California Income Tax Audits
With strict adherence to deadlines and aggressive collection tactics, the state’s Franchise Tax Board (FTB) has a reputation of being more difficult than the IRS to deal with. This can be frustrating for the taxpayer, who ends up getting caught up in the bureaucracy and red tape of the state tax system when they are genuinely trying to resolve their issues.
Sometimes the counsel and representation of an experienced tax attorney familiar with the nuances of the FTB is the right course to take when faced with a state income tax audit.
Selection for an Income Tax Audit
To ensure taxpayers are in compliance with state income tax laws, the FTB regularly audits personal and business tax returns.
A variety of factors can cause a taxpayer to be selected for an audit, but many times the cause is an IRS tax audit that resulted in additional tax due. The IRS in most cases will report their audit results to the FTB, which will then send you a Proposed Notice of Assessment based on the IRS’s findings, along with a bill for the additional state income tax due. The FTB has a limited amount of time to make changes to a taxpayer’s return after learning of changes made by the IRS, so some taxpayers choose to strategically inform the FTB of IRS changes of their own accord, thus initiating the time period during which the FTB can make the assessment.
Even if you have not been audited by the IRS, the FTB can initiate its own audit, using unique criteria such as Department of Motor vehicle records as well as state property tax bills. Head of Household status, execution of tax-deferred Section 1031 like-kind exchanges, cancellation of debt deductions, gambling losses and sourcing of income often raise a red flag and trigger an FTB audit.
If the FTB has chosen you or your business for an audit, you will first receive an initial contact letter that identifies the issues under examination in your tax return and provides the name of the auditor and requests the name and contact information for the taxpayer or the designated tax representative.
There are two types of audits:
- Desk/Office-These audits are normally performed through written letters and secure emails, and typically do not involve face-to-face meetings.
- Field-These audits generally involve attempts by the FTB auditor to conduct the audit at the location of the original books, records and source documents. Field audits are usually used to audit more complex tax transactions and large corporation tax returns.
To keep the process moving forward, the auditor will create an audit plan, which is a road map and timeline of how the audit begins, progresses and ends as well as identifying key potential audit issues and setting deadlines. The taxpayer is allowed to give input during the development of the plan.
You or the auditor might also request an opening conference in order to set the necessary groundwork for an effective and efficient audit, limit the issues for audit, and establish lines of communication. At your request, the auditor’s supervisor might attend.
Once the audit plan is agreed upon, the auditor will submit the Information Document Requests (IDR), which serve to gather the facts and documents necessary to understand and substantiate the items reported on your tax return. The auditor maintains and updates a master IDR log, which is provided to the taxpayer. Failure to respond to IDRs does not relieve the taxpayer of responsibility to substantiate the amounts reported on the tax return, and can often create an adversarial relationship with the auditor that inhibits progress. If you are unable to respond to an IDR either because you need more time or cannot find the documents, it is important to communicate this to the auditor, including an explanation for why the documents cannot be found or some alternative documentation.
An Audit Issue Presentation Sheet (AIPS) will also be prepared for each audit issue and will include a discussion of the facts, the relevant law and the proposed adjustment. You might receive several AIPS documents at various points throughout the audit process, and you will be given an opportunity to respond to each one. Like the IDRs, the auditor maintains and updates a master AIPS log, which is provided to the taxpayer.
During the audit process, there will be status conferences to review, discuss and, if needed, adjust the audit plan, manage the fact and information gathering and solve problems as early as possible.
At the closing conference, items not already covered in the status conferences will be discussed along with a review of the final audit results and outline of the review process. The auditor will also explain the notification process of changes made during the review process and the proposed assessments, and will provide an estimate of time frames.
At the end of the audit, the FTB will provide to you in writing the audit results and one or more of the following, as applicable:
- Letter stating the FTB accepted the tax return as you filed it and you do not owe any additional tax.
- Notice of Proposed Assessment (NoPA) showing the additional tax the FTB believes you owe.
- Notice of Overassessment or a Notice of Proposed Overassessment showing the refund the FTB owes you.
- Notice of Proposed Adjusted Carryover Amount showing how the FTB reduced a carryover item that did not results in any additional tax for the tax year examined.
After the Audit
If you receive a NoPA and agree with the proposed tax change as a result of the audit, there are various payment options available.
Interest accrues from the original return due date to the date the FTB receives payment in full. However, the FTB does not charge any additional interest between the date of the NoPA and the date of full payment if the payment is received within 15 days of the date on the NoPA.
Filing a Protest
If you do not agree with the proposed tax change in the NoPA, you have the right to file a written protest. A letter of protest must be filed with the FTB by the “protest by” date shown on the NoPA, which is sixty days after the date of the NoPA. Under California law, the mailbox rule applies for protest filings, which means the postmark date is the filing date.
The protest must include your general information and clearly explain why you believe the FTB’s assessment is wrong. It is recommended that the protest also include a request for an oral hearing and a discussion of any relevant law.
You can protest without paying the proposed assessment, but interest will continue to accrue throughout the protest process. If you have paid the proposed assessment, the process converts to a claim for refund.
The protest process is informal and provides an opportunity for you to present your case to a hearing officer, who is an FTB staff member assigned to resolve your protest. At this time, you will be able to provide any additional documents or information to substantiate your position.
After considering the protest, the FTB will send its final decision to you in a Notice of Action (NOA), which can affirm, modify or withdraw the NoPA. If you disagree with the NOA, you can appeal to the State Board of Equalization within 30 days of the date the NOA was mailed.
After you file an appeal, both you and the FTB are given an opportunity to provide additional information and file supporting briefs. You can also request a hearing before the BOE.
After the BOE considers the law and facts in your appeal, they will issue a decision in writing. Both the taxpayer and the FTB can request a rehearing within thirty days of the written decision. A rehearing allows the BOE to hear the appeal for a second time if there were mistakes of law or errors made in the original appeal or if new evidence is discovered.
Superior Court Action
If you do not agree with BOE’s final decision, you can pay the tax due and file an action against the FTB in California Superior Court within 90 days. However, the BOE’s decision is final and binding on the FTB and the agency cannot file action against you with the Superior Court.
After the Superior Court decision, either you or the FTB can file an appeal of the decision to the California Court of Appeals, and in some cases, to the California Supreme Court and, ultimately, the U.S. Supreme Court.
If your tax return is selected, you have the right to have someone represent you during the audit. The tax attorneys at Brown, PC have comprehensive knowledge of California tax laws and experience dealing with the FTB. If you have received an FTB notice or need guidance with an FTB tax matter, please contact the firm online or by calling 424-252-1100. We represent client in Los Angeles and throughout California.