Can California's large corporate understatement penalty be waived?

The penalty and its threshold

Revenue and Taxation Code Section 19138 imposes a penalty of 20 percent of any understatement of tax for corporate taxpayers whose understatement exceeds a threshold. For taxable years beginning on or after January 1, 2010, the threshold is the greater of one million dollars or 20 percent of the tax shown on the original return (RTC 19138(a)(1)). The understatement is measured as the amount by which the tax ultimately imposed exceeds the tax shown on the original return, or on an amended return filed on or before the original or extended due date (RTC 19138(b)(1)). An amended return filed after the extended due date does not raise the baseline: the self-assessed number that counts is the one reported while the return was still timely. One statutory exception applies: additional tax shown on the first amended return reflecting a proper election under section 338 of the Internal Revenue Code is treated as shown on the original return (RTC 19138(b)(3)).

For members of a combined reporting group, the threshold applies to the aggregate tax liability of all taxpayers included or authorized to be included in a combined report under RTC 25101 or 25101.15 (RTC 19138(a)(2)). A group with a large California liability can therefore cross the one million dollar line through an error that would be comfortably below the threshold for any single member, while the alternative 20 percent prong gives some protection to large filers whose understatement is modest relative to the tax they originally reported.

The penalty stacks. Section 19138(c) states that it is in addition to any other penalty imposed under the corporate tax law or the administrative provisions, so accuracy-related and other penalties are analyzed separately and can apply to the same deficiency.

What strict liability means

Many California penalties yield to a showing of reasonable cause: the taxpayer demonstrates that the failure occurred despite the exercise of ordinary business care and prudence, and the penalty is abated. The LCUP does not work that way. The statute contains no reasonable cause language at all, and the FTB's Manual of Audit Procedures states that "There is no reasonable cause exception" (FTB Manual of Audit Procedures, section 11.12). Appeal of Kimberly-Clark Worldwide, Inc. (OTA No. 18042575, May 10, 2019), a nonprecedential opinion, illustrates the same reading. Good faith, reliance on competent advisers, the complexity of the issue, and the reasonableness of the original filing position are not grounds for relief from the penalty. A corporation that filed carefully, on a defensible position, and lost the issue years later on audit owes the same penalty as one that filed carelessly, if the resulting understatement crosses the threshold.

The one published appellate decision on the statute, California Taxpayers' Association v. Franchise Tax Board (2010) 190 Cal.App.4th 1139, review and depublication denied March 16, 2011 (S189996), addressed its constitutional footing. The Court of Appeal held that Section 19138 imposes a penalty rather than a tax, so the two-thirds legislative vote required for state tax increases did not apply (Cal. Const., art. XIII A, sec. 3). It also held that subdivision (e) alone would not satisfy due process, construed that subdivision as limited to administrative refund claims, and held that RTC 19382 provides a constitutionally adequate postdeprivation remedy: a judicial refund action in which taxpayers may contest the validity of the penalty.

The Franchise Tax Board's penalty reference chart, FTB 1024, is a 2012 revision reflecting the law as enacted on September 21, 2011. Its entry for this penalty lists the two exceptions then in force, a change in law and reliance on a Chief Counsel legal ruling, and no reasonable cause ground, in contrast to the delinquent filing and late payment penalties (RTC 19131 and 19132), for which the chart lists reasonable cause relief. The chart predates the two exceptions added in 2015.

The procedural design reinforces strict liability. Under Section 19138(d), the deficiency assessment procedures do not apply to the penalty, which means there is no proposed assessment of the penalty to protest. The Franchise Tax Board assesses the penalty when the underlying deficiency becomes final, so the penalty is measured on the deficiency as finally determined after any protest or appeal (FTB Manual of Audit Procedures, sections 11.1 and 11.12). Section 19138(e) then limits administrative relief: the FTB may allow a refund or credit of amounts paid under the section only on the ground that the penalty was not properly computed by the Franchise Tax Board. A claim may argue arithmetic, the measurement of the understatement, or the application of a statutory exception, although no published decision defines how far the "not properly computed" ground reaches. A validity challenge of the kind the Court of Appeal recognized belongs in the refund suit, and the suit is limited to the grounds stated in the claim (RTC 19382).

The claim follows the ordinary refund timetable. It must be filed within four years from the date a timely return was filed, four years from the original due date without regard to extensions, or one year from the date of the overpayment, whichever is later (RTC 19306(a)). A denial may be appealed to the Office of Tax Appeals within 90 days of the mailing of the notice of action (RTC 19324(a); Gov. Code 15672(a)). If the FTB does not mail a notice of action within six months after the claim is filed, the taxpayer may treat the claim as disallowed and appeal to the Office of Tax Appeals (RTC 19331), but that office takes jurisdiction over FTB inaction only on a perfected claim for refund, and not on a claim filed solely to toll the limitations period under RTC 19322.1 (Cal. Code Regs., tit. 18, section 30103(a)(4)). The same six months, counted from the date the claim was filed, also allow the taxpayer to treat the claim as disallowed and sue in superior court (RTC 19385). An appeal to the Office of Tax Appeals is not a prerequisite to suit. A refund action may follow payment and the FTB's denial of the claim, must rest on the grounds stated in the claim, and must be filed within the latest of four years from the last date prescribed for filing the return, one year from payment, or 90 days after the notice of action on the claim or after a final appeals determination (RTC 19382, 19384, 19385). The underlying deficiency remains subject to protest, appeal, and settlement in the ordinary way, and any reduction in that deficiency reduces the understatement on which the penalty is computed.

