254 F.3d 1014 (11th Cir. 2001). 43 Id. at n Id. 45 Id. 8

9 transactions and abusive tax avoidance transactions. 46 Another example is found in addback deductions in connection with intangible property. 47 Although the codification of the sham transaction doctrine by the states may be a new concept, the application is not new. A number of statutes have allowed administrators to adjust income and apportionment factors to accurately reflect the business activities of the taxpayer in the states. 48 D. Economic Substance The economic substance doctrine is closely related to both the sham transaction doctrine and a Section analysis. Several courts have used the economic substance analysis as part of the sham transaction determination when examining substance versus form. Recently the courts have applied the doctrine in evaluating the validity of capital losses 50. In remanding United Parcel Service of America v. Commissioner, 51 the United States Court of Appeals for the Eleventh Circuit sets forth an economic substance analysis involving an evaluation of both subjective and objective economic substance. With regard to subjective economic substance, the Eleventh Circuit indicated, [a] business purpose does not mean a reason for a transaction that is free of tax considerations. Rather, a transaction has a business purpose when we are talking about a going concern like UPS, as long as it figures in a bona fide, profit-seeking business See CAL. REV. & TAX. CODE ; 35 ILCS 5/1005(b)-(c); and N.Y TAX LAW 685(p), (p-1). 47 See, for example, H.B. 1001, 114th Gen. Assem., Reg. Sess. (Ind. 2006). 48 See for example 35 ILCS 5/404, granting discretion to the Illinois Director of Revenue to adjust income, apportionment factors or credits 49 I.R.C. 482 (2006). 50 Colte Industries, In. v. U.S. Court of Appeals for the Federal Circuit, Dkt. No , July 12, 2006, and Black & Decker v. U.S. 436 F.3d 431 (2006) F.3d 1014 (11th Cir. 2001). 52 Id. at

10 Also, a transaction is not required to be free from tax considerations; it must facilitate a genuine profit-seeking business. 53 In addition, it is permissible to choose a taxpreferential form, provided the form does not undermine the business objectives. 54 Finally, there is no obligation to choose the most direct means of achieving the business objectives. 55 With regard to objective economic substance, the Eleventh Circuit in United Parcel Service of America 56 stated, [t]he kind of economic effects required to entitle a transaction to respect in taxation include the creation of genuine obligations enforceable by an unrelated party. 57 The court also indicated that there is need for a genuine transaction to be enforceable by a third party. Application of the economic substance doctrine requires consideration of factors other than motive. Specifically, in determining whether the taxpayer s transaction constituted a sham, the courts consider both the objective substance of the transaction and the subjective business motivation behind it. 58 Furthermore, the economic substance and business purpose aspects of the inquiry are not discrete prongs in a two-step analysis, but instead are related factors that are both used to determine if the transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes Id. at Id. 55 Id F.3d 1014 (11th Cir. 2001). 57 Id. at See, e.g., ACM P ship v. Comm r, 157 F. 3d 231, 247 (3rd Cir. 1998). 59 Id. 10

11 III. Federal Tax Shelter Regulations A. Overview of Federal Scheme The 1970s and the early 1980s were the heyday of the individual tax shelter industry. 60 The IRS responded in 1986 by passing laws to deal with the industry. The result was a shift in the industry from a focus on the individual taxpayer to the corporate taxpayer. Although the IRS was initially successful in some of its litigation to combat corporate tax shelters, it soon became apparent that those cases were only the tip of the iceberg, and many additional abusive tax shelters that were concealed likely existed. 61 The Federal laws of the 1980s tended to focus heavily on penalties concerning the taxpayers participating in abusive tax shelters, rather than the promoters of the shelters. It was not until 1984 that Congress began to seriously monitor tax shelters by enacting Section 6111, 62 which requires tax shelter organizers to register the shelters with the Secretary of Treasury. Also in 1984, Congress enacted Section 6112, 63 which required that organizers and sellers of potentially abusive tax shelters keep lists of those investors to whom they sold tax shelters, as well as related information. Such lists are also referred to as investor lists. There was a substantial increase in the use of corporate tax shelters during the late 1980s and into the 1990s. This prompted the IRS to issue a series of temporary and proposed regulations addressing tax shelters. 64 Three sets of temporary and proposed regulations were issued that sought compliance from taxpayers that participated in 60 Sheldon D. Pollack and Jay A. Soled, Tax Professionals Behaving Badly, 105 TAX NOTES 201 (October 11, 2004). 61 Id. 62 I.R.C (200 ). 63 I.R.C (200 ) I.R.B , 767; I.R.B

