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State & Local Tax Bulletin (October 2008)

California Imposes New 20 Percent
Understatement Penalty on
Corporate Taxpayers




By Kerne H. O. Matsubara, a tax partner in the San Francisco office of Pillsbury Winthrop Shaw Pittman LLP.

If you have or can obtain the Acrobat Reader, or have an Acrobat-enabled web browser, you may wish to download or view our October 2008 State & Local Tax Bulletin (a 178K pdf file), containing a printed version of this article and also available via ftp at:

    ftp.pmstax.com/state/bull0810.pdf.

This bulletin concerning state and local tax matters is part of the Tax Page, a World Wide Web demonstration project, no portion of which is intended and cannot be construed as legal or tax advice. Comments are welcome on the design or content of this material.

On October 1, 2008, Governor Schwarzenegger signed into law Senate Bill No. 28X ("SB 28X") imposing a new 20 percent understatement penalty (the "Penalty") under newly added Section 19138 of the California Revenue and Taxation Code. The Penalty applies to corporate taxpayers with an understatement of tax in excess of $1 million for any taxable year beginning on or after January 1, 2003 for which the statute of limitations on assessment has not expired. A taxpayer can reduce or avoid the Penalty by filing an amended return and paying the tax shown on that return by May 31, 2009.

Understatement of Tax

For purposes of the Penalty, an "understatement of tax" is defined as the amount by which the California corporation franchise and income tax exceeds the amount of tax shown on an original return or an amended return filed on or before the due date of the return, including extensions, for the taxable year. The amount of the Penalty is equal to 20 percent of the understatement and is in addition to any other penalties. Since the Penalty is based on an understatement, rather than underpayment, of tax for a taxable year, any offsets, credits or overpayments of tax from prior or subsequent taxable years would not appear to reduce or eliminate the Penalty for such year. For combined report filers, the $1 million understatement threshold applies to the aggregate amount of the understatement for all taxpayers included in the combined report.

Limited Exceptions

The Senate's analysis of SB 28X describes the Penalty as "a strict liability penalty, where no reasonable cause exception exists, and contains no allowance for a taxpayer relying on substantial authority." Revenue and Taxation Code Section 19138 sets forth limited exceptions to the Penalty, as follows:

  • Change in law. The Penalty does not apply to any understatement that is attributable to a change in law that occurs after the earlier of (i) the date the taxpayer files the return or (ii) the extended due date for the return for the taxable year for which the change is operative. A "change of law" includes a statutory change or an interpretation of law by regulation, rule or court decision.

  • FTB Chief Counsel Ruling. The Penalty will not be imposed to the extent that a taxpayer's understatement is attributable to the taxpayer's reasonable reliance on written advice of the Franchise Tax Board ("FTB") in the form of a legal ruling by the Chief Counsel.

  • Correction by Amended Return by May 31, 2009. For purposes of the Penalty, an understatement does not include amounts shown on an amended return filed on or before May 31, 2009 for which the tax is paid by such date. Thus, a taxpayer can reduce or avoid the Penalty by filing an amended return and paying the tax shown on that return by May 31, 2009.

Narrow Grounds for Claiming a Refund of the Penalty

Similar to the amnesty penalty procedures under Revenue and Taxation Code Section 19777.5, a claim for refund of the Penalty can be filed only on the basis that the amount of the Penalty was not properly computed by the FTB. In addition, the FTB's normal protest and collection procedures do not apply to the assessment and collection of the Penalty.

FTB Guidance Forthcoming

Revenue and Taxation Code Section 19138, which instructs the FTB to implement the Penalty provisions in a "reasonable manner," leaves many questions unanswered. For example, if the taxpayer and FTB agree that additional tax is owing, is the taxpayer required to file an amended return to pay the undisputed tax? If a taxpayer files an amended return and pays the tax by May 31, 2009 to avoid the Penalty but not to concede the tax, how should the taxpayer claim a refund of the tax? Must the taxpayer wait until after May 31, 2009 to file an amended return claiming the refund? How should tax payments be made? Will the application of overpayments from other taxable years be allowed? We understand that the FTB currently is drafting guidance to taxpayers regarding the Penalty in the form of "Frequently Asked Questions" that will be posted on the FTB's website in the coming weeks.


This material is not intended to constitute a complete analysis of all tax considerations. Internal Revenue Service regulations generally provide that, for the purpose of avoiding United States federal tax penalties, a taxpayer may rely only on formal written opinions meeting specific regulatory requirements. This material does not meet those requirements. Accordingly, this material was not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal or other tax penalties or of promoting, marketing or recommending to another party any tax-related matters.


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