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California Targets Abusive Tax Shelters with New Round of Audits

The California Franchise Tax Board (FTB) is continuing to crack down on abusive tax shelters with a new round of audits launched today. The FTB is mailing 150 audit contact letters to suspected tax cheats.

“California has zero tolerance for people who cheat the system through illegal tax shelters. I will do everything in my power to recover taxes legally owed but not paid,” State Controller and Chair of the Franchise Tax Board Steve Westly said at a news conference today.

The FTB estimates that California loses $600 million in tax money every year due to illegal tax shelters.

“Abusive tax shelters victimize honest citizens who pay their fair share of taxes, while the tax cheats profit,” Westly explained.

The FTB says abusive tax schemes have been on the rise since 1999. The FTB uses federal and state data to identify and examine tax returns for illegal tax schemes. The FTB also obtains information on taxpayers from informant communications, FTB audit activity that identifies other investors, and media advertisements pitching tax shelters. In cases where the FTB determines that a taxpayer did employ an illegal tax scheme, the penalties equate to 20 percent of the amount of tax unreported. Proposed legislation would increase penalties and extend the time period the FTB has to audit tax shelter cases.

Abusive tax shelters are transactions marketed with the promise of tax benefits with no correlating economic losses experienced. These transactions typically have no economic purpose other than reducing taxes, and most involve the use of multiple layers of domestic and foreign pass-through entities such as partnerships, S corporations, trusts, and limited liability companies. Another common abusive tax shelter is where money is sent to offshore banks that in turn issue debit/credit cards thereby allowing the account owners easy access to the cash here at home.

Editor's Note: See the attached list for examples of abusive tax schemes.

Examples of abusive tax shelter schemes identified:

Basis Shifting This tax scheme uses foreign corporations (in tax haven countries) and instruments to artificially increase and shift the basis of foreign shareholder stock (not subject to U.S. taxation) to stock owned by U.S. shareholders. By applying tax laws in a manner inconsistent with legislative intent, U.S. taxpayers ultimately sell their stock and report an inflated loss, despite incurring no economic loss.

Inflated Basis These schemes use transactions that are “contingent” (not completed) to inflate an owner's basis (ownership interest/true economic risk) in a pass-through entity investment. The taxpayer contributes cash or securities and a “contingent” liability or obligation to the pass-through entity. The taxpayer does not reduce his basis in the pass-through entity for the contingent liability under the contention that the liability item is “contingent” for tax purposes. Thus, the taxpayer creates an artificially inflated basis for the pass through entity interest, which is then used to deduct losses received from the pass through entity (losses are only deductible against the owner's basis in a pass-through entity).

Commercial Domicile This scheme promises taxpayers that if they incorporate in non-income taxing states, such as Nevada or Delaware, they can avoid California income taxes. This scheme requires an S corporation doing business in California to reincorporate in Nevada. Promoters of this reincorporation scheme argue that the source of the S corporation income is Nevada regardless of its business activity in California. However, a corporation doing business in California remains subject to California franchise tax, and a California resident is taxable on income from all sources, including sources in Nevada. In this situation, neither the S corporation has terminated its business activity in California, nor has the individual taxpayer terminated his or her California residency.