It is a Tax Shelter if...
Determining whether you were involved in a transaction that fits the definition of an Abusive Tax Avoidance Transaction (ATAT) is more important now than ever, as time is running out to participate in California's Voluntary Compliance Initiative 2 (VCI 2). Taxpayers who underreported their tax liability as a result of an ATAT can avoid penalties and criminal prosecution by filing amended returns reversing their ATAT transaction and participating in VCI 2 by October 31.
We and the IRS are having great success in demonstrating that a transaction is abusive. Because of our success in identifying and litigating existing ATATs, those who create ATATs continue to create new transactions that attempt to disguise their abusive nature. It may not be immediately clear that a transaction fits into the definition of an ATAT, and taxpayers should be aware that even though they may have been told that a transaction is not "abusive," this information could be contrary to the law. The cost of not resolving the transaction could be severe. The following information may help you make your own determination.
First, consider what the law defines as an ATAT:
- Tax shelter (IRC Section 6662(d)(2)(C)).
- Listed transaction (IRC Section 6707A(c)(2)).
- Gross misstatement (IRC Section 6404(g)(2)(D)).
- Transaction subject to the noneconomic substance penalty under R&TC Section 19774.
- Reportable transaction that is not adequately disclosed (IRC Section 6707A(c)(1)).
Having an understanding of what each of these terms means will aid you in determining what transactions are considered "abusive" under the law. Below, you will find explanations of each of these terms, detailed examples of some common transactions that fall into these categories, and some questions that you can ask yourself to help determine if you have participated in an ATAT.
Tax Shelter (IRC Section 6662(d)(2)(C)) and Transaction subject to the noneconomic substance transaction penalty under R&TC Section 19774
A tax shelter includes a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, if a significant purpose of the partnership, entity plan, or arrangement is the avoidance or evasion of federal or California income or franchise tax. The tax shelter scheme often overlaps with transactions subject to the noneconomic substance transaction penalty. This is because a tax strategy set up for the primary purpose of avoiding taxes may also lack economic substance because the taxpayer may not be able to demonstrate a valid business purpose other than tax savings.
Taxpayers should also be aware of the step transaction, sham transaction, and substance over form doctrines, which may be applied to conclude a transaction is abusive when a tax strategy includes unnecessary or extra steps that create a tax savings, that otherwise, would not exist.
Examples of these types of transactions include:
- Transactions involving Trusts or Related Parties
Transactions which unreasonably defer or eliminate gain on the sale of assets through the use of a private annuity or promissory note between related parties may be considered abusive. In these cases, property sales or transfers occur between related parties, where one party is a trust and actual or effective control of the trust remains with the original property owner or a related or closely affiliated party.
Another transaction involves making the taxpayer's charitable remainder trust (CRT) a majority, nonmanaging partner in a partnership before liquidating appreciated partnership property. In the ATATs, the partnership's income or gain is allocated to the CRT, but the sale proceeds remain in the partnership where actual or effective control of the proceeds remains with the original property owner.
- Oil and Gas Partnerships
Promoters of these arrangements promise substantial tax deductions that are primarily intangible drilling costs in the initial year. A substantial amount of the tax benefit is derived from the use of promoter-financed notes or loans. In some cases, no actual drilling occurs or the promoter uses the funds to purchase previously drilled wells and the promoter financed loans are not expected to be repaid.
- Transactions involving Charities
Transactions that make a bona fide charitable organization a majority, nonmanaging, nonvoting owner of a pass-through entity (PTE) before liquidating appreciated property are abusive when the PTE's income or gain is allocated to the charity, but the sales proceeds remain in the PTE and actual or effective control of the proceeds remains with the original property owner. In the abusive situations, the proceeds are reinvested in new assets or other ventures controlled by the taxpayer or "loaned" to the taxpayer for personal use or investment.
- Abusive Horse Breeding Schemes
In these abusive schemes, taxpayers claim to breed race horses as a farming or trade or business activity. The promoter of these schemes will charge the participant inflated fees or expenses which are largely financed by promoter granted loans that will never be collected. The participants in these schemes are not actually active in breeding or raising horses.
Reportable transaction that is not adequately disclosed (IRC Section 6707A(c)(1)) and Listed Transaction (IRC Section 6707A(c)(2))
A reportable transaction is any transaction that we or IRS determines as having a potential for tax avoidance or evasion. A reportable transaction will become a listed transaction when either we or IRS specifically identifies it as a tax avoidance transaction. These transactions can be specifically identified in several publications, including Revenue Rulings, Regulations, and Notices, and can be found by searching IRS and our websites. For example, we have identified two new "listed" transactions in our 2011 Notices:
- Apportioning corporations and partnerships should be aware of FTB Notice 2011-01. This notice describes transactions between apportioning corporations and partnerships (and variations using different entities and structures) undertaken to improperly inflate the denominator of the California sales factor.
- Corporate taxpayers who artificially increase their basis in the stock of their subsidiary, without any outlay of cash or property, prior to the corporation selling the stock are involved in a transaction known as Circular Cash Flow. This transaction is described in more detail in FTB Notice 2011-04.
Gross misstatement (IRC Section 6404(g)(2)(D))
A gross misstatement includes both the omission of income of more than 25 percent of the gross income reported on a return and the substantial undervaluation of property as described in IRC Sections 6662(e) and 6662(h)(2).
So how do you know if a tax position is an ATAT?
- Is the tax loss, deduction, or credit a significant amount and used to offset income from unrelated transactions?
- Is the taxpayer's economic and out-of-pocket loss minimal compared to the tax benefits realized from the transactions?
- Does the transaction lack a business purpose other than the reduction of income taxes?
- Does the transaction lack a reasonable possibility of making a significant profit?
- Are multiple entities involved to unnecessarily complicate the transaction?
- Does the tax position ignore the true intent of relevant statutes and regulations?
- Does the transaction produce a result that is too good to be true?
If you answered yes to any of these questions, chances are you are dealing with an ATAT.
What can you do to reverse your ATAT and avoid most penalties?
Taxpayers who filed original tax returns including the ATATs described in this article or other ATATs can file amended returns reversing these transactions until October 31 and participate in VCI 2 to receive the benefits and protections VCI 2 provides. After October 31, any assessment of additional tax resulting from an ATAT may include a 40 percent Noneconomic Substance Transaction Penalty and a 50 percent or 100 percent Interest Based Penalty. With these penalties, taxpayers could pay nearly double what they would have paid under VCI 2. If you have any questions regarding VCI 2, go to ftb.ca.gov or call our hotline, 888.825.9868, 7 a.m. to 5 p.m., weekdays except state holidays.