CDTFA of Equalization Penalties Generally
California Department of Tax and Fee Administration (CDTFA) declared that it its policy is to encourage and assist all taxpayers in making an accurate and timely self-declaration of tax liability. CDTFA will impose penalties when justified by the acts or omissions of the taxpayer. However, whenever there is any doubt as to whether factual conditions justify a penalty for negligence or fraud, that doubt must be resolved in favor of the taxpayer.
Negligence and fraud penalties are based on recommendations submitted to CDTFA by field auditors and their supervisors based on facts they find during audit. CDTFA cannot impose negligence penalty and fraud penalty concurrently because they are mutually exclusive. Only one or the other can be imposed at the same time. The same is true of the penalty for negligence and the penalty for failure to file a return. However, for example, a fraud penalty and a 10 percent penalty for failure to file a return can be imposed in relation to the same amount of tax owed to CDTFA.
Penalties are divided into two categories: mandatory or discretionary penalties. Both categories of penalties are imposed in accordance with provisions of the Revenue and Taxation Code (RTC). Mandatory penalties are imposed automatically, but the taxpayer may receive relief (cancellation or reduction). Discretionary penalties can be assessed by auditors during audits. When there is a choice between discretionary or mandatory penalty, CDTFA will usually apply mandatory penalty. For example, the penalty for failure to file a return (mandatory penalty) rather than the negligence penalty (discretionary penalty) will be applied in those cases where either penalty could be applied.
CDTFA provides examples of the following mandatory penalties:
- Failure to file a return – 10% under RTC 6511 and 6591
- Failure to pay taxes - 10% under RTC 6565 and 6591
- Failure to pay prepayment amounts - 6% under 6476 and 6477
- Amnesty interest penalty - 50% under RTC 7074(a) and Double amnesty penalty 7073
- Failure to pay prepayment amounts by suppliers and wholesalers of fuel - 10% under RTC 6480.4 The rate of penalty is increased to 25 percent if the supplier or wholesaler knowingly or intentionally fails to make a timely remittance of the prepayment amounts.
Discretionary payments include:
- Negligence or intentional disregard of the law or authorized rules and regulations (can be applied in a variety of circumstances) - 10% under RTC 6478 and 6484
- Fraud or intent to evade the law or authorized rules and regulations - 25% under RTC 6485 and 6514
- Improper use of a resale certificate for personal gain to evade the tax penalty can be imposed under RTC 6072 and 6094.5 (10% of the tax due or $500 whichever is greater)
- Failure to remit sales tax reimbursement or use tax collected - 40% under RTC 6597
- Knowing failure to obtain a valid permit for the purpose of evading the payment of tax - 50% under RTC 7155
- Registration of a vehicle, vessel, or aircraft outside the State of California for the purpose of evading the payment of tax - 50% under RTC 6485.1 and 6514.1
- Failure to obtain evidence that the operator of catering truck holds a valid seller’s permit - $500 under RTC 6074
- Failure of a retail florist to obtain a permit before engaging in or conducting business as a seller - $500 under RTC 6077
Penalties are billed on a Notice of Determination sent by CDTFA to taxpayer and can be protested, or even canceled, if they are found to have been imposed by CDTFA by mistake. Only CDTFA can make a decision to impose penalties and any change in penalty must be made only by the elected CDTFA members – the CDTFA. This means that auditors generally can not on their own impose penalties.
Relief From Mandatory Penalties
The CDTFA is allowed to remove (cancel) mandatory penalties when taxpayers fails to pay taxes or file a return for a good reason and because of circumstances beyond his or her control. However, the taxpayer must still be able to prove that he or she exercised diligence and did not simply neglect tax obligations.
Taxpayers who wish to request a relief from penalties must do it after they receive a determination letter form the CDTFA. Taxpayer must present a request for relief in a written statement, under penalty of perjury, explaining the facts on which the request is based. The use of CDTFA Form CDTFA–735, Request for Relief from Penalty (available at www.CDTFA.ca.gov), is recommended but not required. After submission of the written statement by taxpayer, CDTFA will review and approve or deny the request. Recommendation to approve or deny a request for relief above $50,000 is usually forwarded to the CDTFA Deputy Director for additional review and then submitted to the CDTFA for consideration.
