California Court Tentatively Holds 50% Tax Shelter Promotion Penalty Cannot Apply Retroactively

A San Francisco Superior Court has released a tentative statement of decision, holding that the Franchise Tax Board (FTB) could not retroactively apply an increased penalty rate for tax shelter promotion activities.1 In Quellos Financial Advisors, LLC v. Franchise Tax Board,2 the court held that the statute authorizing the increased penalty rate did not provide for, and California case law did not allow, the FTB to apply the increased rate retroactively.

The statute at issue in Quellos was section 19177.3 For the taxable years at issue in Quellos, section 19177 conformed to Internal Revenue Code (IRC) section 6700, which provided for a maximum penalty of $1,000 for promoting abusive tax shelters. On October 2, 2003 (and after the tax years at issue in Quellos), California amended section 191774 to replace the maximum penalty of $1,000 with a new maximum penalty of 50 percent of the gross income derived from the penalized activity. For all other purposes, section 19177 continued to conform to IRC section 6700.5

The bill that enacted the increased maximum penalty stated, "this act shall apply with respect to any penalty assessed on or after January 1, 2004, on any return for which the statute of limitations on assessment has not expired. All other provisions of this act shall apply on and after January 1, 2004."6 It is important to note that the bill enacted or revised several assessable penalties in addition to the penalty on tax promoters.

In Quellos, the FTB argued that the increased maximum penalty for tax shelter promotion activities should apply retroactively-i.e., to pre-2004 conduct-because the first sentence of the effective-date provision quoted above allows the FTB to assess the penalty at the higher rate as long as the assessment occurs on or after January 1, 2004, regardless of when the penalized activities took place. However, the Superior Court stated that the bill language allowing retroactive application of penalties only applied to penalties assessed on a return. Under federal case law, which California follows, the tax shelter promotion penalty is not a penalty assessed on a return.

The Superior Court cited numerous California cases that stand for the proposition that a statute cannot be applied retroactively, and that a contrary conclusion cannot be inferred from vague phrases and broad general language. Rather, the court said absent an "express retroactivity provision" in the statute itself, "[a] statute will not be...