Increase State Revenues by Making Changes to Tax Programs

The Legislature can increase net tax revenues by improving the state’s ability to deter tax noncompliance, by reducing the cost of tax administration, and by making changes to how the state conforms with federal tax laws. Below, we estimate that implementing a number of these changes at FTB and BOE would increase General Fund revenues in the low hundreds of millions of dollars annually. Specifically, our recommendations include:

• Administrative Changes. We have identified various administrative changes that could improve BOE’s and FTB’s ability to collect taxes due to the state. We estimate that making these changes would increase General Fund revenues by $34 million in 2009–10, increasing to more than $100 million in annual net General Fund revenues in future years.
• Penalties and Interest. We estimate that making the proposed changes to penalties and interest charges assessed would increase General Fund revenues by $7 million in 2009–10, increasing to more than $22 million in annual net General Fund revenues in future years. In addition, there would likely be greater revenues that would result from the deterrent effects of increased penalties and fees.
• User Fees. We estimate that increasing user fees would result in greater General Fund revenues of $4 million annually beginning in 2009–10.
• Federal Conformity. We estimate that making two changes in how state tax law conforms to federal tax law would increase General Fund revenues by $35 million in 2009–10, increasing to about $50 million annually beginning in 2010–11.

Figure 2 summarizes the recommendations that we discuss below.

Administrative Changes Would Improve the Collection of Taxes

Below, we discuss many administrative changes that we recommend making at FTB and BOE to improve the collection of taxes.

Increase Access to Information About Taxpayer Assets. The FTB lacks access to information about taxpayers’ accounts at financial institutions. This information is one of the three most reliable sources of data about taxpayer assets that could be used for the collection of unpaid tax debts. The FTB already has access to the two other sources of information—real property records and wage and payment reporting. The financial institutions records match (FIRM) system proposed last year by FTB (but not included in the Governor’s budget) would provide FTB information about taxpayers’ accounts at financial institutions. It would require financial institutions doing business in California to match delinquent income tax and non–tax debtors’ information from FTB against customer records on a quarterly basis. The FTB’s proposal also would reimburse financial institutions $100 for each match related to their costs in providing the information. This would better enable FTB to seize assets for the payment of tax debts and thereby increase state revenues. We recommend that the Legislature direct FTB to implement FIRM. The FIRM system would result in General Fund revenues of $35 million in 2009–10, increasing to more than $100 million in annual net General Fund revenues by 2011–12. The FTB estimates ongoing costs of about $2.2 million to implement FIRM.

Impose Liens Earlier in the Collection Process. The FTB and BOE send taxpayers a notice of collections after (1) the taxpayer has exhausted all appeals rights and (2) contact with the taxpayer during the audit and collections processes was ineffective at resolving the tax debt. State law then allows—60 days after the notice of collections has been sent to the taxpayer—FTB and BOE to apply a lien on the taxpayer’s property. A tax lien is a legal claim on property to secure the payment of taxes. The FTB applies a lien after 60 days when the tax debt is $1,000 or more. The BOE, however, in most cases waits 180 days before applying a lien, and only when the tax debt is $2,000 or more. The FTB believes that applying a lien more quickly and to a minimum debt of $1,000 allows it to more effectively seize assets, if necessary, for the payment of tax debts. We recommend that the Legislature require BOE to apply a tax lien 60 days after a collections notice has been sent to the taxpayer and decrease its minimum threshold of tax debt owed to $1,000 in order to increase the collection of taxes owed. The fiscal benefit is unknown, but probably in the range of $1 million annually.

Complying With Federal Withholding Requirement Would Increase State Revenues. Recent changes to federal law requires states to withhold 3 percent of the payments the state makes to businesses for contracts entered into on or after December 31, 2010. For example, under the new requirement the state would be required to withhold payments to a software developer for work performed. The State Controller’s Office (SCO), which will be required to make changes to its systems to comply with this requirement, does not have a plan in place at this time to meet the federal deadline. The FTB estimates that implementation of the federal withholding requirement could result in a one–time accelerate of state General Fund revenues of $26 million in 2010–11 due to the earlier receipt of taxes owed. The costs to implement such a requirement are unknown at this time. We recommend the Legislature direct SCO to develop a plan and cost estimate for implementing the federal requirement. We note, however, that this federal requirement is being considered for repeal as part of the federal economic stimulus package.

Penalty and Interest Modifications Would Increase State Revenues

Tax laws generally impose penalties in order to encourage taxpayers to comply with their tax obligations and penalize taxpayers for late payments. While the state currently assesses some penalties and interest on noncompliance, we have identified many circumstances where penalties currently are not assessed or are inadequate to deter noncompliance.