Even if taxpayer's request for relief from penalty is denied, taxpayers can apply to CDTFA for reconsideration of the negative decision. For penalties of $50,000 or less, CDTFA sends taxpayer a denial letter, in which it usually explains that the decision to recommend denying relief from penalty can be reconsidered by CDTFA if the taxpayer provides new information within 15 days of the denial letter. The letter also explains that if the taxpayer provides additional information and the CDTFA staff still recommends to deny taxpayer's request, the request for relief will then be reviewed by the Deputy Director. If the Deputy Director agrees with the recommendation to deny the request, the Deputy Director will send a letter to the taxpayer saying that he or she agrees with the CDTFA staff recommendation. Despite established 15-day deadline, CDTFA may still consider information received from taxpayer after 15-day period has expired.
Penalty for Failure to File a Return
CDTFA can impose penalty for failure to file a tax return. Every taxpayer with active CDTFA account is required to file returns at regular intervals as required by the law and CDTFA. RTC section 6591 imposes a 10 percent penalty for failure to file a return on the amount of taxes due, with respect to the time period for which that return was required. For example, if the taxpayer is on a monthly reporting basis and failed to file a return for only one month during a period under audit, a penalty would apply only to tax due for that month.
Failure to Pay Penalty
Revenue ans Taxation Code section 6591 imposes a 10 percent penalty for failure to pay tax if tax is not paid on time, as follows:
- To self-declared tax, when not paid on or before the due date of the return or before the expiration of any extension.
- To determinations made by the CDTFA, when not paid on or before the penalty date shown on the Notice of Determination, unless a timely petition (for redetermination) has been filed.
- To redeterminations, when not paid on or before the penalty date shown on the Notice of Redetermination.
RTC section 6565 imposes a 10% penalty for failure to pay amount determined by the CDTFA if it is not paid before or on the date determination becomes final (30 days after service of the notice of determination on taxpayer). However, this period is extended if the taxpayer files a petition for redetermination with the CDTFA.
RTC section 6476 imposes a 6 percent penalty on the amount of a prepayment that is paid late, but which is paid before the last day of the month following the quarter in which that prepayment was due. If the failure to make the prepayment was because of negligence or intentional disregard of the Sales and Use Tax Law or other rules and regulations, RTC section 6477 is increased by RTC section 6478 to 10 percent instead of 6. The same 10 percent penalty applies under similar circumstances to any deficiency in prepayment. The penalties imposed in RTC sections 6479.3 and 6591 apply to taxpayers who are required to pay taxes by means of Electronic Fund Transfer (EFT) but fail to do so. Prepayment penalties are not assessed in sales and use tax audits.
Negligence Penalties Generally
Generally, a penalty of 10% will be added if any part of the tax deficiency resulting form taxpayer's negligence or intentional disregard of the law. Negligence is defined in general as a failure to exercise due (proper) care, which means care that a reasonable and prudent person would exercise under similar circumstances. According to CDTFA, with respect to business tax matters, negligence may be further defined as a substantial breach by the taxpayer of some duty imposed by the law. CDTFA recognizes two major classes of negligence: negligence in keeping records and negligence in preparing returns. These two types of negligence allow for the imposition of the negligence penalty.
In general, where an agent, employee, or partner of the taxpayer is guilty of negligence, with a resulting tax deficiency, the 10 percent penalty will also apply, even though the agent, employee, or partner acted without the taxpayer’s knowledge or approval, or acted contrary to the express instructions of the taxpayer. This applies even where the taxpayer has been defrauded by an agent, employee, or partner and as a result did not benefit from the understatement of tax. Application of penalties in this case is more likely if taxpayer had opportunities to discover and stop the fraud but did not do so.
The negligence penalty can be applied only to deficiency determinations (when CDTFA determines that taxpayer still owes some amount in back taxes), and it applies to the total tax amount still owed. Generally, this means that, if the penalty applies, it will be for the entire period of the audit regardless of class of transactions involved.
In some cases, however, it would be improper for CDTFA to impose penalty for the whole reporting period. For example, if a company changes management in the middle of reporting period, it would be inappropriate to extend a penalty for the entire reporting period. In such a a case auditor usually prepares two forms, one for penalty imposed on one portion of the period, and another without penalty prepared for another portion of the period where there was no negligence on the part of the new management. Taxpayers can provide evidence to the auditor that may justify such split of penalty period. The auditor will also check if subsequent management made an effort to eliminate negligence. If so, then penalty reduction is appropriate.
