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State of California Franchise Tax Board

Large Corporate Understatement Penalty FAQs

Introduction

Revenue and Taxation Code (R&TC) Section 19138 authorizes the Large Corporate Understatement Penalty (LCUP).

  • Senate Bill (SB) X1 28 (Stats. 2008, 1st Ex. Sess. 2007-2008, Ch. 1), effective December 19, 2008, added it.
  • SB 858 (Stats. 2010, Ch. 721), effective October 19, 2010, amended it.

For taxable years that begin on or after January 1, 2003, the LCUP applies to corporations with a tax understatement in excess of $1 million.

For taxable years that begin on or after January 1, 2010, the LCUP applies to corporations with an understatement of tax that exceeds the greater of $1 million or 20 percent of the tax reported on an original return or on an amended return filed on or before the original or extended due date of the return for the taxable year.

The penalty is 20 percent of the entire understatement amount. We measure the understatement as the difference between the correct tax and tax the corporation reports on the original or amended return, filed on or before the original or extended due date.

If you have any additional questions, call the Large Corporate Understatement Penalty Hotline at 916.845.3030.

General

  1. What is the LCUP?
  2. What is an "understatement of tax"?
  3. What tax years are subject to the LCUP?
  4. Who is subject to this penalty?
  5. How is the LCUP computed?
  6. When will you impose the LCUP?
  7. I am currently under audit and filed an amended return to self-assess additional tax for the same year. When will you impose the LCUP?
  8. Can I protest the LCUP?
  9. Is there any exception to the LCUP?
  10. I am currently under federal examination. Will the outcome of the examination affect the LCUP application or computation?
  11. Will you provide the IRS with the amended return information we filed under this section?
  12. When is the last date I can file a claim for refund on the payment I submitted with the amended return?
  13. What happens if the tax liability is reduced after you impose the LCUP (e.g., if a subsequent audit determination or allowed claim for refund reduces the correct tax liability)? Will you automatically reduce and refund the penalty or do I have to file a separate claim for refund?

Computation of the penalty

  1. I filed an $800,000 claim for refund for the 2005 tax year after the extended due date. You have yet to make a final determination. My original 2005 return shows a $3 million tax liability. What amount do you use as a starting point to determine whether I have an understatement of tax for 2005, $3 million or $2.2 million?
  2. You adjusted my 2005 tax liability when you disallowed a $2 million enterprise zone hiring credit. As a result, 2005 has $500,000 additional tax due. The disallowance also reduces subsequent years’ claimed carryover amounts. Will I be subject to the LCUP?
  3. How do you compute the penalty?
Combined report
  1. If a unitary group files a single group return using the combined reporting method, how do the unitary members compute the LCUP understatement of tax threshold?
  2. How do you compute the LCUP when a single group return is filed using the combined report method?
  3. Upon examination, if you determine additional members should be included in or excluded from the combined reporting group, which members are subject to the LCUP?
  4. If I have been granted a variation under R&TC Section 25137, am I protected from the penalty?

General

  1. What is the LCUP?

    For each tax year that begins on or after January 1, 2003, corporate taxpayers with an understatement of tax in excess of $1 million are subject to a 20 percent penalty on the understated tax amount.

    For taxable years that begin on or after January 1, 2010, the understatement of tax must exceed the greater of $1 million or 20 percent of the tax reported on an original or on amended return filed on or before the original or extended due date for the taxable year.

  2. What is an “understatement of tax"?

    Any additional tax amount that exceeds the tax reported on an original or amended return filed on or before the original or extended due date, including audit adjustments or tax self-assessed on an amended return. For this purpose “tax” means tax after the application of business credits (e.g., 2012 Form 100, line 31) and does not include any penalties or interest.

  3. What tax years are subject to the LCUP?

    Tax years that begin on or after January 1, 2003, for which the statute of limitations for assessments had not expired by December 19, 2008.

  4. Who is subject to this penalty?

    Banks, corporations, and any other entity (e.g., S corporations, partnerships or limited liability companies that elected to be treated as corporations) subject to tax under Part 11 of the R&TC.

  5. How is the LCUP computed?

    It is 20 percent of the entire understatement of tax. See Computation of the Penalty.

  6. When will you impose the LCUP?

    For audit adjustments, we generally impose it after a Notice of Proposed Assessment (NPA) for additional tax liability becomes final.

