California Tax and Fee Administration

The CDTFA announced that it was authorized under the Governor’s COVID-19 Executive Order to “assist individuals and businesses impacted by complying with a state or local public health official’s imposition or recommendation of social distancing measures related to COVID-19.” This assistance included filing and payment extensions, relief from interest and penalties, and extension of deadlines for filing claims for refund. Many of those relief provisions expired on July 31, 2020. The CDTFA’s website currently directs taxpayers to call their office for more information about filing, extensions, and relief. Additionally, the CDTFA is administering the Main Street Small Business Tax Credit, which was enacted by Senate Bill 1447 on September 9, 2020.

Office of Tax Appeals

Pursuant to OTA Notice 2020-01, the OTA granted an automatic 60-day extension for appeals with briefing or other deadlines that fell between March 1 and May 18. Currently, the OTA is not conducting hearings in person, and is instead conducting remote, electronic hearings.

Legislative Review

The pandemic not only strained California’s healthcare system, but also severely crippled its economy. The revenue shortfall in 2020 led California legislators to introduce almost $82 billion in tax- and fee-related bills. We will discuss a few bills that passed, some that failed, and what we may expect in the future.

What Passed

The most significant piece of legislation enacted directly in response to the pandemic was Assembly Bill 85.¹ Assembly Bill 85 introduced a host of measures aimed at stemming the cash flow crisis in California. Some the measures, such as the suspension of the use of net operating losses for the 2020, 2021, and 2022 tax years by individual and corporate taxpayers with business income in excess of $1 million should be familiar to California taxpayers.² However, Assembly Bill 85 also included a limitation on the use of business tax credits for the 2020, 2021, and 2022 tax years. The bill provides that credits may not reduce the applicable combined group tax by more than $5 million. Finally, Assembly Bill 85 included a few small gifts for taxpayers. Notably, the bill included an exemption from the annual minimum franchise tax for limited partnerships, limited liability partnerships, and limited liability companies for their first taxable year beginning on or after January 1, 2020, and before January 1, 2024.

A few other notable bills that passed:

• Assembly Bill 3372 –if a non-U.S. affiliate becomes a California taxpayer solely due to California’s economic nexus standard in a tax year beginning on or after January 1, 2021, it will be deemed to have made a water’s edge election with the existing water’s edge combined reporting group.
• CARES Act conformity bills
  • Assembly Bill 276 conforms California to the federal treatment of qualified loans from retirement accounts.
  • Assembly Bill 1577 conforms California to federal law for Paycheck Protection Program Loans.
• Assembly Bill 2660 allows certain nonresident taxpayers to file a group return if they receive taxable income for services performed in California.

What Didn’t Pass

Assemblyman Mark Stone hoped he would get lucky the second time around when he introduced Assembly Bill 2570³, proposing to remove the bar to tax-related claims under California’s False Claim Act. Just like Stone’s 2019 Assembly Bill 1270, which also aimed to remove the bar to tax-related claims, Assembly Bill 2570 died on the Senate floor. Both the 2019 and 2020 bills aimed to allow whistleblowers to file complaints with the Attorney General’s office for tax-related false claims actions if (1) the damages pled in the action exceed $200,000, and (2) the amount of reported taxable income, net income, or sales equals $500,000 or more.

Senate Bill 956, which aimed to make California’s tax credit and incentive programs more transparent by establishing a California Tax Expenditure Review Board to assess major tax expenditure programs. Senate Bill 956 died in the Assembly Revenue and Taxation Committee, largely due to opposition from Governor Gavin Newsom, who felt that the board would duplicate efforts already performed by FTB, CDTFA, and Board of Equalization.

Finally, Senate Bill 37 sought to increase the top corporate tax rate to as high as 16.84% for corporations with net income of $10,000,000 or more, with the rate increasing based on the ratio of the CEO’s salary to the average worker wages. The bill died in the Senate Rules Committee.

Notable California Court of Appeal Decisions

Despite the disruptions caused by COVID-19, the California Court of Appeal still issued a number of important tax decisions.

