United States: California Taxpayers Should Fight Imposition Of The LCUP And Other Penalties In The Wake Of Gillette.

Last Updated: May 17 2018
Article by Kyle O. Sollie, Shail P. Shah, Mike Shaikh and Yoni Fix


In October 2012, a California Court of Appeal held that taxpayers could, under the Multistate Tax Compact, elect to apportion income using an equally weighted, three-factor method instead of the standard double-weighted sales method or single-sales factor method (the Gillette Election).1 The FTB appealed the decision to the California Supreme Court. In December 2015, that court reversed the Court of Appeal decision, thereby denying taxpayers the right to make the Gillette Election.2 Now, the FTB has begun to issue assessments to taxpayers who made the election.3 In addition, the FTB is also imposing the LCUP on taxpayers who made the election. In our view, as explained in this alert, the FTB's assessment of penalties, including the LCUP, is contrary to law.

To understand why the FTB's imposition of these penalties is contrary to law it is necessary to examine the period leading up to the Court of Appeal decision. At that time, the California Legislature made an attempt to eliminate the Gillette Election by repealing the Multistate Tax Compact.4 Also, as part of that effort, the Legislature determined that tax elections must be made on an original return.5 Thus, as we wrote in our October 4, 2012, and August 15, 2014, alerts, taxpayers faced a dilemma: They were forced to choose between making a valid Gillette Election on an original return (and potentially face penalties) or make the Gillette Election after filing the original return and face the possibility that the election was invalid. Taxpayers who made the election on original returns are now being penalized by the FTB.

Filing a protest to contest these penalties

In our view, neither the accuracy-related penalty nor the LCUP should apply if the taxpayer made the Gillette Election on original returns before the California Supreme Court decision based on the exceptions discussed below. Taxpayers should protest the penalties assessed by the FTB.

Exception to the LCUP

The LCUP applies to corporate taxpayers with an understatement of tax that exceeds the greater of $1 million or 20 percent of the tax shown on an original return.6 The LCUP does not have a statutory exception for a position that is supported by substantial authority or for a taxpayer who acts in good faith, such as the accuracy-related penalty exceptions discussed below.

But the LCUP does contain an exception that applies to circumstances involving ambiguous interpretive issues – such as the issue concerning the proper interpretation of the Gillette Election. Specifically, the LCUP statute provides that no "penalty shall be imposed ... on any understatement ... attributable to a change in law that ... becomes final after the earlier of ..." the date the taxpayer files its return or the extended due date for filing.7

Importantly, "change in law" is a defined term. A "'change in law' means ... an interpretation of law ... by ... a published ... California court decision." Here, it is important to note that a "California court decision" does not need to conflict with an earlier, established rule of "law" in order to fit the definition of a "change in law." A "change in law" is statutorily defined; it means, simply, "an interpretation of law" by a court decision that is published. It is not necessary for that "interpretation" to conflict with an earlier established rule of "law."8

Whenever there is litigation over the interpretation of a point of law, the resulting decision "changes" the understanding of the law for the party on the losing side. It is certainly reasonable for the Legislature to have concluded, in defining "change of law," that parties waiting for a final interpretation of a point of law should not be penalized for guessing the wrong way. This is especially significant when the alternative would be to lose a benefit forever.

Further, this interpretation follows the California precedent that statutes imposing penalties are to be interpreted in favor of the taxpayer.9 Finally, a contrary interpretation of the "change in law" exception would violate due process. If the FTB's position were to prevail, a taxpayer, in order to vindicate its right to make the Gillette Election, would have been required to expose itself to penalties. After all, the Legislature made it clear that a taxpayer could not make the Gillette Election on an amended return. Courts have held that a person cannot be put in the position of exposing himself to penalties in order to vindicate a right under state law.

Thus, in our view, it is clear that the FTB cannot impose the LCUP on any taxpayer who made the Gillette Election on an original return filed before the California Supreme Court's decision in Gillette was final.

Exceptions to the accuracy-related penalty

The 20 percent accuracy-related penalty is imposed on any portion of underpayment of tax that is attributable to: (i) negligence or disregard of rules or regulation,10 or (ii) any substantial understatement11 of income tax.12

There are three exceptions to the imposition of the accuracy-related penalty:

  • The "Substantial Authority" Exception applies if there is or was substantial authority for the understatement.13
  • The "Adequate Disclosure and Reasonable Basis" Exception applies if the relevant facts affecting the item's tax treatment are adequately disclosed and there is a reasonable basis for the tax treatment of such item.14
  • The "Reasonable Cause and Good Faith" Exception applies if the underpayment was due to reasonable cause and the taxpayer acted in good faith with respect to such portion of the underpayment.15

The accuracy-related penalty is abated if any one of the above exceptions is satisfied. In many cases, taxpayers that made the Gillette Election on an original return will have satisfied more than one, if not all, of the above exceptions. For example, we believe that the substantial authority exception should apply. That exception requires substantial authority at the time the return is filed or on the last day of the taxable year to which the return related.16 Court cases, among other authorities, are considered substantial authority for purposes of the exception, as long as the case has not been overruled or reversed.17 Thus, a decision by a Court of Appeal that was not overruled at the time a return was filed is considered a substantial authority that may be relied upon for purposes of the "substantial authority" exception.18

