California passed a law imposing a 20 percent levy on any franchise tax understatement if, for any taxable year beginning on or after Jan. 1, 2003, the understatement exceeds $1 million.1 For past tax years, a taxpayer may avoid the levy by filing amended "safe harbor" returns by June 1. (The statutory May 31 date falls on a Sunday.) A unitary group, to avoid penalty risk, must report and pay an amount of no less than $1 million below the group's greatest possible tax liability for each year by the June 1 deadline.2

This, of course, creates problems for a taxpayer with tax liabilities that are difficult to determine. It also creates a dilemma for taxpayers that have recently settled their tax liability for any year with the Internal Revenue Service. The Franchise Tax Board is not bound to follow an IRS settlement and, in some cases, has explicitly refused to follow IRS settlements.3 Even worse off may be a taxpayer that faces ambiguities related to timing items. For purposes of the 20 percent levy, an overstatement in one year will not offset an understatement in another year, even if the overstatement and understatement are attributable to the same timing item that reverses itself entirely. The only way that a taxpayer with an uncertain timing item can avoid the penalty with a June 1 return is to compute its tax based on the maximum possible tax liability for each year.

What do I do while the Cal-Tax lawsuit is pending?

The California Taxpayers' Association has sued the California Franchise Tax Board to invalidate the levy.4 The petition was filed in February and Cal-Tax's briefs were filed last month.5 The FTB has responded by filing a demurrer to Cal-Tax's petition challenging (among other things) Cal-Tax's standing and the ripeness of the claim. The hearing regarding the FTB's demurrer will be held April 24. If the demurrer is denied, argument regarding the substantive issues is scheduled for May 8.

It is hoped that Cal-Tax will prevail and the court will enjoin the levy. In the meantime, for the upcoming June 1 deadline, taxpayers should consider:

  • Preparing amended returns (or Form 650) to be ready to meet the June 1 deadline. These documents must be thoughtfully prepared so that a taxpayer pays and discloses as little as necessary to avoid the levy, while meeting the legal standards required for a valid report. If a taxpayer is uncertain or uneasy about its approach, consider consulting with legal counsel.
  • Holding the returns or Form 650 until as late as possible to see if the court will rule in favor of Cal-Tax.6

For 2008 returns, consider the following steps, which will take some time and thus require immediate attention:

  • Getting a ruling from the FTB on items, especially timing items, for which even a conservative filing position offers little practical protection.
  • Filing a parallel suit to Cal-Tax's suit in a county other than Sacramento (where Cal-Tax filed its lawsuit), or perhaps in federal court, to increase the odds that at least one court will ultimately enjoin the levy.