United States: California’s “Tax Amnesty”: What Every California Taxpayer Should Know

On August 16, 2004, California enacted a tax amnesty ("Amnesty Program") covering both sales and use taxes and personal and corporate income taxes.¹ The stated purpose of the Amnesty Program is to accelerate revenue as well as raise new revenue for California. The Senate Budget and Fiscal Review Committee estimated that the Amnesty Program would generate $567.8 million in revenues for the state.² At the December 1, 2004, meeting of the Franchise Tax Board ("FTB"), State Controller Steve Wesley stated that the revenues expected to be generated from the Amnesty Program should solve 14 percent of the state's budget crisis. However, while the program is expected to result in net revenue gains in 2005 and 2006, a revenue loss is projected for 2007, when the state will be required to refund early payments made by cautious taxpayers seeking to avoid the onerous penalties of the Amnesty Program.

This article describes the major provisions of the Amnesty Program, and highlights the key differences between the sales and use tax provisions and the income tax provisions.

As discussed below, the legislation employs a "carrot and a stick" approach, rewarding taxpayers who participate in the Amnesty Program, and punishing some of those who don't. The reader should be aware that, as of the date of this writing, some important issues regarding the administration of the Amnesty Program are still being decided.

The Amnesty Program

The amnesty period runs from February 1, 2005 to April 1, 2005,³ and the Amnesty Program applies to tax liabilities due and payable for tax reporting periods beginning before January 1, 2003.⁴ The legislation provides that the sales and use tax program will be administered by the California State Board of Equalization ("SBE"), and the personal and corporation income tax program will be administered by the FTB.⁵

Relief Provided by the Amnesty Program

The primary benefit of participating in the Amnesty Program is that the SBE and FTB shall waive all penalties and fees for the tax reporting periods for which the Amnesty Program applies for the nonreporting or underreporting of tax liabilities or the nonpayment of any taxes previously determined or proposed to be determined.⁶ In addition, no criminal action will be brought against the taxpayer unless the taxpayer was already on notice that a criminal investigation had been initiated.⁷ However, no refund or credit shall be granted of any penalty paid prior to the time the taxpayer makes a request for tax amnesty.⁸

One significant difference between the sales and use tax program and the income tax program is that taxpayers participating in the Amnesty Program may file claims for refund on sales and use tax paid but are prohibited from filing claims for refunds for franchise and income taxes paid to the extent that the taxpayer participated in the Amnesty Program.⁹ Consequently, a taxpayer entering the income tax program (unlike the sales and use tax program), relinquishes any further rights to contest the taxes paid in the income tax program. Thus, the issues involved in considering whether to participate in the income tax program are more complex than for the sales and use tax program.

New Penalties

Except for taxpayers who have valid installment agreements, the Amnesty Program also creates a strict new penalty for underpayment of tax existing as of April 1, 2005, regardless of whether the SBE or FTB has determined that an underpayment exists by that date. The penalty is equal to 50 percent of the accrued interest payable for the period beginning on the last date prescribed by law for the payment of that tax (determined without regard to extensions) and ending on the last day of the amnesty period.¹⁰ This penalty is in addition to any other penalty that may be imposed.¹¹ Thus, for example, if on June 1, 2005, the FTB initiates a personal income tax audit for tax year 2001 and issues a deficiency assessment on March 1, 2006, the taxpayer would be subject to a penalty of 50 percent of the interest that accrued between April 16, 2002, and April 1, 2005, in addition to any other penalties that might have applied.

It is important to note that this 50 percent interest penalty is mandatory; there is no statutory exception to the penalty nor any provision to waive the penalty. This has obvious implications for matters that are currently pending at audit, in protest, on appeal, or in settlement, as well as for matters that have yet to be identified by the SBE or FTB. In addition, because taxpayers may not file a claim for refund on the 50 percent interest penalty,¹² the only way to avoid the penalty appears to be to successfully defeat the underlying tax.

In addition, for underpayments of sales and use tax found to be due after April 1, 2005, for a period prior to January 1, 2003, the SBE may assess a penalty "that is double the rate of penalties described in law...."¹³ If the SBE issues a deficiency assessment under this provision, it may do so within 10 years after the last day of the calendar month following the quarterly period for which the amount is proposed to be determined.¹⁴ In effect, the SBE is given a limited 10-year statute of limitation for all open years prior to January 1, 2003.

In contrast, the FTB cannot issue penalties at double the rate, nor does it have a 10-year statute of limitation. However, the accuracy-related penalty is increased from 20 percent to 40 percent for any underpayments of income tax found to be due after April 1, 2005, for a period prior to January 1, 2003.¹⁵ This increased accuracy-related penalty rate does not apply if the taxpayer is under audit, protest, appeal, settlement or in litigation as of February 1, 2005.¹⁶

In addition, if any overpayment of tax shown on an original or amended return filed under the income tax amnesty is refunded or credited within 180 days after such return is filed, no interest shall be allowed on that overpayment.¹⁷

Requirements for Participation in the Amnesty Program

There are three general requirements to qualify for participation in the Amnesty Program: (1) the taxpayer must be eligible to participate in the Amnesty Program; (2) the taxpayer must file a completed amnesty application with the SBE or FTB, signed under penalty of perjury, electing to participate in Amnesty Program; and (3) within 60 days after the conclusion of the Amnesty Program, the taxpayer must file completed tax returns for all tax reporting periods for which he or she has not previously filed a tax return and file completed amended returns for all tax reporting periods for which he or she underreported his or her tax liability, and the taxpayer must pay in full the taxes and interest due for all periods for which amnesty is requested.¹⁸ The taxpayer also may apply for an installment agreement, to be paid in full by June 30, 2006.¹⁹ It is unclear whether the FTB and SBE will automatically accept all requests for installment payments, along with the terms requested. If these agencies intend to exercise discretion in accepting or rejecting these requests, it is unclear what standards they would apply in the exercise of this discretion.

