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Illinois's new tax shelter rules.

Editor's Note: The Illinois legislation that is the focus of this article was enacted before the American Jobs Creation Act of 2004, a federal bill that contains several provisions related to tax shelters at the federal level. The federal legislation is the subject of another article in this issue of The Tax Executive, and hence the changes to the federal rules are not addressed in this article. Please refer to the afterward for late-breaking developments.

Background: The Federal Rules

During the past five years, the Internal Revenue Service has taken steps to combat abusive tax shelters and transactions. The IRS seeks to put a comprehensive strategy in place to (1) identify and deter promoters of abusive tax transactions; (2) publish guidance on transactions and shelters that are determined to be abusive; and (3) promote disclosure by those who market and participate in abusive transactions.

The execution of this strategy has led to the issuance and amendment of temporary reportable transaction disclosure regulations culminating in final regulations issued in February 2003 and amended in December 2003. (1)

In general, sections 6011, 6111 and 6112 of the Internal Revenue Code provide "tax shelter" rules that require disclosure, registration, and list maintenance for certain transactions. These statutory provisions and the related regulations define tax shelters, listed transactions, and reportable transactions.

Certain investments are characterized as a "tax shelter" if they meet specific criteria. (2) Under the federal rules, a "tax shelter" can also include any entity, plan, arrangement, or transaction if:

(1) A significant purpose of the structure is the avoidance or evasion of Federal income tax for a direct or indirect participant that is a corporation;

(2) The shelter is offered to any potential participant under conditions of confidentiality; and

(3) The tax shelter promoters may receive a fee in excess of $100,000 in the aggregate. (3)

Tax shelters that are determined by the IRS to be abusive tax avoidance transactions are identified as "listed transactions." The IRS identifies listed transactions in published guidance. (4) There are six categories of reportable transactions:

(1) Listed transactions or substantially similar transactions;

(2) Transactions offered under terms of confidentiality;

(3) Transactions with contractual protection;

(4) Loss transactions under section 165 of the Code over certain specified amounts;

(5) Publicly traded companies or business entities with $250 million in gross assets entering into transactions with a $10 million book-tax difference (with certain exceptions); and

(6) Transactions reasonably expected to generate $250,000 in foreign tax credits and involving an asset holding period of less than 45 days. (5)

In summary, the federal rules require the registration of tax shelters and the disclosure of reportable transactions.

Summary of California's Tax Shelter Rules

Editor's Note: California's tax shelters and amnesty provisions are the subject of another article in this issue.

The first state to follow the federal lead in the area of tax shelters was California. In October 2003, anti-tax shelter legislation was signed into law in California. (6) While the California rules extensively borrow from and refer to the federal rules, they require separate disclosure, impose stiffer penalties, and provide for the identification of additional transactions. (7)

California's new rules also provide for a variety of penalties for taxpayers in various circumstances, including a failure to report penalty; (8) a 100-percent interest penalty for taxpayers contacted regarding the use of a potentially abusive shelter; (9) reportable-transaction understatement; (10) noneconomic-substance transaction understatement; (11) and enhancement of an accuracy-related penalty. (12)

In order to encourage compliance with their tax shelter rules, California also commenced a Voluntary Compliance Initiative (VCI) effective for a limited period. (13) The California rules require taxpayers to (1) file amended returns, and (2) pay the tax that would have been otherwise due had the taxpayer not participated in the reportable transaction. (14) Further, California's VCI program provided taxpayers an election to retain the right to subsequently appeal taxes paid pursuant to the VCI.

Illinois' New Tax Shelter Rules

On July 30, 2004, the Governor of Illinois signed new legislation into law containing tax shelter disclosure requirements. (15)

Covered Transactions

This Illinois legislation requires taxpayers to disclose the use of reportable transactions entered into on or after February 28, 2000, that became a listed transaction. (16) These disclosure provisions extend to taxpayers that are members of consolidated or combined reporting groups where one of the members of such consolidated or combined groups entered into a reportable transaction. (17) Disclosure is made through the disclosure statement specified in Treas. Reg. [section] 1.6011-4 and filed with the Illinois Department of Revenue (IDOR). (18)

As of October 31, 2004, neither regulations, forms, nor instructions regarding satisfying the disclosure requirement have been issued. Based on informal discussions with IDOR, however, attaching Federal Form 8886 to a timely filed Illinois return should satisfy the requirements of the new legislation.

Taxpayers who fail to use a disclosure statement regarding the use of a reportable transaction will face the extended six year statute of limitations on notices of deficiency. (19)

Penalties

As part of the tax shelter legislation, Illinois has aimed an enhanced penalty regime at taxpayers participating in reportable transactions.

