California Tax Court: It’s Time To End "Pay-to-Play" In California

In 1992, distinguished UCLA Law School Professor Michael Asimow, an expert on California administrative law, observed in a law review article, "to put it charitably, California’s present arrangement for adjudicating tax cases is a patchwork that can only be understood as a series of historical accidents; to put it less charitably, the system is a mess."¹. Things have not improved in the last 12 years, and California still finds itself in a minority of states that place responsibility for collecting taxes and adjudicating tax disputes in the hands of the same agency.

Indeed, California was ranked among the bottom five states in every category of CFO Magazine’s annual state tax survey, causing "no state to come near California’s dismal ranking."² More specifically, California was rated as being among the "least desirable" when it came to determining the impact of a state’s revenue department policies and systems on a company’s decision to locate or expand in the state, and "least independent" when rating the independence of the state’s administrative appeal process from the audit department.

Taxpayers have two basic concerns when it comes to the adjudication of their tax disputes: they want (1) due process in the form of a fair, impartial tax hearing that is separate from the tax collection function; and (2) the ability to contest alleged deficiencies without the heavy burden of prepaying the tax, a requirement commonly referred to as "pay-to-play." Creating an independent tax adjudication system that does not require taxpayers to "pay-to-play" would go a long way toward improving the perception of California as a fair and decent place to live and do business.

Currently, California taxes are administered and collected by various administrative agencies, including the Franchise Tax Board ("FTB"), the State Board of Equalization ("SBE"), and the Employment Development Department ("EDD"). In general, the FTB administers corporate franchise taxes and income taxes, while the SBE administers sales and use taxes, state-assessed property taxes, and a myriad of other "special" taxes (e.g., cigarette taxes, environmental taxes, fuel taxes, and insurance taxes). The SBE also hears taxpayer appeals of the taxes administered by the FTB. The EDD primarily administers employment taxes. Typically, an aggrieved taxpayer who seeks to appeal a final decision of one of these revenue collection agencies must first pay the tax, and then file a suit for refund in Superior Court. Thus, unlike federal taxpayers and taxpayers in most other states, California taxpayers must pay their tax before having their "day in court" before a tribunal other than the tax collection agency. This is true regardless of the size or propriety of the proposed liability.³

To understand where we are today, and why an independent tax court is needed in California, a brief history lesson is helpful. The SBE was created in 1872 to equalize property taxes across the state. At the time it was formed, there were no personal or corporate income taxes, no sales and use taxes, and few specialized taxes. When the Bank and Corporation Franchise Tax Act was originally enacted in 1929, the SBE and the State Controller both sought to administer the new tax. A compromise was reached whereby a new Franchise Tax Commissioner was to be appointed by the Chairman of the SBE, the State Controller, and the Director of Finance. A similar struggle ensued in 1935, with similar results, when the personal income tax law was enacted. In 1949, the FTB replaced the office of the Franchise Tax Commissioner. The FTB consisted of the same three officers who formerly had the power to appoint the Franchise Tax Commissioner. Since two of those three FTB members also sit on the five-member SBE, the boards overlap.

The rationale behind California’s "pay-to-play" system can be traced back at least to the United States Supreme Court’s 1870 decision of Dows v. City of Chicago.3 At the time Dows was decided, the states and their municipalities primarily relied upon the payment of property taxes to operate, and did not have the wide variety of income, sales and other taxes that exists today.⁵ The ability of states and municipalities to function with such limited funding sources necessitated that they be able to collect taxes in an orderly manner, even if the taxes were subject to challenge. Thus, the rule that a taxpayer must pay a tax in order to contest it served to protect the state from being paralyzed by taxpayers who might contest assessments, even if the taxpayer was in fact, correct.

In the last 70 years, the complexity of the Revenue and Taxation Code, the size of the assessments at issue, and the general nature of business have changed dramatically. Today, approximately 98 percent of personal and corporate income taxes and sales and use taxes paid to California are self-assessed taxes. The concerns about the uninterrupted operation of government expressed in Dows that supported "pay-to-play" no longer apply; today, California simply is not going to collapse if taxpayers with legitimate complaints are able to contest the remaining 2 percent of tax revenues before paying their proposed assessment. The variety of funding sources available to the State further undermines the rationale for "pay-to-play."

Other states have come to realize that this is indeed true. For example, in 1997 then-Massachusetts Revenue Commissioner Mitchell Adams likened his state’s "pay-to-play" system as one of "shoot first, ask questions later." The Massachusetts Legislature ended "pay-to-play" in 1999 after recognizing that its tax system was contributing to Massachusetts’ bad reputation as a place to do business. Not surprisingly, Massachusetts has not fallen into Boston Harbor, but is alive and functioning well. Other states, such as Tennessee and Florida, have long allowed taxpayers to contest assessments in their civil courts without prepayment if the taxpayer posts a bond. Still others, such as Minnesota, Oregon, and Indiana, provide administrative tax courts that afford prepayment relief. The District of Columbia recently created an independent Office of Administrative Hearings to hear tax appeals from the Office of Tax and Revenue, starting in October 2004. And, of course, the United States government has long recognized the efficacy and reasonableness of allowing prepayment contests before impartial judges in the United States Tax Court ("USTC").

The time has come for California to end the unfair practice of requiring taxpayers to "pay-to-play." California needs an independent tax tribunal, staffed with the necessary expertise, to handle the often complicated tax issues that now face both individuals and businesses across the state.

A wide variety of interests support the creation of an independent tax court as a mechanism to ending "pay-to-play." For example, recently the bipartisan California Commission on Tax Policy in the New Economy, established by Governor Davis to review all state tax issues in light of California’s changing economy, unanimously endorsed the creation of a California tax court modeled on the USTC. The very first reason cited by the Commission was the lack of a sufficient prepayment procedure to contest assessments; the Commission further noted that most taxpayers could not afford to "pay-to-play" and thus are "stuck with whatever the SBE or its staff decides." ⁶ Even the former director of the Multistate Tax Commission, Gene Corrigan, called California’s "pay-to-play" system "simply unfair."

Academics support the idea as well. For example, distinguished University of California, Davis Law School Professor Daniel Simmons, who in 1978 was Chair of the California Commission on Government Reform ("Post Commission") that examined conforming California’s tax code to the Internal Revenue Code, supports the creation of the tax court along the lines of the highly successful USTC model.⁷

And, of course, taxpayers support the notion of a fair, impartial prepayment body for contesting taxes. Where a tax collection agency also adjudicates the tax, the appearance of a lack of independence is imparted to taxpayers who view the agency as both the prosecutor and the judge.

Some have questioned why a specialized court is needed for taxes when there are few, if any, specialized courts for employment and labor law, environmental law, or other similar highly codified "specialty" areas of law.

There are fundamental reasons why the need for a special court for taxes is different from the need for a special court for other areas of the law. First, nearly all citizens and certainly all businesses must deal with the taxing authorities each and every year, at least once if not quarterly for income taxes, at least once but as often as monthly for sales and use tax, not to mention the other taxes that individuals and businesses must pay. To the contrary, a union employee can work for 40 years and never have to interact with the government with regard to labor issues. Given the frequency with which citizens come into contact with government through the taxing authorities, it is important that such contact be seen as professional and fair.

Moreover, and perhaps more importantly, most of California’s taxes are based upon self-assessment by taxpayers. Without widespread adherence to this self-assessment system by California’s taxpayers, California’s taxes would not be administrable, and the system would collapse.

When a dispute arises, it is important that the resolution be seen as fair and impartial to avoid taxpayers abandoning this system. Where the judge is also the prosecutor, the credibility of the decision, even if correct, is undermined. While the staff of the FTB, the SBE, the EDD, and other state agencies all act professionally and do the best job they can, they can make mistakes, and reasonable differences of opinion can arise between those agencies and taxpayers. Who could possibly be against a fair and impartial process for resolving such disputes?

