Office of Tax Appeals

’Precedent’ Applied Retroactively to Negate Taxpayer’s Successful Appeal

OTA with State Seal

The Office of Tax Appeals posted 36 opinions on its website for May, including a ruling that reversed a taxpayer’s partial win based on a precedential decision released after the ruling.

In the Appeal of A. Edwards, the OTA’s initial ruling, dated February 1, 2021, sided with the Franchise Tax Board on most issues but concluded that the “demand penalty” should be abated, using similar logic applied in a majority of the cases on the demand penalty up to that point. The taxpayer’s win on that issue has been overturned, however, based on a precedential decision that was issued more than a month after the initial ruling.

In the now-superseded ruling, the OTA concluded that the notice of proposed assessment was not issued “during” the four tax years prior to the years at issue, and therefore “the prerequisites of Regulation 19133 are not satisfied, and the demand penalty is abated.”

The precedential Jones appeal, issued March 4, 2021, used a different definition of “during” to expand the timeframe in which the FTB could impose the demand penalty. The precedent upheld the FTB’s interpretation even though a majority of the OTA’s administrative law judges had rejected that interpretation in numerous appeals.

The taxpayer in the latest appeal is a nonresident of California who did not file a California return for the 2013 tax year. The FTB received a 2013 Schedule K-1 reporting that the taxpayer received California-source income. Since the taxpayer failed to file a return, the FTB estimated the 2013 income based on the amount reported on the K-1, $411,133. The taxpayer argued that the K-1 was issued due to a clerical oversight, and submitted an amended K-1 on appeal with the California-source income zeroed out.

The OTA concluded for the vast majority of income at issue, the location of the benefit of the services was outside of California, and calculated California-source income totaling $13,654.

After the initial opinion was issued, the FTB filed a petition for rehearing, arguing that the opinion “is contrary to law and that there was an irregularity in the proceedings.” The OTA disagreed, concluding that the FTB “has not

established that the Opinion was contrary to law or that there was an irregularity in the proceedings” regarding the conclusion on California-source income.

However, the FTB’s petition for rehearing kept the initial opinion from becoming “final” under the OTA’s procedures, and the subsequent precedent relating to the demand penalty thus became an issue. “[G]iven these circumstances, we find that there is sufficient basis to find that the underlying Opinion in this appeal, which is not yet final, is contrary to law as to the issue of the application of Regulation section 19133(b), such that a rehearing should be granted.”

Six months after the initial opinion was issued, the OTA granted a rehearing on the demand penalty issue. The OTA’s opinion on rehearing concluded that the “FTB properly imposed the demand penalty.” The OTA provided limited relief by reducing the demand penalty based on the revised California-source income of $13,654.

(CalTax: This case could prompt the tax agencies to file petitions for rehearing anytime the taxpayer wins on any issue, as doing so will delay the opinions from becoming final and keep the window of opportunity open for a change that would harm the taxpayer’s case. A precedent, by definition, is something that precedes, or comes before. The benefit of allowing a “precedent” to be applied retroactively likely will be one-sided in favor of the tax agencies, as they can file petitions for rehearing using public dollars, whereas taxpayers have to weigh the costs of doing so.)

Accuracy of CDTFA’s “Observation Tests” at Issue in Cannabis Tax Appeal. One of the issues in the Appeal of MMD Inc., involving a cannabis dispensary in Los Angeles, was the validity of the CDTFA’s “observation tests” – situations where the tax agency sends staff to observe business activity to estimate the amount of taxable sales. Since the results of relatively brief observation periods are extrapolated to cover lengthy audit periods, any inaccuracy can be magnified significantly, thus resulting in much higher or lower estimates.

The business was audited after agents from the Statewide Compliance and Outreach Program (SCOP) visited the dispensary and came to the conclusion that the taxable sales reported by the cash-only business would not be sufficient to pay its eight employees and cover other overhead. Further investigation by the SCOP team and the CDTFA uncovered additional evidence of underreporting and a lack of thorough sales records, prompting the CDTFA to conduct three one-hour observation tests.

