Kentucky does not have a reputation as a taxpayer-friendly jurisdiction. Not so long ago, the State’s Legislature took steps to deny taxpayers refunds plainly due under a Kentucky Supreme Court decision.1 Now, the State Legislature has taken another step to alienate the taxpayer community by enacting a hopelessly complex “amnesty” program with ridiculously onerous penalties for failure to comply.
Kentucky’s new amnesty program went into effect on October 1, 2012 and remains open until November 30, 2012. Like all amnesty programs, it is designed to motivate taxpayers to file and pay taxes for past periods with a “carrot and stick” approach. The “stick” Kentucky wields includes “fees” and penalties of up to 150% of the tax liability and additional interest. Unlike many amnesty programs, Kentucky’s program not only requires taxpayers to file and pay for past periods, but also threatens to retroactively disqualify taxpayers that fail to pay taxes for future periods!
Whether or not the new program violates the Due Process Clause–and it may well do so–the program is certainly the wrong direction for a state that already draws animosity from a sizeable segment of the business community.
In this article, we summarize the terms of Kentucky’s amnesty program and outline the reasons why we believe the program goes too far. Then, we briefly review challenges taxpayers have brought to onerous penalties in other jurisdictions and offer a few reflections on a potential challenge to Kentucky’s amnesty penalties, known in the statute as “costof- collection fees.”
Tax Amnesty: Carrot and Stick
First, let’s take a look at the carrot: when a taxpayer applies to the amnesty program, it is eligible for a waiver of all penalties and half of the interest for taxes2 paid for the periods ending between December 1, 2001 and September 30, 2011 (the “Eligible Periods”).3
In order to achieve this benefit, the taxpayer must make several significant concessions. The taxpayer must file returns and pay the tax due for the Eligible Periods and must pay any taxes “previously assessed by the department that are due and owing” when the taxpayer applies for amnesty.4 In addition, the taxpayer must also file returns and pay the taxes due for periods after the Eligible Periods, beginning October 1, 2011 through the date that the amnesty is granted. Finally, the taxpayer must agree to file returns and pay the taxes due for the three years after the date that the taxpayer is granted amnesty.5 Thus, for example, if a taxpayer applies for and is granted amnesty effective November 1, 2012, then the taxpayer must: (1) file returns and pay the taxes due for the Eligible Periods; (2) file returns and pay the taxes due for the 13 months after the Eligible Periods through the date that amnesty is granted (i.e., October 1, 2011 through October 31, 2012); and (3) agree to file returns and pay the taxes due for the three years after amnesty is granted (i.e., November 1, 2012 through October 31, 2015). In total, then, the taxpayer has filed returns and paid the taxes due for the nearly 10-year Eligible Periods, plus an additional period of approximately four years.
Furthermore, the taxpayer waives all right to claim a refund of amounts paid under the amnesty program.6 In this regard, the statute provides that: “Unless the department in its own discretion redetermines the amount of taxes due, no refund or credit shall be granted for any taxes paid under the amnesty program. Any administrative or judicial proceeding or claim seeking the refund or recovery of any amount paid under an amnesty program is hereby barred.”7
In exchange, Kentucky will waive penalties and half of the interest for taxes paid for the Eligible Periods only.
