Analysis of the 2004-05 Budget Bill
Legislative Analyst's Office
The personal income tax (PIT) and the corporation tax (CT) are two of the state's most important sources of General Fund revenues. Under these tax programs, taxpayers are allowed to legitimately "shelter" certain income from taxation. Much of this tax sheltering activity is specifically identified in law—such as retirement accounts—or involves other permitted tax planning activity. However, in the last few years there has been a significant increase in tax sheltering activities that violate state and federal tax law, and therefore represent abusive tax shelters (ATSs).
Abusive tax shelters can occur under either the PIT and the CT and are usually marketed to and used by high-income or high-net-worth taxpayers. Such ATSs vary considerably, but they are usually quite complex, involving many layers of transactions, and multiple entities. This complexity makes it difficult for state and federal tax agencies to identify them and take corrective action in order to curtail their use. In general, California's Franchise Tax Board (FTB) and the federal Internal Revenue Service consider that the key feature of ATSs is that they have no true economic purpose but exist solely for reason of tax avoidance.
The current level of ATS activity—and its potential for future expansion—raises significant administrative challenges for FTB and for the continued viability of the state's revenue system. The use of ATSs not only results in significant immediate term revenue losses to California—in the hundreds of millions of dollars annually—but can also result in declining compliance by an increasing number of taxpayers over the longer term. While the Legislature has taken important steps to curtail the use of ATSs, it may want to consider additional measures in this regard. This discussion provides an overview of the ATS phenomenon, addresses the impacts of such shelters on the state, and suggests measures the Legislature may want to consider to address the ATS problem.
The PIT and CT are two of the state's most important sources of income, with estimated revenues in 2004-05 of approximately $38 billion and $7.5 billion, respectively. Revenues from these tax programs are expected to constitute almost two-thirds of General Fund revenue in 2004-05. Both tax programs are administered by FTB.
Under both the PIT and the CT, taxpayers are able to shelter certain income from taxation. For example, under the PIT, establishing retirement accounts—such as under Section 401k of the Internal Revenue Code (IRC)—is a form of tax sheltering. Similarly, under the CT, businesses are allowed to engage in certain activities that either result in the avoidance of or delay in the payment of taxes—such as accelerated depreciation of particular types of equipment. Thus, some tax sheltering activity is explicitly allowable under the state's tax laws. Other types of tax sheltering activities, however, are not specifically identified in federal or state tax law. Some such activities are not considered allowable by the FTB or the Internal Revenue Service (IRS) and are deemed to represent ATSs.
Inappropriate tax sheltering activity has always existed as a compliance problem under the PIT to some degree. However, in recent years such activities have proliferated, and have grown in size, scope, and sophistication. As a result, there have been substantial concerns raised at both state and federal levels regarding the magnitude and revenue impacts of ATS activity. This sheltering activity represents tax avoidance methods that are quite distinct from the typical (and legitimate) forms identified above.
The first generation of these schemes—which proliferated in the 1980s—represented transactions that were relatively straightforward in structure. The current generation, however, is often characterized by legally complex, opaque and financially technical transactions, coupled with an aggressive interpretation of state and federal tax law. The new ATS schemes are designed for either individuals or businesses and can vary substantially depending upon taxpayer circumstances.
Abusive tax shelters are usually marketed by accounting, banking, and consulting firms, and frequently involve several entities "teaming-up" in order to provide a tax shelter program, legal opinion regarding the transaction, and other financing assistance. In addition, such transactions can involve the provision of insurance policies that provide financial protection to the investor in the event of any tax losses related to the ATS, such as if the ATS is deemed nonallowable after an audit. Because of the complexities involved in many ATSs, their legal, accounting, and associated fees can be substantial. As a result, tax shelters tend to be marketed most aggressively to high-income and high-net-worth individuals, as well as large business entities such as major corporations or partnerships.
As noted above, there are many types of ATSs, with their exact characteristics varying considerably depending upon a taxpayer's situation. They can be quite difficult to identify and often even harder to understand, even for trained tax auditors. The Congressional Joint Committee on Taxation—which is responsible for drafting much of the federal legislation intended to restrict ATS activity—has itself indicated the difficulty in drawing distinctions between legitimate and unacceptable tax shelter activity. Despite the absence of a uniform and exact standard as to what constitutes a tax shelter, however, there exist statutory provisions, judicial doctrines, and administrative guidance that represent attempts to limit or define transactions in which the primary purpose is the avoidance of income tax.
Based on these rules and guidelines, the FTB and the IRS have arrived at an operational definition of an ATS. According to this definition, the key feature with respect to ATSs is that they have no true economic purpose but exist solely for reason of tax avoidance, and thus generate no true or economic loss with respect to taxpayer's income or assets that would justify a tax savings. In addition, ATS transactions typically:
Administrative and court decisions have required that financial and related transactions must have economic substance or business purpose to avoid being considered an ATS. These requirements have been interpreted to mean that the transaction in question must have economic advantages other than those related merely to tax savings, and its business purpose must be separate and distinct from any tax consequences.