Failure to Disclose. A taxpayer who fails to disclose a reportable transaction will be subject to a $15,000 penalty for each failure. (20) The penalty will be increased for a failure to disclose a listed transaction to $30,000 for each occurrence. (21) The IDOR may rescind all or a portion of the penalty under certain circumstances. (22)

Reportable Transaction Penalty. If a taxpayer has an understatement of tax due to a reportable transaction for any taxable year, a penalty will be imposed equal to 20 percent of the amount of the understatement. (23) If a reportable transaction gives rise to a carryback or carryforward of a loss, deduction, or credit, the penalty shall apply to such carryforward or carryback year, to the extent that any portion of an understatement is attributable to the reportable transaction. (24) While there is a "reasonable cause" exception to this penalty, it will only apply in certain, somewhat narrow, circumstances. (25) Conditions for qualifying for a reasonable cause exception to the reportable transaction penalty are:

(1) The relevant facts pertaining to the tax treatment of the transaction are adequately disclosed;

(2) Substantial authority for such treatment; and

(3) Taxpayer's reasonable belief that such treatment was more likely than not the proper treatment. (26)

In this context, reasonable belief relates solely to the taxpayer's chances of success on the merits and does not include reliance on the tax opinion of a "disqualified tax advisor" or a "disqualified tax opinion." (27)

100-Percent Interest Penalty. Taxpayers who have been contacted by the IRS or the IDOR regarding the use of a potential tax avoidance transaction with respect to a taxable year, and having a deficiency for such year attributable to the use of a potential tax avoidance transaction, are penalized an amount equal to 100 percent of the interest assessed under Illinois Uniform Penalty and Interest Act. (28) In general, this penalty is effective for taxable years ending on and after December 31, 2004. (29)

150-Percent Interest Rate. For taxable years ending after July 1, 2002, in situations where the taxpayer has not been contacted by the IRS or the IDOR regarding the use of potential tax avoidance transactions, taxpayers will be subject to interest at a rate of 150-percent of the otherwise applicable rate for any deficiency attributable to such transactions. (30)

Voluntary Compliance Program

The Illinois legislation establishes a tax shelter voluntary compliance program from October 15, 2004, to January 31, 2005. (31) Eligible taxpayers are those who file amended returns for taxable years for which the taxpayer used a tax avoidance transaction, and those who make full payment of the additional tax and interest due for the taxable years that is attributable to the use of the tax avoidance transaction. (32) Rules, forms, and instructions will be forthcoming from the IDOR. In general, taxpayers participating in Illinois's Voluntary Compliance Program will not face criminal or civil prosecution for such taxable year with respect to tax avoidance transactions, and certain penalties may also be waived depending on the taxpayer's election to forgo the right to appeal. (33)

Effective Dates

The legislation requires disclosure by the due date, including extensions, of the first return required to be filed after the effective date of the new legislation (July 30, 2004). (34) At the time of publication, there were indications that IDOR will construe this requirement as requiring disclosure by the first original due date for a return due after the July 30, 2004, effective date of the legislation. In other words, the disclosure must take place no later than seven months after the original due date of any income tax return due after July 30, 2004. As a practical matter, this means that fiscal year filers with original due dates for returns of August 15, 2004, will be required to make a disclosure no later than seven months after the August 15, 2004 original due date. (35) Therefore, calendar year 2003 filers with extended due dates of October 15, 2004, will not be required to make disclosure until October 15, 2005. The IDOR has advised that this policy will be included in draft regulations that are currently being prepared.

Afterward--Illinois Tax Shelter Emergency Voluntary Compliance Regulation

The Illinois Department of Revenue recently released Emergency Regulation 100.9900. This Regulation is intended to provide taxpayers with guidance regarding Illinois' Voluntary Compliance Program. Significant features of the regulation include the following:

* Certain tax shelter-related terms are defined including, "Tax Avoidance Transaction" and "eligible liability;"

** A "tax avoidance transaction" is a plan or arrangement devised for the principal purpose of avoiding federal income tax. Tax avoidance transactions include, but are not limited to, "listed transactions" as defined in Treasury Regulations Section 1.6011-4(b)(2);

** "Eligible Liability means (1) the excess of any Illinois income tax liability for a taxable year properly computed without allowing the net tax benefits of any tax avoidance transaction over (2) the Illinois tax liability for that taxable year computed allowing the tax benefits of any tax avoidance transaction in which the taxpayer participated.

* Requirements for participation in the Voluntary Compliance Program are detailed, specifically:

** The form required to be used is identified, Form VCP-1;

** Information is provided regarding filing Form VCP-1; and

** The election of voluntary compliance with or without appeal is explained.

(1) Treas. Reg. [sections] 1.6011-4 includes a detailed discussion about the evolution of the federal tax shelters rules, but these disclosure requirements are beyond the scope of this article.

(2) Specifically, these are investments that yield high amounts of deductions or credits per dollar of investment and are required to be registered under federal or state law. I.R.C. [sections] 6111(c)(1).

(3) I.R.C. [sections] 6111(d)(1).

(4) Treas. Reg. [sections] 1.6011-4. The IRS maintains a web site that helps taxpayers identify listed transactions: http://www.irs.ustreas.gov/ businesses/corporations/article/0,,id=97384,00.html

(5) Treas. Reg. [sections] 1.6011-4(b).