The first requirement regarding eligibility is not clearly defined. It appears that any taxpayer with an open year prior to January 1, 2003, qualifies, including taxpayers currently under audit, on a petition for redetermination, in settlement or in litigation. Consistent with the statutory requirement that the process be as streamlined as possible to ensure maximum participation, it is anticipated that the SBE and FTB will take an expansive view of who is eligible. Two clear exceptions exist for eligibility in the program: (1) taxpayers in bankruptcy, who are required to have an order of the bankruptcy court to participate in the Amnesty Program,²⁰ and (2) tax violations for which a notice of criminal action has been sent to the taxpayer.²¹

In addition, the franchise/income tax Amnesty Program does not apply to any nonreported or underreported tax liability amounts attributable to tax shelter items that could have been reported under either the FTB's 2004 Voluntary Compliance Initiative or the IRS's Offshore Voluntary Compliance Initiative described in Revenue Procedure 2003-11.²² Thus, the Amnesty Program is not intended to provide a "second bite at the apple" for taxpayers who should have entered VCI. However, inasmuch as taxpayers were required to "self-assess" their qualification for VCI, this raises issues as to the meaning of what "could have been reported under" VCI. Although we have not received confirmation from the FTB, we assume that this limitation will only apply to items such as listed transactions or other clearly identified tax shelter transactions. In addition, we believe that taxpayers should be able to put some non-listed transactions into the Amnesty Program, even if the taxpayer also has listed transactions for those same years that are barred from the Amnesty Program.

The second requirement is self-explanatory. The SBE has released its application: SBE Form 899.²³ In addition, the FTB has released its application forms: FTB Form 2300 PIT for individuals, and FTB Form 2300 BE for businesses.²⁴ These forms are relatively straightforward two-page forms.

The third requirement also is self-explanatory, in that returns must be filed or amended and all taxes and interest must be paid by May 30, 2005, except that persons entering into installment agreements have until June 30, 2006, to pay the tax and interest due.

Administration of the Amnesty Program

The SBE and FTB are required to issue forms and instructions and take other actions needed to implement the amnesty. In addition, the SBE shall adequately publicize the Amnesty Program so as to maximize public awareness of and the participation in the amnesty. The SBE shall coordinate to the highest degree possible its publicity efforts and other actions taken in implementing this article with similar programs administered by the FTB. In addition, the FTB is also specifically required to make reasonable efforts to identify taxpayer liabilities and, to the extent practicable, send written notice to taxpayers of their eligibility for the Amnesty Program. However, the FTB's failure to notify a taxpayer of the existence or correct amount of a tax liability eligible for the Amnesty Program shall not preclude the taxpayer from participating in the Amnesty Program, nor shall such failure be grounds for abating the 50 percent interest penalty (discussed in detail above).²⁵ The FTB anticipates sending out over 2 million notices to taxpayers, many of which have already been sent.

Conclusion

Taxpayers should carefully consider their filing strategies when assessing the impact of the Amnesty Program on any existing or potential deficiencies for periods prior to January 1, 2003, as well as the potential for deficiencies that may be assessed after April 1, 2005, for such periods. "California Tax Amnesty Considerations in a Nutshell" on page 3 provides an overview of certain considerations to be taken into account when deciding if, and how, to participate in the Amnesty Program.

California Tax Amnesty Considerations in a Nutshell

All taxpayers that owe or may owe California corporate or personal income taxes or sales and use taxes for open periods beginning before January 1, 2003 should consider the following:

Corporate and Personal Income Taxes

• If you will owe taxes for a period covered by the Amnesty Program (i.e., open years beginning before 1/1/03), consider paying those taxes on or by 4/1/05 to avoid the 50% interest penalty

• In evaluating whether you will owe taxes for a period covered by Amnesty Program, do not forget to identify federal RARs that will flow through to California

• If accuracy-related penalties have been or are likely to be assessed and upheld, consider entering the Amnesty Program, but understand that you will waive your right to seek a refund of any amounts paid

• If accuracy-related penalties are unlikely to be assessed or upheld, consider paying an amount you estimate might be owed outside of the Amnesty Program (i.e., under normal payment procedures) and then file a claim for refund

• If you are in the Settlement Bureau or the Protest Section, try to get the case resolved by 3/31/05 to allow payment of the agreed amount by 4/1/05

Sales and Use Taxes

• If you will owe sales and use taxes for a period covered by the Amnesty Program (i.e., open years beginning before 1/1/03), consider paying those taxes on or by 4/1/05 to avoid the 50% interest penalty and doubling of other penalties and file a claim for refund

• Payment outside of the Amnesty Program only requires payment of the tax

• Payment through the Amnesty Program will enable you to avoid penalties for the nonreporting, nonpayment and underpayment of tax, and you will not waive your right to further contest the tax

• Payment through the Amnesty Program requires the payment of tax and interest

• If you are in the Settlement Bureau or the Appeals Section, try to get the case resolved by 3/31/05 to allow payment of the agreed amount by 4/1/05

Footnotes

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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