Now, let’s look at the stick: if a taxpayer elects not to participate in the amnesty program, then the taxpayer subjects itself to a series of additional impositions (called “cost-of-collection fees,” but which are plainly penalties) and interest. First, all taxes “which are or become due and owing to the department for any reporting period” are subject to a 25% “cost-ofcollection fee.”8 Second, any taxes that are assessed and collected after the conclusion of the amnesty program for tax periods during the Eligible Periods, are subject to another 25% “cost-ofcollection fee.”9 Third, a taxpayer that fails to file a return for any of the Eligible Periods (e.g., because it disputes nexus) is subject to an additional 50% “cost-ofcollection fee.”10 It appears that each of these fees is assessable in addition to the other fees11 and in addition to all of the State’s normal penalties, which themselves can add up to 50% to the assessment.12 Finally, the Department may also add 2% to the normal interest imposed on deficiencies.13 The shocking math here can be illustrated in a simple example:
Suppose Company A has concluded that it has no use tax collection responsibility on sales of products into Kentucky for tax year 2010. In 2013, the Department audits and imposes use taxes of $500,000. Taking the new amnesty statute at face value, the Department may now add cost-of-collection fees and penalties of up to $750,000 and impose interest at the normal rate (currently 6%) plus an additional 2%.14
Some amnesty program, huh? And, if you are still sanguine, consider that the taxpayer apparently has no right whatsoever to protest the cost-ofcollection fees.15
These blows can be softened if the Department chooses to do so. The statutes provide that “[t]he commissioner shall have the right to waive any penalties or collection fees when it is demonstrated that any deficiency of the taxpayer was due to reasonable cause.”16 “Reasonable cause” is defined as “an event, happening, or circumstance entirely beyond the knowledge or control of a taxpayer who has exercised due care and prudence in the filing of a return or report or the payment of moneys due the department pursuant to law or administrative regulation.”17 But without some process for requiring the Commissioner to exercise this right, it’s hard to feel confident that a taxpayer will avoid these onerous fees and penalties, given that taxpayers and tax collectors often disagree about what is “reasonable.”
In sum, Kentucky’s amnesty program stands out as a particularly coercive means to encourage taxpayers to file and pay liabilities for past and future periods. Because tax issues are often subject to good faith controversies, the interplay of onerous “fees” and interest and the prohibition against refund claims for taxpayers who submit to the program to avoid this exposure makes the program profoundly unfair. Certainly, we are not aware of any other state that has recently implemented an amnesty program that requires the taxpayer to: (1) file returns and pay the taxes that may not be due; (2) waive any right to a refund of those controversial taxes; and (3) pay all of the other taxes that may be due for a number of future years.18 All of this is in order to avoid fees and penalties of up to 150% of the tax, plus additional interest.
Challenges to Other Onerous Penalties
In evaluating the prospects of challenging the Kentucky program, we should note that taxpayers have generally been unsuccessful in challenging onerous penalties imposed in connection with other amnesty programs. For example, in 2004, California implemented an amnesty program that required taxpayers to pay the tax and interest due for the eligible periods and also to pay the tax and interest proposed to be assessed for the eligible periods.19 As in Kentucky’s program, the taxpayer waived any right to a claim for refund for amounts paid under the program.20 If a taxpayer elected not to participate, it was subject to an additional penalty in the amount of 50% of the accrued interest.21 River Garden Retirement Home (“River Garden”) challenged the program on various grounds. In that case, there was a tax liability for the eligible periods that was the subject of a pending administrative appeal during the period in which the amnesty program was in effect.22 River Garden chose not to participate in the amnesty program. When River Garden lost its administrative appeal, the Franchise Tax Board imposed the amnesty penalties, in addition to the other penalties and interest, as part of the final assessment.23 River Garden paid the assessment and sued for a refund, arguing, inter alia, that the penalties were “aimed at coercing taxpayers to pay liabilities before they are finally determined” and, therefore, were “contrary to a long-standing policy affording taxpayers an opportunity to challenge disputed assessments before paying.”24
The court rejected this argument. It observed that River Garden “could have paid the proposed assessment [under the amnesty program] . . . , and pursued its administrative remedy without fear of accruing [the amnesty penalties].”25 The court emphasized the purported voluntary nature of the amnesty program by stating that “River Garden seems to forget that this is an amnesty program – there are benefits to participating and adverse consequences for not participating, which means the taxpayer can undertake a costbenefit analysis to determine if coming in under amnesty is worth it.”26 Thus, the court implied that the terms of the amnesty program at issue in that case were not so onerous as to be tantamount to an involuntary, coercive means to force taxpayers to pay outstanding liabilities.
