Ask The California Employment Tax And Payroll Tax Attorney – The Sales Tax Fraud Penalty – The Farrell Case

By Robert S. Schriebman
2023

Introduction

In late February 2023, the Office of Tax Appeals (OTA) affirmed the imposition of a 25% civil fraud penalty in addition to holding the president of the corporation personally responsible for all taxes, late penalties, and interest.  The imposition of the sales tax fraud penalty is a rare event, but it does happen.  This article will discuss the case of R. Ferrell (In the Matter of the Appeal of R. Farrell OTA Case No. 18083583, CDTFA Case ID 600710).

The Farrell Case

R. Farrell was the president of Irvine Photo Graphics, Inc. (IPG), a seller of printed material. One of IPG’s customers was The Gap, Inc. IPG sold printed material to The Gap, Inc. (Gap) in interstate commerce transactions.  These transactions are exempt from the collection of California sales and use taxes.  Nevertheless, IPG collected sales tax computed on these exempt interstate sales.  They are not subject to sales tax and if collected, are labeled “Excess Sales Tax Reimbursements.”  These excess sales taxes amount to more than $500,000.  As IPG collected these improper sales taxes, IPG sent them on to the CDTFA.  When Gap discovered this overcharge, they demanded that IPG file a claim for refund.  IPG complied, filed the refund claim, and received more than $500,000 from the CDTFA.  However, IPG did not remit the refund to Gap.  Instead, it stalled Gap’s request.  IPG then told Gap that it had expenses relating to the refund process in excess of the $500,000 and would not be refunding anything back to Gap.

By law the refund is supposed to be given to the paying taxpayer and if it is not, the refund must be given back to the CDTFA.  IPG failed to return the refund proceeds to the CDTFA. The excuses offered by IPG were that it had costs in excess of the refund amounts and that it did not have funds available to pay either the Gap or the CDTFA.  IPG was required to refund the excess sales tax reimbursement to the Gap or return it to CDTFA when IPG received the refund.  Additionally, the CDTFA directed IPG that “the tax refunded by the State of California to IPG must be refunded to Gap by IPG.”

Excess sales tax reimbursement must be refunded either to the consumer or to the CDTFA (R&TC § 6901.5)

IPG’s President Personally Liable

The CDTFA charged IPG’s president R. Ferrell with personal liability for the issued refund together with interest and a rare 25% civil fraud penalty.

R&TC § 6829 provides that one is personally liable for the unpaid sales tax, penalties, and interest owed by a corporation if the following four elements are met:

1. The corporation’s business has been terminated, dissolved, or abandoned;
2. The corporation collected sales tax reimbursement on its sales of tangible personal property and failed to remit such tax reimbursement to CDTFA;
3. The person had control or supervision of, or was charged with the responsibility for, the filing of returns or the payment of tax, or was under a duty to act for the corporation in complying with the Sales and Use Tax Law; and
4. The person willfully failed to pay taxes due from the corporation or willfully failed to cause such taxes to be paid.

A person is regarded as having willfully failed to pay taxes where he/she had actual knowledge that the taxes were not being paid, had the authority to pay the taxes, and had the ability to pay those taxes, but chose not to do so.

The OTA found that R. Farrell met all the above criteria.  And therefore, he was held personally liable.

The Fraud Penalty is Imposed

If any part of the deficiency determination is due to fraud or an intent to evade the law or authorized rules and regulations, a penalty of 25% of the amount of the determination shall be added (R&TC § 6485.)  Fraud or intent to evade shall be established by clear and convincing evidence.  The OTA found that R. Farrell intentionally failed to remit the reimbursements to The Gap, Inc. and misrepresented that IPG incurred costs in excess of the refund amount. IPG also represented that it had no funds available to pay Gap.

The code does not define fraud.  The OTA uses federal guidelines and precedents.  Fraud is the intentional wrongdoing on part of the taxpayer with the specific intent to avoid the payment of a tax known to be owing.  Fraud can be proven by circumstantial evidence.

Is There Reasonable Cause for Abating the Fraud Penalty

Unlike civil penalties such as late filing and late payment penalties, the fraud penalty may not be relieved by attempting to prove reasonable cause.  That is because there is no reasonable cause for committing fraud.

Conclusion

The assessment of civil fraud penalties in a sales tax case is a rare event, but it can happen if the facts and circumstances show egregious conduct on the part of the taxpayer.  Mr. Farrell’s conduct in attempting to avoid remitting sales tax reimbursements by claiming false costs, and otherwise avoiding doing the right thing, got him into serious trouble.  The Gap, Inc. also sued Farrell in civil court and obtained a judgment against IPG.

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Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 50 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD, and he is not employed by the EDD or any other agency of the State of California.

Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.

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