When taxpayer is audited for the first time, CDTFA advises its auditors that for such taxpayers negligence penalty is generally not recommended, but in making that decision auditor should take into consideration taxpayer’s prior business experience, the nature and state of the records provided, and whether the taxpayer used an outside accountant or bookkeeper to compile and maintain the records, and/or to prepare the sales and use tax returns. A penalty may be appropriate in any of the following circumstances: the taxpayer has no records of any kind, the taxpayer has a history of prior permits or business experience, analysis shows that purchases have exceeded reported sales, or the taxpayer has two sets of books.
The auditor's recommendation to impose a penalty is subject to CDTFA review as follows:
- Audit tax deficiency over $25,000 — Reviewed and approved by the auditor’s supervisor.
- Audit tax deficiency over $50,000 — Reviewed and approved by the District Principal Auditor subsequent to the review and approval by the auditor’s supervisor.
Negligence in Keeping Records
Guidelines for the maintenance of records are provided by Regulation 1698, Records. In general, this regulation provides that “a taxpayer shall maintain and make available for examination on request by the CDTFA (CDTFA) or its authorized representative, all records necessary to determine the correct tax liability under the Sales and Use Tax Law and records necessary for the proper completion of the sales and use tax return.” Such records that must be kept include:
- Normal books of account usually maintained by the “average prudent business person” engaged in the activity in question.
- Bills, receipts, invoices, cash register tapes, or other documents of original entry supporting the entries in the books of account.
- Schedules or working papers used in connection with the preparation of tax returns.
Complete absence of records will constitute strong evidence of negligence. However, auditors must determine if there are mitigating circumstances for the lack of records. The term “records” as used by CDTFA includes not only those specifically mentioned in Regulation 1698, but also any supporting data as resale certificates, shipping documents in support of interstate transactions, etc.
The primary test for negligence used by CDTFA is whether a taxpayer keeps the type of records usually maintained by a “reasonable and prudent businessperson” with a business of similar kind and size. http://www.CDTFA.ca.gov/sutax/manuals/am-05.pdf. This means that auditor will compare record keeping practices of taxpayer with those generally used in the industry, with similar businesses or in the local geographical area. Taxpayer should note, however, that other taxpayers of similar kind also can be negligent, and other taxpayers' negligence can not be used by him or her as an excuse and penalty still can be imposed by CDTFA.
If the evidence indicates that a taxpayer failed to keep proper records and, as a result, failed to compile tax returns with a reasonable degree of accuracy, and cannot substantiate the reported amounts when audited, negligence can be indicated by auditor and the 10 percent penalty may be imposed. Records need to be only adequate for sales and use tax purposes, to meet the tax requirements of the type of business involved. For example, large business will require larger amount of records due to more complex accounting system. Lack of knowledge of the requirements of the law is not a defense to penalties. However, CDTFA asks its auditors to pay attention to such factors as the lack of formal education by a taxpayer. Generally, the more knowledgeable and experienced taxpayer is, the higher the bar, as the benchmark is for taxpayers in similarly situated circumstances. By the way, the taxpayer cannot be regarded as negligent merely because the records are kept in a foreign language. (See CDTFA Penalties Manual)
Where records are adequate for sales and use tax purposes but contain errors that result in under reporting of tax, the test for negligence is whether or not the taxpayer exercised proper care and diligence in keeping the records. No matter how carefully records are prepared and checked, some errors may still occur. Auditor will consider the frequency and importance of errors, any difficulties inherent to business that result in errors, and other factors. Some of the factors considered by auditor are: number of errors comparative to number and dollar amount of transactions, the ratio of understatement of tax to reported amounts (larger amount of understated tax comparative to reported amount can indicate negligence), and the cause of errors (the cause of errors may result from procedural or operational problems unrelated to negligence. For example, sharp change in sales volume resulting in staffing problems versus just negligence). CDTFA advises their auditors: “If the errors are too frequent in relation to the volume of transactions, or if the errors result in a higher ratio of understatement than would be expected of a reasonable and prudent businessperson engaged in a business of similar kind and size, or if there appears to have been an absence of due care, the 10 percent penalty should apply.”
Taxpayers must keep records related to transaction for a minimum of 4 years, unless CDTFA authorizes taxpayer in writing that records can be destroyed sooner. Accidental destruction of records is not a negligence if taxpayer properly maintained and cared for records, and if auditor is shown that records were really destroyed by accident. Intentional destruction of records, however, may be viewed by CDTFA as potential fraud or tax evasion. In case of intentional destruction of records, any tax deficiency will result in 10% penalty if it stems from the destruction of tax records.
