On December 22, California’s Franchise Tax Board (FTB) released the state’s amnesty application for purposes of California’s personal income and corporate income/franchise taxes. The FTB has also provided, in the form of Frequently Asked Questions on its website, guidance on various aspects of the amnesty program. The State Board of Equalization (BOE) plans to make available an application for the sales/use tax component of the amnesty program on January 14, 2005. The analysis that follows largely focuses on guidance provided by the FTB.
The California amnesty program, created by SB 1100, was signed by Governor Schwarzenegger on August 16, 2004 as Stats. 2004, Ch. 226 (the “amnesty legislation”). Although taxpayers can potentially avoid penalties and any criminal action related to non-reporting or underreporting of tax liabilities or nonpayment of taxes as with other state tax amnesties, be forewarned that this is not the typical amnesty program. Complex rules and new or increased penalties create a scenario in which unwary taxpayers could be assessed hefty penalties for not having taken advantage of the program. Likewise, participating in amnesty may create hazards as taxpayers are required to give up protest/appeal rights, as well as the ability to seek a refund of amnesty amounts. These factors create circumstances in which some taxpayers may be well-advised to make payments to reduce existing or potential tax liabilities outside the amnesty program.
Under the amnesty program, taxpayers who come forward and pay all outstanding liabilities and interest for taxable years beginning before January 1, 2003, will have most penalties and fees waived and will avoid any related criminal action. Taxpayers may apply for amnesty in situations in which there is an outstanding obligation, no return has been filed or tax liability has been underreported.
Amnesty applications must be filed between February 1 and March 31, 2005. Because March 31 is a state holiday, applications postmarked on or before April 1, 2005 will be accepted. In addition, all tax returns connected with an amnesty application must be filed and any related tax liability paid by May 31, 2005 (for individuals, an installment payment agreement may extend the time to pay to June 30, 2006).
Certain taxpayers and transactions are not eligible for the amnesty program. Taxpayers currently under criminal investigation or prosecution for tax-related matters are ineligible for the program. In addition, a taxpayer that has filed for bankruptcy must submit an order from a federal bankruptcy court allowing the taxpayer to participate in amnesty. Moreover, transactions considered “abusive tax avoidance transactions” eligible for relief under California’s Voluntary Compliance Initiative (VCI), which ran from January 1, 2004 through April 15, 2004, or the 2003 IRS Offshore Voluntary Compliance Initiative are not eligible for amnesty. Identifying transactions that are “abusive tax avoidance transactions” and, as such, ineligible for amnesty may be difficult in some circumstances. During VCI, the FTB gave this term a broad construction, ostensibly to increase the number of taxpayers that were eligible to participate in VCI. During the upcoming amnesty period, the FTB may likewise encourage a broad construction of the term in order to disqualify taxpayers from amnesty participation and subject them to amnesty-related penalties
Once submitted, an amnesty application is binding. Moreover, no claim for refund or credit may be asserted for any amount paid under the income/franchise tax component of the program. In contrast, no such restriction on refundability applies for amounts paid in connection with the sales/use tax component of the program. If a taxpayer chooses to participate in the amnesty program, it may not maintain a protest or appeal of amnesty amounts. To the extent that a taxpayer is involved in pending refund litigation relating to amnesty amounts, a dismissal must be requested from the court.
In order to maintain amnesty, a taxpayer must remain in compliance by filing returns and paying taxes for 2005 and 2006. If this requirement is not satisfied, the FTB notes on its website that it will “revoke . . . amnesty, reinstate canceled penalties and fees, and assess new amnesty-related penalties.” Although this is not always clear in the FTB’s guidance under the amnesty legislation (specifically, Cal. Rev. & Tax. Code § 19737(a)), the standard for revoking amnesty will be where a taxpayer’s failure to pay taxes for 2005 or 2006 results in the imposition of a collection cost recovery fee under Cal. Rev. & Tax. Code § 19254.
The income/franchise tax component of the amnesty legislation created a new penalty (the amnesty penalty, found in Cal. Rev. & Tax. Code § 19777.5) and increased the accuracy-related penalty from 20 percent to 40 percent for certain tax assessments (the accuracy-related penalty, modeled after IRC § 6662 and found in Cal. Rev. & Tax. Code § 19164).