12 abusive tax transactions and promoters of such transactions. 65 The first set of regulations 66 involved IRC Section 6111(d) and required promoters to register confidential corporate tax shelters with the IRS. 67 The second set of regulations 68 involved IRC Section 6112 and required promoters to maintain lists of investors and copies of all offering materials and to make this information available for inspection by the [IRS] upon request. 69 The third set of regulations 70 involved IRC Section 6011 and required corporate taxpayers to report or disclose their participation in reportable transactions. 71 Although amended a number of times, the regulations were finalized on February 28, The final regulations list six categories of reportable transactions and generally apply to transactions entered into on or after the effective date of the final regulations, February 28, It is important to note that a reportable transaction does not automatically mean that it is an illegal tax shelter. The six categories of reportable transactions include the following: (1) listed transactions; (2) confidential transactions; (3) transactions with contractual protection; (4) Section loss transactions; (5) transactions with a significant book-tax difference, for example, exceeding $10 million 65 Id. 66 Temp. Treas. Reg T (2000); Prop. Treas. Reg , 65 Fed. Reg (Mar. 2, 2000). 67 T.D. 8876, IR.B. 753; REG , IR.B Temp. Treas. Reg T (2000); Prop. Treas. Reg , 65 Fed. Reg (Mar. 2, 2000). 69 T.D. 8875, I.R.B. 761; REG , I.R.B Temp. Treas. Reg T (2000); Prop. Treas. Reg , 65 Fed. Reg (Mar. 2, 2000). 71 T.D. 8877, I.R.B. 747; REG , I.R.B Fed. Reg (Mar. 4, 2003); T.D. 9046, I.R.B Treas. Reg (b) (2006). 74 I.R.C. 165 (200_). 12

13 on a gross basis; and (6) transactions involving a brief asset holding period that generate a tax credit in excess of $250, With regard to listed transactions, a listed transaction is one that is the same or substantially the same as any transaction that has been identified by the IRS as a tax avoidance transaction in published guidance. 76 With regard to confidential transactions, a confidential transaction is any transaction in which the taxpayer s disclosure of the tax treatment or the structure is limited in any manner by an express or implied understanding or agreement. 77 This relates to the advisor s requirement of confidentiality. 78 This category is not affected by the existence of attorney-client privilege. 79 With regard to transactions with contractual protection, the issue is whether the taxpayer has the right to a refund of all or a part of the fees if the intended tax treatment of the transaction is not upheld and/or whether the fees are contingent on the realization of tax savings or benefits from the transaction. 80 With regard to loss transactions, the transaction is expected to result in a gross loss under Section that equals or exceeds the threshold amounts. 82 For corporations the threshold is $10 million in a single year or $20 million in multiple years. 83 With regard to significant book/tax differences, generally, a transaction will have a significant book to tax difference if the tax treatment differs from Generally Accepted 75 Treas. Reg (b) (2006). 76 Treas. Reg (b)(2) (2006). 77 Treas. Reg (b)(3) (2006). 78 Treas. Reg (b)(3) (2006). 79 Treas. Reg (b)(3) (2006). 80 Treas. Reg (b)(4) (2006). 81 I.R.C. 165 (200_). 82 Treas. Reg (b)(5) (2006). 83 Some transactions that are excluded from this category. See Rev. Proc , I.R.B

