Identify areas of Recurrent Taxpayer Noncompliance Taxpayers’ Bill of Rights Annual Report to the Legislature
Sample Data from the Audit Process
We compiled and analyzed data from FTB's audit process to identify areas of recurrent taxpayer noncompliance. The data, some of which is derived from statistical samples, includes:
- The statute or regulation violated by the taxpayer.
- The amount of tax involved.
- The industry or business engaged in by the taxpayer (sample data).
- The number of years covered in the audit period.
- Whether the taxpayer used professional tax preparation assistance (sample data).
- Whether the taxpayer filed individual or corporate tax returns.
We reviewed the Notice of Proposed Assessment (NPA) information for assessments that became final in fiscal year (FY) 2019/2020. When we used sample data, the volumes and dollar amounts represent the sample study numbers projected to the total universe of assessments. We have displayed the data separately for corporate and individual tax returns. (For details, please refer to the tables within Appendix 1 – Assessments.)
Corporate Income and Franchise Tax
For corporation income and franchise taxes, the largest dollar amount in proposed assessments resulted from allocation and apportionment audits, which involves corporations doing business within and outside of California. (For details, please refer to Appendix 1 – Assessments, Table 1A.)
“Allocation” is the assignment of nonbusiness income to a particular state. “Apportionment” is the division of business income among states by the use of an apportionment formula. Within the apportionment formula, the sales factor is the most frequent audit issue for corporations. The higher rate of noncompliance associated with allocation and apportionment may be attributed to the complexity of the issues involved, as well as the diverse interpretations of the tax laws.
Appendix 1, Table 2 refers to taxes assessed on corporations. The industry group that was assessed the largest dollar amount was in the row labeled “other,” which includes agriculture, construction, utilities, transportation, communication, information, and other industries not classified in the sample.
We consider all corporation tax returns as professionally prepared as an in-house accounting department or an accounting or legal firm prepares virtually all corporation tax returns.
Personal Income Tax
For personal income taxes, the largest dollar amount in proposed assessments resulted from filing enforcement assessments, which refers to taxpayers who have not filed their California state income tax return after we notified them of their filing requirements. (For details, please refer to Appendix 1 – Assessments, Table 1B.)
We issue a separate NPA to the taxpayer for each tax year included in an audit adjustment. Individuals typically have audit changes for just one tax year. Ninety-five percent of the individuals who received NPAs that went final during FY 2019/2020 had audit changes for a single tax year.
The data indicates that tax professionals file over 63 percent of all personal income tax returns. In the absence of a paid tax professional’s signature, we consider that taxpayers self-prepared their personal income tax returns.
Taxpayer Filing Errors
FTB identifies the most common errors taxpayers make when they file their tax returns, and we evaluate how those errors may be avoided or corrected.
We compiled Personal Income Tax (PIT) and Business Entity (BE) taxpayer error information on approximately 18.7 million tax returns (17.1 million of PIT returns and 1.6 million of BE returns) processed between July 1, 2019, and June 30, 2020. During this time, FTB sent approximately 1,063,000 return notices (895,000 PIT— Notices of Tax Return Change and 168,000 BE — Return Information Notices) to taxpayers who filed tax returns with errors that resulted in a change. This figure equates to approximately six percent of tax returns. We explain the errors in the notices and inform customers how they can resolve any discrepancies.
Adjustments on paper-filed tax returns accounted for 38 percent of the PIT and BE adjustments, even though only 12 percent of total tax returns were paper-filed. Adjustments on electronically filed tax returns (88 percent of total tax returns) accounted for the remaining 62 percent of the adjustments.
The two most common taxpayer errors, for all filing methods, are PIT wage withholding and PIT and BE payment/credit discrepancies. Together, these two errors account for 36 percent of all taxpayer errors identified during the processing of tax returns.
Of all change notices sent, 15 percent contained a PIT wage withholding adjustment. Taxpayers claimed a PIT wage withholding amount that could not be verified based on the withholding information provided by the taxpayer and/or based on amounts reported to the California Employment Development Department (EDD) by the taxpayer’s employer.
The other most common taxpayer error identified during tax return processing is claiming the incorrect payment/credit amount. This error accounted for another 21 percent (18 percent for PIT and 3 percent for BE) of FTB notices sent to taxpayers that resulted in an adjustment. This error is also one of the most common reasons PIT and BE taxpayers and/or their authorized representatives call during our peak pre-filing season.
In an effort to help taxpayers report the correct amount of estimated tax payments, FTB piloted a project over the past two filing seasons, aimed at the BE community, by providing a letter detailing their 2018 and 2019 annual estimate payments and credit information. Unfortunately, the project was not as successful as anticipated. There was no significant reduction in contacts during pre-filing season, nor was there a significant reduction in notices sent for this reason. Instead, FTB continues to use marketing campaigns to promote the use of MyFTB for both PIT and BE taxpayers and their authorized representatives.
Additionally, amended tax returns typically have processing errors. In order to help resolve these issues, we modified our PIT forms and expanded our filing methods to allow amended tax returns to be filed electronically. In tax year 2017, we added an amended checkbox to all individual tax return forms (Forms 540, 540NR, and 540 2EZ) and required that the Schedule X, California Explanation of Amended Return Changes, be attached if it was checked. The Schedule X reconciles the difference between the original tax return and amended tax return to determine any additional amount owed or refund due. The Schedule X also provides a simplified approach for taxpayers to report the reason(s) for amending their tax returns. At the same time the forms were modified, FTB began to accept amended tax returns through the e-file program, and we encouraged our software vendors to support the new Schedule X. Over the past couple of tax years, our software vendors’ support has grown so that a majority of tax software developers support the Schedule X today. The benefits of allowing amended tax returns to be e-filed include the following: ensuring FTB receives accurate tax return information, providing taxpayers and practitioners with an acknowledgment that FTB has received the amended tax return, and saving FTB time in processing the tax return.
As of August 17, 2020, the Internal Revenue Service (IRS) started supporting amended tax returns in their Modern e-File Program. As IRS e-filing has grown over the past 30 years, the 1040-X, Amended U.S. Individual Income Tax Return, has been one of the last major individual tax forms that needed to be paper filed. Now, Form 1040, Amended Return, can be filed electronically with the 1040-X for tax year 2019 and forward. This will allow more tax software developers to support the California amended tax returns in their e-file software now that it is an option at the federal level.
The Tables in Appendix 2 display the number of adjustments for PIT returns by tax return type and filing method, and they include a definition of what typically caused each adjustment.