The amnesty penalty may be imposed where a taxpayer does not request amnesty for an eligible year (i.e., tax reporting periods beginning before January 2003) and there is an unpaid amount due on March 31, 2005 (referred to by the FTB as the amnesty noncompliance penalty); and additional tax is assessed for an amnesty eligible tax year after the end of the amnesty period (referred to by the FTB as the post-amnesty penalty). In either case, the amnesty penalty is imposed at a rate of 50 percent of the unpaid interest amount due for years eligible for amnesty. It is computed based on the underpayment interest due or computed from the original due date of the return to March 31, 2005. There is no right to protest the amnesty penalty or pay the penalty and file a claim for refund for penalty amounts; in other words, the amnesty penalty can be avoided only if the underlying tax, upon which the unpaid interest is calculated, is found invalid.
Although not a new penalty, the existing accuracy-related penalty increases from 20 percent to 40 percent for any proposed assessment related to an amnesty-eligible year that is issued after the end of the amnesty period. Unlike the amnesty penalty, the accuracy-related penalty does not apply to any understatement that is subject of an audit, protest, appeal, settlement or litigation as of the start of the amnesty period.
While the rules for each penalty differ slightly, the calculus for whether a taxpayer should participate in amnesty is similar. Essentially, to the extent a taxpayer believes that it is likely that positions taken on returns related to amnesty years will not be successful, it should consider participating in the amnesty program. By participating in the amnesty program, it will avoid penalties related to underreporting, as well as the amnesty penalty and the increased accuracy-related penalty (the accuracy-related penalty will only apply if no audit has been commenced). As amnesty amounts are nonrefundable, however, a taxpayer should be comfortable conceding any contested (or potentially contested) issues before considering this course of action. Note that it is possible to choose partial amnesty participation for a given amnesty year. A taxpayer may choose partial participation where, for example, the FTB has issued an assessment for an amnesty year and there are issues that the taxpayer does not wish to contest. The taxpayer could seek amnesty for the non-contested issues and still protest all other issues related to the amnesty year.
While not participating in the income/franchise component of California’s tax amnesty puts taxpayers at risk of significant new penalties, the decision to participate in the program may create a separate set of unforeseen consequences. No matter the final decision, the following considerations should not be overlooked.
Retaining Protest/Appeal Rights and Refundability
By applying for amnesty, a taxpayer will be forced to waive all protest/appeal rights and, critically, cannot seek a refund of amnesty amounts. Therefore, as noted above, if a taxpayer believes there is some likelihood of success for a particular position, amnesty may not be a good choice. In order to retain the ability to protest/appeal and seek refund of amounts paid but avoid new penalties, it is worthwhile to consider making pre-amnesty payments to the FTB (note that the FTB’s guidance appears to indicate that posting a cash bond will not be sufficient to reduce underpayment amounts upon which the amnesty penalty is calculated). The FTB has specifically noted on its website that taxpayers are permitted to designate pre-amnesty payments to apply to existing or future tax obligations (although not stated explicitly in FTB guidance, it also appears that payments made during the amnesty period may be designated as non-amnesty payments). Pre-amnesty payments will reduce the base amount upon which either the amnesty penalty or the increased accuracy-related penalty (only applicable when no audit has commenced by February 1, 2005) is computed.
It should also be noted that the same analysis must be applied to determine the likelihood of federal adjustments to the extent that such adjustments would increase California taxable income and create corresponding California adjustments for amnesty years.
Netting Underpayments and Overpayments
According to the FTB’s guidance, if a taxpayer has an overpayment for one year and a smaller underpayment for another years (resulting in a net overpayment), the overpayment will only reduce the base amount upon which the amnesty penalty is based if it is credited before March 31, 2005.
Comparing with Voluntary Disclosure Program
Taxpayers that would qualify for California’s Voluntary Disclosure Program (under Cal. Rev. & Tax. Code §§ 19191 - 19194) should weigh the merits of this program in comparison to amnesty. Although the Voluntary Disclosure Program is generally more restrictive than the amnesty program (e.g., only qualified taxpayers that meet certain criteria may participate; approval must be obtained from the three-member Franchise Tax Board), it may be worth considering for some taxpayers.
Information Sharing with the IRS and Other States
Another important consideration is the fact that California has entered into broad information-sharing agreements with the IRS and many other states. In their guidance, the FTB advises taxpayers to expect that any information provided to them as part of the amnesty program will be disclosed to the Internal Revenue Service. As such, taxpayers considering California’s amnesty program should also consider whether the information they provide to California could impact tax determinations at the federal level as well as in other states.