14 Accounting Principles (GAAP) by more than $10 million. 84 There are thirty categories of transactions in which the book/tax differences will not be taken into consideration when determining if a transaction is a reportable transaction. 85 With regard to a brief assetholding period, this includes a transaction involving an asset that is held for 45 days or less and generates a tax credit in excess of $250, This category includes foreign tax credits as well. 87 The final regulations impose certain record retention requirements. 88 All documents and other records related to a disclosed transaction must be maintained until the expiration of the statute of limitations for the final taxable year for which disclosure is required. 89 Included are any documents that describe the business purpose of the transaction. 90 In 2004, the American Jobs and Creation Act of made further changes to federal law in connection with abusive tax avoidance transactions. The 2004 Act primarily added penalties to the law for failures to file as required under Treas. Reg The law became effective for returns fled after October 22, 2004, the effective date of the Act. 92 These 2004 changes will be discussed as applicable. B. Issues Concerning Taxpayers: The Disclosure Requirement and Related Penalties 84 Treas. Reg (b)(6) (2006). 85 Rev. Proc , I.R.B Treas. Reg (b)(7) (2006). 87 Treas. Reg (b)(7) (2006). 88 Treas. Reg (g) (2006). 89 Id. 90 Id. 91 Pub. L. No , 118 Stat (2004). 92 Pub. L. No , 118 Stat (2004). 14

15 A taxpayer must disclose on its tax return for each year it participated in a reportable transaction. 93 In addition, the disclosure for the first year must also be filed with the Office of Tax Shelter Analysis. 94 Furthermore, if an undisclosed transaction becomes a listed transaction after the filing of the return and the statute is not closed, the disclosure must be filed on the first return filed after the listing of the transaction. 95 This filing must be made even if the transaction does not affect that return. 96 The American Jobs and Creation Act of added a penalty provision to federal tax law under IRC Section 6707A for the failure to include reportable transaction information on a return. 98 The penalty is $10,000 for individuals, and $50,000 for all other taxpayers, such as corporations. 99 In the event a failure to disclose involves a listed transaction, the penalty increases to $100,000 for individuals, and $200,000 for all other taxpayers. 100 The Commissioner has the authority to rescind the penalty if the transaction does not involve a listed transaction. 101 There is no appeal, however, from the refusal to rescind the penalty. 102 In addition, in certain circumstances, taxpayers may have to make related disclosures to the Securities and Exchange Commission, and failure to do so results in the penalty for the failure to disclose listed transactions. 103 IRC Section 6707A 93 Treas. Reg (2006). Form 8886 is the disclosure form 94 Treas. Reg (d) (2006). 95 Treas. Reg (e)(2)(i) (2006). 96 Treas. Reg (2006). 97 Pub. L. No , 118 Stat (2004). 98 I.R.C. 6707A (2006). 99 I.R.C. 6707A(b)(1) (2006). 100 I.R.C. 6707A(b)(2) (2006). 101 I.R.C. 6707A(d) (2006). 102 I.R.C. 6707A(d)(2) (2006). 103 I.R.C. 6707A(e) (2006). 15

