On March 30, 2022, a California intermediate appellate court held that a penalty waiver of approximately $1.7 million was required for the taxpayers, owners and operators of San Francisco boutique hotels, inasmuch as the taxpayers established that they “exercised ‘ordinary business care and prudence in the payment of their tax obligations.’” Gajanan, Inc. v. City of San Francisco, No. A160539, at 8 (Cal. Ct. App. Mar. 30, 2022). In reaching its conclusion, the court rejected San Francisco’s argument that “as a matter of law, reliance on an employee cannot constitute ordinary care ... no matter how careful plaintiffs were in hiring and supervising the employee.” Id. at 2. This case is a reminder that when states or localities impose waivable penalties as if they are strict liability, taxpayers should consider whether there are arguments justifying a waiver and, if so, they should not be afraid to press those arguments in court.

Facts: The hotel owners contracted with a hotel management company to manage and staff six hotels. The hotel management company had been managing hotels for a long time and had a good reputation. The hotel management company hired an employee in the position of controller (“the employee”) after confirming that the employee had the requisite experience and credentials and having the employee interviewed and vetted by experienced professionals. The employee’s duties for the hotels included filing returns and paying the San Francisco transient occupancy tax, the tourism improvement district fee, and the Moscone expansion district fee. The hotels collected these taxes from their customers and deposited them into an account accessible to the employee.

The employee failed to file the required returns and pay the taxes for three quarters before being terminated by the hotel management company after it was discovered that the employee had made an unauthorized transfer out of the account of one of the hotels. The new controller hired by the hotel management company then discovered that the employee had altered journal entries and balance statements to make it look like the taxes were being paid. When the taxpayers learned of what had transpired, returns were filed for the back periods and all taxes due for those periods were paid. The city imposed late filing and late payment penalties, which the taxpayers paid before seeking a refund in court.

Ruling: The Court ruled that penalties should be waived inasmuch as the taxpayers produced evidence that demonstrated that they had exercised ordinary care in connection with the filing and paying of the taxes in question. Relevant to the court’s determination was the following: (a) the hotels hired a qualified company to manage the hotels, as is common in the industry; (b) the hotel management company hired a qualified individual who was responsible for paying the taxes; and (c) the employee did not pay the taxes but made it appear to the taxpayers as though the taxes had been paid by lying to them, providing them with false financial statements, and offering plausible explanations for the non-filing notices that the taxpayers received from the city. Under these circumstances, the Court reasoned, the relevant penalty waiver provision at issue required San Francisco to refund the penalty amounts paid by the taxpayers.