Existing law imposes penalties when a taxpayer fails to timely file an income tax return or fails to timely pay the tax due as shown on, or as required to be shown on, the tax return, unless it is shown that the failure is due to reasonable cause and not due to willful neglect.

Existing law imposes penalties when a taxpayer fails to timely file an income tax return or fails to timely pay the tax due as shown on, or as required to be shown on, the tax return, unless it is shown that the failure is due to reasonable cause and not due to willful neglect.

This bill, for taxable years beginning on and after January 1, 2018, would require the Franchise Tax Board to provide relief from a penalty that otherwise would be applicable for failure to file a tax return or failure to pay tax when due if the taxpayer was not previously required to file a return or the taxpayer has no penalties for the 4 taxable years before the taxable year for which the penalty was applied, the taxpayer has filed all currently required returns or filed an extension of time to file, and the taxpayer has paid, or arranged to pay, any tax due.

SENATE COMMITTEE ON

Senator Ricardo Lara, Chair

2017 - 2018 Regular Session

SB 375 (Bradford) - Income taxation: timeliness penalty: abatement

This bill meets the criteria for referral to the Suspense File.

Bill Summary:

SB 375 would allow a modified first-time penalty abatement program for qualified taxpayers under the Personal Income Tax Law.

Fiscal Impact:

The Franchise Tax Board (FTB) indicates that this bill would result in a General Fund revenue loss of $2.2 million in 2018-19, and $11 million in 2019-20. FTB’s administrative costs resulting from the bill have yet to be determined.

Background:

With certain exceptions, California law generally does not automatically conform to changes to federal tax law. On the contrary, the Legislature must affirmatively conform to federal changes. It does so either through (1) individual tax bills to conform to specific federal changes, or (2) as one omnibus bill that provides that state law conforms to federal law as of a specified date (currently January 1, 2015).

Federal and state tax law impose penalties for both (1) failure to file, and (2) failure to pay timely. However, these penalties can be abated if the taxpayer can demonstrate that the failure was due to reasonable cause and not willful neglect. Reasonable cause means that the act occurred despite the exercise of ordinary business care and prudence, and the failure was due to events beyond the taxpayer’s control. Examples include business records being destroyed by a fire, the taxpayer’s mental incompetence, or a dishonored payment due to a banking error.

In California, the failure to file penalty is 5 percent of the tax due after allowing for timely payments for every month that the return is late up to a maximum of 25 percent. The failure to pay penalty is 5 percent of the unpaid tax plus 1/2 of 1 percent each month up to 25 percent of the total unpaid tax. The penalty is imposed regardless of an extension of time to file.

The administrative policy of the Internal Revenue Service (IRS) allows a "first-time" abatement procedure, which requires it to abate these timeliness penalties based on compliance history without making a separate reasonable cause determination. Under the policy, IRS must waive penalties if (1) the taxpayer had not previously been required to file a return, or (2) if no prior penalties have been assessed in the past three years, except the estimated tax penalty. The taxpayer must also file a valid extension for all currently required returns and paid, or arrange to pay under a payment plan, any tax due. Penalty abatement applies only to single tax periods. Neither California law nor Franchise Tax Board (FTB) administrative policy currently allows for a first time abatement program.

Proposed Law:

This bill would allow individual taxpayers to request abatement of the timeliness of either the failure to file or timely pay penalties after FTB has rejected a request for a reasonable cause waiver, or instead of requesting a reasonable cause waiver. FTB must abate the penalty if: (1) the taxpayer has not been required to file a return previously, (2) FTB has not imposed any other timeliness penalty in the calendar year of the request, or in the immediately preceding four years, (3) the taxpayer has filed all returns required as of the date of the request, and (4) the taxpayer has paid in full, or arranged to pay in an installment agreement, any tax, penalties, fees, and interest due with the required returns.

Related Legislation:

AB 1777 (Quirk-Silva, 2013-14), was similar to this bill, and would have established penalty abatement authority similar to the federal first-time abatement procedure. This bill would have allowed taxpayers subject to the PITL or Corporation Tax Law to apply for abatement, but specified that a “qualified taxpayer” would mean any corporation with gross receipts of less than one million dollars in the taxable year on which the timeliness penalty is imposed or an individual taxpayer. AB 1777 failed to pass out of the house of origin by the constitutional deadline.

Staff Comments:

This bill would generally conform California income tax law to IRS procedures that allow for relief of select timeliness tax penalties, as specified.

FTB’s revenue estimate is based on its penalty data for failure to file a tax return and failure to timely pay the amount due. On average, FTB assesses $93 million in net penalties annually. The department then grew this amount to $98 in tax year 2018 to reflect growth in the economy. Of this amounts, FTB estimates that approximately 25 percent, or $25 million, would qualify for the penalty relief proposed in this bill, and would request abatement in tax year 2019. FTB notes that with each year the program is in place, the amount of qualifying penalties would decrease. The estimated penalty relief request amounts would be $25 million in 2020, and $21 million in 2021. Of these amounts, it is estimated that 30 percent would have been collected in the year assessed, 15 percent one year after assessed, and would continue to decline each year thereafter.

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SENATE COMMITTEE ON GOVERNANCE AND FINANCE

Senator Mike McGuire, Chair

2017 - 2018 Regular

Income taxation: penalty relief

Allows a modified first time penalty abatement program for qualified taxpayers.

Background

California law does not automatically conform to changes to federal tax law, except for specific retirement provisions. Instead, the Legislature must affirmatively conform to federal changes. Conformity legislation is introduced either as individual tax bills to conform to specific federal changes, like the Regulated Investment Company Modernization Act (AB 1423, Perea, 2011), or as one omnibus bill that provides that state law conforms to federal law as of a specified date, currently January 1, 2015 (AB 154, Ting, 2015).

Federal and state law impose both a failure to file and a failure to timely pay penalty, which can be abated if the taxpayer can demonstrate that the failure was due to reasonable cause and not willful neglect. Reasonable cause means that the act occurred despite the exercise of ordinary business care and prudence, and the failure was due to events beyond the taxpayer’s control. Examples include business records being destroyed by a fire, the taxpayer’s mental incompetence, or a dishonored payment due to a banking error.

In California, the failure to file penalty is 5 percent of the tax due after allowing for timely payments for every month that the return is late up to a maximum of 25 percent. The failure to pay penalty is 5 percent of the unpaid tax plus 1/2 of 1 percent each month up to 25 percent of the total unpaid tax. The penalty is imposed regardless of an extension of time to file.

The Internal Revenue Service (IRS) allows as part of administrative policy a "first-time" abatement procedure, which requires IRS to abate these timeliness penalties based on compliance history without making a separate reasonable cause determination. Under the policy, IRS must waive penalties if the taxpayer had not previously been required to file a return, or if no prior penalties have been assessed in the past three years, except the estimated tax penalty. The taxpayer must also file a valid extension for all currently required returns and paid, or arranged to pay under a payment plan, any tax due. Penalty abatement applies only to single tax periods.

Neither California law nor Franchise Tax Board (FTB) administrative policy currently allows for a first time abatement program. Board of Equalization Member Fiona Ma wants to allow taxpayers to request abatement of the timeliness penalty in specified circumstances.

Proposed Law

Senate Bill 375 allows individual taxpayers to request abatement of the timeliness of either the failure to file or timely pay penalties after FTB has rejected a request for a reasonable cause waiver, or instead of requesting a reasonable cause waiver. Taxpayers can request the waiver orally or in writing. FTB must abate the penalty if:

• The taxpayer has not previously been required to file a return,
• FTB has not imposed any other timeliness penalty in the calendar year of the request, or in the immediately preceding four years. A previously imposed timeliness penalty that FTB subsequently abates for reasonable cause doesn’t disqualify the taxpayer for making a request for a waiver under this bill,
• The taxpayer has filed all returns required as of the date of the request, and
• The taxpayer has paid in full, or arranged to pay in an installment agreement, any tax, penalties, fees, and interest due with the required returns.

The bill applies its changes to the 2018 taxable year and thereafter, and provides that timeliness penalties are considered imposed on the date the return is filed. The measure provides that the Administrative Procedures Act doesn’t apply to any rule, guideline, or procedure FTB prescribes to implement the bill.

State Revenue Impact

According to FTB, SB 375 does not lead to a loss of revenue in 2017-18, but results in revenue losses of $2.2 million in 2018-19, and $11 million in 2019-2020.

Comments

1. Purpose of the bill. According to the author, “The intent of SB 375 is to provide a penalty relief program for failure to file or failure to pay when requested by taxpayers filing under the Personal Income Tax Law. Penalty abatement would be available to taxpayers who timely filed and timely paid their taxes within the previous four years. The bill creates a penalty relief process similar to federal law that benefits historically compliant taxpayers, reduces taxpayer’s confusion and dissatisfaction, and increases compliance.”

2. Penalties. Tax collection relies on tangible penalties for non-compliance: without enforcement, taxpayers in our largely self-assessed tax system would only remit money to the government out of generosity. The state cannot fund vital public services such as education, health care, and public safety without timely paid tax revenue. SB 375 requires FTB to absolve taxpayers with clean track records of specified timeliness penalties upon request, but in doing so, reduces the incentive for taxpayers to comply in the first place. Additionally, SB 375 allows abatement of penalties only in cases where FTB has found that the taxpayer failed to demonstrate that he or she had reasonable cause for not filing a return or paying the appropriate amount of tax, or before the taxpayer has requested a reasonable cause waiver. The Committee may wish to consider SB 375’s effects on taxpayer compliance.

3. Inspector General’s Report. In 2012, the Treasury Inspector General for Tax Administration (TIGTA) audited the IRS first-time abatement program. TIGTA found that IRS did not grant penalty abatement for most taxpayers with compliant histories because taxpayers have to apply first, and the IRS did not widely publicize the program. As a result, taxpayers in similar circumstances were not treated consistently. TIGTA also found that in some cases, IRS abated penalties before the taxpayer had paid due and payable amounts in full, negating its effect as a compliance tool. While FTB will have to consider requests from fewer taxpayers than IRS, and the bill only applies to penalties incurred for noncompliance in future taxable years, the Committee may wish to consider inserting sunset provisions to enable a future Legislature to review the bill’s implementation.

4. Being reasonable. SB 375 fills a gap where taxpayers who fail to file and timely pay may be penalized due to circumstances beyond their control, but not sufficient to meet the reasonable cause standard. Tax practitioners point out that the taxpayer may not retain evidence sufficient to meet the reasonable cause standard if they negotiated a resolution of an IRS audit through the stipulation process in IRS appeals or the United States Tax Court. Taxpayers are also unlikely to be aware of the differences in state and federal law with regard to penalty abatement. While not automatic, SB 375 grants taxpayers the ability to request penalty abatement if they can demonstrate past compliance while paying previous liabilities in full.

5. Scope. SB 375 only applies to individuals, and not business entities, such as partnerships, S-Corporations, or limited liability companies. Additionally, the only penalties that FTB can waive under the bill are the penalties for failure to timely file a return and pay tax.

6. Technicals. FTB and Committee staff recommends the following technical amendments:

• Strike “waiver, or rescission” on P.3, L.4.
• Strike “waiver, or rescission” On P.3, L.7.
• Strike “taxable” and insert “calendar” on P. 3, L. 18
• Insert “to the Franchise Tax Board” after “due” on P.3, L.26.
• Strike “for the required returns pursuant to paragraph (2)” on page 3, lines 26-27
• Strike “taxpayer or the taxpayer’s spouse” and insert “individual or the individual’s spouse” on page 3, line 35-36.

Support and Opposition

(3/30/17)

Support: BOE Member Fiona Ma, California Society of Certified Public Accountants, California Taxpayers Association.

Opposition: None received.

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