Penalize Taxpayers Claiming Baseless and Overstated Tax Refunds. Taxpayers can claim a tax refund on their income tax if the tax they owe is less than the amount they paid during the tax year through withholding. Sometimes taxpayers overstate the refund due to them, and FTB estimates that in 2007 it received approximately 930 claims for refunds that were overstated. The FTB estimates that among these, 200 had no basis in law (called “baseless” overstated claims for refunds) valued at an estimated $60 million in tax refunds.

Assessing a penalty for baseless claims for refunds would provide an additional deterrent to taxpayers and would allow FTB to redirect staff from processing, auditing, and resolving refund disputes to other revenue–generating audit activities. If the Legislature were to direct FTB to mirror federal policy, the state would impose a penalty that would be equal to 20 percent of the disallowed portion for refund for which there is no reasonable legal basis. The FTB estimates one–time costs to implement this change would be $106,000 with $840,000 in on going costs. This recommendation is estimated to result in a net increase in General Fund revenues of $500,000 in 2008–09 and increasing to more than $12 million in annual net General Fund revenues by 2011–12.

Extend Period Before Interest Charges Are Suspended. Currently in an audit situation, FTB charges interest from the time the tax payment is due (usually April 15th) to the time the taxes are paid. However, if audit activities take more than 18 months, then it charges interest from when the audit is completed to when the taxes are paid. This restriction is estimated to have limited the accrual of $4.5 million in interest in 2007. The restriction can limit the application of interest to tax returns that have been selected by FTB for audit or special study. The state could extend this period to 36 months to mirror federal law. This would give FTB more time to complete audit–related activities before interest is suspended. Costs to implement the proposal would be minor and one time (approximately $62,000). This recommendation is estimated to produce $1.3 million in net General Fund revenues in 2008–09 and increasing to nearly $5 million in annual net General Fund revenues by 2011–12.

Increase Penalty for Failure to File Partnership Tax Returns. The FTB has identified more than 26,000 instances where a partner in a partnership failed to file a tax return in 2006. This represents an estimated $13 million in unreported taxes owed to the state. Currently, FTB assesses a $10 penalty per partner for each month or part of a month (for a maximum of five months) that the failure to file continues. By increasing the amount of the penalty to the federal penalty amount of $17 per partner, the adjusted penalty would act as an additional incentive for taxpayers to file the appropriate, completed tax returns on time. The costs to implement this proposal would be absorbable. This penalty increase is estimated to result in about $1 million in General Fund revenues in 2009–10, increasing to almost $2 million annually.

Assess Penalty on Shareholders Failing to File S–Corporation Returns. An S–corporation is similar to a partnership, in that the taxable income or loss of the corporation is captured on the tax returns of shareholders. An S–corporation is considered to have failed to file a timely return if it does not file the appropriate return on time, including approved extensions, or if it files a return that does not include all of the required information. The FTB estimates that there were approximately 16,000 failures to file S–corporation returns in 2007, representing an estimated $16 million in unreported taxes owed. While the FTB can levy a penalty on the S–corporation for failure to file, it does not have the authority to assess shareholders for failure to file. A shareholder penalty of $17 per partner, consistent with federal policy, would result in about $600,000 in net General Fund revenues in 2009–10, increasing to $1.4 million in annual net revenues by 2011–12. One–time costs to implement the proposal are estimated at $118,000.

Increase Penalties for Bad Checks and Money Orders. The FTB and BOE processed nearly 55,000 dishonored or bad checks or money orders with a face value of more than $100 million in 2007. Bad checks and money orders disrupt the tax collection process and delay the deposit of funds into the state’s General Fund. The FTB assesses a $15 penalty on bad checks or money orders of less than $750, and if the dishonored check or money order exceeds $750, the penalty increases to 2 percent of the face value. The BOE does not charge a penalty on bad checks or money orders. The federal government assesses greater penalties for bad checks and money orders than the state. Specifically, if the amount of the bad check is between $25 and $1,250 the federal penalty is $25 and if the amount is $1,250 or more, the penalty is 2 percent of the face value of the bad check or money order.

Aligning the amount of California’s penalty with federal penalties would act as a greater deterrent to taxpayers considering paying taxes owed with checks and money orders that have insufficient funds. In addition, increasing the penalty for bad checks and money orders would potentially result in General Fund revenues of $400,000 in 2009–10 and increase to nearly $1 million in additional annual General Fund revenues beginning in 2010–11.

Assess Penalty on Tax Return Preparers That Understate Taxpayer Liability. A tax return preparer is someone who prepares—in exchange for compensation—all or a substantial portion of a tax return or claim for refund. If the tax preparer does not appear to have used a reasonable interpretation of tax law when preparing the tax return, a tax preparer is considered to have understated a taxpayer’s liability. In some cases, the understatement of the taxpayer’s liability is considered intentional. The FTB estimates more than 700 tax preparers understated taxpayer liabilities in 2007, accounting for nearly $30 million in taxes owed to the state, but not paid.

