Enforcement, Credits, and Apportionment
Summary
Welcome to the fifth and final part of this series on Proposition 40, “The 2026 Billionaire Tax Act.”[1] This part discusses penalties, enforcement provisions, credits, and apportionment. The penalties are largely copied from the income tax law. Proposition 40 attempts to preempt avoidance attempts by delegating the Franchise Tax Board with extensive powers to generally disregard any transaction or series of transactions performed to escape this wealth tax. The credit and apportionment provisions contemplate constitutional challenges to Proposition 40, but generally place a heavy burden on any attempt for relief on constitutional grounds.
Penalties
In addition to any other penalty imposed by law, there would be a penalty of 20% for the “understatement of tax” in the event of a “substantial understatement” and a penalty of 40% of the “understatement of tax” in the event of a “gross understatement.”[2] An “understatement of tax” is defined as “ the amount by which the tax imposed by this part exceeds the amount of tax shown on an original return or shown on an amended return filed on or before the original or extended due date of the return for the taxable year.”[3] If the understated amount is more than the greater of $1 million or 20% of the tax shown on the return, the understatement is a “substantial understatement.”[4] If the understated amount is more than the greater of $10 million or 40% of the tax shown on the return, the understatement is a “gross understatement.”[5] However, these penalties “shall not apply to estimated payments required to be made by April 2027.”[6]
The FTB would be empowered to treat the appraiser as the taxpayer “[i]n the case of any underpayment of tax attributable to a substantial or gross overstatement or understatement of valuation in a certified appraisal,” and be penalized as if the appraiser were the taxpayer, except that the penalties would be 2% or 4% of the understatement of tax for substantial or gross overstatements or understatements respectively.[7]
The 2026 Billionaire Tax Act borrows the standard defenses to penalties from income tax law, including:
- Changes in the law giving rise to the understatement.[8]
- This “means a statutory change or an interpretation of law or rule of law by regulation or legal ruling of counsel, within the meaning of subdivision (b) of Section 11340.9 of the Government Code, or a published federal or California court decision.”[9]
- Reasonable reliance on a legal ruling by the chief counsel of the Franchise Tax Board (akin to a Private Letter Ruling).[10]
- “[S]ubstantial authority” for the treatment of the item giving rise to the understatement.[11]
- “[R]easonable basis” for the treatment of the item giving rise to the understatement if there is adequate disclosure of the tax treatment.[12]
Administrative Procedures
Unless “inconsistent” with the 2026 Billionaire Tax Act (specifically, proposed RTC §§ 50308-50313), “the provisions for the administration, assessment, collection, enforcement, and appeals of the income tax shall apply to the taxation of net worth.”[13] The 2026 Billionaire Tax Act would exempt the Franchise Tax Board from the Administrative Procedure Act for rules and guidance regarding the 2026 Billionaire Tax Act until January 1, 2028.[14] The agency would be empowered to issue regulations regarding the 2026 Billionaire Tax Act, including (without limitation) regulations:[15]
- “Identifying abusive transactions whose aim is to change the nature of an asset from public to nonpublic or vice versa.”
- “Identifying abusive transactions whose aim is to artificially reduce the assessed value of a taxpayer’s assets.”
A separate section provides that the 2026 Billionaire Tax Act “shall be liberally construed to effectuate its purposes.”[16] The treatment of gifts is perhaps an exemplar of such purposes. Most substantial gifts will be included in net worth even if given before Proposition 40 comes into effect.[17] Proposition 40 anticipates taxpayers to take steps to avoid its tax. Similarly, an individual’s net worth will generally include their dependents’ net worth.[18]
The 2026 Billionaire Tax Act would codify the economic substance doctrine regarding this new tax. That is, if “a transaction or series of transactions lack economic substance, or that a substantial purpose for any transaction or series of transactions was to obtain a tax benefit” under the 2026 Billionaire Tax Act “that is not intended by the voters or the Legislature, the Board may determine the tax consequences to any person in a manner that is reasonable in light of all the facts and circumstances in order to deny such benefit.”[19] Economic substance is determined by whether a person has “a valid and substantial nontax business purpose for entering into the transaction or series of transactions, taking into account the overall economic effect of the transaction or series of transactions apart from state and federal tax effects.”[20]
The Franchise Tax Board would also be empowered to allocate tax items relevant to net worth “[i]n any case of two or more organizations, trades, businesses, entities, or arrangements owned or controlled, directly or indirectly, by the same interests” when “necessary in order to prevent avoidance of the tax imposed” by the 2026 Billionaire Tax Act “or clearly to reflect the economic ownership and enjoyment of such tax items.”[21] As part of this process, “the Board may disregard any entity, arrangement, or transaction that lacks economic substance, treat related transactions as a single transaction under the step transaction doctrine, or otherwise give effect to the substance rather than the form of the transaction.”[22] Furthermore, “legal principles developed with respect to interpretation and application of state and federal income taxes, including, without limitation, doctrines relating to economic substance, business purpose, sham transactions, step transactions, and substance over form” apply.[23]
Proposition 40 would “provide for expedited, conclusive resolution of the facial validity of this Act through a validation action.”[24] The deadline would be 60 days after Proposition 40 passes. “If no action is filed within that period, the tax and all proceedings in relation thereto, including the adoption and approval of the Act, shall be held to be facially valid and in every respect legal and incontestable.”[25] This would begin in the Superior Court for the County of Sacramento.[26] “Any appeal from an adverse determination in the Sacramento County Superior Court shall be directly to the California Supreme Court, without intermediate appellate review.”[27] Proposition 40 would give specific deadlines for these courts: “[T]he Sacramento Superior Court shall make every effort to resolve any validation action by April 1, 2027, and the California Supreme Court shall make every effort to resolve any review proceeding by November 1, 2027, or as soon as possible thereafter.”[28]
Credits
There are two credits under the 2026 Billionaire Tax Act:
- A credit for other taxes on net wealth.[29]
- This is “an amount equal to the taxpayer’s pro rata share of any taxes paid on a tax on net wealth that is also taxed under” the 2026 Billionaire Tax Act.