Negligence in Preparing Returns
The test for negligence in preparing returns is the same as test for negligence in keeping records – whether proper care and diligence was exercised by taxpayer. Mechanical errors in compiling returns do not mean there was negligence, unless there are too many of such errors. Wrong application of the Sales and Use Tax Law when completing returns does not constitute negligence, unless taxpayer failed to exercise proper care to check if transactions are subject to tax under law (failed to check with his or her accountant, for example). Where there is doubt concerning the correct application of the tax, the taxpayer has a duty to make an inquiry. If the taxpayer fails to make an inquiry, the 10 percent penalty may apply. In general, if the taxpayer does make an inquiry and fails to act on the received information, the 10 percent penalty also may apply.
A taxpayer who was misinformed about the proper application of tax can be relieved from the payment of tax, interest and penalty if the taxpayer meets the requirements for relief under RTC section 6596. If taxpayer was misinformed by CDTFA staff, then penalty generally should not be imposed, but taxpayer is still liable for tax and interest. Taxpayer must be able to prove that the CDTFA staff misinformed him or her.
The same standards which determine the application of the negligence penalty to tax deficiencies arising from an understatement of gross receipts or an overstatement of claimed deductions are used to determine the application of the negligence penalty to a tax deficiency arising from failure to report purchases subject to use tax.
If the auditor finds that working papers used by the taxpayer in preparation of the tax returns have been destroyed and the taxpayer is unable to explain substantial deficiencies in reporting, taxpayer must be given a opportunity to prepare new working papers or to explain how amounts reported on returns were computed. Failure or inability by the taxpayer to do so will usually constitute evidence of negligence and can justify the imposition of the 10 percent penalty.
Tax Evasion Penalties Generally
Generally, penalties for fraud or intent to evade are imposed only when tax deficiency determinations are made by the CDTFA and CDTFA must prove evasion to impose tax evasion penalty. The RTC sections that impose evasion penalties are as follows:
- RTC sections 6072 and 6094.5 — misuse of resale certificate to evade tax, 10 percent or $500, whichever is greater.
- RTC section 6485 — fraud or intent to evade tax, 25 percent of determination.
- RTC sections 6485.1 and 6514.1 — registration of a vehicle, vessel, or aircraft outside of California for the purpose of evading tax, 50 percent of tax due.
- RTC section 6514 — fraud or intent to evade tax by failure to file return, 25 percent of tax, in addition to the mandatory RTC section 6511 failure to file penalty of 10 percent.
- RTC section 6597 — failure to remit sales tax reimbursement or use tax collected, 40 percent of amounts representing sales tax reimbursement or use tax collected and not timely remitted to the CDTFA.
- RTC section 7155 — failure to obtain valid permit by due date of first return for the purpose of evading tax, 50 percent of tax due before permit obtained.
“Fraud” is defined as acts with intent to deprive state of taxes due under the law. Intent to evade is intent to escape paying tax through misrepresentation or deception. CDTFA does not really distinguish between fraud and intent to evade, and calls all resulting penalties as “evasion penalties” in either case. Evasion is one step above negligence and occurs when taxpayer acts beyond just failing to exercise proper care and diligence, and if such failure was intentional and for the purpose of tax evasion. CDTFA must prove such deliberate intent by so called “clear and convincing evidence”. However, the standard of proof is not “beyond a reasonable doubt” as in a criminal prosecution (which is higher than clear and convincing evidence). (See Helvering v. Mitchell (1938) 303 U.S. 391). Instead, the standard of proof in civil tax fraud cases is “clear and convincing evidence” (In re Renovizor’s Inc. v. CDTFA (9th Cir. 2002) 282 F.3d 1233). “Clear and convincing evidence” requires evidence so clear as to leave no substantial doubt as to the truth of an evidence of fraud. That is, there is a high probability that the assertion of fraud by CDTFA is true. Taxpayer's intent is the key to impose tax evasion penalties. Intent can be shown, for example, by consistent multiple tax under-reporting by taxpayer. If under-reporting is random, CDTFA will look at other factors, such as falsified records.
The size of the deficiency in relation to the tax reported is always be taken into account. The higher the understatement of tax, the more CDTFA is inclined to consider that there was tax evasion.