Special Tax Voter Initiative Litigation

In the wake of the California Supreme Court’s decision in California Cannabis Coalition v. City of Upland,⁴ it became unclear whether a two-thirds supermajority is required to pass voter initiatives implementing special taxes. This uncertainty led to taxpayers and local governments collectively filing six separate cases in state court:

• Howard Jarvis Taxpayers Assn., et. al v. City and County of San Francisco, No. CGC-18-568657: Proposition (“Prop”) C imposes an additional gross receipts tax (“GRT”) on persons engaged in leasing commercial properties in San Francisco. The San Francisco trial court held that the special tax initiative was valid even though it only received a simple majority vote.
• City and County of San Francisco v. All Interested Parties in Prop C on the November 6, 2018 San Francisco Ballot, No. CGC-19-573230: This Prop imposes tax, also known as the Homelessness GRT, on all business located in San Francisco that receive more than $50 million in total San Francisco taxable gross receipts, effectively doubling the GRT rate on businesses. The San Francisco trial court held that the Homelessness GRT was valid even though it only received a simple majority vote.
• City and County of San Francisco v. All Interested Parties in Prop G or the June 5, 2018 San Francisco Ballot, CGC-18-569987: Prop G imposes a parcel tax to fund the San Francisco Unified School District. The San Francisco trial court found that the voter initiative was valid under the San Francisco Charter and was valid even though it only received a simple majority vote.
• Jobs and Housing Coalition v. City of Oakland, No. RG19005204: Measure AA imposes a parcel tax for 30 years to fund educational programs. The Alameda trial court held that Measure AA was unenforceable because it did not receive the necessary two-thirds vote required for special tax initiatives.
• City of Fresno v. Fresno Building Healthy Communities, No. 19CECG00422: Measure P authorized Fresno City to collect sales and use tax to fund a number of community improvements. Because Measure P received a simple majority vote, Fresno’s City Council declared Measure P had failed. The City Council then filed an action in Fresno Superior Court asking the court to declare the appropriate voter threshold for voter initiatives like Measure P. The Fresno trial court found that special tax initiatives, such as Measure P, need a two-thirds vote in order to be valid.
• Fresno Building Healthy Communities v. City of Fresno, No. 19CECG00432: The nonprofit Fresno Building Healthy Communities (the “Nonprofit”) initiated this action regarding the validity of Measure P. Because its facts were identical to Fresno Council’s declaratory action, the court issued one decision that applied to both Measure P cases.

These rulings only increased the uncertainty regarding the voter threshold required for passage of special tax initiatives – with the San Francisco trial court holding a simple majority suffices and the Fresno and Alameda trial courts both holding that a two-thirds supermajority is required. All six trial court decisions were appealed. In 2020, the Court of Appeal issued two decisions affirming that voter initiatives implementing special taxes only require a simple majority to be valid. On June 30, 2020, the court affirmed the San Francisco trial court’s decision that voter initiatives like the Homelessness GRT only require a simple majority vote to by valid.⁵ On December 17, 2020, the court reversed the Fresno trial court’s judgments and found Measure P to be valid.⁶ The Court of Appeals decision regarding Measure P relied heavily on the Court of Appeals’ earlier decision in June regarding San Francisco’s Homelessness GRT.

The Paula Trust Case

On June 29, 2020, the California Court of Appeal reversed in part the trial court’s summary judgment order in Steuer v. Franchise Tax Board (referred to as the “Paula Trust decision”). Specifically, the Court of Appeals held that a trust is taxed on all California-source income, regardless of the residency of the trust’s fiduciary. In making this determination, the court examined the structure of the trust (the “Paula Trust”). The Paula Trust’s sole beneficiary was a California resident, while its two co-trustees included a California resident and a Maryland resident. The Paula Trust sought a refund under Revenue and Taxation Code (“Code”) Section 17743. It alleged that Code Section 17743 provides that a trust’s income, even if entirely derived from California sources, is only taxable under residence-based taxation. The Court of Appeal disagreed, stating that Code Section 17743 and FTB’s regulation interpreting it “require taxing all of a trust’s California-source income and then apportioning only income derived outside of California according to the number of resident fiduciaries.”⁷ Only a trust’s non-California source income is apportioned based on the residency of a trust’s fiduciaries.