The FTB has the authority to levy a penalty of $250 per return filed on tax preparers who understate tax liabilities. This penalty could be modified to be more consistent with federal penalties by increasing the penalty amount for understatements and employing a tiered penalty structure—making the penalty as high as the greater of $5,000 or 50 percent of the income from preparing the return when the understatement by the tax preparer was intentional. Costs to implement this change would be absorbable. This penalty increase is estimated to produce $300,000 in net General Fund revenues in 2010–11, increasing to $600,000 in annual net General Fund revenues in 2011–12.

Fee Modifications Would Increase State Revenues

Fees are used to cover the cost of providing a service. While the state currently assesses fees for some services related to increasing tax compliance, we have identified two circumstances where fees are not currently assessed or do not cover the cost of services provided.

Structure Fees for Installment Agreements to Reflect Processing Costs. The BOE does not charge a fee for installment agreements (IAs), which are agreements between the state and a taxpayer that allow the taxpayer to pay their delinquent tax debt over a specified period of time. The FTB and IRS, however, do charge fees for this service. The IRS charges $52 per agreement for electronic funds transfer (EFT) payment arrangements and $105 per agreement for paper check agreements. The FTB, in contrast, charges a flat fee of $20 per agreement, which does not cover the cost to provide the service or reflect the higher cost of processing non–EFT payments. The FTB has determined that a fee of $35 for EFT IAs and a fee of $63 for non–EFT IAs would cover the costs of installment agreements. We estimate that implementing a fee at BOE and increasing the fee at FTB would result in combined annual General Fund savings of approximately $4 million annually.

Modify Agreements to Settle Taxes Owed and Assess Fees. The FTB allows taxpayers under certain circumstances to enter into an agreement, also known as an offer in compromise (OIC), to settle taxpayer liabilities for less than the full amount owed. The BOE currently allows businesses that are no longer operational to enter into OICs, and the administration’s 2009–10 budget proposes to allow BOE to enter into OICs with businesses that are still operational. The FTB’s OIC process also requires the taxpayer to agree that if there is an unanticipated increase in income in the five–year period following execution of the OIC, the taxpayer is obligated to pay an additional percentage of that increased income to FTB to offset the forgiven portion of the OIC–retired tax debt. These are known as collateral agreements. The FTB reviews approximately 300 collateral agreements each year and over the past several years has collected an average of $500,000 in additional annual General Fund revenue as a result of these agreements.

We recommend the Legislature adopt the administration’s proposal to expand use of OICs at BOE but also require BOE to enter into collateral agreements with open businesses. One of the advantages of the administration’s OIC proposal is that it would allow BOE to offer taxpayers a payment plan, rather than requiring a lump sum payment. We recommend that the Legislature direct FTB to allow the use of a payment plan (not to exceed one year) for its OICs. Additionally, since OICs are a service provided to taxpayers, it would be appropriate to assess a fee. The Internal Revenue Service charges a flat fee of $150 per OIC. If FTB and BOE charged an application fee of $75 for each OIC, it would result in General Fund savings of approximately $400,000 annually.

Federal Tax Conformity

Many California tax provisions conform to changes the federal government makes to its tax system. Some of these changes occur without the state needing to change its tax laws, but in most cases legislation is needed to adopt the federal changes for California’s purposes. We have identified two instances where it would make sense for the Legislature to pass legislation that would conform state tax rules to federal rules.

Implement Backup Withholding. Under federal law, if an employee or other payee who receives a taxable payment fails to supply his or her correct taxpayer identification number (TIN) to the employer, the payer is required to withhold 28 percent of the payment over and above the payee’s normal withholding. This process is called backup withholding and is intended to compensate the government for potential lost revenues in cases where the inability to match a payment with a TIN makes enforcement problematic.

California does not require backup withholding. Assembly Bill 1848 (Ma), introduced in 2008, would have required the state to implement backup withholding. We recommend FTB conform to federal law (as would be required by AB 1848) in order to reduce the difference between taxes owed and taxes collected. The FTB estimates that approximately 155,000 California taxpayers would be subject to backup withholding. Costs to implement the proposal would be approximately $200,000 annually. If the state withheld 7 percent (this rate is consistent with FTB’s withholding program for certain nonresident payments above a certain amount), FTB estimates that it would result in $35 million in net annual General Fund revenues in 2009–10, increasing to more than $38 million annually by 2011–12.

Conform to the Federal “Kiddie Tax.” The federal kiddie tax requires unearned income in excess of $1,700 per year on assets owned by children to be taxed at the parents’ tax rate. Federal law first applied this rule to the unearned income of children under 14 years of age. The age limit was later increased to 18. Subsequently in 2008, the limit can apply to the unearned income of dependent students until they reach age 24. California tax law does not fully conform to the federal kiddie tax and the state taxes only the unearned income of children under age 14 at their parents’ rate. Costs to implement the proposal would be absorbable. The FTB estimates that conformity with the federal kiddie tax would generate approximately $15 million in net General Fund revenues in 2010–11.