California Franchise Tax Board Designates Microcaptive Insurance Transactions, Some Conservation Easements as Tax Avoidance Transactions

On May 31, the California Franchise Tax Board (FTB) issued Notice 2023-02 to alert taxpayers and their representatives that it is following the Internal Revenue Service's designation of specific microcaptive insurance transactions and conservation easement transactions (collectively, eligible transactions) as tax avoidance transactions.

Notice 2023-02 also offers eligible taxpayers a process to resolve eligible transactions that may be subject to California’s noneconomic substance transaction understatement penalty by providing reduced penalties.

Eligible Transactions

Microcaptive Insurance Transactions

Microcaptive insurance transactions generally involve deductions of payments made by a taxpayer to a microcaptive insurance company, which is a captive insurance company that elects under Internal Revenue Code Section 831(b) to be taxed only on its investment income and not on its underwriting income (which must be less than the amount determined under IRC Section 831(b)(2)(A)(i)). As a tradeoff for this election, the captive insurer may not deduct its underwriting losses.

A major question for captive insurance companies is whether the captive program sufficiently resembles traditional insurance so that premiums can be deducted by insureds, or whether the captive insurance lacks such features and is merely nondeductible self-insurance. Insurance premiums paid to a captive insurance program are deductible for federal and California income tax purposes only if three requirements are satisfied: (i) the insurance risk is shifted from the insured to the insurer; (ii) the insurance risk is sufficiently distributed — that is, via the “law of large numbers;” and (iii) the program reflects “insurance” in the commonly accepted sense of the term.

In March and July 2020, the IRS issued letters to taxpayers who participated in transactions described in Notice 2016-66 (since vacated), alerting them that IRS enforcement activity in this area would expand significantly and providing them an opportunity to inform the IRS if they had discontinued their participation in microcaptive transactions before the IRS initiated examinations.

On March 10, 2021, the U.S. Tax Court held in Caylor Land & Development Inc. v. Commissioner, T.C. Memo. 2021-30, that yet another microcaptive arrangement failed to qualify as insurance for federal tax purposes. Caylor followed several Tax Court decisions that also affirmed the IRS's determinations that some microcaptive arrangements were not eligible for the claimed federal tax benefits. In Caylor, the Tax Court also sustained the IRS's assessment of accuracy-related penalties and rejected the taxpayer's claim that it acted in good faith and with reasonable cause based on tax advice.

Syndicated Conservation Easements

Syndicated easements involve several investors forming a partnership or company to purchase or invest in land, and then donating the property for a charitable deduction. Investors typically acquire an interest in a partnership that owns the land and then claim an inflated charitable contribution deduction based on a grossly overvalued appraisal when the partnership donates a conservation easement on the land.

A conservation easement is a restriction on the use of real property. Generally, taxpayers may claim a charitable contribution deduction for the fair market value of a conservation easement transferred to a charity if the transfer meets the requirements of IRC Section 170.

In Notice 2017-10, the IRS listed situations in which syndicated conservation easements can be abusive transactions. Further, it issued proposed regulations (REG-106134-22) identifying some syndicated conservation easement transactions as listed transactions, or abusive tax transactions that must be reported to the IRS.

Eligible Taxpayers

Taxpayers meeting the following criteria in FTB Notice 2023-02 will be considered eligible taxpayers:

• Taxpayers currently under examination by the FTB or IRS or with an appeal pending with the IRS Appeals Office regarding their participation in eligible transactions.
• Taxpayers that have received from the FTB a notice of proposed assessment regarding their participation in eligible transactions and have filed a protest of the proposed assessment with the FTB or are at appeal before the California Office of Tax Appeals.
• Taxpayers in litigation with the IRS regarding eligible transactions, but not taxpayers that are in litigation with the FTB regarding eligible transactions.
• Taxpayers that are direct or indirect partners in a partnership currently under examination by the IRS or the FTB or that is in litigation with the IRS.
• A partnership that is required to report final federal adjustments pursuant to Cal. Rev. & Tax. Code section 18622.5, or which has reported such adjustments for eligible transactions.
• A tiered partnership that is a partner to any of the situations above.

FTB Procedures

Under FTB Notice 2023-02, eligible taxpayers have from July 10, 2023, until November 17, 2023, to submit closing agreements to the FTB to resolve California income tax issues and agree to remit all tax, interest, and reduced penalties resulting from the concession of all previously claimed tax benefits pertaining to the eligible transactions and provide documentation regarding the eligible transactions.

The notice provides various instructions on courses of action taxpayers should take depending on whether they have received a notice of proposed assessment from the FTB, are under audit examination by the IRS or the FTB, or have already settled with the IRS regarding an eligible transaction.

Further, eligible taxpayers who do not participate in the resolution described in the notice or who fail to comply with all the requirements of the notice will be subject to all penalties and interest applicable to an eligible transaction. The FTB also states that it has 12 years to assess taxpayers with regard to eligible transactions.

Finally, FTB Notice 2023-02 outlines what procedures taxpayers need to take, such as correctly filing their returns with updated information and where to make payments.

Insights

Taxpayers who have engaged in transactions similar to those described above should document similar comparables to demonstrate that their transactions are at arm’s length and are not abusive. For instance, purchasing property with a value similar to that of other properties in the area would support a claim that a syndicated conservation easement is not abusive.

However, taxpayers currently involved in an audit with the FTB or IRS on such issues should be cognizant of the FTB notice and the dates that relief is available to avoid further penalties.