    For self-assessed amounts, such as amounts shown on amended returns, we generally impose it when we assess the additional amount on our records. The FTB 5947, Notice of Balance Due, will include the penalty along with the total tax, interest, and any other applicable penalty or fee.

    The penalty will begin to accrue interest from the assessment date.

  7. I am currently under audit and filed an amended return to self-assess additional tax for the same year. When will you impose the LCUP?

    The auditor will contact you on how to proceed with your specific case. They will give you the option to receive a bill now or to wait for the tax year’s final determination.

  8. Can I protest the LCUP?

    You cannot protest it. However, we may allow a refund of amounts you paid to satisfy it if we did not properly compute it.

  9. Is there any exception to the LCUP?

    There is no reasonable cause exception. However, we will not impose it if the understatement of tax is attributable to:

    • A change of law that occurs after the earlier of the date you file the return or the extended due date, for the year the change is operative.
    • Reasonable reliance on a formal FTB Chief Counsel Ruling.

    Any other type of ruling from us will not provide a basis to avoid it (e.g., an R&TC Section 25137 petition where the material facts have changed).

  10. I am currently under federal examination. Will the outcome of the examination affect the LCUP application or computation?

    The penalty applies any time there is an increase in the total tax liability that exceeds the LCUP threshold. The LCUP may result from our assessments based on both state and federal adjustments that exceed applicable thresholds, regardless of when the examinations were started or completed

  11. Will you provide the IRS with the amended return information we filed under this section?

    Yes. We have a long-standing agreement with them to share information. It includes any amended return you filed under this section.

  12. When is the last date I can file a claim for refund on the payment I submitted with the amended return?

    The payment you make with the amended return is not a tax deposit; the normal statute of limitations for claiming a refund or credit apply (R&TC Section 19306).

    You must file a claim for refund by the later of:

    • Four years from the original due date.
    • Four years from the date filed if within the extension period.
    • One year from the date of the overpayment.
  13. What happens if the tax liability is reduced after you impose the LCUP (e.g., if a subsequent audit determination or allowed claim for refund reduces the correct tax liability)? Will you automatically reduce and refund the penalty or do I have to file a separate claim for refund?

    Whenever a tax year has a new final tax liability, we will recompute the LCUP and it may increase or decrease accordingly. As a result, we will bill for any increased amount or refund/credit any reduced amount. You do not have to file a separate refund request for any reduced LCUP. If you disagree with our LCUP computation, you can file a claim for refund under R&TC Section 19138(e).

Computation of the penalty

  1. I filed an $800,000 claim for refund for the 2005 tax year after the extended due date. You have yet to make a final determination. My original 2005 return shows a $3 million tax liability. What amount do you use as a starting point to determine whether I have an understatement of tax for 2005, $3 million or $2.2 million?

    The starting point to determine whether you have an understatement of tax is the $3 million shown on your original return because you filed the amended return after the extended due date, regardless of whether we have taken action on your claim for refund.

  2. You adjusted my 2005 tax liability when you disallowed a $2 million enterprise zone hiring credit. As a result, 2005 has $500,000 additional tax due. The disallowance also reduces subsequent years’ claimed carryover amounts. Will I be subject to the LCUP?

    If the $500,000 is the only understatement of tax for the 2005 tax year, you are not subject to the LCUP for that year.

    • We measure the understatement of tax only by the amount the correct tax for the taxable year exceeds the tax reported on the original return or on an amended return filed on or before the original or the extended due date.
    • It does not include any carryover adjustments.
    • The $1.5 million additional enterprise zone hiring credit disallowance may impact subsequent tax years when we compute the understatement of tax for those years, but it will not affect the 2005 tax computation.
    • We treat Net Operating Losses (NOL) and other carryover items disallowances similarly.
  3. How do you compute the penalty?

    This example illustrates how we compute the penalty

    Corporation X files its original 2008 return on October 15, 2009. It report a $2 million total tax liability.

    On July 1, 2010, we issue an NPA for $800,000 additional tax. When this assessment finalizes on September 1, 2010, X is not subject to the LCUP because the final $2.8 million tax amount exceeds the tax shown on the original return ($2 million) by only $800,000, which is less than the $1 million threshold.

    On November 1, 2010, we issue a second NPA based on a final federal determination for the same tax year. The additional proposed tax is $700,000. On January 2, 2011, when the second NPA finalizes, the correct 2008 tax amount is now $3.5 million ($2 million + $800,000 + $700,000). The correct tax amount now exceeds the tax shown on the original return by more than $1 million. Therefore, X is subject to the LCUP. The penalty is $300,000, or 20 percent of the total $1.5 million understatement (the difference between the $3.5 million correct tax and the $2 million original return tax).

