California's Franchise Tax Board (FTB) recently announced that taxpayers who filed a tax return that included "certain ESOP transactions" should resolve their accounts to avoid penalties:
The Franchise Tax Board (FTB) announced that taxpayers who filed a state income tax return or an amended return that included a state tax benefit from transactions referred to as either "bogus optional basis" (BOB) transactions or certain "employee stock ownership plan" (ESOP) transactions may qualify for relief from the noneconomic substance transaction (NEST) penalty.
Eligible California taxpayers have from June 23 to September 12, 2008, to resolve certain transactions that may be subject to the NEST penalty. To participate, taxpayers must submit a signed and completed closing agreement (FTB Notice 2008 - 4) on or before September 12, and pay all tax, penalties, and interest relating to the conceded tax benefits in full.
If a taxpayer previously received a Notice of Proposed Assessment (NPA) that included a 40 percent NEST penalty, FTB's Chief Counsel will use his authority under the tax code to reduce the NEST penalty from 40 percent to 20 percent. To receive the penalty reduction, the taxpayer must pay the revised penalty amount in full when submitting the closing agreement.
For taxpayers who paid a 40 percent NEST penalty prior to the date of this notice, FTB's Chief Counsel will reduce the penalty to 20 percent and refund any overpayment that is within the applicable statute of limitations. The taxpayer must fully comply with the terms of FTB Notice 20084.
If the taxpayer previously received an NPA that included a 100 percent interest-based penalty, FTB will abate the penalty if the assessment is still pending.
Taxpayers who have not been mailed an NPA for a BOB or ESOP transaction, whether they are under audit or not, should comply with the requirements of FTB Notice 20084. For taxpayers who comply, FTB will assess a 20 percent accuracy related penalty and will not assess the 100 percent interest-based penalty and will be relieved of other potential penalties relating to their participation in the eligible transactions including penalties under Revenue and Taxation Code Sections 19164(c), 19164.5, 19772, 19777, 19778, and former 19773.
FTB estimates that abusive tax shelters cost California $500 million in lost tax dollars each year. FTB will continue to aggressively pursue taxpayers and the promoters who participate in or recommend these tax shelters.
FTB Notice 2008 - 4 Resolution of Bogus Optional Basis (BOB) Transactions and Certain Employee Stock Ownership Plan (ESOP) Transactions describes the eligible and ineligible transactions:
ESOP Transactions. Transactions involving the use of employee stock ownership plans (ESOPs) that could be subject to a NEST penalty and were not eligible to participate in California's Tax Shelter Resolution Initiative, FTB Notice 2006-1. Three transactions involving ESOPs that were eligible under FTB Notice 2006-1 and that are not eligible under this Notice are: (1) transactions covered by Revenue Ruling 2003-6, 2003-1 C.B. 286; (2) transactions covered by Revenue Ruling 2004-4, 2004-1 C.B. 414; and (3) Management S corporation ESOP transactions described in the IRS's Transaction-specific Frequently Asked Questions released as part of IRS Announcement 2005-80, 2005-2 C.B. 967. The eligible transactions described in this paragraph may be referred to as "certain ESOP transactions."
Transactions, or any part, step or intermediate transactions, that are the same as, or substantially similar to, the following: (1) an ESOP purchases or otherwise obtains, or purports to have obtained, shares of stock or other equity interests in an entity (ESOP Entity) that is or was owned by Taxpayer and/or one or more of its related parties, directly or indirectly, at any time (ESOP Equity Purchase); (2) in one or more of the Taxable Years at Issue, fifty percent or more of the taxable income of the ESOP Entity is or was allocated, directly or indirectly, to the ESOP (ESOP Income Allocation); and/or (3) in one or more of the Taxable Years at Issue, Taxpayer recognized less taxable income from or attributable to (a) the ESOP Entity, and/or (b) the stock or other property transferred to the ESOP Entity than Taxpayer would have otherwise recognized without the ESOP Income Allocation.
One example of an eligible ESOP transaction is the following. Taxpayer A holds 100 percent of the outstanding stock of XYZ Corporation (an S corporation) on December 30, 2000. On December 31, 2000, Taxpayer A forms an ESOP. On January 1, 2001, Taxpayer A sells stock in XYZ Corporation to the ESOP. During tax years 2001 through 2004, Taxpayer A assigns income to XYZ Corporation or otherwise provides services through XYZ Corporation. All income earned or assigned to XYZ Corporation during tax years 2001 through 2004 is allocated to the ESOP. Prior to or on December 31, 2004, XYZ Corporation obligates itself to compensate Taxpayer A for prior services. Such obligation substantially reduces the fair market value of XYZ Corporation. Taxpayer A purchases one or more shares of XYZ Corporation stock from XYZ Corporation. XYZ Corporation repurchases the ESOP's shares of XYZ Corporation stock for substantially less than the fair market value of XYZ Corporation's assets due to its obligation to Taxpayer A. Taxpayer A again holds 100 percent of the outstanding stock of XYZ Corporation. Other variations of this transaction use different methods or obligations to reduce the value and/or increase the adjusted tax basis of XYZ Corporation or its outstanding stock.
- FTB Notice 2008 - 4 Resolution of Bogus Optional Basis (BOB) Transactions and Certain Employee Stock Ownership Plan (ESOP) Transactions
- FTB Notice 2006-1 California Tax Shelter Resolution Initiative California's Program for Participants in Internal Revenue Service (IRS) Settlement Initiative. Revenue Ruling 2003-6, 2003-1 C.B. 286
- IRS Announcement 2005-80, 2005-2 I.R.B. 967 Settlement Initiative Management S Corporation ESOP Transactions (Transactions where the taxpayer has claimed that it is entitled to exclude income of an operating business by asserting, incorrectly, that the taxpayer had established, on or before March 14, 2001, an employee stock ownership plan entitled to an exemption from unrelated business income and an S corporation that is a management corporation, and whatever actions that were taken to attempt to establish an employee stock ownership plan and a management S corporation were taken on or before March 14, 2001
- IRS Revenue Ruling 2004-4, 2004-6 I.R.B. 414 Prohibited Allocations of Securities in an S Corporation Transactions that involve segregating the business profits of an employee stock ownership plan (ESOP)-owned S corporation in a qualified subchapter S subsidiary, so that rank-and-file employees do not benefit from participation in the ESOP
- IRS Revenue Ruling 2003-6, 2003-3 I.R.B. 286 Prohibited Allocations of Securities in an S Corporation Certain arrangements involving the transfer of ESOPs that hold stock in an S corporation for the purpose of claiming eligibility for the delayed effective date of § 409(p)
- FTB Notice 2008-4 Closing Agreement (fill-in PDF)
- Instructions for Completing FTB Notice 2008-4 Closing Agreement