The four statutory exceptions

The statute recognizes four situations in which an understatement does not draw the penalty, and they share a theme: each involves the ground shifting after the taxpayer filed, or the state itself changing the rules of measurement.

First, a change in law. No penalty applies to the extent an understatement is attributable to a change in law enacted, promulgated, issued, or becomes final after the earlier of the date the return was filed or the extended due date (RTC 19138(f)(1)). The change can be statutory or interpretive, including a regulation, a legal ruling of counsel, or a published federal or California court decision. A corporation that filed correctly under the law as it stood, and was made wrong retroactively, is not penalized for it.

Second, alternative apportionment imposed by the FTB. If the understatement results from the FTB exercising its authority to impose an alternative apportionment or allocation method because the standard formula does not fairly represent the taxpayer's California activity, the penalty does not apply to that portion (RTC 19138(f)(2)). The taxpayer cannot be penalized for failing to anticipate a departure from the standard formula that only the FTB could impose.

Third, certain accounting method changes. An understatement attributable to a change in accounting method under Internal Revenue Code Section 446 is excepted, but only for taxable years whose due date, determined without regard to any filing extension, precedes the date of the consent to the change (RTC 19138(f)(3)). This exception, added in 2015, applies to taxable years beginning on or after January 1, 2015, while the alternative apportionment exception applies to taxable years still open as of September 30, 2015, the effective date of the 2015 act (RTC 19138(h)(3)).

Fourth, reliance on a Chief Counsel Ruling. No penalty applies to the extent the understatement is attributable to reasonable reliance on the FTB's written legal advice to the taxpayer in the form of a Chief Counsel Ruling (RTC 19138(g)). This is the exception most within the taxpayer's control, and it requires the formal ruling process: advice from an auditor, a phone call, or general FTB publications does not qualify.

The statute provides no exception for reliance on advisers, for substantial authority, for adequate disclosure, or for positions taken in good faith. The federal accuracy-related penalty framework, with its defenses and disclosure rules, has no counterpart here.

The reserve question

The LCUP's strict liability character changes how it behaves in a tax provision. When a corporation identifies an uncertain California position and records a reserve for the potential tax, the ordinary instinct is to treat penalties as contingent and negotiable, something that resolves in the wash of an eventual audit settlement. The LCUP resists that instinct. If the reserved tax, once assessed, would produce an understatement over the threshold, and no statutory exception applies, the statute gives the examiner no discretion to waive it and no protest in which to contest it. It attaches by operation of law when the deficiency becomes final. A measurement of the exposure that includes the tax but omits a penalty of this character is measuring a different liability than the one the statute imposes. Whether and how the penalty enters the reserve is an accounting judgment for the company and its auditors, but the legal inputs to that judgment are unusually fixed: no protest, no waiver or abatement authority, no reasonable cause.

The same character cuts the other way before the return is ever wrong. Because the threshold is measured against the tax shown on the original return, the penalty analysis belongs in the filing process for any corporation with a large California liability, not in the audit response. A position that might move tax by more than the threshold deserves to be identified before filing, while the options are still open: filing the position with the exposure understood, obtaining a Chief Counsel Ruling where the issue qualifies, or reconsidering the position.

Managing an exposure that already exists

When a corporation discovers after filing that a return understated California tax by more than the threshold, the choices narrow but do not vanish. Amending and paying does not itself remove a penalty on the understatement, since the baseline remains the original return, but the discovery is also the right moment to test whether the understatement is as large as it first appears. Both the threshold test and the penalty turn on the understatement for the year (RTC 19138(a)(1), (b)(1)), so anything that legitimately reduces the corrected liability for the same year reduces the understatement. A careful second review of the year, covering apportionment factor composition, business and nonbusiness classification, state modifications, credits, and the makeup of the combined group, can identify offsets that bring the corrected tax down, and with it the understatement, in some cases below the threshold. That review is worth performing before the year is examined, while the taxpayer still controls the presentation of the corrected numbers.

Practice notes

LCUP analysis starts at filing, not at audit. First, for any year where California tax runs into seven figures, the sound practice is to quantify the understatement that the year's uncertain positions could produce and compare it to the greater-of threshold at the group level, because the group aggregation rule means the threshold analysis belongs to the combined report, not the single entity. Second, the Chief Counsel Ruling process is the exception most within a taxpayer's control, and it merits serious weight for recurring positions large enough to trip the threshold. Third, when an exposure surfaces after filing, the offset review comes before conceding the understatement's size: the penalty is fixed by statute, but the understatement it is measured on is still a computation the taxpayer can get right. Fourth, once the penalty is assessed there is no protest as to the penalty itself, and the refund claim does the work: because a refund suit is limited to the grounds set forth in the claim (RTC 19382), the sound practice is for the claim to state every ground the taxpayer may want to litigate, including validity grounds the FTB cannot grant administratively under Section 19138(e), alongside computation, measurement, and the statutory exceptions, documented while the facts are fresh. The underlying deficiency is a different matter; it can be contested through protest and appeal where the merits support it, since every dollar removed from the deficiency comes off the understatement. G&G State Tax Group provides large corporate understatement penalty analysis and Franchise Tax Board controversy representation alongside its state and local tax practice.