In another California case, a taxpayer organization, California Taxpayers Association (“CalTax”), challenged California’s “large corporate understatement penalty,” which imposed a 20% penalty on any corporate underpayment of more than $1 million.27 CalTax argued that the penalty violated the State constitution and also violated procedural due process because it did not afford taxpayers an adequate pre- or post-payment review process.28 The court relied on the McKesson rule that, in order to “satisfy the commands of the Due Process Clause,” a state must provide “a predeprivation or postdeprivation procedural safeguard against unlawful exactions.”29
The court agreed with CalTax that the penalty statute, taken alone, did not provide a constitutionally adequate review process.30 The statute provided that “[a] refund or credit for any amount… may be allowed only on the grounds that the amount of the penalty was not properly computed by the Franchise Tax Board.”31 Because the statutory remedy was so limited, the court held that it did not “satisfy th[e] due process mandate.”32 However, the court also found that the limitation on claims for refund applied only to administrative claims and that the generally applicable statutes permitting a taxpayer to sue for a refund in court applied and provided constitutionally adequate protection for the taxpayer.33
Although neither of the plaintiffs were successful in challenging the penalties at issue in River Garden and CalTax, the cases provide a few guidelines that are helpful in framing an analysis of the Kentucky amnesty program. First, under the terms of Kentucky’s amnesty statutes, can it fairly be said that the taxpayer may perform a “cost-benefit” analysis and make a free choice as to whether or not to participate in the program? Second, does the taxpayer have access to a constitutionally adequate process to challenge the amnesty “fees,” if they are imposed?
Is Kentucky’s Amnesty Program Subject to Challenge?
As we noted above, Kentucky’s amnesty program seems to impose particularly onerous penalties and fees (i.e., of up to 150%) and a particularly harsh requirement that taxpayers waive their rights to challenge taxes paid both during the Eligible Periods and for approximately four years afterward. In light of these facts, we question whether a taxpayer can be characterized as having a choice as to whether to participate in the program.
For example, if a taxpayer has a potential tax liability for the Eligible Periods of approximately $1 million, but has a strong legal argument that the tax is not due, the taxpayer’s “choice” is to: (1) participate in the amnesty program, pay $1 million and give up its right to challenge the tax; or (2) not participate in the program and risk being assessed $1 million in tax, plus $1.5 million in amnesty cost-ofcollection fees and additional amnesty interest, in addition to the otherwise applicable interest and penalties. The costs associated with the taxpayer’s challenge of the potential tax liability are vastly increased by the amnesty “fees,” to such an extent that many taxpayers may be forced to forgo such challenges entirely. Can a taxpayer’s decision to participate in the amnesty program under these circumstances be described as a free “choice”?
Clearly, at some point an amnesty “fee” that forces the payment of taxes that are not refundable is so coercive as to violate Due Process. In River Garden, the penalty was 50% additional interest. So, assuming that the interest was approximately 6%, the amnesty “fee” would have amounted to an additional 3%. In that case, the court found that this additional penalty was not coercive. But here the penalty may be as high as 150% plus additional interest, thereby more than doubling the tax due. Under such circumstances, we believe that a court should reach a different conclusion. Moreover, the Kentucky amnesty statutes specifically deny the taxpayer the right to protest the imposition of the amnesty “fees.”34 As the court noted in CalTax, the U.S. Supreme Court has held that the Due Process Clause requires that the taxpayer be afforded either a pre- or postdeprivation remedy to challenge a tax.35 This rule applies equally to penalties. Here, at least on the face of the statute, it seems that Kentucky’s amnesty “fee” is not subject to challenge by way of a claim for refund. It is not clear how, if at all, a taxpayer might be able to challenge the penalty in a pre-payment action.
In summary, Kentucky’s new “amnesty” program appears to be another legislative shakedown of taxpayers. While the Kentucky Department of Revenue has signaled, in informal comments, its intention to administer reasonably some of the more egregious provisions, the proper solution is for the Kentucky Legislature to restore some balance to the program by dramatically reducing the “fees” that may be imposed under the program and allowing taxpayers the right to obtain redress in the courts for any taxes, penalties or interest that are not reasonable and that are paid under the program that are not ultimately due. Until then, taxpayers are reminded by the Department’s Tax Amnesty Countdown Clock that they have, as of the time of this writing, “44 days: 14 hours: 43 minutes: 53 seconds” to sign up for the program.36