California Court of Appeals Orders Penalty Waiver

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On March 30, 2022, a California Intermediate Court of Appeals ruled that a penalty waiver of approximately $1.7 million was required for taxpayers, owners and operators of boutique hotels in San Francisco, extent that the taxpayers have established that they “exercised ordinary commercial care and prudence”. in the payment of their tax obligations. Gajanan, Inc. vs. City of San Francisco, No. A160539, at 8 (Cal. Ct. App. Mar. 30, 2022). In reaching its conclusion, the court rejected San Francisco’s argument that “as a matter of law, reliance on an employee cannot constitute ordinary care … no matter how cautiously the plaintiffs hired and supervised the employee”. ID. at 2. This case serves as a reminder that when states or localities impose waiveable penalties as if they were strict liability, taxpayers must consider whether there is a case for a waiver and, in if so, they should not be afraid to make these arguments in court.

Facts: The hotel owners contracted with a hotel management company to manage and staff six hotels. The hotel management company had been managing hotels for a long time and had a good reputation. The hotel management company hired an employee to act as controller (“the employee”) after confirming that the employee had the required experience and credentials and having had the employee interviewed and reviewed by experienced professionals. The clerk’s duties for hotels included filing returns and paying the San Francisco Transient Occupancy Tax, Tourism Improvement District Fee, and Moscone Expansion District Fee. The hotels collected these taxes from their customers and paid them into an account accessible to the employee.

The employee failed to file the required returns or pay taxes for three quarters before being fired by the hotel management company after discovering that the employee had made an unauthorized transfer from the account of one hotels. The new controller hired by the hotel management company then discovered that the employee had altered journal entries and account statements to make it look like taxes were paid. When taxpayers learned of what had happened, returns were filed for prior periods and all taxes due for those periods were paid. The city imposed late-filing and late-payment penalties, which taxpayers paid before seeking reimbursement in court.

Decision: The Court ruled that the penalties should be waived provided the taxpayers produced evidence demonstrating that they exercised due diligence in filing and paying the taxes in question. Here is what is relevant to the court’s decision: (a) the hotels hired a qualified company to manage the hotels, as is common in the industry; b) the hotel management company has hired a qualified person to pay the taxes; and (c) the employee did not pay the taxes, but gave the taxpayers the impression that the taxes had been paid by lying to them, providing them with false financial statements and offering plausible explanations for the notices of non-production that taxpayers received from the city. In these circumstances, the Court held, the relevant penalty waiver provision at issue required San Francisco to reimburse the penalty amounts paid by the ratepayers.

This article is part of a series of articles written for the April 2022 edition of The BR State + Local Tax Spotlight.

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