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.
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.
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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Last Updated: 01/24/2018