Tax Amnesty Brings State a Windfall

Cash-starved California is getting significant relief from an unexpected place: a tax amnesty program that has shocked officials by raking in $838 million for the state -- nearly 10 times more than expected.

Considered a long shot for major budget savings when it was passed by the Legislature last year, the amnesty is directed at Californians who used illegal tax shelters to hide their money from the government. It has shaped up to become one of the most clever budget moves since the state’s finances went into free fall.

“At a time when there is no good budget news, we have done something very proactive to make this happen in a way that is bigger than anybody ever dreamed of,” said state Controller Steve Westly.

The money could help the state stave off some program cuts as officials struggle with a projected $14-billion shortfall for the budget year that begins in July.

The amnesty is part of a crackdown on illegal shelters that tax officials estimate have cost the state as much as $4 billion over the last four years, and which in some cases are being sold by major accounting firms. State officials scoured the last few years’ worth of tax returns for signs of participation in such schemes, and then sent 31,000 letters out to Californians to warn them they might not have paid everything they owed, and could be subject to harsh fines if they didn’t settle up during the amnesty period, which ended last week.

The new law extends the length of time tax officials have to build their cases and dramatically increases penalties. For example, a person who evaded paying $10 million in taxes would have had to pay only that amount plus interest, about $13 million total, if he or she were caught under the old law.

Now that person would be forced to pay nearly $28 million in back taxes and fines, and the company that created the shelter could also be fined millions of dollars.

Officials are still tallying tax returns and say the final count could still be tens of millions of dollars higher.

So far, they say, 460 individuals have registered for amnesty, generating $589 million for the budget. In addition, 182 businesses have paid back taxes under the program to date, bringing in $249 million, according to the state Franchise Tax Board.

“We knew there were a lot of shelters out there, but nobody thought we would get so much from this,” said Joseph Bankman, a professor of tax law at Stanford who helped write the legislation.

The success of the amnesty highlights how widespread the complicated tax shelter schemes are. They generally involve wealthy individuals and corporations being approached by firms with proposals to exploit loopholes in tax law. In many cases, they are challenged by the state or federal government and struck down in court, but investigators wouldn’t have the resources to go after every taxpayer using them.

According to the Franchise Tax Board, the shelters proliferated in the 1990s as taxpayers experienced large stock market gains and the Internal Revenue Service scaled back its investigations into the schemes. Firms that marketed the shelters would even produce letters from lawyers saying they were “legally defensible.”

Many of those assurances turned out to be worthless, tax officials say, and now some of the taxpayers who have been caught using illegal shelters are suing the accounting firms that created them.

Last month, one such case was filed by Howard Ruby, chairman of Los Angeles-based corporate housing and apartment developer Oakwood Worldwide, against KPMG, one of the country’s biggest accounting firms. Ruby alleges that he paid the firm $2.9 million to generate the appearance of a $40-million loss he could deduct from his taxes -- and that the firm advised him that “more likely than not” the IRS would accept the deductions, even though KPMG representatives knew otherwise.

Now the tax shelter he used is under investigation by the IRS.

A KPMG spokesman said Ruby’s allegations were “without merit.”

In a typical shelter, a person might take money out of the bank, put it into a corporation he or she created, draft an IOU for himself or herself and then sell the corporation for nothing. The person then would report a loss, even though he or she would get the money back through the IOU.

Most of the shelters “promise things too good to be true,” Bankman said. “They are based on some technical snafus in the regulations that can be used to produce false law.”

According to Bankman, an individual needed at least $50 million to be able to use one of the shelters, “so they don’t apply to the average person.”

The cost and time involved in investigating made it difficult for authorities to go after everyone using them. Before the law was changed last year, the penalties for illegally sheltering money were negligible.

“The penalties were so low it was not a big risk. There was not even a slap on the wrist,” said Assemblyman Dario Frommer (D-Los Angeles), who led the effort to crack down on the shelters.

He became interested in the issue after a hiking companion who works as a tax investigator suggested the state could generate hundreds of millions of dollars if the penalties were stiffer and the Franchise Tax Board had more time to investigate cases.

“It would take years to build a case against someone,” Frommer said. “By the time the state did, the statute would have retired.” In many cases, the government was settling for 80 cents on the dollar. Getting caught was so rare, Frommer said, that buyers of the shelters could even get insurance for them that would cover their penalties if the state did catch them.

“People are realizing the state is serious about this and they are stepping forward,” Bankman said.