State tax shelters and state taxation of capital.

I. INTRODUCTION

State income tax is a most demanding area of practice. It requires knowledge of federal income tax, constitutional issues that play no role in federal income tax, and the substitutes at the state level for the income tax. I have not specialized in this field and will not address many of the important doctrinal distinctions or policy options that occupy the time of the practitioner or state official. However, I have had long experience with the larger topic of this issue: tax shelters and the taxation of capital. I have also had some limited experience with real life issues in state tax planning. In any event, I am prepared to venture an overview of where I think we are with respect to the tax shelter problem and the greater issue surrounding state taxation of income from capital.

To anticipate, I think we have had some signal victories in the fight against combined federal and state tax shelters. The shelter market as it existed a decade ago is pretty much gone. There is more to be done, at the state as well as federal level; but I think there is the will to do it. The only cloud on the horizon is the prospect of a Supreme Court decision (or a series of appellate court decisions) that could pump new life into the shelter market.

I am less optimistic as to whether we can prevent aggressive tax planning aimed at reducing state (but not federal and state) revenue from capital. The reason for this is the growing ascendancy of intellectual over physical capital. Traditional tax concepts, such as sourcing, are difficult to apply to intellectual capital. Intellectual capital is also more mobile, and because of that, tax competition for intellectual capital is more powerful. Unfortunately, some of the same reasons that make it hard to tax income from capital also threaten the state's ability to tap other revenue sources, such as sales and payroll. State tax officials will have to work hard to come up with the revenues needed to fund the typical functions of state and local government.

II. DEFINITIONS

One difficulty in discussing the tax shelter problem is that there is no uniform definition of the term tax shelter. Here, I will use the definition I have put forth in earlier writings. A tax shelter is a transaction that (a) reduces the tax on capital; (b) in a manner that is consistent (or purports to be consistent) with the literal language of a statute (regulation); (c) but is strongly inconsistent with any notion of legislative (administrative) intent or purpose; and (d) that has little or no non-tax business purpose. (1)

Shelters often exhibit "secondary" characteristics. These include the presence of non-taxable entities and the role of financial intermediaries as promoters. In a typical shelter, a revenue stream is bifurcated for tax purposes, with items of income shunted to the nontaxable entity and items of expense shunted to the shelter purchaser. (2)

I will use the term "quasi-tax shelter" or "aggressive jurisdictional tax planning" to define transactions that reduce state taxes but do not fall within this definition of shelter. A transaction that transfers intellectual property of a related corporate group to an intangible holding company is an example of a quasi-tax shelter or aggressive jurisdictional tax planning. I will use the term jurisdictional tax planning to describe less aggressive means to reduce state taxes, including but not limited to the practice of placing property in low tax states.

I differentiate between tax shelters, quasi-tax shelters, and jurisdictional tax planning because I believe transactions that fall into these categories raise different issues. To take but one example, tax shelters can be attacked through the economic substance and related doctrines; the same is not true of jurisdictional tax planning.

Other commentators have used other terms to describe the transactions discussed in this article. The State of California, for example, uses the term "abusive tax shelter" to describe what I call a tax shelter. (3) The Multistate Tax Commission includes most of what I call jurisdictional tax planning in the definition of tax shelter. (4) In general, my definition of tax shelter is narrower than other definitions. This is due to the prong of my definition that deals with legislative (administrative) intent. Under my definition, a transaction is not a shelter unless it is strongly inconsistent with legislative intent or purpose. Many aggressive transactions can fit within some notion of legislative intent or rely on statutes for which no meaningful notion of legislative intent can be gleaned. These transactions do not fall within my definition of tax shelter.

In the end, no definition can adequately encompass all transactions, and nothing much hinges on whether one adopts one definition over another. What is important is that we recognize that taxpayers use many different methods to reduce the tax on capital and that we separately discuss the proper response for each of these methods.

III. STATE AND FEDERAL TAX SHELTERS

Most of the transactions I describe as tax shelters are used, or have been used, to reduce taxable income on both the federal and state levels. The federal government has had considerable success in limiting these transactions and the states have benefited from that federal success. There have been significant victories at the state level, too, with corresponding benefit to the federal government.

A decade ago, the shelter market was in full flower. Some of the nation's largest companies had entered into transactions without (nontax) business purpose in order to generate a tax loss. Some of these transactions--such those involving contingent installment sale or stepped-down preferred--had been uncovered by the Internal Revenue Service (Service) or stopped by quick administrative action. The Service had not detected most shelters (such as lease strips or loss import shelters). (5) As a result, shelters had proven an attractive investment for "early bird" purchasers. Shelters were sold by leading financial intermediaries who had access to corporate America and who could amortize costs over many purchasers. Those intermediaries were just gearing up to "down" market shelters to individual entrepreneurs and executives.

These corporate and individual shelters were primarily aimed at reducing federal taxes but substantially reduced state taxes as well. Some idea of the effect of shelters on state revenues can be gleaned from the 2003 anti-shelter legislation enacted in California. That legislation did not change the substantive law but it did significantly increase penalties on certain transactions that were held invalid due to lack of economic substance. The increase was effective prospectively, and for adjustments made to past years still subject to audit. The increase was accompanied by an amnesty provision; taxpayers could avoid the new penalties by filing amended returns, giving up shelter losses and paying the full amount due, plus interest and any penalties under prior law, on the recomputed income. (6)

The amnesty provision raised approximately $1.4 billion dollars. (7) This reflected a "give back" of approximately $15 billion dollars of shelter losses claimed by California taxpayers or corporate taxpayers on income subject to California tax. (8) Some of the amounts received were paid by taxpayers who are contesting their liability and will be returned to taxpayers if their positions are upheld. In that respect, the amnesty overstates wrongful shelter deductions. In general, though, the amnesty figures undoubtedly understated shelter deductions. Many taxpayers did not qualify for amnesty and others no doubt decided to forgo the amnesty and bank instead on escaping detection on audit, or successfully defend their positions on audit, administrative hearings, or court.

Most of the readers of this article will be familiar with many of the state and federal responses to the shelter problem. A primary weapon against shelters has been stepped-up enforcement, due to better and more thorough audits, a series of victories giving the government the right to follow the paper trail of promoters, and, perhaps most importantly of all, the promulgation of disclosure rules. (9) Statutory civil penalties have increased, at the federal and state level. There also seems to be a noticeable increase in the number of cases in which the government asserts penalties. The government has substantially strengthened Circular 230, which governs practice before the Service. Circular 230 now imposes stringent requirements on attorneys who write shelter opinions or otherwise aide shelter promoters. (10) As noted above, there is no agreed-upon definition of a tax shelter and increased shelter-related penalties inevitably spill over and affect non-shelter related transactions. The most obvious consequence of new Circular 230 is the disclaimer that accompanies e-mails and other correspondence from most law firms. Of greatest interest, perhaps, is the criminal case now pending against promoters associated with the accounting firm of KMPG and the criminal charges settled with that firm. (11) Whatever the outcome (or even merits) of that case, the fact that the government is even willing to bring criminal charges against a leading financial intermediary and its employees is certain to have a chilling effect on the shelter market.