The California Franchise Tax Board (FTB), recently released Legal Guidance Division 2012-03-02 where it addressed the following question:

Can a taxpayer make a valid single sales factor (SSF) election and also report tax computed without the election in order to avoid the large corporate understatement penalty (LCUP) in the event the taxpayer is later determined to be ineligible to use the SSF formula?

First, it might be helpful to briefly remind taxpayers about the FTB’s single sales factor, which became effective January 1, 2011. The single sales factor election requires taxpayers to choose between a single-sales factor and a three-factor formula (double-weighting sales) based on the costs-of performance sourcing method. Essentially, the single sales factor election provides taxpayers an annual opportunity to evaluate whether such an election will reduce income apportionment to California and thus lower California tax liability.

Under California Revenue and Taxation Code Section 25137;

  • Taxpayers that do not elect to apportion income via a single-sales-factor apportionment formula will be required to use California’s three-factor apportionment formula (consisting of a payroll factor, a property factor, and a double-weighted sales factor), and they must source receipts from sales ”other than sales of tangible personal property” using California’s longstanding preponderance costs-of-performance method; and
  • Taxpayers that elect to apportion income via a single-sales-factor apportionment formula will be required to source receipts from ”sales other than sales of tangible personal property” using California’s new market sourcing provisions.

If the taxpayer elects to use the singles sales factor, then the tax determined under that method will be used as the tax-base for determining the large corporate understatement penalty (LCUP). The taxpayer cannot avoid the LCUP by also reporting the amount of tax computed without the election. The LCUP is based on tax reported on the latest filed tax return, measured against the future understatement of tax as determined by the FTB. This base amount of tax will be the amount shown on the last return filed.

A taxpayer cannot, therefore, determine its apportioned income for the same taxable year under both the SSF formula election and the three-factor formula in order to avoid the LCUP in the event the taxpayer is later determined to be ineligible to use the SSF formula.

The FTB will only recognize one tax base for measuring tax understatements with regard to the LCUP. If, however, the taxpayer subsequently amends an original tax return before the extended due date, then the tax shown on the amended return will serve as the penalty base.