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Tax Law

“Pay up or shut up”: California Court of Appeal holds that taxpayer must pay up before challenging a tax regulation’s validity

The California Court of Appeal recently held that a taxpayer must pay a tax assessment before seeking a declaration that the regulation giving rise to the tax assessment is invalid. California taxpayers cannot challenge unpaid tax assessments under Article XIII, section 32 of the California Constitution (“Section 32”). Therefore, a taxpayer seeking to challenge an assessment must generally pay the tax first and then pursue a refund claim, which is known as the “pay first, litigate later,” or “pay up or shut up” rule.

Although Cal Gov. Code § 11350 (“Section 11350”) authorizes declaratory relief actions challenging the validity of regulations, the court held that Section 11350 did not supersede the “pay up or shut up” rule for three reasons:

  1. The plain language of Section 11350 did not exempt declaratory relief actions from Section 32’s prepayment requirement, and a state constitutional provision could not be “impliedly partially repealed” by statute;
  2.  The purpose underlying Section 11350 did not justify exempting declaratory relief otherwise subject to Section 32’s prepayment requirement because the refund procedures provided administrative and judicial forums for testing the validity of tax regulations; and,
  3. California Supreme Court precedent provides that Section 11350 is to be “strictly construed in tax cases and may not be used to prevent the state from collecting taxes or, by parity of reasoning, to compel the state to refund taxes.”

The taxpayer was an officer and shareholder in a corporation that allegedly continued to do business after its corporate status was suspended while failing to pay sales tax. The California Board of Equalization assessed the taxpayer for unpaid taxes and penalties pursuant to a regulation and policy of holding a suspended corporation’s officers and shareholders liable for its unpaid taxes. The taxpayer sought to challenge this policy and regulation as a “responsible officer” of a different closely-held corporation that could be subject to the policy and regulation in the future, and as a general California citizen interested in “having all branches of government act within the bounds of their constitutional authority.”

The court held that the taxpayer could not avoid the “pay up or shut up” rule by challenging an unpaid assessment via his declaratory relief claim under these alternative standing theories. This is because the net effect of the declaratory relief claim would be to absolve the taxpayer of liability for the disputed unpaid tax. Thus, resolving such claims would effectively prevent or enjoin the state from collecting the disputed tax, triggering the prepayment requirement of the state constitution.

California Department of Tax and Fee Administration et al., v. Superior Court, No. BC684614 (Cal. Ct. App. May 7, 2020)