This article examines the decision reached by the Office of Tax Appeals (OTA) in In the Matter of the Appeal of: J. Lunt, OTA Case No. 230112468, concerning a proposed assessment of additional tax, a late filing penalty, and applicable interest for the 2018 tax year. The case provides guidance regarding the respective burdens of proof borne by the Franchise Tax Board (FTB) and the taxpayer when residency and income sourcing are disputed, and an initial return was never filed. The FTB proposed an assessment totaling $12,315 in tax and a late filing penalty of $3,078.75, plus interest.

Factual Background

The appellant, J. Lunt, failed to file a timely California income tax return for the 2018 tax year. Based on information indicating the appellant received sufficient income to trigger a filing requirement, the FTB sent a Request for Tax Return to the appellant’s address in Coronado, California (California Address). The appellant did not respond to this Request.

The FTB subsequently issued a Notice of Proposed Assessment (NPA) to the appellant’s address in Toston, Montana (Montana Address). The NPA estimated $170,684 in California taxable income based on information indicating specific items of income, including: (1) wage income totaling $96,948 from Delta Master Retirement Trust and Delta Air Lines, Inc.; (2) miscellaneous income totaling $77,881 from Prudential Insurance Co. of America and The Entrust Group; and (3) $256 in interest income from Wells Fargo Bank, N.A.. The proposed tax assessment was $12,315, after applying California withholding credits of $576.

Taxpayer’s Request for Relief

On August 16, 2022, the appellant protested the NPA. The appellant asserted that he was a Montana resident, had no California source income during 2018, and claimed that the California state income tax withheld by Delta Master Retirement Trust and Delta Air Lines, Inc. was an error. The appellant subsequently submitted a jointly filed 2018 Montana state income tax return, reporting that he and his spouse were full-year residents of Montana and paid income tax to Montana.

Additionally, the appellant submitted a joint 2018 Form 540NR, California Nonresident or Part Year Resident Income Tax Return, reporting the Montana Address, $0 in California wages, and a handwritten note claiming the CA tax withheld on the W-2 was an error and should have been Montana tax. Although the form reported a federal adjusted gross income (AGI) of $211,743, it contained no entries for California AGI, California taxable income, or total tax, and was deemed an incomplete return by the FTB. Despite the FTB requesting a complete return, the appellant failed to respond, leading the FTB to affirm the NPA. Furthermore, during the appeal process, the appellant failed to provide requested documentation regarding the number of days resided at the California Address versus the Montana Address, any rental income from the California property, or whether any California source income was received.

Legal Framework for Proposed Assessments

The OTA began its analysis by establishing the foundational rules for California taxation. California residents are subject to tax on their entire taxable income regardless of source, whereas nonresidents are taxed solely on income derived from California sources (R&TC, §§ 17041(a), (b), & (i); 17951(a)). A filing requirement is imposed on every individual taxable under the Personal Income Tax Law if their gross income exceeds certain threshold amounts (R&TC, § 18501(a)). For 2018, taxpayers filing jointly who were over 65 had a filing requirement if their California gross income was at least $47,188 or their California AGI was at least $40,112.

Where a taxpayer fails to file a return, the FTB is authorized to make an estimate of net income using any available information and propose an assessment of tax, interest, and penalties (R&TC, § 19087(a)).

Regarding the burden of proof for the assessment, the FTB must first demonstrate that its assessment is reasonable and rational (Appeal of Sheward, 2022-OTA-228P). An assessment based on unreported income gains a presumption of correctness when the taxing agency introduces a minimal factual foundation linking the taxpayer with the unreported income (Ibid.). Utilizing income information from various sources to estimate taxable income when a valid return is absent is considered a reasonable and rational method of estimation (Ibid.). Once this initial burden is met, the assessment is presumed correct, and the taxpayer bears the burden of proving error in the assessment (Ibid.).

