Abusive Tax Shelters Debbie Langsea California Franchise Tax Board October 28, 2004

National Abusive Tax Shelter Problem FEDERAL: up to $85 billion loss over last decade (GAO estimate) FEDERAL: up to $85 billion loss over last decade (GAO estimate) ALL STATES: up to $12 billion corporate loss in 2001 (MTC estimate) ALL STATES: up to $12 billion corporate loss in 2001 (MTC estimate) CALIFORNIA: $600 million to $1 billion loss annually (FTB estimate) CALIFORNIA: $600 million to $1 billion loss annually (FTB estimate)

California General Fund Revenues (Amount in billions)

Capital Gains and Options Income ($ Billions)

Definition – Abusive Tax Shelter promoted with the promise of tax benefits promoted with the promise of tax benefits predictable tax losses or consequences predictable tax losses or consequences no true or correlating economic loss of income or assets no true or correlating economic loss of income or assets follows literal reading of the tax statute, but applies the meaning inconsistent with the purpose or intent of the tax statute follows literal reading of the tax statute, but applies the meaning inconsistent with the purpose or intent of the tax statute

Characteristics – Abusive Tax Shelters Separation of income and expenses Separation of income and expenses Use of pass-through entities Use of pass-through entities Use of third-party accommodators Use of third-party accommodators Offshore foreign account or accommodator Offshore foreign account or accommodator Double benefit for the same tax loss Double benefit for the same tax loss Conducted over a short period of time Conducted over a short period of time

California Abusive Tax Shelter Compliance Program Voluntary Compliance Voluntary Compliance Detection Detection Enforcement Enforcement

Voluntary Compliance Educational Efforts: U.S. Senate Hearings, Press Conferences, Press Releases, Newspapers, Symposiums, Tax News, and Presentations U.S. Senate Hearings, Press Conferences, Press Releases, Newspapers, Symposiums, Tax News, and Presentations Internet ( VCI address and telephone number Internet ( VCI address and telephone number 32,000 Letters: Taxpayers, Preparers, Promoters, and Accounting/Law Firm Employees 32,000 Letters: Taxpayers, Preparers, Promoters, and Accounting/Law Firm Employees 40,000 Brochures, Quick References 40,000 Brochures, Quick References

Voluntary Compliance Initiative California’s 106-Day VCI Program: $1.4 Billion Additional Tax Revenues $1.4 Billion Additional Tax Revenues 1,200 Taxpayers 1,200 Taxpayers 2,100 Tax Years 2,100 Tax Years

VCI by Taxpayers

VCI by Revenue

VCI by Tax Years

VCI by States Amounts = $0 Amounts < $1 Million Amounts > $1 Million Amounts > $1 Billion

Detection – Information Sharing IRS ATAT Memorandum of Understanding (Sept. 2003) IRS ATAT Memorandum of Understanding (Sept. 2003) States ATAT Memorandum of Agreement (Feb. 2004) States ATAT Memorandum of Agreement (Feb. 2004)

Detection – Reportable Transactions 6 Reportable Transaction Categories: Listed Transactions Listed Transactions Confidential Transactions Confidential Transactions Transactions with Contractual Protections (contingency fees) Transactions with Contractual Protections (contingency fees) Loss Transactions Loss Transactions Transactions with Significant Book-Tax Differences Transactions with Significant Book-Tax Differences Transactions with Brief Asset Holding Period Transactions with Brief Asset Holding Period

Detection - Taxpayers INVESTORS NEW Registration and Reporting Requirements: Disclose Reportable Transactions Disclose Reportable Transactions Disclose Listed Transactions from 2/28/00 Disclose Listed Transactions from 2/28/00

Detection - Promoters PROMOTERS NEW Registration and Reporting Requirements: Register Tax Shelters or Listed Transactions (from 2/28/00) Register Tax Shelters or Listed Transactions (from 2/28/00) Provide List of Investors for Reportable Transactions or L isted Transactions (from 2/28/00) Provide List of Investors for Reportable Transactions or L isted Transactions (from 2/28/00)

Enforcement Conduct investor and promoter audits Conduct investor and promoter audits Establish Abusive Tax Shelter Unit Establish Abusive Tax Shelter Unit Pursue leads, investors lists, registrations, and other informational sources Pursue leads, investors lists, registrations, and other informational sources Issue subpoenas Issue subpoenas Focus on promoters, firms, financial intermediaries, and insurance companies Focus on promoters, firms, financial intermediaries, and insurance companies Assess abusive tax shelter penalties Assess abusive tax shelter penalties Evaluate for criminal prosecution Evaluate for criminal prosecution

Enforcement - Taxpayers Investor Penalty Amount Noneconomic Substance 20%-40% Reportable Transaction 20%-30% Interest Based 100% interest Failure to Disclose Transaction $15,000-$30,000 Accuracy Related 20%

Enforcement - Promoters Promoter Penalty Amount Failure to Register Reportable $15,000 Failure to Register Listed Transaction $100,000 or 50%-75% gross income Failure to Maintain Investor List $10,000/day Failure to Provide Listed Transaction $100,000 or 50% Preparer$1,000-$5,000 Promoter 50% gross income

Enforcement - Other Other Abusive Tax Shelter Curtailments: No suspension of interest No suspension of interest Doubles statute of limitations to 8 years Doubles statute of limitations to 8 years Enhances subpoena provisions Enhances subpoena provisions Ability to enjoin promoters Ability to enjoin promoters Increases interest on amended returns Increases interest on amended returns Eliminates accountant confidentiality Eliminates accountant confidentiality

Recent Updates Federal Tax Shelter Legislation Federal Tax Shelter Legislation Federal District Court Decisions Federal District Court Decisions Federal Settlements Federal Settlements Federal De-listed Transaction Federal De-listed Transaction

Comparison of Tax Shelter Laws Provision CA Law Federal Law Noneconomic Substance 20-40% of understatement None Interest Based Penalty 100% of interest None Reportable Transaction 20-30% of understatement Same Failure to Disclose $15,000 $15,000 $30,000 for Listed $30,000 for Listed Only certain taxpayers Only certain taxpayers $10,000-$50,000 $10,000-$50,000 Up to $200,000 for Listed. Up to $200,000 for Listed. Failure to Register $15,000 $15,000 $100,000 or 50% gross income if Listed. $100,000 or 50% gross income if Listed. Repealed registration regime and associated penalties. Failure to File Information Return for Reportable Transaction None $50,000 $50,000 $200,000 or 50% gross income if Listed. $200,000 or 50% gross income if Listed. Statute of Limitations 8 years after return filed Extended 1 year after disclosure if originally undisclosed.

What’s New Summary? Investors Beware?Investors Victory? Black & Decker vs. IRS Black & Decker vs. IRS –Summary decision held Black & Decker contingent liability transaction had economic substance –Judge did not perform any analysis of profit motive –IRS is reviewing appeal options Delisting of the PORC transaction Delisting of the PORC transaction Long Term Capital Management vs. IRS – Long Term Capital Management vs. IRS – –Penalties can be applicable even with a legal opinion regarding the transaction Revision to IRS settlement terms – cost to settle with the IRS has gone up Revision to IRS settlement terms – cost to settle with the IRS has gone up Federal legislation passed enhancing penalties and registration requirements Federal legislation passed enhancing penalties and registration requirements

Additional information can be found on our website at: