Pursuant to Revenue and Taxation Code section 6597, any person who knowingly collects sales tax reimbursement and who fails to remit the sales tax reimbursement to the California Department of Tax and Fee Administration (CDTFA) can be held liable for a penalty of 40% of the unreported tax amount, if the tax amount exceeds $1,000 per month and is in excess of 5% of the total tax due for any reporting period.

Historically, CDTFA has been hesitant to apply the penalty in most circumstances even when the numerical thresholds are met unless CDTFA has been able to establish that the failure to remit was most likely due to fraud. The basis for the hesitancy was well-placed because the penalty for fraud and evasion is only 25% of the unreported tax amount, less than the 40% penalty for unremitted tax collected. CDTFA’s historical policy made sense, in such that a harsher penalty should not be applied in instances where there is no indication that fraud has occurred.

Recently, acting on behalf of guidance from the Office of Tax Appeals, including the precedential case of ISIF Madfish (2019-OTA-292P), CDTFA has revised its longstanding policy and has decided to apply the penalty in instances where the unreported tax amounts exceed the numerical thresholds defined in the law without fully considering the circumstances of the underreporting.

CDTFA argued in the ISIF Madfish case that the 40% penalty was a fraud penalty that suspended the statute of limitations. In the ISIF Madfish opinion, OTA concluded that the 40% penalty did not suspend the statute of limitations because it was not a fraud penalty based on a plain reading of the statute, and the legislative record.

“The Senate Floor Analyses for the chaptered version of SB 1449 explains:

‘ARGUMENTS IN SUPPORT: According to the author’s office, the purpose of this bill is to enhance the penalty in cases where a retailer collects sales tax reimbursement from customers and fails to timely remit the tax to the state. Proponents assert that it is difficult for [the state] to establish that the failure of a retailer to remit sales tax reimbursement is due to fraud or the intent to evade taxes, which results in many retailers avoiding the 25 percent penalty. This bill does not require [the state] to demonstrate fraud or an intent to evade taxes in order to impose a 40 percent penalty for failure to remit sales tax reimbursement.’ (Senate Floor Analyses, SB 1449, Aug. 8, 2006; [emphasis added].)

We recognize that courts are generally reticent to rely on statements made by an individual member of the Legislature as an expression of the intent of the entire Legislature. (See Walters v. Weed (1988) 45 Cal. 3d 1, 10.) Nevertheless, under appropriate circumstances such evidence may be considered. (Ibid.) In this case, the statements by the author, and distributed to the senate, give valuable background to help understand the beneficial aim of the penalty, and the statements distributed to the senate are consistent with the clear and unambiguous language of the statute.”

In reviewing the Legislature’s statements, one may conclude that the purpose of the penalty was to provide CDTFA with an enforcement tool in instances where it appeared an underreporting was due to fraud, but CDTFA did not have clear and convincing evidence to support that claim. The penalty was not intended to apply to underreporting that was a result of mere negligence or to taxpayers with unknown systemic errors in reporting. This is evidenced not merely by the reference in the legislative record to evasion and the evidence required to impose a fraud penalty, but also by the fact that the penalty requires certain numerical thresholds to be established in order for it to be applicable, i.e. it does not apply to small amounts where fraud is unlikely. Finally, the law states that the penalty shall only be relieved if the underreporting occurred notwithstanding the exercise of ordinary care and the absence of willful neglect, which indicates that the penalty should be applied in instances when there is a lack of ordinary care or there is willful neglect even if there is reasonable cause or circumstances that arose outside of the person’s control. This suggests that the legislature intended the penalty to apply where fraud was likely but the evidence is insufficient to support evasion.

Revenue and Taxation Code section 6597 notes that the penalty may be relieved for reasonable cause and that reasonable cause includes, but is not limited to, the following:

  • A death or serious illness of the person or person’s next of kin.
  • An emergency as defined in section 8558 of the Government Code.
  • A natural disaster or other catastrophe directly affecting the business operations of the person.
  • CDTFA failed to send returns or other information to the correct address of record, that caused the person’s failure to make a timely remittance.
  • The person’s failure to make a timely remittance occurred only once over a three year period, or once during the period in which the person was engaged in business, whichever is shorter.
  • The person voluntarily corrected errors in remitting tax that were made in previous reporting periods and remitted payment of the liability owed as a result of those errors prior to being contacted by CDTFA about the possible errors or discrepancies.

Although the law clearly states that reasonable cause is a basis for relief and that reasonable cause can be more broadly defined than the examples in the statute, in our experience, CDTFA has decided that only the examples listed within the statute constitute reasonable cause for purposes of this penalty. As a result, we are seeing numerous instances where the 40% unremitted tax penalty is being improperly applied. CDTFA’s new policy, with no change in the underlying statute, is resulting in the imposition of onerous and significant penalties that are not legally due.

If you or your business has recently undergone an audit and you have been assessed a 40% penalty, please feel free to reach us at 858-995-6789 or at taxhelp@salestaxhelp.com.

Mitchell Stradford

Mitchell Stradford

Mitchell Stradford is a former senior sales and use tax auditor with the California State Board of Equalization. Mitch leads McClellan Davis’ efforts to advocate on behalf of the cigarette and tobacco industry. He graduated from California State University Sacramento with a B.S. in Business Administration with a concentration in accountancy. Email Mitchell

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