In addition to their working definition, the IRS and FTB have identified certain characteristics that typify such ATSs. Such transactions usually have some or all of the following characteristics:
A couple of very simplified examples of tax shelters are provided in the shaded box below. These examples and the descriptions above provide only a general outline of an ATS transaction. In actuality, such shelters tend to be highly complex and extremely sophisticated, involving multiple layers of transactions and numerous participants.
There exist a wide variety of tax sheltering schemes, making it impossible to easily capture the shared essence of all such types of transactions. Nevertheless, the two examples below are representative of the types of abusive tax shelter (ATS) transactions that have occurred in the recent past.
There are a number of reasons why ATSs began proliferating in the 1990s. Tax analysts generally believe that the increase in ATSs was due in large part to the large stock market-related capital gains that were occurring during this period, as well as other large income gains on the corporate side. In response, there developed an increasingly sophisticated ATS industry that relies on complex tax and income optimization modeling and convoluted 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 factors associated with the tax collection agencies—especially at the federal level. These institutional factors included: (1) a decline in the rate of 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.
Estimates of the revenue impact of ATSs represent approximations primarily due to the difficulty of measuring revenues that are never paid to the federal or state governments. Nevertheless, there are a number of studies that have been conducted regarding the revenue impacts of the ATS phenomenon that provide a rough gauge as to its likely revenue magnitude.
Because much ATS activity revolves around one-time income events, annual figures involving revenue losses may not always provide a particularly accurate portrayal of the ongoing revenue importance of these tax-avoidance methods; however, based on the FTB figures above, they would appear to average in the $600 million to $1 billion range annually. Thus, it is evident that ATS activity currently poses a significant challenge to California's revenue system. When the potential for significant future expansion of ATS activity is considered, the risk to California's revenue system is even greater.
In addition to revenue losses, the concerns at the state and federal levels about ATS activity are related to some of the most fundamental principles that underlie tax and revenue systems. In particular, at this basic level there is a concern that individual and business taxpayers each remit what is appropriately owed by them. Tax avoidance by some taxpayers shifts the relative tax burden towards taxpayers in full compliance.
This principle of fairness is not only important for individual taxpayers and society as a whole, but it also has ramifications for the tax system itself. A perception that the tax system is not equitable could result in noncompliance and tax avoidance by an increasing proportion of taxpayers, potentially jeopardizing the viability of the tax system to raise funds for public purposes. This, in turn, could undercut the very ability of the tax system to function efficiently and effectively.
At both the state and federal level, tax administration agencies have begun focusing on the ATS problem. As part of this effort, state and federal officials have developed cooperative programs to coordinate tax compliance activities and avoid any duplication of enforcement efforts. This coordination is vital, not only due to the fact that many ATS transactions involve multistate and international activity (which would generally be difficult for a single state to pursue alone), but also because the sheer complexity of many ATS transactions makes the efficient use of limited available resources essential.
For the most part, the IRS has chosen to focus on the promoters of (as opposed to the investors in ) tax shelters—including accounting firms, law firms, financial advisory firms, and certain banking institutions—as a means of curtailing tax abuse. As part of its efforts, the IRS established an Office of Tax Shelter Analysis, which has specifically identified—and issued revenue rulings for—more than two dozen specific types of tax shelter transactions that it considers abusive. The IRS has also required promoter firms to disclose and register transactions deemed to be potentially ATSs. In addition, audits of promoter firms are now being conducted to determine whether such reporting requirements have been met—including the provision of investor lists if requested. Finally, as part of this initiative, taxpayers are required to notify the IRS if they have used such "listed" transactions.
The IRS recently completed a memorandum of understanding (MOU) with 33 states (including California) to share information and coordinate enforcement efforts regarding ATS activity. The MOU—executed in September 2003—allows state and federal governments to share information related to tax-avoidance transactions, including promoter information and investor activity. The IRS has also established contracts with various private firms in order to gain access to additional technical expertise in this area.
New Budget Proposals. As part of its efforts to curtail the use of ATS transactions, the U.S. Treasury announced new budget and regulatory proposals that are a component of the 2004-05 federal budget. These include additional penalties for disclosure violations; new disclosure rules; injunctions against ATS promoters; curbs on specific transactions (including sales of depreciation rights, as discussed in our January 2003 publication "Lease-Leaseback Transactions By Public Transit Districts—Sales and Use Tax Exemption"); as well as other enforcement measures. According to the Treasury Department, the President's 2004-05 budget includes $300 million in funding for the IRS's tax compliance efforts, including efforts to combat the use of ATSs. As part of this effort, the IRS is expected to shift emphasis from processing to enforcement, adding 2,200 new employees to its compliance effort, including ATS-related activities.