Tax Evasion Penalties Special Issues
In majority of cases CDTFA relies on circumstantial evidence of tax evasion because direct evidence is very difficult to obtain. CDTFA uses following factors in consideration of whether there was tax evasion:
- Falsified records, especially when more than one set of records is maintained.
- Substantial discrepancies between recorded amounts and reported amounts which cannot be explained.
- Willful disregard of specific advice as to applicability of tax to certain transactions.
- Failure to follow the requirements of the law, knowledge of which requirements is evidenced by permits or licenses held by taxpayer in prior periods.
- Tax or tax reimbursement properly charged, evidencing knowledge of the requirements of the law, but not reported.
- Transferring accumulated unreported tax from a tax accrual account to another income account.
Auditors usually recommend the 25 percent penalty when a taxpayer’s agent, partner, or employee has acted with intent to evade tax payment, even though the attempted evasion occurred without the taxpayer’s knowledge or consent. However, this penalty can not be recommended in the cases when agent or employee defrauded the taxpayer too. Taxpayer also must benefit from acts if fraud or tax evasion is implied before penalty can be imposed. Generally, if a taxpayer has not benefited from the intent to evade, the evasion penalty should not apply. If tax evasion penalty is approved by CDTFA, agency must issue a memorandum describing in detail evidence to support tax evasion penalty. Taxpayers should keep in mind that even if tax evasion was not discovered during first audit, if it is present and discovered during subsequent audits, all previous periods, even those already audited, can be included by CDTFA when it comes to penalty for tax evasion.
Penalties for Misuse of a Resale Certificates and for Failure to Remit Tax
Revenue and Taxation Code (RTC) section 6072 imposes a penalty of 10 percent or $500, whichever is greater, for each transaction when a purchaser, for personal gain or to evade the payment of tax, knowingly issues a resale certificate while the person is not actively engaged in business as a seller. RTC section 6094.5 imposes the same penalty when the purchaser knowingly issues a resale certificate for personal gain or to evade the payment of tax, for the property which the purchaser knows at the time of the purchase will not be resold in the regular course of business. Various examples of when this penalty applies and does not apply are laid out in CDTFA of Equalization Penalty Manual which can be found here: http://www.CDTFA.ca.gov/sutax/manuals/am-05.pdf
The penalty will apply in those cases where a pattern of intentional misuse of resale certificate is present, regardless of how large or small amount involved. In those instances where a number of small purchases from the same vendor are noted, a single, rather than multiple, penalty of $500 or 10 percent (whichever is greater) generally will be imposed. But if the purchaser has been previously advised of the consequences of misusing a resale certificate, then possibly more than one penalty may be imposed. If the misuse involves large amounts with the intent of evading the tax, the 25 percent fraud penalty under RTC section 6485 for intent to evade the tax will considered by CDTFA if the evidence exists to support the imposition of the penalty.
CDTFA auditors treat investigation of misuse of resale certificates as one of their priority assignments. In such cases Auditor will always investigate purchaser and will verify seller's records. RTC sections 6485.1 and 6514.1 provide a 50 percent penalty on a purchaser who registers a vehicle, vessel, or aircraft outside of California (i.e., in another state or foreign country) for the purpose of evading the tax. The standards of proof for this penalty are similar to those for fraud in general. The penalty will generally be applicable when the purchaser is a California resident who purchased a vehicle, vessel, or aircraft for use in California and is unable to provide convincing evidence for registration out of state.
For reporting periods beginning January 1, 2007, RTC section 6597 imposes a 40 percent penalty on any person who knowingly collects sales tax reimbursement (Regulation 1700, Reimbursement for Sales Tax 2) or knowingly collects use tax, and fails to timely remit that sales tax reimbursement or use tax (tax) to the CDTFA.
The penalty is discretionary and may only be applied when all the conditions listed below are met:
- The unremitted tax averages over $1000 per month for the reporting period.
- The total unremitted tax exceeds five percent of the total tax collected in the same quarterly reporting period in which the tax was due.
- The taxpayer does not provide a credible explanation showing the failure to remit the tax was due to reasonable cause or circumstances beyond the taxpayer’s control (see Regulation 1703(c)(3)(D)) and occurred notwithstanding the exercise of ordinary care and the absence of willful neglect. In this case taxpayer has to explain CDTFA why tax was not remitted and why it was not taxpayer's fault. CDTFA must disprove taxpayers’ explanation, or simply prove taxpayer's fault with “clear and convincing” evidence.