16 applies to returns and statements that are due after October 22, The IRS issued interim guidance concerning Section 6707A on February 14, Related regulations are pending. C. Accuracy-Related Penalties Another related and notable section of the IRC is Section 6662, which involves an accuracy-related penalty concerning the underpayment of tax. 106 For purposes of this Section, a tax shelter is defined as the following: (I) a partnership or other entity, (II) any investment plan or arrangement, or (III) any other plan or arrangement, if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax. 107 Section 6662 imposes a penalty when an underpayment is attributed to any of the following: (1) [n]egligence or disregard of rules or regulations; (2) [a]ny substantial understatement of income tax; (3) [a]ny substantial valuation misstatement under chapter 1; (4) [a]ny substantial overstatement of pension liabilities; understatement. 108 [and] (5) [a]ny substantial estate or gift tax valuation The IRC defines substantial understatement for the purposes of this Section. 109 The penalty amount under Section 6662 is twenty percent of the underpayment, 110 and the penalty increases to forty percent if a gross valuation misstatement is involved. 111 The Section 6662 penalty will not apply, however, if the taxpayer had reasonable cause 104 [IRB ]. 105 I.R.S. Notice , I.R.B I.R.C (200_). Section 6664(a) of the Code provides a definition of underpayment. I.R.C. 6664(a) (200 ). 107 I.R.C. 6662(d)(2)(C)(iii) (200_). 108 I.R.C. 6662(b) (200_). 109 I.R.C. 6662(d)(1) (200_). 110 I.R.C. 6662(a) (200_). 111 I.R.C. 6662(h) (200_). 16

17 and acted in good faith with regard to the underpayment. 112 Nor will the Section 6662 penalty apply to any portion of an underpayment where a penalty is imposed for fraud under Section The American Jobs Creation Act of added additional accuracy-related penalty provisions to federal tax law for understatements in connection with reportable transactions. 115 In general, there is now a twenty percent penalty for any accuracy-related reportable transaction understatement. 116 The penalty increases to thirty percent if the tax treatment was not adequately disclosed. 117 Similar to Section 6662, a reasonable cause exception was added and is available for reportable transaction underpayments, although the exception is stricter with regard to reportable transaction understatements than underpayments. 118 The IRS issued interim guidance concerning Section 6662A on February 14, D. Issues Concerning Material Advisors, Organizers and Promoters: Registration Requirements, List Requirements, and Related Penalties The IRC provides various penalties related to promoters of tax shelters. Section 6700 penalizes those who promote or organize abusive tax shelters. 120 Section 6701 penalizes those who knowingly aid and abet in the understatement of tax liability. 121 Those individuals that provide advice with respect to tax shelters are also subject to reporting requirements and penalties. 112 I.R.C. 6664(c) (200_). 113 I.R.C. 6664(b) (200_). 114 Pub. L. No , 118 Stat (2004). 115 I.R.C. 6662A (2006). 116 I.R.C. 6662A(b) (2006). 117 I.R.C. 6662A(c) (2006). 118 I.R.C. 6664(d) (2006). 119 I.R.S. Notice , I.R.B I.R.C (200_). 121 I.R.C (200_). 17

18 The federal law defines a material advisor as any person who provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction, and who directly or indirectly derives gross income in excess of the threshold amount for such aid, assistance, or advice. 122 The threshold amount is $50,000 for a reportable transaction when the taxpayer is a person, and is $250,000 for all other cases. 123 Material advisors are required to disclose reportable transactions. 124 Form 8264 is the Application for Registration of a Tax Shelter. There are penalties found at IRC Section 6707 for the material advisors who fail to meet these requirements. 125 Also, generally, material advisors must maintain, and provide to the IRS if required, lists of those parties to whom they acted as advisor. 126 Penalties will be imposed for the failure to meet these requirements. 127 IV. State Legislative Approaches to Tax Shelters The states in the last three to four years have begun to address the issue of tax shelters and perceived abusive transactions. It is notable, however, that while some states have acted, a number of states have chosen to take no action thereby electing a wait and see approach. The approach taken by the states to address the issue has taken several forms. A number of states have enacted legislation that focuses on specific types of transactions, such as holding companies, inter-company financing arrangements, or intercompany royalty arrangements. This approach has resulted in legislation or regulations 122 I.R.C. 6111(b)(1)(A) (2006). 123 I.R.C. 6111(b)(1)(B) (2006). 124 I.R.C. 6111(a) (2006). 125 I.R.C (2006). 126 I.R.C. 6112(a) (2006). 127 I.R.C (2006). 18

