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 California's NEST penalty

California's noneconomic substance transaction understatement penalty, commonly referred to as the NEST penalty, imposes a 20 percent penalty for understatements attributable to noneconomic substance transactions (Revenue and Taxation Code  (R&TC) Section 19774). The penalty increases to 40 percent for transactions that are not adequately disclosed.

A transaction lacks economic substance either because: (1) it lacks an economic benefit or, (2) there is no bona fide, non-tax California business purpose for entering into the transaction.

In cases where your client has received a final federal audit report, we may assess the NEST penalty in lieu of the accuracy-related penalty assessed on the audit report if both of these criteria are met:

  • The federal adjustment was from a transaction lacking economic substance.
  • Tax benefits from this same transaction were reported on the California tax return.

Unlike California, the Internal Revenue Service does not have a NEST penalty.

This penalty is imposed on a Notice of Proposed Assessment. To dispute the NEST penalty, your client should file a protest of the penalty within the required 60-day time period (R&TC Section 19041), and also file a Request for Chief Counsel To Relieve Penalties (form FTB 626).

The factors relating to whether the penalty was properly imposed will be developed during the protest process. The Chief Counsel relief process (R&TC Section 19774(d)) is the mechanism for determining whether to withdraw or reduce the NEST penalty. The Chief Counsel's determination will consider all grounds raised in the dispute of the penalty including substantive arguments concerning economic substance and business purpose.

The Chief Counsel will issue a determination on the Request for Penalty Relief. Your client cannot appeal or challenge the Chief Counsel's refusal to compromise the penalty before the State Board of Equalization or in court. A Notice of Action will be issued on the remaining issues which are the subject of the protest.

Your client may also contest the penalty after paying the full amount and filing a claim for refund with FTB, and may appeal to the State Board of Equalization or file an action in court after the refund claim is denied or deemed denied.