Room for Improvement. While the IRS is following a broad-based multifaceted strategy to combat ATS activity, the GAO noted in its previously cited report that the IRS has not incorporated long-term performance goals and associated measures that could help evaluate its progress. The GAO observes that given the shift in resources toward tax shelter enforcement, the IRS should make a concerted effort to refine its current assessment of the scope and magnitude of the ATS problem as well as the amount of time required to resolve ATS cases. The GAO notes that an improvement in the analytic basis for resource deployment would facilitate the effective allocation of staff to ATS and other tax compliance activity.
The ATS-related enforcement efforts of the FTB have focused both on investors in and promoters of ATSs, and represent an attempt to complement the IRS effort to focus on shelter promoters. Although California is somewhat constrained in its ability to curtail the use of certain ATSs—particularly those involving interstate or international activities—it does possess the ability to pursue its own enforcement program in many areas.
The state maintains its own compilation of listed ATS transactions, which includes those on the IRS schedule but also contains certain other shelter schemes of particular importance to California. As noted above, FTB also cooperates with the IRS with respect to the federal ATS initiatives and participates in a number of multistate task forces and organizations (including the MTC and the Federation of Tax Administrators) focused on particular ATS activities.
Recent Legislative Action. Recently, California took legislative action with respect to ATSs, approving measures intended to make the state's tax enforcement against ATS activities more effective. Chapter 656, Statutes of 2003 (SB 614, Cedillo), and Chapter 654, Statutes of 2003 (AB 1601, Frommer), were modeled after S 476 (Grassley), which is currently being considered by Congress. The California law:
Administrative Steps. In addition to ATS policy initiatives resulting from actions taken by the Legislature, certain administrative steps have also been taken. For example, the FTB last year redirected certain tax compliance resources to the auditing of ATS transactions. This redirection—of which the Legislature was informed in June 2003—is expected to result in a net increase in revenues during a five-year period of approximately $350 million, with an additional $130 million received after the end of the five-year period. According to FTB, each ATS audit may take from 12 months to 24 months to complete, representing 150 hours to 500 hours of staff time.
The complex nature of ATS transactions and the extensive staff time required to pursue such cases place new and increased demands on FTB's existing enforcement efforts. Below we raise various questions regarding the board's ATS-related activities.
Are Current Resources Being Appropriately Shifted to ATS Auditing? As noted earlier, FTB has already shifted auditing resources from standard audits to ATS-related audits. The Legislature may want to consider directing additional shifts in resources to ATS activity. Such shifts would allow FTB to develop a comprehensive ATS plan more quickly than it otherwise could. However, redirecting staff from standard audits could result in revenue losses in the current and budget years, even though future audit revenues would likely increase as a result. This is because ATS audits require more initial investment in resources than other types of audits and it can take more years to close out these audits and realize the revenues.
Should Auditing Resources Be Increased? The federal government has proposed to increase spending on tax compliance during the next year—including spending on ATS enforcement—by increasing its auditing resources. Based on our analysis, FTB might benefit from additional resources in the ATS area as well, in order to allow for the hiring of auditors and attorneys skilled in the areas of ATS detection and enforcement. While additional resources may not result in near-term net revenues, such additional resources may be an appropriate long-term investment in tax compliance and enforcement from a revenue standpoint.
To What Extent Would Outside Assistance Be Suitable? The federal government has retained certain specialized tax consultants for its ATS enforcement efforts. The retention of outside consultants in the fields of economics, accounting, and tax analysis by FTB—on a limited-term and targeted basis—might provide valuable assistance by:
As with the addition of auditing resources, the limited use of outside consultants would be unlikely to result in near-term revenues, but rather would represent a long-term investment in tax compliance.
Should Additional Legal Tools Be Provided? There may be additional legal tools that the Legislature could consider regarding ATS enforcement, including:
Given the level of current ATS activity—and the potential for vastly increased activity in the future—we recommend that FTB report at budget hearings regarding ATS-related issues as well as various options for improving and expanding its tax compliance programs. Specifically, we recommend that the FTB (1) address the current status of its ATS enforcement efforts, (2) discuss the need for and potential effectiveness (including the net revenue impact) of the various approaches outlined above for curtailing ATSs, and (3) provide information regarding an integrated plan for ATS enforcement, including the development of performance goals.
We also recommend that the FTB expand its existing annual Supplemental Report on FTB Audits and Collections Activities to include a section that specifically addresses the status of ATS enforcement activities. Given the nature of ATS transactions and their adverse impact on the state's tax system, we recommend that these activities be analyzed not just with respect to net revenues, but also with reference to the impact of these activities on overall tax compliance.