19 that requires the add-back of deductions in connection with royalties and other intangible expenses ex. interest expenses, that are paid to related parties. This approach deviates from the concept of listed and reportable transactions. A second legislative approach adopts the broader federal concept of a tax shelter. 128 A third approach is to target specific transactions that lack either economic substance or a substantive business purpose. 129 A fourth approach has been the enactment of general amnesty programs designed to bring the non-compliant taxpayer into compliance using the carrot and stick method. 130 In addition to the various statutory approaches, there is further disparity among the states with regard to the details of these approaches. For example, some states, such as California, Illinois, New York, Minnesota, West Virginia, and Utah 131, have disclosure, registration, and investor list maintenance requirements. Other states, such as Connecticut and Massachusetts, only provide penalties for failures to disclose at the federal level. In addition, some states require, such as California and Utah, or enable the state to require, such as New York, the disclosure of state listed and reportable transactions, in addition to the federal transactions. Other states, such as Illinois and Minnesota, are restricted to only federal listed and reportable transactions. This disparity in approach is also reflected in the application of amnesties generally known in the tax shelter context as voluntary compliance initiatives. Some states included voluntary compliance initiatives as part of new legislation concerning tax 128 For example, California and Illinois have used this approach. 129 For example, Massachusetts and Ohio have used this approach that, [Massachusetts and Ohio] have attempted to change the legal standards used to differentiate legitimate tax planning and impermissible tax avoidance. Id. at v. 130 For example, North Carolina used this approach. In addition, California and Illinois recently administered such amnesty programs. 131 The Utah tax shelter law is not effective until January 1, Utah S.B. 139, enacting Utah Code Ann , et. seq. 19

20 shelters, such as California and Illinois. Other states utilized voluntary compliance initiatives as the sole means to address abusive tax transactions, such as North Carolina. A number of states developed their own versions of voluntary disclosure (rather than compliance) initiatives to combat abusive tax transactions, ex. Arizona, Connecticut, and New Jersey, and South Carolina. Finally, some states have adopted programs with altogether different characteristics, such as Massachusetts and Ohio. Constitutional concerns exist with respect to some of these approaches. The third approach, targeting transactions that lack either economic substance or a substantive business purpose, raises issues since as noted at the federal level there is a lack of a specific definition for either concept. This lack of a definition will inject uncertainty into the analysis. There is a question as to whether with this uncertainty the goal of eliminating abusive transactions can be achieved. The fourth approach, which utilizes amnesties, often raises due process concerns. 132 More importantly there is a valid argument that amnesties benefit non-compliant parties, as opposed to the law-abiding taxpayers. An indirect result of these amnesty programs is the re-evaluation of transactions by all taxpayers due to threat of enhanced penalties. There has been speculation with respect to the reason for the rise in the use of tax shelters at the corporate level. While there may be a number of causes, the state legislation in most instances is structured to tackle the following: 1. minimal audit coverage; 2. the lack of penalties to deter taxpayers from engaging in inappropriate tax shelters; 3) overly aggressive tax and financial advisors; and 4) inconsistent court decisions. The states with the earliest abusive tax shelter laws, California and Illinois 132 Paul H. Frankel & Amy F. Nogid, Hammers Disguised as Amnesties: States Take a Wrong Turn, (August 2005). 20