(6) A.B. 1601, October 2, 2003 (Cal. Laws 2003, ch 654) and S.B. 614, October 2, 2003 (Cal. Laws 2003, ch 656). Other states have also issued non-statutory, abusive transaction rules, including Connecticut (Connecticut Department of Revenue Services Announcement 2004(5)) on June 16, 2004) (announcement of its abusive tax shelter compliance initiative) and South Carolina (Tax Shelter Amnesty Period, announced July 22, 2004).

(7) See Cal. Rev. & Tax Code [subsections] 19773, 19774, and 19164; Chief Counsel Announcement No. 2003-1 (Cal. FTB Legal Dept., December 21, 2003).

(8) Cal. Rev. & Tax Code [sections] 19772.

(9) Cal. Rev. & Tax Code [sections] 19777.

(10) Cal. Rev. & Tax Code [sections] 19773.

(11) Cal. Rev. & Tax Code [sections] 19774.

(12) Cal Rev. & Tax Code [sections] 19164(a)(3).

(13) Cal. Rev. & Tax Code [sections] 19751. California's Voluntary Compliance Initiative ran from January 1, 2004, through April 15, 2004.

(14) Cal. Rev. & Tax Code [subsections] 19754(a) and (b).

(15) Public Act 93-0840, Article 35, (35 ILCS 20--Tax Shelter Voluntary Compliance Law). This new law has not yet been codified into the Illinois Compiled Statutes. For the text of this new legislation, visit the Illinois General Assembly website at: http:// www.legis.state.il.us/legislation/publicacts/fulltext.asp?Name=0930840.

(16) Treas. Reg. [sections] 1.6011-4; see also 35 ILCS 5/501(b).

(17) Id.

(18) Id.

(19) 35 ILCS 5/905(b)(2).

(20) 35 ILCS 5/1001(b)(1).

(21) 35 ILCS 5/1001(b)(2). Listed transactions are a subset of reportable transactions under the federal rules that have been identified in specific IRS guidance as potentially abusive transaction and include transactions "substantially similar" to the listed transactions themselves.

(22) The situations in which the IDOR may not apply the failure to disclose penalty include (1) where the failure to comply did not jeopardize the best interests of the state; (2) where the taxpayer has a history of complying with the tax laws; (3) where the violation is due to an unintentional mistake; and (4) where the taxpayer can show reasonable cause. 35 ILCS 5/1001(b)(3).

(23) 35 ILCS 5/1005(b).

(24) 35 ILCS 5/1005(b)(1)(B).

(25) 35 ILCS 5/1005(b)(4).

(26) 35 ILCS 5/1005(b)(4)(B)(i),(ii) and (iii).

(27) 35 ILCS 5/1005(b)(4)(C)(ii). For purposes of this section, "disqualified tax advisors" are generally material advisors who participate in the organization, management, promotion, or sale of the transaction. 35 ILCS 5/1005(b)(5)(A)(I). A "disqualified opinion" means an opinion that meets any of the following conditions: (1) is based on unreasonable factual or legal assumptions; (2) unreasonably relies on representations, statements, finding, or agreements of the taxpayers or any other person; (3) does not identify or consider all relevant facts; or (4) fails to meet other requirements of the federal Secretary of Treasury. 35 ILCS 5/1005(b)(5)(B)(I)-(IV).

(28) 35 ILCS 5/1005(c).

(29) This penalty, however, may also be imposed with respect to any taxable year for which the statute of limitations has not expired as of January 1, 2005, when such understatement is attributable to a listed transaction which was entered into after February 28, 2000, and before December 31, 2004. Id.

(30) 35 ILCS 5/1005(d).

(31) Public Act 93-0840, Article 35, 35-5(a), (35 ILCS 20--Tax Shelter Voluntary Compliance Law). This new law has not yet been codified into the Illinois Compiled Statutes.

(32) Public Act 93-0840, Article 35, 35-5(c), (35 ILCS 20--Tax Shelter Voluntary Compliance Law). This new law has not yet been codified into the Illinois Compiled Statutes. For purposes of the Voluntary Compliance Program, a "tax avoidance transaction" means a plan or arrangement devised for the principal purpose of avoiding federal income tax. Tax avoidance transactions include, but are not limited to, "listed transactions" as defined in Treas. Reg. [sections] 6011-4(b)(2). See also Public Act 93-0840, Article 35, 35-10, (35 ILCS 20--Tax Shelter Voluntary Compliance Law).

(33) Public Act 93-0840, Article 35, [subsections] 35-5(b)(1) and (2), (35 ILCS 20--Tax Shelter Voluntary Compliance Law). This new law has not yet been codified into the Illinois Compiled Statutes.

(34) 35 ILCS 5/501(b).

(35) Illinois provides an automatic seven month filing extension in the case of corporate income return filers.

GILES SUTTON is a Director of State & Local Tax in the Washington National Tax Office of Grant Thornton LLP. KEITH STAATS is a Director and TODD ZOELLICK is an Associate in the firm's State & Local Tax practice in Chicago.
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Author:Zoellick, Todd
Publication:Tax Executive
Date:Nov 1, 2004
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