Although the Court of Appeal reversed the trial court’s interpretation of Code Section 17743, it affirmed the trial court’s finding that the sole beneficiary’s interest in the Paula Trust was contingent. The court’s analysis centered on whether the trust documents placed any limitation on the co-trustees’ discretion to distribute income to the Paula Trust’s sole beneficiary. It found no such limitations, noting the trust documents grant “sole absolute discretion” to the co-trustees to make distributions of trust income and principal. Moreover, the co-trustees are not required to make any distributions.

Office of Tax Appeals Highlights from 2020

Despite the pandemic, 2020 was a busy year for the OTA. The OTA published 377 opinions, of which:

• 351 were non-precedential opinions;
• 7 are pending precedential opinion status; and
• 19 were precedential opinions.

The OTA opined on a range of commonly applicable and important taxpayer issues including, but not limited to, California residency, thresholds for doing business in California, eligibility for research and development credits, interest and penalty abatement, and resale exceptions.

The OTA continued to hold oral hearings during the pandemic but conducted these hearings remotely. The OTA held oral hearings for around:

• 12% of decided franchise and income tax cases; and
• 55% of decided business tax cases.

Over 400 cases were closed in 2020 without an opinion being published, either:

• by agreement between the parties (~20%); or
• by withdrawal by either the taxpayer or the tax agency (~80%).

There are currently over 1,400 cases pending at the OTA, the majority of which are franchise and income tax appeals (~75%) and the rest are business tax appeals (~ 25%). In over 250 of those pending cases, briefing has already been completed and are in either the hearing preparation phase or have already been scheduled for oral hearings.

Impact of FTB Notice 2020-03 on the Resolution of OTA Cases

As the OTA enters its fourth year, we expect the number of OTA hearings and published decisions to increase. We also expect an increase in the number of cases being resolved via settlement agreements. The FTB recently issued Notice 2020-03, which discussed the FTB settlement program, the process for requesting consideration, and the settlement process. The notice establishes a 9-month settlement deadline. If a tentative settlement has not been reached within the 9-month timeframe, the appeal will be removed from the settlement program and returned to its pre-settlement status (i.e., protest, claim for refund, or OTA appeal), unless the Director of the FTB Settlement Bureau approves allowing the case to remain at the Bureau based on extraordinary circumstances. As a result, many OTA cases that are currently deferred for purposes of settlement discussions with the FTB will either be settled more quickly or returned to the regular OTA schedule for briefing and decision.

Proposed changes to OTA Regulations

The OTA is considering adding a fast-track option for small claims (appeals involving less than $5,000 in personal income tax cases or less than $20,000,000 of gross receipts for purposes of business taxes administrated by the CDTFA) to its regulations. Under this option, small claims appeals would be decided by a single Administrative Law Judge (“ALJ”). The OTA is also considering revising its regulations to add a requirement that the panel deciding a petition for rehearing shall consist of a presiding ALJ, an ALJ who was not on the original panel, and the lead ALJ who authored the written OTA opinion that is the subject of the rehearing petition.

Looking into the Crystal Ball—What to Keep an Eye on During 2021

Although 2020 has taught us that the future is hard to predict, here are a few things taxpayers should keep an eye out for in 2021:

