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Avoiding Problems

You can avoid many problems by keeping accurate records, filing timely and accurate tax returns, understanding the basics of tax accounting, staying away from tax scams, and understanding the audit process.

Keeping Records

A good record keeping system is essential in avoiding not only income tax problems, but other problems with federal, state or local agencies.

File Timely and Accurate Tax Returns

Taxpayers should file all required returns that are past due now to avoid additional penalties and interest. Please see Frequently Asked Questions for detailed information regarding the filing process.

Understand and Select the Appropriate Accounting Method for Your Business

An accounting method is a set of rules used to determine when and how income and expenses are reported. While there are several methods of accounting, the two most common are the cash and accrual basis. You should choose an accounting method for your business that will most accurately match your income and associated expenses. This is referred to as the "matching principle".

Following are some of the generally used accounting methods:

  • Cash method.
  • Accrual method.
  • Special methods such as percentage-of-completion or completed contract method which are generally only used for long-term construction projects like real estate developments.
  • Combination method using elements of two or more of the above.

If we examine your tax return, we may ask you to show:

  • The method of accounting used to report your income and expenses.
  • That it accurately reflects your income, and
  • That it is used consistently.

Understand What Constitutes Taxable and Nontaxable Income and Deductible Business Expenses

You will generally compute taxable income by starting with gross income, excluding nontaxable income and exemptions, and subtracting allowable deductions. The accounting method that you select will determine the items of income and deductions that you will include in any taxable year.

To take advantage of what the tax laws allow you to deduct, it is important that you understand what are deductible business expenses. Deductible expenses are ordinary and necessary expenses incurred in the operation of your trade or business. On the other hand, you should also know the type of expenses that are not deductible for tax purposes such as fines, state taxes, etc. For audit purposes, it is important that you provide supporting documentation for the expenses you are reporting on your return and demonstrate how these expenses are "ordinary and necessary" for your business.

For most common business expenses, see FTB 984.

Tax Scams: How to Recognize and Avoid

Participating in an illegal scheme to avoid paying taxes can subject you to penalties, criminal investigations or civil injunctions. Education is the best way to avoid the pitfalls of these "too good to be true" tax scams.

We estimate California loses billions of dollars in tax revenues due to abusive tax schemes. The real cost is borne by taxpayers who correctly file their returns and pay their fair share of taxes.

To help you recognize and avoid abusive tax schemes, please see Abusive Tax Shelters.


The Franchise Tax Board encourages self-compliance by administering the California income tax laws and regulations in a timely, responsible, and fair manner. One aspect of our compliance efforts includes auditing individuals and businesses to ensure they reported and paid the correct amount of tax. If we select your business for an audit, please refer to FTB 1015B, Frequently Asked Questions About Your Tax Audit. In addition, the May 2007 edition of the Tax News provides detailed information regarding Streamlining Corporate Audits.

Top Audit Issues

The following list includes FTB′s Top Audit Issues. Please review in order to gain an understanding of the common errors or mistakes, which may help you avoid problems in the future.

Abusive tax shelters – Abusive tax shelters have become a major issue not only in California, but also throughout the country. Abusive tax shelters have resulted in billions of dollars of lost tax revenue. FTB has joined forces with other state agencies and the Internal Revenue Service (IRS) to actively exchange information related to audit activity and leads to identify abusive tax schemes. FTB will continue to aggressively pursue those taxpayers who use abusive tax shelters.

Enterprise zone credit – Over the last year, we worked with other state agencies to address the issuance of invalid hiring vouchers. FTB will review supporting documentation for those vouchers determined to be inappropriately issued, and will give taxpayers an opportunity to obtain a valid voucher.

Manufacturers' Investment Credit (MIC) – Although the MIC was repealed as of January 1, 2004, we have audits for tax years prior to 2004. Our audit issues include qualified property, qualified costs, and payment of California sales tax. We encourage auditors to use statistical sampling where it would be costly and time consuming to review all qualifying purchases. This is an efficient audit tool, and reduces the burden on taxpayers.

Research & Development Credit (R&D) – Recently, we have seen an increase in the number of R&D credits claimed where documentation of qualified expenditures has been inadequate or lacking. We are addressing these issues through educational articles and audit activity as necessary.

