Can California's large corporate understatement penalty be waived?
Edvin Givargis Published 8 minute read
The short answer
No. California's Large Corporate Understatement Penalty is a strict liability penalty, and the statute contains no reasonable cause exception, no waiver authority, and no abatement provision. The Franchise Tax Board cannot negotiate it down on audit, and its auditors and settlement officers have no discretion over it. The only escapes are four narrow statutory exceptions: an understatement attributable to a change in law enacted or announced after the return was filed, reasonable reliance on a written Chief Counsel Ruling issued to the taxpayer, a change in accounting method for certain years, or the FTB's own imposition of an alternative apportionment or allocation method. Outside those four, a corporation whose understatement crosses the threshold owes the penalty, and the only way to contest it is to pay it and file a refund claim on the sole ground that the amount was not properly computed.
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.
For members of a combined reporting group, the threshold applies to the aggregate tax liability of all taxpayers required or authorized to be included in the combined report (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 very 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.
Strict liability means exactly that
Most 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 has consistently administered it as a strict liability provision. Good faith, reliance on competent advisers, the complexity of the issue, and the reasonableness of the original filing position are all irrelevant. 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 procedural design reinforces this. Under Section 19138(d), the deficiency assessment procedures do not apply to the penalty, which means there is no proposed assessment to protest, no administrative appeal of the penalty's imposition, and nothing for a settlement officer to trade. Section 19138(e) then closes the loop: a refund or credit of amounts paid under the section may be allowed only on the ground that the penalty was not properly computed. A refund claim can argue arithmetic, the measurement of the understatement, or the application of a statutory exception. It cannot argue that the penalty is unfair, that the taxpayer acted reasonably, or that the underlying position was close.
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 or legal ruling. 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 precedes the date of the consent to the change (RTC 19138(f)(3)). The exception covers the catch-up effect of a method change on years already filed, not the ongoing application of the new method.
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 only exception within the taxpayer's power to create in advance, and it requires the formal ruling process: advice from an auditor, a phone call, or general FTB publications does not qualify.
Nothing else works. There is 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 penalty is not a matter of examiner discretion or settlement posture. It attaches by operation of law, and there is no administrative path on which it can be traded away. 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 negotiation, no waiver, 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: file the position with the exposure understood, obtain a Chief Counsel Ruling where the issue qualifies, or reconsider 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 really as large as it first appears. The threshold and the penalty are both computed on the net understatement, so anything that legitimately reduces the corrected liability for the same year reduces both. 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, sometimes identifies offsets that bring the corrected tax down, and with it the understatement, occasionally below the threshold entirely. That review is worth performing before the year is examined, while the taxpayer still controls the presentation of the corrected numbers.
Practice notes
The LCUP file starts at filing, not at audit. First, for any year where California tax runs into seven figures, 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, treat the Chief Counsel Ruling process as the one exception a taxpayer can build in advance, and weigh it seriously for recurring positions large enough to trip the threshold. Third, when an exposure surfaces after filing, run the offset review 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, remember the dispute path when the penalty is assessed: there is nothing to protest, so preserve the arguments that fit a refund claim, which are computation, measurement, and the statutory exceptions, and document them while the facts are fresh.
This article states the law as of September 14, 2026
Statutes, rates, thresholds, and agency practice change, and a different set of facts can change the answer. Before acting on anything discussed above, contact G&G State Tax Group to confirm what has changed since this was written and how the rules apply to a specific situation.
G&G State Tax Group, LLC is a state and local tax advisory firm. The firm provides state and local tax consulting and representation in state and local tax controversies. G&G does not prepare or file tax returns, perform attest services, or provide bookkeeping, and is not a CPA firm.