An Overview of a Franchise Tax Board Audit and How they are Different than IRS Audits

Like the Internal Revenue Service (“IRS”), the Franchise Tax Board (“FTB”) is authorized to audit tax returns and assess additional tax liabilities, interest, and penalties. Although a FTB audit seems similar to an IRS audit, an FTB audit is very different in nature, and the outcome of an FTB audit may be dramatically different than an IRS audit.

The Initial Contact Letter

Just about every FTB audit will begin with an initial contact letter. In most cases, the FTB will send to the individual or business being audited an Information Document Request. The reason the FTB sends an Information Document Request to taxpayers is to determine if there was omitted taxable income from a tax return and to determine if a taxpayer can substantiate expenses claimed on a tax return. Nobody ever likes responding to an Information Document Request, but it is extremely important to timely respond to an Information Document Request. What happens if you fail to timely respond to an Information Document Request? Depending upon the facts and circumstances of the particular case, the Franchise FTB may consider an untimely response as evidence of a badge of fraud and a reason to assess a seventy-five percent civil fraud penalty. The case may even be referred to a special investigations unit for criminal prosecution consideration. Consequently, it is extremely important to timely respond to a FTB Information Documentation Request, and carefully respond to a FTB Information Document Request.

Taxpayers that participated in a tax shelter (such as captive insurance or conservation easement) or received income from an undisclosed foreign asset may receive a contact letter that is different from usual Information Document Requests from the FTB. In these cases, it is extremely important to take a closer look at the initial correspondence received from the FTB. If the initial correspondence from the FTB states that the agency received information that the taxpayer may have participated in a tax shelter or received income from a previously undisclosed foreign financial account, it may be possible to avoid an audit and significant penalties by filing amended tax returns. In these cases, the FTB must be contacted quickly.

Administratively Contesting an Audit

After a taxpayer receives notice from the FTB of an audit, the audit will proceed much like an IRS audit. However, there are significant differences that should be taken into consideration. For example, many tax professionals believe they can request a conference with an FTB auditor and attempt to espouse legal theories to settle a case or attend a protest hearing as if it were an IRS appeals conference. A professional doing either of these two examples may be wasting their client’s time and money. This is because neither an auditor nor a hearing officer has the authority to resolve a state tax liability on a theory of the hazards of litigation. With that said, unlike the IRS, the FTB has a special Settlement Bureau. This Settlement Bureau was created for the sole purpose of reaching settlements based on the hazards of litigation. However, the Settlement Bureau cannot consider a settlement until a Notice of Proposed Assessment has been issued.

Federal and State Tax Law Differences

Statute of Limitations Differences

For federal income tax purposes, the IRS generally must assess a tax liability within three years of the filing of a tax return. On the other hand, the FTB must only issue a Notice of Proposed Assessment within four years of the filing of a tax return rather than making an assessment. However, if a transaction was taken to avoid taxes, the statute of limitations on an assessment is eight years from the date of the filing of a tax return. There is a six year statute of limitations that will apply both for state of California and federal purposes if there has been a greater than twenty-five percent omission of income. The statute of limitations is unlimited for federal and state of California purposes if a taxpayer filed a false or fraudulent tax return with the intent to evade tax or a willful attempt to defeat or evade tax.

It may be possible to utilize the statute of limitations as leverage to favorably resolve an examination. However, it must be understood when the statute of limitations can be used as leverage. The IRS and FTB have entered into a Memorandum of Understanding regarding the sharing of information relating to tax audits. This means that if the IRS timely audited a taxpayer and is sharing information with the FTB, an attempt to delay an audit to insure that the state statute of limitations has run will not likely be effective. Therefore, a tax professional must carefully consider both federal and state of California statute of limitations in any audit of a California resident.

California Tax Penalties that are Unique

California has two civil penalties that have no federal counterparts. These penalties are the 1) interest based penalty and the 2) noneconomic substance transaction penalty (“NEST”).

The interest based penalty is imposed by the FTB if a taxpayer was assessed a liability that is the result of an abusive tax shelter. The penalty is equal to 100 percent of the interest assessed against the taxpayer.

The NEST penalty is a 40% penalty which applies to a noneconomic substance understatement. A transaction is treated as lacking economic substance if the taxpayer does not have a valid nontax business purpose for entering into the transaction. Once assessed, the authority to compromise a NEST penalty is delegated solely to the Chief Counsel. The Chief Counsel’s decision may not be reviewed by a state court.