Indeed, a reasonable taxpayer, looking into the law at the time the return was filed, would find the only authority on the topic was the Court of Appeal decision. The fact that the Court of Appeal decision was never published because the California Supreme Court granted review should not change this result. The fact remains, at the time taxpayers made the Gillette Election, the only authority they had to rely on was the proclamation by a Court of Appeal that they could do so. The fact that the California Supreme Court later invalidated the election is not relevant for purposes of determining whether it was appropriate to make the election at the time the return was filed.

Additionally, a taxpayer that made the Gillette Election – equally averaging its factors without super-weighting its sales – is obvious on the face of the return. Thus, the election is self-evident and the simplicity and obviousness of the calculation is an adequate disclosure. Finally, if nothing else, a taxpayer that made the election before the decision of the California Supreme Court certainly had reasonable cause for the election and could make the election in good faith.

Therefore, a taxpayer who made the election before the California Supreme Court issued its decision in Gillette should not be subject to accuracy-related penalties.

For more information on contesting assessments containing an accuracy-related penalty or an LCUP due to the Gillette Election, contact the authors of this alert or another member of the Reed Smith State Tax Group.

The Reed Smith State Tax team has lawyers based in Los Angeles and San Francisco focused exclusively on California state tax matters. The Reed Smith team handles California tax matters of all types, from audit defense to appeals and litigation.


1 See The Gillette Company v. Franchise Tax Board, 209 Cal. App. 4th 938 (1st Dist., Oct. 2012).

2 62 Cal. 4th 468 (2015), cert. denied, 137 S. Ct. 294 (2016).

3 Generally, for taxable years beginning before January 1, 2013, taxpayers were required to apportion income using three factors – property, payroll and sales. The sales factor was given double weight. However, for taxable years beginning on or after January 1, 2013, the three-factor test has been replaced by a single sales factor. See Cal. Rev. & Tax. Code §§ 25128, 25128.7.

4 In June 2012, the Legislature attempted to repeal the Gillette Election with a simple majority. This action would only be valid if the Gillette Election was already invalid, otherwise, the repeal would be a tax increase, requiring a supermajority. See S.B. 1015, ch. 37 (June 27, 2012) (S.B. 1015). In 2010, the people of the state of California voted in Proposition 26 to only permit a tax increase with a supermajority. See Cal. Const. Art. XIIIA, Sec. 3.

5 S.B. 1015.

6 Cal. Rev. & Tax. Code § 19138.

7 Cal. Rev. & Tax. Code § 19138(f).

8 By contrast, under Cal. Rev. & Tax. Code § 19138(f), in order for a statute to be a "change in law," the statute must occasion a "statutory change."

9 See, e.g., Microsoft Corp. v. Franchise Tax Bd. 39 Cal.4th 750, 759 (2006) ("To the extent the language is ambiguous, we generally will prefer the interpretation favoring the taxpayer"); Apple, Inc. v. Franchise Tax Bd., 199 Cal.App.4th 1, 16 (1st Dist., September 2011) ("ambiguities in the governing statutes are resolved in favor of the taxpayer").

10 For purposes of the statute, "negligence" includes any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code. The term "disregard" is defined to include any "careless, reckless, or intentional disregard." See IRC § 6662(c).

11 "Understatement" means the excess of the amount required to be shown on the return for the taxable year over the amount of the tax imposed which is shown on the return, reduced by any rebate. See IRC § 6662(d)(2).

12 Cal. Rev. & Tax. Code § 19164, subdivision (a)(1)(A), provides for an accuracy-related penalty that is determined in accordance with IRC § 6662. In the case of a corporation, other than an S corporation, a substantial understatement of tax exists if the amount of the understatement exceeds the lesser of 10 percent of the tax required to be shown on the return (or, if greater, $2,500) or $5,000,000. See IRC § 6662(d)(1)(B), as modified by Cal. Rev. & Tax. Code § 19164(a)(3).

13 See IRC § 6662(d)(2)(B)(i).

14 See IRC § 6662(d)(2)(B)(ii).

15 IRC § 6664(c)(1); Treas. Reg. § 1.6664-1(b)(2); Treas. Reg. § 1.6664-4.

16 Treas. Reg. § 1.6662-4(d)(3)(iv)(C).

17 Treas. Reg. § 1.6662-4(d)(3)(iii).

18 Kretschmer v. Comm'r, T.C. Memo 1989-242 (1989) (U.S. Tax Court concluded that where, at the time the return was filed and on the last day of the tax year covered by the return, the only authority on an issue supported taxpayer's position, there was substantial authority even though by the time of the trial, the large majority of cases opposed that position).

This article is presented for informational purposes only and is not intended to constitute legal advice.

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