On Friday, December 5, the California Franchise Tax Board (FTB) conducted an Interested Parties Meeting to elicit public questions and comments regarding the very unpopular new 20% underreporting penalty enacted by the California State Legislature October 1, 2008 in S.B.28x. As reported in Sutherland’s September 29, 2008 Legal Alert, this legislation enacted Cal. Rev. & Tax Code Sec. 19138 which imposes a 20% mandatory penalty on corporations that underreport their corporate income tax liabilities in excess of $1.0 million for any taxable year beginning on or after January 1, 2003. The legislation allows corporations to file amended returns on or before May 31, 2009 that reflect the “correct” tax for each tax period to avoid the underreporting penalty. The purpose of the FTB meeting was to discuss issues and concerns with the penalty in order to develop a Frequently Asked Questions (FAQ) document. The FTB expects to issue the FAQs in January 2009 to provide additional guidance for taxpayers planning to file amended returns by May 31, 2009.
Who Needs Legislative Intent?
The business community and its representatives engaged in a lively and sometimes heated debate with the FTB regarding concerns and issues surrounding the new 20% penalty. In response to direct questions regarding the legislative intent, the FTB stated that the purpose of the legislation was not to raise revenue from the penalty itself but to “encourage” taxpayers to file more “accurate” returns. According to the FTB, the legislation is based on the IRS substantial understatement penalty language of IRC § 6664. However, because the legislation passed quickly and quietly in what some have characterized as a “midnight surprise,” no recorded legislative history is available. As a result, the FTB acknowledged that it has been forced to interpret the legislative intent as well.
Notwithstanding the FTB’s insistence that the legislation encourages taxpayers to “do the right thing,” the State Senate analysis of the legislation provides that the expected revenue from the penalty is $1.4 billion for the 2007/2008 fiscal year, $75 million for the 2008/2009 fiscal year and $45 million for the 2009/10 fiscal year. However, similar to the 2005 “amnesty” penalty, many expect that a significant amount of the revenue initially collected by the FTB will eventually be returned to taxpayers as a result of refund claims filed with amended returns for periods prior to May 31, 2009.
The FTB “recommended” that taxpayers can avoid future penalties by taking more conservative positions in uncertain compliance areas. For prior years, the FTB encouraged taxpayers to file original returns with additional taxes paid and then follow up with amended returns.
Can I Make a “Penalty Deposit”?
Much of the discussion dealt with what would be considered an “amended return” for purposes of the May 31, 2009 filing deadline. The FTB indicated that its interpretation of the legislation is that a “qualified amended return” must be filed. A “qualified amended return” would be one where the taxpayer states with specificity the basis for the additional tax shown on the amended return and that such additional tax is actually paid by the taxpayer.1
Practitioners and corporate taxpayers implored the FTB to allow taxpayers to make “deposit” or “penalty avoidance” payments on any amended returns. The purpose of this method would be to allow taxpayers to avoid the penalty without detailing the nature of the underlying issue(s) that caused the understatement. The participants argued that the state would receive the revenue anticipated by the legislation without providing California auditors and potentially aggressive IRS revenue agents a roadmap of taxpayers’ audit issues. One suggestion, well received by the business community and practitioners, was made to add an additional line item to the corporate amended tax return (Form 100X) where taxpayers would simply indicate the amount of additional taxes being paid for purposes of avoiding the Sec. 19138 penalty, without further specificity.
Sutherland Observation: Taxpayers currently under audit face additional concerns with the May 31, 2009 deadline. One option is to try to reach an audit settlement before the deadline. Such agreement and payment is likely to be considered an “amended return” for purposes of the penalty provision. Taxpayers who do not expect to reach a settlement within this timeframe should consider filing amended returns for the audit periods for tax years beginning on or after January 1, 2003 along with a contemporaneously filed refund claim.
Many participants commented about the wisdom of the legislation and urged the FTB to support the legislation’s repeal. Large taxpayers contend that the complexity of both state and federal tax issues makes it nearly impossible to speculate and file within $1 million of the ultimate “correct” liability as determined by federal and state administrative and judicial authorities. Further, California requires that taxpayers and tax preparers who sign corporate income tax returns, original or amended, sign under penalty of perjury. As a matter of policy, tax practitioners questioned their ability to sign an amended return under penalty of perjury that the return is accurate and then contemporaneously filing a refund claim for the same tax period — again under penalty of perjury. How could both returns be accurate? Finally, during times of significant personnel restraints resulting from serious budget concerns in California, the onslaught of amended returns, both prior to May 31, 2009 and contemporaneously with each originally filed returns for 2008 and future periods, is likely to lead to a more and chaotic tax administration.
Other Issues Addressed
- The legislation provides that the FTB will not impose a penalty if the understatement is attributed to a “change in law that is enacted, promulgates, issues, or becomes final” after the earlier of the date the taxpayer files the return or the extended due date for the taxable year for which the change is operative. “Change in law” is defined to mean a “statutory change or interpretation of law or rule of law by regulation, legal ruling of counsel, within the meaning of subdivision (b) of Section 11340.9 of the Government Code, or a published federal or California court decision.” Attendees requested that the FTB consider publishing a regularly updated list of recent law changes for taxpayers to use as a reference for purposes of this provision. Although the FTB took notice of this request, because of the breadth of California legal changes and the reliance on federal taxable income, it is unlikely that such a list could or would be published by the FTB.
- The penalty provision is effective only if the understatement is for $1 million of actual tax owed, as compared with just the adjustment of tax attributes. However, it was recommended that additional guidance be provided regarding audit adjustments and the utilization of NOL carryovers.
Sutherland Observation: Despite concerns regarding the fairness of the legislation and calls for its repeal or amendment, the FTB is only charged with administration of the penalty and is required to develop procedures to provide taxpayers guidance on administration. As California continues to search for revenue raising measures, it is unlikely that there will be a repeal of the new penalty. In fact, it is possible that similar penalties may be enacted in order to generate revenue for the state.