By Matt Spradling and Hale Stewart
The State of California recently released FTB Notice 2023-02, which announced the Franchise Tax Board’s creation of a “resolution process” enabling certain taxpayers to resolve specific transactions that are possibly subject to the non-economic substance transaction (“NEST”) understatement penalties. Taxpayers must decide whether to voluntarily amend returns and unwind the benefits of these transactions by November 17, 2023. The Notice suggests further targeted enforcement of these transactions (audits) will begin in earnest following that date.
According to the notice, taxpayers who have engaged in certain micro-captive insurance or syndicated conservation easement transactions could be “subject to the NEST penalty under Revenue and Taxation Code (“RTC”) section 1974 as well as other penalties.” However, qualifying taxpayers will now be eligible for reduced penalties if they opt into the FTB’s resolution process.
Taxpayers that are eligible for the resolution process are able to submit closing agreements in order to reverse the tax benefits while receiving reduced penalties for applicable tax years.
Notice 2023-02 defined micro-captive insurance transactions as including those in “which a taxpayer attempts to reduce the aggregate taxable income of the taxpayer, related persons, or both, by using contracts the parties treat as insurance contracts and a related company the parties treat as a captive insurance company.”
In these transactions, the entity the parties are treating as a captive insurance company elects to be taxed only on investment income under Internal Revenue Code (“IRC”) Section 831(b).
“The captive insurance company uses the premium income for purposes other than administering and paying claims under the contracts, and instead uses the premium income to benefit the taxpayer, the insured entities, or related persons, such as through transfers of the premium income to them in a manner the taxpayer contends is not taxable, such as via loans,” the notice stated.
In these scenarios, the manner in which the parties apply the contracts is not consistent with an arm’s length transaction. Because the arrangement doesn’t meet the standard requirements for insurance such as insurance risk, risk shifting, risk distribution or insurance in the commonly accepted sense, the notice explained that the transactions do “not constitute insurance for purpose of the deductibility of the payments as business expenses for federal and California income tax purposes.”
Certain syndicated conservation easement transactions will also qualify for the state’s resolution process. According to the notice, which described in detail the inner workings of syndicated conservation easements, these transactions include ones “where a taxpayer participates in an investment opportunity which purport to grant investors charitable contribution deductions with respect to conservation easement or fee simple donations in amounts that significantly exceed the amounts invested.”
Transactions that promote deductions equal to or greater than two and one-half times the investor’s investment, or where the promotional materials for the transaction don’t specify a charitable deduction multiple of the investor’s investment will be considered “Eligible Transactions” under the notice.
In order to qualify for participation in the resolution process, taxpayers must have claimed state tax benefits on an original or amended return from an “Eligible Transaction” described in the notice. Further, qualifying taxpayers include those in specific circumstances outlined in the notice.
Some examples include taxpayers who:
- Are currently under examination by the FTB or under examination by the Internal Revenue Service (IRS) or at IRS appeals with respect to their participation in Eligible Transactions;
- Have received a notice of proposed assessment from FTB with respect to their participation in an Eligible Transaction and are at protest with FTB or are at appeal before the Office of Tax Appeals; or
- Are in litigation with the IRS with respect to Eligible Transactions, but do not include taxpayers who are in litigation with the FTB regarding an Eligible Transaction.
The notice outlined the actual resolution procedure and stated that taxpayers will need to submit a Notice 2023-02 Closing Agreement that is completed and signed between July 10, 2023, and November 17, 2023.
Taxpayers who submit a closing agreement will need to pay all taxes, applicable penalties, and accrued interest by the closing date of November 17, or enter into an installment payment arrangement.
In addition, taxpayers who “directly or indirectly entered into an Eligible Transaction(s) prior to the date of this Notice but have not yet realized the tax benefits from any Eligible Transaction(s) are not eligible to participate in the resolution [process].”
Matt Spradling is a Senior Associate at Zerbe, Miller, Fingeret, Frank & Jadav LLP. He currently assists clients with tax compliance and planning issues; he also represents taxpayers before the IRS, in Federal Tax Court, and before various state taxing authorities. mspradling@zmflaw.com.
Hale Stewart is a Senior Associate at Zerbe, Miller, Fingeret, Frank & Jadav LLP. He has been practicing in the area of captive insurance and alternative risk transfer for over 12 years. He is the author of U.S. Captive Insurance Law, Captive Insurance in Plain English and is a regular contributor to the International Risk Management Institute’s alternative risk financing library. hstewart@zmflaw.com