    On March 1, 2011, X files a $600,000 claim for refund for the 2008 tax year. We allow the claim for refund. The correct tax amount is now $2.9 million ($3.5 million less $600,000). The correct tax is now only $900,000 in excess of the original return tax; which is less than the $1 million penalty threshold. Therefore, X is no longer subject to the LCUP. We will cancel and refund the $300,000 penalty you previously paid at the applicable interest rate.

    For taxable years that begin on or after January 1, 2010, the understatement must exceed the greater of $1 million or 20 percent of the tax reported on an original return or on an amended return filed on or before the original or extended due date.

Combined report

  1. If a unitary group files a single group return using the combined reporting method, how do the unitary members compute the LCUP understatement of tax threshold?

    If two or more corporations are required to be included in a combined report under R&TC Section 25101 or are authorized to be included in a combined report under R&TC Section 25101.15, the LCUP threshold applies to the aggregate amount of the tax liabilities of all taxpayers that are required to or authorized to be included in the combined report (R&TC Section 19138(a)(2)).

    Tax Year ending 12/03 Combined Corp A Corp B Corp C
      30% 10% 19.985% .015%
    Amount of tax required to be shown on the return $1,500,050 $500,000 $999,250 $800
    Less amount of tax shown on the return $2,400 $800 $800 $800
    Understatement of tax $1,497,650 $499,200 $998,450 $0
    Understatement of tax threshold $1,000,000      
    Does the aggregate understatement of tax for all taxpayers included in the combined report exceed the threshold? Yes      

    For taxable years beginning on or after January 1, 2010, the understatement of tax must exceed the greater of $1 million or 20 percent of the tax reported on an original return or on an amended return filed on or before the original or extended due date.

  2. How do you compute the LCUP when a single group return is filed using the combined report method?

    To compute the penalty for each taxpayer in the combined group:

    • Determine each taxpayer’s understatement of tax.
    • Apply the 20 percent penalty to that amount.

    This is similar to how you compute the tax liability when you file a single group return using the combined report method. The electing group members’ penalty liabilities are aggregated and reported on a group basis.

    Tax Year ending 12/03 Combined Corp A Corp B Corp C
      30% 10% 19.985% .015%
    Amount of tax required to be shown on the return $1,500,050 $500,000 $999,250 $800
    Less: Amount of tax shown on the return $2,400 $800 $800 $800
    Understatement of tax $1,497,650 $499,200 $998,450 $0
    Understatement of tax threshold $1,000,000      
    Does the aggregate understatement of tax for all taxpayers included in the combined report exceed the threshold? Yes      
    Does the penalty apply?   Yes Yes Yes
    Large Corporate Understatement Penalty (20 percent) $299,530 $99,840 $199,690 $0

    For taxable years beginning on or after January 1, 2010, the understatement of tax must exceed the greater of $1 million or 20 percent of the tax reported on an original return or on an amended return filed on or before the original or extended due date of the return

  3. Upon examination, if you determine additional members should be included in or excluded from the combined reporting group, which members are subject to the LCUP?
    • If we determine that additional members are required to be included in the combined reporting group all new and existing members would be subject to the LCUP if the aggregate understatement of tax for the revised group exceeds the threshold.
    • If we determine that members are required to be excluded from the combined reporting group, all members that remain would be subject to the LCUP if the aggregate understatement of tax for the revised group exceeds the threshold.

    In addition, taxpayers that we exclude from the original combined reporting group are subject to the LCUP if the understatement of tax exceeds the LCUP threshold, either separately or in the aggregate if included in another combined reporting group.

  4. If I have been granted a variation under R&TC Section 25137, am I protected from the penalty?

    A variation from the standard apportionment and allocation rules we granted under R&TC Section 25137 does not protect you from the LCUP if an understatement of tax occurs. There are two exceptions to the penalty, see question 9. A variation we granted under R&TC Section 25137 does not meet either exception.

    If we granted the taxpayer a variation for a particular year or set of years, and the facts are consistent with those facts we relied upon when we granted the variation, there should be no understatement of tax attributable to that variation. However, if the facts are different from those facts the taxpayer provided and we relied upon when we granted the petition, an understatement of tax may occur.

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