• While the California taxing agencies have not issued formal guidance regarding 2021 filing deadlines, taxpayers should keep an eye out for any new notices or bulletins. To the extent that the IRS extends deadlines for the 2021 filing season, it is likely that the FTB and CDTFA will follow suit. Additionally, taxpayers can expect that virtual meetings and hearings will be the norm for at least the first half of 2021.
• Third times the charm? Given Assemblyman Mark Stone’s persistence over the last two years, it is possible he will introduce another bill in 2021 that would remove the tax bar from California’s False Claims Act. It appears the key driver that sunk both Assembly Bills 1270 and 2570 was widespread criticism from the business community. Without key provisions that provide transparent safe harbors for businesses in California, any proposed legislation in 2021 is likely to fail.
• While Senate Bill 37 failed in 2020, the success (or failure) of San Francisco’s “CEO Tax” (Proposition L which passed November 2020) may direct state lawmakers to reintroduce the bill in its original or a modified form. San Francisco’s Controller estimates the tax will generate $60 million to $140 million of additional revenue annually. While this may seem enticing to state lawmakers, the outflow of companies from San Francisco to other parts of the country may severely diminish the tax base. This may be give state lawmakers some pause given the recent publicity regarding technology companies relocating outside of California.
• Although there are still appeals pending, the 2020 Court of Appeal decisions regarding San Francisco’s Homelessness GRT and Fresno’s Measure P establish that voter initiatives implementing special taxes only require a simple majority in order to be valid. These decisions will make it easier for special tax measures to pass. As a result of the strain COVID-19 has placed on California state and local government budgets, California may see an increase in special tax voter initiatives being proposed and passed.
• Although the Paula Trust decision sheds light on the tax treatment of trusts’ income, there are still questions regarding the application of Code Section 17743 as well as the factors for determining whether a beneficiary’s interest is contingent. Taxpayers should also follow the Metropoulos Family Trust case, which deals with the treatment of flow-through gain form an S corporation. On November 19, 2019, the OTA upheld the FTB’s denial of the taxpayers’ refund claims finding that the income received by two trusts, as shareholders in a multistate unitary S corporation, was apportionable to California based on an apportionment formula determined at the S corporation level, in accordance with Regulation 17951-4(f) and (d)(1). It also found that the trusts’ distributive share of the S corporation gain from the sale of goodwill was not sourced to the business situs of the S corporation stock under the sourcing rule for income from intangibles in Code Section 17952. On March 4, 2020, the taxpayer appealed the OTA’s decision to the San Diego Superior Court.⁸
• Taxpayers should also follow Online Merchants Guild v. Maduros⁹, which addresses whether the CDTFA’s pursuit of back sales taxes from out-of-state sellers with inventory stored at Amazon fulfilment centers in California is unconstitutional. In its complaint, the Online Merchants Guild, a trade association for small businesses, argues that the CDTFA’s demand for out-of-state businesses to remit uncollected sales tax on sales made through Amazon violates (1) the U.S. Constitution’s Due Process Clause and (2) the Internet Tax Freedom Act. The Online Merchants Guild filed a Motion for Preliminary Injunction and the CDTFA has filed a Motion to Dismiss the action. The case is currently being briefed.
• Finally, depending on the facts and legal issues in your case, if you have refund claims or protests making their way through the administrative process to the OTA, or are already docketed at the OTA, you may want to consider requesting settlement consideration by the FTB as it might be a quicker and more cost-efficient route to resolution based on the 9-month settlement timeline set forth in FTB Notice 2020-03.

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For more information on California’s responses to COVID, legislation, OTA and court litigation, or any other California related tax issues, contact the authors of this alert or another member of the Reed Smith State Tax Group.

The Reed Smith State Tax Group has lawyers focused exclusively on California state tax matters and handles California tax matters of all types, from audit defense to appeals and litigation. 

1. reedsmith.com.
2. See reedsmith.com.
3. reedsmith.com.
4. California Cannabis Coalition v. City of Upland, 3 Cal. 5th 925 (2017). For a more detailed analysis of the San Francisco Superior Court's decision and the constitutional issues at play, please refer to law360.com and law360.com.
5. See City and County of San Francisco v. All Persons Interested in Matter of Proposition C, 51 Cal. App. 5th 703 (Cal. Ct. App. 2020). On September 9, 2020, the California Supreme Court denied review. Thus, this decision is final.
6. The Court of Appeal ordered that in the City of Fresno’s action the trial court enter a new judgment in favor of the Nonprofit declaring Measure P has passed. In the Nonprofit’s action, the Court of Appeals ordered the trial court to enter a new judgment granting the Nonprofit’s request for declaratory relief and declaring Measure P has passed.
7. Steuer v. Franchise Tax Bd., 51 Cal. App. 5th 417, 426 (Cal. Ct. App. 2020).
8. The 2009 Metropoulos Family Trust and Its Successors v. Franchise Tax Board of the State of California, Case No. 37-2020-00011877-CU-MC-CTL (filed on March 4, 2020).
9. Online Merchants Guild v. Maduros, Docket No. 2:20-cv-01952 (E.D. Cal. Sep. 29, 2020). 

In-depth 2021-013