21 laws appear to address the aforementioned causes one, two and three, and the Massachusetts and Ohio laws appear to address the aforementioned cause four. There is also an inherent challenge in defining the term tax shelter, some states, have not attempted to define the term e.g. California and Illinois. Rather these states have adopted the federal tax scheme that has identified characteristics that indicate a transaction has the potential to be a tax shelter. Another consideration for state legislatures in drafting and implementing this type of legislation should be the administrative costs to the taxpayers for compliance with the new statutory requirement. The reality is that multistate corporate taxpayers must comply with the laws of several jurisdictions. The states should keep in mind that if the laws are clear,and uniform the compliance is then not unduly burdensome. While the states undertake various approaches with regard to perceived abusive tax shelters, taxpayers should remember certain realities. Taxpayers should keep in mind that proper tax planning is still valid. However, as new legislative and policy regimes are being administered by the various states, taxpayers must consider the hazards of litigation and penalty assessments when evaluating their options. The Multistate Tax Commission (MTC) 133 has also undertaken a project to address the tax shelter issues. In connection with corporate tax sheltering, the MTC recently decided to propose three uniform statutes. 134 The proposals include (1) a model addback statute intended to restrict corporate tax sheltering based on royalty and interest 133 The MTC is an agency consisting of tax administrators of member states. It was established to improve the fairness, efficiency and effectiveness of state tax systems as they apply to interstate and international commerce, and preserve state tax sovereignty. The MTC analyzes state tax issues and recommends uniform tax laws and regulations to the states, which apply to multistate and multinational enterprises. Id. According to the MTC, [g]reater uniformity in multistate taxation helps ensure that interstate commerce is neither undertaxed nor overtaxed and helps reduce the potential for Congress to preempt or unduly limit state taxing authority. Id. 134 Karen Setze, MTC to Survey States on Proposed Corporate Tax Statutes, 2006 STT

22 payments to intangible holding companies; 2) a model statute on reportable transactions and inconsistent filing positions that includes a mandate for taxpayers to create a 51-state spreadsheet providing tax data for some issues regarding tax positions taken in each state and the District of Columbia; and 3) a companion statute on voluntary compliance programs for tax avoidance transactions. 135 This first proposed MTC uniform statute was generally modeled after Massachusetts law. There is some concern that it is simply too late for such a statute. Administrative concerns exist with regard to second proposed statute. The third MTC statute concerning voluntary compliance is modeled after the 2004 California law. A. California California was the first state to adopt tax shelter legislation. The California legislature enacted Assembly Bill 1601 and Senate Bill 614 on October 3, These bills amended California tax law to adopt a modified version of the federal tax shelter rules and impose stiff penalties for any abusive tax avoidance transactions. This legislation also provided for a limited amnesty. Furthermore, in 2005, the legislature enacted Assembly Bill in order to comply with the changes to federal law concerning tax shelters resulting from the American Jobs Creation Act of The 2005 laws generally target the tax shelter promoters, or material advisors, rather than the investors. 135 Id. The drafted versions of the statues are available at AB 1601, Session (Cal. 2003); SB 614, Session (Cal. 2003). 137 AB 115, Session (Cal. 2005). 138 Pub. L. No , 118 Stat (2004). 22

23 Section was added to the California Revenue and Taxation Code as a result of Senate Bill 614, and it conforms California tax law to IRC Section 6011 and the underlying regulations requiring the disclosure of reportable transactions. Reportable transactions include those identified by the IRS and those determined by the California Franchise Tax Board (FTB) 140 as having potential for tax avoidance or evasion including deductions, basis, credits, entity classification, dividend elimination, or omission of income. 141 In addition, the FTB is required to publish listed transactions. 142 The FTB has issued one pronouncement to date. 143 This pronouncement adds certain Real Estate Investment Trust transactions and Regulated Investment Company transactions as types of listed transactions. 144 Investors disclose the investment to the FTB by submitting federal Form 8886 with the California return. 145 Another section of California tax law, namely Section 19164(b), allows the FTB to issue a list of positions for which it believes there is no substantial authority for the position or the tax treatment is more likely than not the proper tax treatment. 146 A benefit to this approach is that California can target specific perceived abusive state tax shelter transactions. Section was amended in the California Revenue and Taxation Code in 2003 and 2005, and it conforms California tax law to the federal tax shelter registration requirements found in IRC Section 6111 with a few California modifications. These 139 CAL. REV. & TAX CODE (2006). 140 The FTB is one of the two primary California administrative agencies that oversee state taxes. The other agency is the California State Board of Equalization. The FTB administers the personal income tax and the corporation tax. 141 CAL. REV. & TAX CODE 18407(a)(3) (2006). 142 CAL. REV. & TAX CODE 18407(a)(4)(A) (2006). 143 Chief Counsel Announcement (December 31, 2003). 144 Id. 145 CAL. REV. & TAX CODE (2006). 146 CAL. REV. & TAX CODE 19164(b) (2006). 147 CAL. REV. & TAX CODE (2006). 23