- “[T]he pro rata share shall be the ratio in which the numerator shall be the total number of days the taxpayer resided within the other taxing state or jurisdiction and the denominator shall be 365.”
- However, this credit does not account for “taxes on directly-held real property.”
- “A credit shall additionally be allowed against taxes paid in other jurisdictions to the extent required by the U.S. Constitution.”[30]
Apportionment
Generally, the Constitution requires a state’s tax on a nonresident to be apportioned based on that nonresident’s connection with the state. Proposition 40 provides for two forms of apportionment. The standard apportionment preserves 100% of the wealth tax “without reduction or multiplier based on residency history.”[31] However, “[i]f the standard apportionment method does not fairly represent the extent to which the taxpayer’s excessive wealth was accumulated in, or substantially sustained by, California, the taxpayer may petition for or the Board may require in a notice of proposed assessment, use of an alternative apportionment method for all or any part of the taxpayer’s wealth.”[32] This petition would be proved only if the taxpayer “proves by clear and convincing evidence that both of the following are true:”[33]
- “The excessive wealth did not substantially accumulate in California.”
- “The excessive wealth was not substantially sustained in California for at least 365 days in the aggregate” from January 1, 2025, through December 31, 2026.
In addition, “[t]he petitioning party bears the burden to show the standard method is unfair or invalid and to propose a more fair and reasonable method that is practicable to administer.”[34] If an alternative apportionment method were used, it would be applied before any credit is applied.[35]
The allocation percentage generally could not be lowered below 25%.[36] This limit could be overcome only if “Office of Tax Appeals ( or a court on review) finds on the record that a lower percentage is required to avoid grossly disproportionate taxation in violation of the United States or California Constitutions or governing federal law.”[37] This determination requires consideration of “whether the taxpayer’s net worth has a meaningful connection to California, and shall reduce the apportionment percentage, including below twenty-five percent and, where appropriate, to zero, to the extent necessary to avoid taxation that is arbitrary or out of all appropriate proportion to the taxpayer’s contacts with this State.”[38]
[1] Nothing should be construed as support of or opposition to Proposition 40 by the author or The Burton Law Firm.
[2] Proposed RTC §§ 50312(c) & (d).
[3] Proposed RTC § 50312(c)(1).
[4] Proposed RTC § 50312(a).
[5] Proposed RTC § 50312(b).
[6] Proposed RTC § 50312(i).
[7] Proposed RTC § 50305(c).
[8] Proposed RTC § 50312(f).
[9] Proposed RTC § 50312(f)(2).
[10] Proposed RTC § 50312(g).
[11] Proposed RTC § 50312(h)(1).
[12] Proposed RTC § 50312(h)(2).
[13] Proposed RTC § 50309(d).
[14] Proposed RTC § 50309(b)(2).
[15] Proposed RTC § 50309(b)(1).
[16] Proposed RTC § 50313.
[17] “Net worth shall include the value of any property the individual transferred (other than property transferred to a trust described above) for less than fair market value after October 15, 2025, if such property either considered alone or together with other substantially interchangeable transferred items has a fair market value in excess of $1 million ($1,000,000). An asset included in the net worth of the transferor as a result of this subparagraph shall not be included in the net worth of the transferee.” Proposed RTC § 50303(c)(11).
[18] “Any assets of a person who can be claimed as a dependent that are in excess of fifty thousand dollars ($50,000), shall be deemed to be assets of the taxpayer who can claim them as a dependent.” Proposed RTC § 50303(c)(12).
[19] Proposed RTC § 50312(k)(1).
[20] Proposed RTC § 50312(k)(2).
[21] Proposed RTC § 50312(l)(1).
[22] Proposed RTC § 50312(l)(2).
[23] Proposed RTC § 50312(m).
[24] Proposed RTC § 50314(a).
[25] Proposed RTC § 50314(c).
[26] Proposed RTC § 50314(d)(1).
[27] Proposed RTC § 50314(d)(2).
[28] Proposed RTC § 50314(d)(4).
[29] Proposed RTC § 50307(a).
[30] Proposed RTC § 50307(b).
[31] Proposed RTC § 50306(a).
[32] Proposed RTC § 50306(b)(2).
[33] Proposed RTC § 50306(b)(3).
[34] Proposed RTC § 50306(b)(5). Proposition 40 goes to some length describing the circumstance of the Franchise Tax Board being the petitioning party for an alternative method rather than the standard method. However, it is unclear why the Board would do so when the standard method makes the taxpayer liable for 100% of the tax. Proposed RTC § 50306(b)(5).
[35] Proposed RTC § 50306(b)(2).
[36] Proposed RTC § 50306(b)(6).
[37] Id.
[38] Id.