California Under-Withholding Penalties for 2012 After Passage of Prop 30

Q:

“I have been employed at Facebook for several years. I had substantial equity that vested in November. My 2012 income is higher than normal and I will be affected by Prop 30. I don’t have enough tax withheld. Will I owe penalties?”

A:

In November 2012 California voters amended the California Constitution by approving Prop 30 by a margin of 55% – 45%. Among other things, Prop 30 increased marginal tax rates for taxpayers with taxable income over $250,000 ($500,000 for joint filers). The increase is expected to affect the top 3% of California taxpayers.

The change to the tax rates was made retroactive to January 1, 2012 (were the authors of Prop 30 aware that Facebook would IPO in the first half of 2012, triggering billions in income that otherwise would have been taxed at lower pre-Prop 30 rates? Hmmm….).

Since employers were operating under the pre-Prop 30 withholding tables for most of 2012, most employees affected by Prop 30 will be underwithheld for 2012. The same goes for the self-employed.

Fortunately California law provides that you cannot be subject to underpayment penalties that are caused by “mid-stream” tax changes.¹ By “mid-stream” I mean changes that take effect during the same year they are passed. This applies to retroactive changes (such as Prop 30) and interestingly (although not applicable here) would also seem to apply to laws or ballot measures that take immediate effect, even if not retroactive (e.g. a ballot measure passed on November 6 that affects tax for the period from Nov 6 to Dec 31).

Prop 30 is a textbook example of a “mid-stream” change that will cause massive under-withholding for high-income taxpayers but will not result in underpayment penalties.

However, taxpayers affected by Prop 30 for the 2012 tax year should be mindful of a few things:

1. The provision forgives under-withholding penalties caused by the passage of Prop 30, but doesn’t forgive under-withholding that would have occurred anyway.
2. You should file Form 5805 with your California tax return. The Franchise Tax Board (FTB) is not required to reduce or forgive under-withholding penalties of its own volition.  UPDATE: The FTB has a short explanation here.
3. If you receive a letter from the FTB purporting to impose underpayment penalties (whether or not you filed Form 5805 with your return), do not panic and do not send a check without investigating the claims made in the letter. The FTB has been known to send erroneous letters purporting to impose penalties on innocent taxpayers. Receiving a “payment due” letter from the FTB does not necessarily mean you owe the amount stated in the letter!

Sources

¹ See Revenue and Taxation Code section 19136(g)(1).

See also:

• California Constitution Article XIII, section 36(f)(2)(C)(i) (providing that Prop 30 is considered “chaptered” on the day it becomes effective, intended to specifically follow the language of section 19136(g)(1))
• The rest of R&TC section 19136 (imposing under-withholding penalties similar to Internal Revenue Code section 6654)