24 modifications include the fact that additional information may be required by a FTB Notice. 148 In addition, Section sets forth specific registration requirements in connection with material advisors who have connection to a reportable transaction that was organized in California or derived business from California: Section contains additional provisions that address the timing of registering a tax shelter. There are specific registration requirements for transactions that become California-only listed transactions if the transaction was entered into on or after September 2, 2003, registration is required by the later of 60 days after entering into the transaction, 60 days after the transaction becomes a listed transaction, or 60 days after October 7, Section was added to the California Revenue and Taxation Code in 2003 and amended in 2005, and it conforms California tax law to IRC Section 6112 requiring organizers and material advisors of potentially abusive tax shelters to maintain and provide lists. A material advisor must provide the list to the FTB within 20 days of a request. 151 For a transaction that is entered into after February 28, 2000, that becomes a listed transaction at the federal level the material advisor must provide the list to the FTB no later than 60 days after entering into the transaction, 60 days after the transaction becomes a listed transaction, or April 30, For a transaction that is entered into after on or after September 2, 2003, that becomes a listed transaction at the California level the material advisor must provide the list to the FTB no later than 60 days after 148 See FTB Notice (January 30, 2004) for the additional requirements. 149 CAL. REV. & TAX CODE 18628(f) (2006). 150 CAL. REV. & TAX CODE (2006). 151 CAL. REV. & TAX CODE (2006). 152 CAL. REV. & TAX CODE 18648(d)(3) (2006). 24

25 entering into the transaction, 60 days after the transaction becomes a listed transaction, or April 30, The California penalty provisions concerning material advisors are generally found in Sections and In general, the provisions mirror the related federal provisions, specifically, IRC Section 6708 regarding failure to maintain lists in connection with reportable transactions and make such lists available, and IRC Section 6707 regarding failure to register a tax shelter and failure to file an information return in connection with reportable transactions, respectively. 155 Also, under Section 19173, California law provides a separate penalty for a failure to file an investor list with the FTB in connection with listed transactions. 156 Several new penalty provisions concerning taxpayers were added to California tax law in 2003 as a result of Senate Bill 614. Specifically, Section was amended and Section was added to California tax law to impose a number of new penalties. 157 In general, the accuracy-related penalty was modified 158 and a new reportable transaction understatement penalty was added in lieu of the accuracy penalty. 159 However, this new reportable transaction understatement penalty was subsequently repealed. 160 The rates and defenses vary under these provisions depending on the category of the transaction CAL. REV. & TAX CODE 18648(d)(4) (2006). 154 CAL. REV. & TAX CODE 19173, (2006). 155 I.R.C. 6707, 6708 (2006). 156 CAL. REV. & TAX CODE 19173(d) (2006). 157 CAL. REV. & TAX CODE 19164, (2006). 158 CAL. REV. & TAX CODE (2006). 159 CAL. REV. & TAX CODE (2006). 160 According to FTB Notice (January 11, 2006), pursuant to section 15, subdivision (b), of SB 614 (Stats. 2003, ch. 656) and AB 1601 (Stats. 2003, ch. 654), RTC section was operative for taxable years beginning on or after January 1, AB 115 (Stats. 2005, ch. 691, 50.3 and 50.4) repealed RTC section for taxable years beginning on or after January 1, CAL. REV. & TAX CODE 19164, (2006). 25