Personal Income Tax

Bad debt/worthless stock – We continue to see Schedule D losses where the debt reported was not worthless in the year claimed; was not a valid debt; payments were never received; and no attempt was made to collect the debt. Worthless stock is often not worthless in the year claimed, so it may become a timing issue with large tax implications.

State Adjustments from IRS examinations – California law requires taxpayers to notify us within six months of receipt of a final federal determination. The IRS sends FTB results of over 184,000 examinations each year. We issue notices for all IRS adjustments to which California conforms.

Sale of property through an IRC §1031 exchange – The sale of property through an IRC §1031 exchange raises questions regarding basis and related party transactions. Taxpayers continue to report transactions as IRC §1031 exchanges that do not meet such basic code requirements, as items exchanged must be similar and adhere to the transaction′s timing, and the basis must be correctly calculated.

Sourcing of income and residency determination – The sourcing of deferred compensation, such as stock options, continues to be an audit issue. The accrual provision under California Revenue and Taxation Code Section 17554 was repealed effective January 1, 2002. Another ongoing focus of the Residency Program is determining whether a taxpayer actually changed their domicile and residency status shortly before receiving a large amount of income. It is important for taxpayers who change their residency status to retain documentation to support their residency change.

Gambling Losses from Tribal Casinos – An increase in slot machine gambling in Tribal Casinos has led to a higher number of individuals reporting large gambling losses. Many taxpayers are unaware of the record keeping requirements. This lack of awareness along with the casino operators' reluctance to provide records in their control has resulted in individuals not being able to document their losses. We are in the process of planning education and outreach activities to provide pre-filing assistance to individuals who take part in slot machine gambling.

Personal Residence Issues – Reporting of sales of personal residences and the home mortgage interest deduction continue to be issues with high error rates. Many filers are making the assumption that the gain is less than the allowed exclusion and are not reporting the sale on the return as allowed under current law. Also, poor record keeping results in adjustments to the reported basis on these sales. Many individuals and preparers appear to be unaware of the debt limits on the deductibility of home mortgage interest. We are also seeing the excess home mortgage interest reported as investment interest income in error.

Business Entities Tax

Employee Stock Ownership Plans (ESOP) – A change in tax law permitted ESOPs to become shareholders of an S corporation. In certain situations, this arrangement involves S corporations that are typically very profitable. Since ESOPs are tax–exempt retirement plans, the income that usually would have normally flowed through to the individual shareholders and been taxed at the individual rate, was now flowing through to a tax-exempt entity and not being taxed at all. Information available has shown that in some situations tax avoidance is the primary motivation behind these arrangements. Both the IRS and the FTB are looking at this issue.

Sales factor – Common audit issues for apportioning business entities include defining gross receipts, distortion of income, and whether or not receipts should be assigned to California, particularly receipts from intangible income. As a result, of the Microsoft decision, return of principal receipts for investments held to maturity are includable in the sales factor subject to a distortion analysis.

Unity – When do the parent and newly acquired subsidiary become unitary? Often there is no arbitrary benchmark to determine this date. Resolving this issue involves applying the taxpayer's facts and circumstances to unitary case law. Combination and decombination of corporations within the unitary group are based on the specific facts of the case and the three unity tests (unity of ownership, unity of operations, and unity of use).

Business/nonbusiness – Analyzing excess cash or liquid investments to determine whether the resulting income is business or nonbusiness income is frequently an audit issue. In addition, the sale of assets such as stock and partnership interests often raises the question of whether or not the income from the sale of such assets is business or nonbusiness income to the corporation. When a business asset is sold, the resulting income is most likely business income. Transactional and functional tests are used to determine the business versus nonbusiness income classification.

Useful Suggestions During an Audit

The following list includes some useful suggestions to follow if your business is under audit:

  • Review CCR Section 19032 – Audit Procedures.
  • Maintain open communication with auditor.
  • Respond to all correspondence and notices received.
  • Timely provide accurate information and documents requested by auditor.
  • Inform auditor of any past, current or planned IRS audits, other states audits, or any other audits.
  • Inform the auditor if you are planning to amend a tax return under audit. Amending a return under audit usually results in a delayed audit process.
  • Ask questions.
  • To keep up to date with the latest income tax laws; our regulations, policies, and procedures; and other time sensitive information, subscribe to our free Tax News bulletin service.


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