The observers stayed outside the business due to concerns over the potential of federal raids, criminals targeting the business (because it was thought to have a significant amount of cash on site), and the potential effects of exposure to marijuana smoke. From a distance, they counted the number of people who entered the business during one-hour periods on different days, and initially operated on the assumption that every person who entered made a purchase of 1/8 of an ounce of marijuana – an amount based on the CDTFA’s analysis of sales at similar businesses. Using MMD’s price menu, the CDTFA calculated an average hourly sales figure, and extrapolated that to cover a three-year audit period, using what it believed to be the business’ hours of operation (10 a.m. to midnight, seven days a week).

Several flaws in the observation test were uncovered during the appeal were harmful to the taxpayer:

  • Although the CDTFA and SCOP observed five hours of activity combined, the CDTFA initially did not include one of the hours in its calculations – and since no customers were observed entering the business during that hour, the omission resulted in a much higher estimate of taxable sales.
  • For 10 months of the audit period, the business was open 10 hours a day, not the 14 hours used in the CDTFA’s initial calculation, again resulting in a much higher estimate of daily sales.
  • The assumption that every person who entered the business made a purchase did not account for “window shoppers,” people checking on medical referrals, etc.

What appears to be the largest flaw, however, likely benefitted the taxpayer: the observers were unaware that the business had a rear entrance, so they counted only those who used the front door. The OTA’s opinion does not include an estimate of how many customers might have been missed because of this significant oversight.

After adjusting for some of the flaws, the CDTFA reduced its estimate of unreported taxable sales from approximately $4 million to $2.25 million and withdrew a negligence penalty of more than $37,000.

The OTA upheld those figures, stating in its 3-0 opinion that the taxpayer did not meet its burden of proving that the CDTFA’s modified numbers were erroneous, nor that there were errors in the audit procedures or computations that weren’t addressed by the adjustments. The OTA additionally noted that the business’ lack of required sales records prompted the CDTFA’s decision to rely heavily on observation tests.

The taxpayer offered an alternative computation that acknowledged that 45 percent of its sales went unreported, but the OTA ruled that the business didn’t provide adequate sales tickets or other records to prove that this estimate would be more accurate.

The OTA also rejected the taxpayer’s petition for rehearing. Among other things, the taxpayer argued that there was an irregularity in the proceedings that hindered its ability to get a fair hearing. Specifically, the taxpayer objected to the OTA’s rejection of its effort to subpoena a CDTFA auditor who worked on the case. The CDTFA sent another auditor to the hearing, and the taxpayer alleged that the second auditor misstated facts. The OTA ruled that the auditor sought by the taxpayer was not the lead auditor or the author of the audit reports, and that based on these facts and the period of time he spent on the case, “his testimony would likely be repetitive and not helpful.”

CDTFA Abandoned Observation Test Based on Pro-Taxpayer Result. An observation test also was a point of contention in the Appeal of Tory Inc., involving a sushi restaurant accused of underreporting sales. Due to a lack of proper records, a three-day test was agreed upon by the CDTFA and the restaurant owner to determine the percentage of customers who paid with credit cards. The percentage would be extrapolated to cover a three-year audit period to estimate whether the owner had pocketed money rather than reporting cash sales.

“Respondent indicates that on the first observation date, appellant did not permit the observer to sit in a position from which the details of the sales transactions could be observed and that at the end of the observation test day, the auditor added up the sales from the available guest checks and computed that credit card sales represented 98.38 percent of total sales for that day,” the OTA wrote. “Respondent considered the 98.38 percent credit card sales ratio to be unusually high and concluded that appellant had ‘manipulated’ the guest checks. Respondent abandoned its plan to determine the credit card sales ratio using data from observing sales at the business.”

The auditor instead used available point-of-sale (POS) records to estimate that 78.16 percent of the sales involved credit cards.

The taxpayer argued that it is “fundamentally unfair” to not give him the benefit of the larger ratio after both parties agreed to the observation test. He additionally objected to the auditor’s reliance on a “belief” that 98.38 percent was too high – as opposed to credible evidence – and noted that the CDTFA’s Audit Manual recommends a minimum three-day observation test.

