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.