Determining and Contesting California Taxation of Residency

Due to California’s high income tax rates, many individuals and corporations want to avoid having a nexus with California. However, due to complex California laws, this is not always an easy task.

Domicile is an important concept in California state taxation. An individual or business whose domicile is in California is subject to state tax on worldwide income even if income is received outside of California. Domicile is the place where an individual has his or her permanent home or principal establishment and where he or she intends to return after temporary absences. Domicile does not change until the individual moves to a new location which he or she intends to make his or her new home.

Residency is not equal to domicile since a person or business can have many transient residences where he or she may only have one legal domicile. Residency is significant for California tax purposes because residents of California are taxable on all income, including income from sources outside California. On the other hand, non-residents are taxed only on income from California sources.

The determination of residency requires an evaluation of all relevant contacts with the state of California as compared to contacts with other states. No single factor is conclusive. Under this test, even minor contacts with California could trigger residency if an individual is unable to demonstrate that there are more significant contacts with any other state. This means the weight of any given factor may vary. Factors which tend to indicate residency include, but are not limited to, maintenance of a family home in California, retention of business interests in California, and attendance by a taxpayer’s minor children in California schools. However, the most persuasive evidence of an individual being a resident of California is their physical presence within the state. The longer a taxpayer remains in California, the more likely a finding of California residency becomes. Physical presence within California for as little as 45 days may create a presumption of residency by the FTB. The determination can have serious consequences. This is because reclassification can result in the assessment of significant back taxes, interest, and penalties.

Residency Audits

All residency disputes begin with an FTB audit. Once the audit commences, the FTB may visit any out of state locations claimed to be an individual’s principal residence or business location. In addition, any individual being audited by the FTB should expect a review of credit card statements and bank charges to determine physical presence with California as compared to other states. In certain cases, an individual can file California non-resident tax returns to commence the running of the statute of limitations on income tax assessments. By filing non-resident tax returns, it may be possible to commerce the running of the statute of limitations on income tax assessments. This could be an extremely valuable tool in a potential residency audit.

Residency Litigation

If the FTB makes an adverse determination regarding residency against you and you do not agree with the results, it is very important to retain a tax attorney who not only can vigorously advocate on your behalf, but also understands the administrative process. The residency appeals process in California is multilayered with many strict deadlines. If these strict timelines are not satisfied in an appeal of a residency determination, the case will be dismissed and the FTB will collect on its assessment. A determination by the FTB regarding residency is presumed to be correct. This means if the FTB determines that you are a resident for California tax purposes, you will carry the burden of proving that the FTB’s determination is incorrect. With that said, the presumption of residency is rebuttable and is only presumed correct in the absence of sufficient evidence to the contrary.

If the FTB determines an individual is a California resident for tax purposes, the FTB must mail a Notice of Proposed Additional ASsessment stating the additional tax liability. If you receive this Notice, it must be responded to within 60 days of the notice date. If a protest is not timely filed, the proposed assessment reflected on the Notice of Proposed Additional Assessment becomes final and the state tax liability reflected on the notice will be collected by the FTB. If a protest has been timely filed, the FTB will reconsider the assessment through a conference with a settlement officer. If the controversy cannot be resolved with a settlement officer, the FTB will mail you a Notice of Action. If you receive a Notice of Action, it must be responded to within 30 days of the date of the notice by filing an appeal with the State Board of Equalization affirms the deficiency assessment, the decision becomes final within 30 days after the date of determination unless a Petition for Rehearing is filed. If a Petition for Rehearing is filed, the determination becomes final 30 days after the date the State Board of Equalization issues an opinion regarding the residency controversy.

In the event of an adverse decision by the State Board of Equalization based on residency, if you wish to litigate the matter without payment of tax liability, you must, within 60 days after the determination becomes final, commence an action for determination of residency against the FTB in the Superior Court of the County of Sacramento, the County of Los Angeles, or the City and County of San Francisco. The complaint contesting the residency must be based on the same grounds stated in the initial protest that you filed with the FTB.

Anthony Diosdi focuses a part of his practice on criminal tax enforcement, broad-based civil tax compliance and white collar matters generally. He also advises clients on the IRS voluntary disclosure program, with particular focus on disclosure related to offshore banking accounts.

Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.

Diosdi & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.