Finally, taxes traditionally have been the province of two professions: attorneys and accountants. Accountants have been able to represent their clients before proceedings with the IRS and in the USTC, as well as before the state agencies and the SBE for many years. However, accountants are barred from representing their clients in the state civil courts, the only independent avenue currently available to taxpayers in California. By creating a tax court modeled after the USTC, accountants (and others, such as enrolled agents) would be able to continue in their traditional role as representatives for their clients in a fair and impartial tax adjudication system. Thus, a tax court would preserve the important relationship that has long existed between taxpayers and their accountants.

There have been a variety of criticisms made about the current proposals for an independent tax court in California. The first is that this is somehow an attack on the state agencies that currently administer taxes. This is simply untrue. Under the current proposals, no state agency is being abolished or replaced. Indeed, with the exception of appeals from the FTB of personal and corporate income taxes, all other taxes may still be appealed in the same manner as before. The only difference would be that California taxpayers, for the first time, would be afforded the opportunity to seek prepayment review by an independent and impartial tax court judge following the hearing by the collection agency.

Thus, for example, the SBE still will be free to hold hearings on sales and use tax matters, state-assessed property tax matters, and the myriad other taxes that it currently administers, after the creation of an independent tax court. Although some have questioned the efficiency of having five highly paid elected officials all sitting and hearing thousands of cases with tax disputes that average $1,200, this administrative process is important in resolving disputes and reducing the number of cases to be appealed to the tax court.

Second, some people suggest that the SBE is adequate to handle the task and thus a new adjudicative body is unnecessary. However, taxpayers are only afforded 10 minutes to present their case to the SBE, making it impossible to present a complex factual and legal tax case. As a result, taxpayers must engage in ex parte communications with SBE members prior to their hearing to explain their case, even though the representatives may be reluctant to do so. Indeed, there has long been debate about the ethical considerations involved in such ex parte contacts.

More importantly, in its present form, the SBE is just not equipped to act as a trial court. Some cases involve complex issues and tens of millions of dollars, cover several tax years, and have thousands of pages of documentary evidence. If the SBE was to provide for full evidentiary hearings, the SBE most likely would be required to hold hearings during most business days of the year. This would make it virtually impossible for SBE members to perform their many other required duties.

Finally, some have questioned whether modeling a California tax court after the USTC would present procedural difficulties for taxpayers or their representatives. For example, some have observed that the USTC procedural rules are lengthy, and that a qualifications test is required of all non-attorneys. True, the USTC rules are lengthy; but they were specifically designed to include sufficient details about the procedures to make them more understandable to taxpayers, not to complicate them. Moreover, as anyone who has practiced before the USTC can attest to, most proceedings in the USTC are conducted in a manner that is quite informal and are generally well-received by taxpayers. The statistics bear this out — over 70 percent of the total cases docketed at the USTC are pro se taxpayers.

Moreover, the qualifications test administered by the USTC exists to protect taxpayers by ensuring that their representatives are qualified to practice. This test should pose little concern to tax professionals. At last count, 7,228 non-attorneys have passed this test and were qualified to represent taxpayers before the USTC.

It is time to end "pay-to-play" in California. Despite the pressure from special interests, such as Capitol insiders, who seek to retain the status quo, California taxpayers need the ability to contest taxes before an independent tribunal that is separate from the tax collection agency, without the heavy burden of prepayment. To preserve the integrity of the self-assessment tax system, taxpayers need and deserve a system that is at least viewed as impartial, where the prosecutor is not also the judge.

Creating an independent tax court modeled on the USTC is one way to provide the necessary due process and a reasonable prepayment method for challenging tax assessments. The State will not collapse under such a system, and it would only improve the perception of California as a fair and reasonable place in which to live and conduct business. California’s taxpayers want a fair shake, not a shakedown, and they deserve no less.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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