26 A reportable transaction accuracy-related penalty, specifically, Section , was added to California tax law in The law mirrors the new federal penalties under IRC Section 6662A. The penalty will not include amounts subject to the penalty of Section 19774, namely, the non-economic substance penalty. 163 Also, only the Chief Counsel can waive the penalty, and any such decision is not reviewable or appealable. 164 For taxpayers that have been contacted by the FTB regarding the use of a potentially abusive tax shelter, the definition of substantial understatement has been modified. A substantial understatement will occur if the understatement of the tax exceeds the lesser of ten percent of the tax required to be shown on the return or $5,000,000 if the tax on the return is more than $2, Section extends the statute of limitations to eight years for taxpayers who invest in an abusive tax avoidance transaction. 166 This section applies to any tax return filed on or after January 1, Section imposes a taxpayer penalty for the failure to disclose a reportable transaction, and is analogous to IRC Section 6707A. The penalty under California law is $15,000 and increases to $30,000 if the transaction is a listed transaction. 168 Under prior law, this penalty applied to large entities, such as those with gross receipts in excess of $10 million and high net worth individuals, specifically, net worth in excess of $2 million. 169 This Section was amended in 2005 to apply to taxpayers with taxable income exceeding $200, These penalties cannot be waived if related to a listed 162 AB 115, Session (Cal. 2005). 163 CAL. REV. & TAX CODE (b)(1) (2006). 164 CAL. REV. & TAX CODE (d) (2006). 165 CAL. REV. & TAX CODE 19164(a)(C)(3) (2006). 166 CAL. REV. & TAX CODE 19755(a) (2006). 167 CAL. REV. & TAX CODE 19755(b) (2006). 168 CAL. REV. & TAX CODE 19772(b) (2003), (amended 2005). 169 CAL. REV. & TAX CODE 19772(d) (2003), (amended 2005). 170 CAL. REV. & TAX CODE 19772(d) (2003), (amended 2005). 26

27 transaction. 171 There are specific provisions for rescinding a penalty related to a reportable transaction, and only the Chief Counsel may rescind the penalty. 172 Section creates a new interest penalty for taxpayers contacted by the FTB. 173 Any underpayment of tax due to a potentially abusive tax shelter will incur a penalty equal to one hundred percent of the accrued interest on the underpayment. 174 A potentially abusive shelter is defined as any transaction required to be registered under federal law and is reportable under either the federal or state law. 175 This penalty is in addition to any other penalties that may be assessed. 176 Section increases the interest rate by fifty percent for taxpayers that have not been contacted by either the FTB or the IRS for the use of a reportable transaction. 177 The higher rate applies to any amended return filed after April 15, 2004, and for taxable years beginning after December 31, Another provision, Section removes all tax shelters from the confidentiality provisions of the California tax code. 179 A non-economic substance penalty was also added to California tax law. 180 Section imposes a penalty for an understatement attributable to any transaction that lacks economic substance. 181 This penalty, unlike several of the other penalties that are limited to listed or reportable transactions, applies to any transaction that lacks 171 CAL. REV. & TAX CODE 19772(f) (2003), (amended 2005). 172 CAL. REV. & TAX CODE 19772(f) (2003), (amended 2005). 173 CAL. REV. & TAX CODE (2006). 174 CAL. REV. & TAX CODE 19777(a) (2006). 175 CAL. REV. & TAX CODE 19777(a) (2006). 176 CAL. REV. & TAX CODE 19777(b) (2006). 177 CAL. REV. & TAX CODE (2006). 178 Id. 179 CAL. REV. & TAX CODE 21028(b) (2006). 180 Kathleen K. Wright, California Tax Shelters This Time It s Federal Conformity, 2006 STT Wright noted that, [f]ederal law did not enact a separate penalty for transactions that might lack economic substance. That provision was left on the cutting room floor and was not included in the final version of the [American Jobs Creation Act of 2004]. Id. 181 CAL. REV. & TAX CODE (2006). 27