The California Taxpayers' Association (CalTax) filed a Complaint on February 17, 2009 challenging the constitutionality of California Revenue and Taxation Code section 19138 (which was added by section 5 of Senate Bill X1 28, and became effective on December 19, 2008). The Complaint contained six causes of action.
A Hearing was held on Friday, May 8, 2009 and Tentative Rulings were reached on several of the causes of action. Some of the tentative rulings and open items provide an opportunity for the "right" taxpayer to meet the burden of persuading the courts that California's 20% understatement penalty is unconstitutional.
The following is a summary of the background, complaint and tentative rulings:
BACKGROUND
Section 19138 purports to impose a "penalty" on any corporate taxpayers with an understatement of tax in excess of one million dollars ($1 million) for any taxable year. The penalty is equal to twenty percent (20%) of the total amount of the understatement, which is measured by the difference between the correct tax liability and the tax reported on the taxpayer's "original return."
Taxpayers required to be included in a combined report under Revenue and Taxation Code section 25101, or authorized to be included in a combined report under Revenue and Taxation Code section 25101.15, are combined and treated as a single entity for purposes of determining whether the understatement exceeds $1 million.
Section 19138 applies retroactively to each taxable year beginning on or after January 1, 2003, for which the statute of limitations on assessment has not expired. However, a taxpayer may reduce the likelihood of an underpayment penalty for prior taxable years by filing an amended return. For the 2003-2007 taxable years, if a taxpayer files an amended return and pays the tax shown on the amended return by May 31, 2009, the taxpayer may treat the tax shown on the amended return as the tax shown on the "original return" for purposes of determining any understatement of tax.
There are two express exceptions to liability under section 19138; no penalty shall be imposed where the understatement is attributable to (1) specified changes in law; or (2) the taxpayer's reasonable reliance on a legal ruling by the Chief Counsel of FTB.
The procedures of the Revenue and Taxation Code governing deficiency assessments – including the protest and appeal procedures -- do not apply to the assessment and collection of penalties under section 19138. Further, section 19138, subdivision (d) provides that a refund or credit for any amounts paid to satisfy a penalty imposed under section 19138 "may be allowed only on the grounds that the amount of the penalty was not properly computed by the Franchise Tax Board."
THE COMPLAINT
The Complaint contains six causes of action.
- The First Cause of Action alleges that section 19138 violates article XIIIA, § 3 of the California Constitution because section 19138, while termed a penalty, in substance imposes a tax that was not approved by two-thirds of all members elected to each of the two houses of the Legislature.
- The Second Cause of Action alleges that section 19138 violates article IV, § 8(b) of the California Constitution because SB X1 28 (which enacted section 19138) was not "printed and distributed" to the members of the Assembly and Senate before it was passed, and because the Senate failed to "read the bill by title" on three separate days or to dispense with this requirement by a two-thirds roll call vote.
- The Third, Fourth, and Fifth Causes of Action allege that section 19138 violates the Due Process, Equal Protection, and Commerce Clause of the United States Constitution, respectively, because, among other reasons, it (a) affords no prepayment or post-payment review; (b) operates retroactively for an excessive period of time; (c) fails to give clear notice of what conduct it seeks to prohibit; (d) treats individual corporations different than combined groups of "unitary" corporations; and (e) disproportionately burdens interstate commerce.
- The Sixth Cause of Action seeks declaratory relief that section 19138 is illegal and invalid for each of the reasons set forth above. CalTax seeks a declaration that section 19138 is unconstitutional on its face and a judgment enjoining its enforcement.
TENTATIVE RULINGS
- CalTax did not meet its burden of proving that section 19138 violated Proposition 13.
- No tentative ruling reached on this Complaint/Issue. At oral argument, the parties are directed to be prepared to address (1) how the "Enrolled Bill Rule" applies to this case; and (2) whether the facts presented show substantial compliance.
- Excessive Fines Clause: CalTax did not meet its burden to show that section 19138 was unconstitutional on its face; though the Court did not foreclose the possibility that section 19138 may be found to be unconstitutional as applied to a particular taxpayer.
- Substantive Due Process: The Court did not find the retroactive application of the penalty to be so harsh and oppressive as to transgress the constitutional limitation of the substantive due process clause.
- Procedural Due Process: CalTax persuaded the Court that taxpayers lack a constitutionally adequate remedy in which to challenge the penalty. Accordingly, the portion of section 19138 purporting to limit the grounds upon which a refund claim may be allowed is unconstitutional and unenforceable. However, the Court is not necessarily persuaded that this renders section 19138 void in its entirety. At oral argument, the parties should be prepared to discuss whether it is possible to reform the statute to preserve it against invalidation under the Constitution.
- Commerce Clause: CalTax failed to show that section 19138 facially discriminated against interstate commerce. According to the Court, a statute that has only incidental effects on interstate commerce must be upheld unless the burden imposed on interstate commerce is "clearly excessive" in relation to the putative local benefits.
- Equal Protection Clause: CalTax has failed to show that the classification in section 19138 between taxpayers required to be included in a combined report, and those that are not, is not rationally related to a legitimate governmental purpose.
SUMMARY in Layman's Terms:
In layman's terms, the imposition of the 20% understatement penalty is like playing a game, following the rules outlined, and then after the game is over, the other player or judge changes the rules.
What Should Taxpayers Do?
At this time, taxpayers should review their California tax returns for 2003 through 2007 to determine if they understated their tax liability in excess of $1 million. They should also review their federal tax returns to determine if a federal return change could cause a California understatement in excess of $1 million. If the result is "yes" in either case, taxpayers must decide if they will file an amended return by May 31st to treat the tax shown on the amended return as the tax shown on the "original return" to avoid the 20% penalty.
At this time, the penalty has not been proven to be unconstitutional, but the door is open for the challenge to be made by a taxpayer that can meet the tests and burdens it takes. In the future, the statute could be determined to be unconstitutional, or the statute could be revised to make it constitutional. In either case, May 31st will come before that is decided.
California Taxpayers' Association v. California Franchise Tax Board, et al.,; Dept 29, Superior Court of California, County of Sacramento; (Case Number: 34-2009-80000168)
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http://tr.saccourt.com/courtrooms/trulings/dept29/2009-80000168--05.07.2009.docContact me at leveragesalt@earthlink.net if you have any questions.