While the taxpayer contended that his lack of records stemmed from damage to a computer, the OTA was not sympathetic. “A reasonable and prudent business owner in appellant’s position, having been previously found, on a first audit, to have negligently maintained and provided business records that were inadequate for sales and use tax purposes, would have taken reasonable steps to regularly print or back up POS system data to ensure that its business records would not again be found inadequate,” the OTA wrote.

The OTA additionally found that even if the 98.38 percent ratio on the observation day was correct, “that does not make that day’s data representative of the liability period.” Based on the records that were available, “that high a ratio would be an outlier,” the OTA wrote. The OTA added that the records “revealed probable significant underreporting of taxable sales.”

The OTA also rejected the taxpayer’s petition for rehearing, ruling that he was simply attempting to reargue issues that were decided correctly in the original opinion.

Food Sold to Soldiers Isn’t Exempt From Sales Tax, OTA Rules. Sales to the U.S. government or its unincorporated agencies and instrumentalities are generally exempt from sales tax, but does that mean sales to U.S. soldiers are exempt, too? “No,” the OTA ruled in the Appeal of M. Homami and M. Homami, because the restaurant “was selling food to individuals, and not to the U.S. government.”

The taxpayers, owners of a Persian restaurant near the Naval Postgraduate Academy in Monterey, presented the novel argument that $232,596 in sales should be exempt because, among other things, the restaurant was a place where active duty military personnel could learn Farsi. To that end, the restaurant employed a “chief master language instructor” from the Defense Language Institute to work five hours per day. This was part of an unwritten contract of sorts, the taxpayers contended.

The taxpayers additionally testified that they hadn’t collected sales tax from military personnel, so they did not benefit financially from the failure to remit the tax.

The OTA found that there was no official contract for the restaurant to sell food to the government, and additionally noted that retailers have the option to collect sales tax reimbursement from customers, but “failure to collect reimbursement is not a basis for relief from the tax.”

Taxpayers Overpaid Significantly, but Won’t Get Refunds. Several appeals involved taxpayers who paid more than their fair share of taxes – the FTB and OTA agreed that they overpaid – but the state will keep the money because the appellants missed deadlines for filing refund claims.

In the Appeal of T. Clarke, the taxpayer failed to file returns for many years, prompting the FTB to estimate the amounts he should have paid – based on information from third-party sources – and levy his bank account for the funds. When he eventually filed returns, the FTB accepted them and acknowledged over-collecting almost $25,000 ($5,338 for the 2008 tax year, $7,850 for 2009, $7,232 for 2010, $1,171 for 2011, and $3,321 for 2013). The taxpayer requested that the FTB apply the overpayments to balances owed for more recent years, but the FTB denied the claim for credit or refund, citing the missed deadlines.

The OTA upheld the FTB’s position, and noted that the taxpayer could have avoided problems by filing and paying his taxes on time.

“Federal courts have held that fixed deadlines may appear harsh because they can be missed by a single day or even a single hour, but the resulting occasional harshness is redeemed by the clarity they give to the legal obligation,” the OTA wrote.

The Appeal of D. McBride also involved a situation in which the taxpayer filed a return only after the FTB had issued a notice of proposed assessment and taken collection action. The taxpayer eventually showed that the FTB had collected $4,372 more than necessary for the 2016 tax year, but his refund claim was filed too late. The OTA rejected the taxpayer’s argument that the statute of limitations should be suspended due to housing issues caused by the pandemic.

In the Appeal of L. Cruz and K. Cruz, the taxpayers filed a late return for the 2016 tax year, and missed the deadline for claiming their $4,428 refund of taxes that were withheld from their paychecks. “Appellants’ sole contention on appeal is that the result is unfair,” the OTA wrote. “Appellants claim that they were audited in 2015 and have been ‘unable to pay anyone to do our taxes or assist [us] with appealing.’ Presumably because of their continuing difficult financial circumstances, appellants assert that ‘[the 2016 return] went undone until recently.’ However, we have no authority to grant relief except where the law specifically allows.”