As to income sourcing, Revenue and Taxation Code section 17071 generally incorporates Internal Revenue Code section 61 (IRC, § 61(a)(1)), which defines gross income to include compensation for services. Crucially, when personal services are performed in California, the income source is considered to be within the state (Cal. Code Regs., tit. 18, § 17951-5; Appeal of Cremel and Koeppel, 2021-OTA-222P).

Application of Law to the Proposed Assessment

The OTA determined that the FTB met its initial burden. The FTB possessed federal Forms W-2 reporting California tax withholdings on wage income that exceeded the statutory filing threshold. Furthermore, the FTB had a California Address on file, which suggested the appellant may have resided in California during the 2018 tax year. Having established this minimal factual foundation, the FTB’s assessment was presumed correct (Appeal of Sheward, supra).

The burden then shifted entirely to the appellant to prove the FTB’s assessment was erroneous. Although the appellant asserted nonresidency and claimed that the withholdings were in error and he had no California source income, the appellant failed to provide sufficient substantiating evidence. Specifically, the appellant did not provide documentation, such as contracts or statements from his employer, establishing that all the 2018 wage income was earned while he was a California nonresident or that the services subject to California withholding were provided outside the state.

Moreover, the appellant failed to substantiate his claim of full-year Montana nonresidency. The appellant did not explain the date he allegedly moved from California to Montana, nor did he explain the number of days he or his spouse resided at the California Address versus the Montana Address in 2018. Consequently, based on the failure to establish that the wage, miscellaneous, and interest income were earned outside of the state, the appellant did not satisfy the burden of proving error in the FTB’s assessment (Appeal of Sheward, supra).

Legal Framework for the Late Filing Penalty

Revenue and Taxation Code section 19131(a) imposes a late filing penalty on taxpayers who fail to file by the original or extended due date, unless the taxpayer can demonstrate that the failure was due to reasonable cause and not willful neglect. To establish reasonable cause, the taxpayer must demonstrate that the failure to file occurred despite the exercise of ordinary business care and prudence, or that the cause was one that would prompt an ordinarily intelligent and prudent businessperson to act similarly under the circumstances (Appeal of Head and Feliciano, 2020-OTA-127P). The penalty is calculated at five percent of the tax liability for each month or fraction thereof the return is past due, up to a maximum of 25 percent (R&TC, § 19131(a)).

When the FTB imposes a penalty, the law presumes the penalty was imposed correctly (Appeal of Xie, 2018-OTA-076P). The taxpayer must provide credible and competent evidence to support a claim of reasonable cause to overcome this presumption; unsupported assertions are insufficient (Ibid.; Appeal of Bannon, 2023-OTA-096P).

Application of Law to the Penalty Issue

The appellant’s 2018 tax return was due April 15, 2019, with an automatic six-month extension until October 15, 2019 (R&TC, §§ 18566, 18567; Cal. Code Regs., tit. 18, § 18567). The appellant never filed a valid return. Although an incomplete Form 540NR was submitted on October 15, 2022, the maximum 25 percent penalty had already been reached in September 2019.

The appellant failed to establish that his California gross income or California AGI was below the relevant filing thresholds. Furthermore, the appellant did not provide a distinct reasonable cause argument for abatement. Instead, the appellant argued that the penalty was improper based on the same grounds used to contest the assessment—that he received no California source income. Since the underlying argument to establish error in the assessment failed, the accompanying argument against the penalty similarly failed to satisfy the burden of proof.

Conclusion

The OTA concluded that the appellant failed to meet the burden of proof required to contest the FTB’s estimated assessment or the imposition of the late filing penalty.

The holdings were:

Appellant has not established error in respondent’s proposed assessment.
Appellant has not established reasonable cause to abate the late filing penalty.

The FTB’s action was therefore sustained. This case serves as a stark reminder to tax practitioners that assertions of nonresidency and erroneous withholding must be backed by specific, credible evidence detailing physical location and income sourcing, especially when contesting an assessment initially established by third-party reporting (Forms W-2). Failure to provide comprehensive documentation effectively concedes the statutory presumption of correctness afforded to the FTB’s assessment.

Prepared with assistance from NotebookLM.