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Tax News
Audits: Behind the scenes

Our March issue reported on filing statistics for 2006, as we approached the end of the filing season. We also traced the path of a typical personal income tax (PIT) return after it comes in our door.

In this issue, we're picking up where we left off, and following the path of a typical PIT return during an audit. To set the stage, here is a breakdown of PIT audits conducted in 2006:

Facts and stats

Number of audits (rounded):

PIT 350,000

Assessments (rounded):

PIT total $845 million
PIT audit $480 million
Automated audit $50 million
Head of household $35 million
Federal audit reports $279 million

Investigations:

Number of new cases: 170
Approved for prosecution: 78
Individuals prosecuted: 57
Closed cases: 175
Revenue generated: $18.3 million

The PIT audit process

At the end of filing season processing, tax returns are stored in our data storage facility, which is the end of the line for most tax returns. However, some begin a new life when they become the focus of an audit. All tax returns—corporate, pass-through entity (partnership), and PIT—follow roughly the same path during an audit. This article focuses on PIT returns.

From files to audit

Our Audit Division conducts income tax audits of taxpayers. An audit is a process for gathering and validating information. Depending on the amount of information, and the complexity of the audit issue or issues, an audit can take from a few months to more than a year from start to finish.

Chances are good that you have had clients come to you for help after they received an initial contact letter, or a Notice of Proposed Assessment (NPA). If that has happened, you have no doubt helped your client gather the data that will support the deduction, credit, loss carryover, business expense, filing status, etc., that we propose adjusting. Your clients may have asked you, “Why did this happen? What happens next?” Here are some answers to those questions.

“Why did this happen?”

In many cases, it is likely that our Federal/State and Special Audit program examined the taxpayer's return, and proposed an adjustment. This program actually consists of several programs that gather and compare California tax return data with many other data sources. These audit programs assessed $364 million in 2006, $35 million of which came from the Head of Household (HOH) audit program. The Federal/State and Special Audit program includes:

  • STARS (Selection of Tax returns for Automated Audit Review System): Matching federal information with information from California tax returns, STARS checks for discrepancies in AGI, schedule CA, itemized deductions, foreign earned income credit, and other state tax credit.
  • The CP-2000 program: This program is based on the IRS's automated under-reporter program. The name CP-2000 is derived from name given by the IRS: "Computer Program 2000." This Internal Revenue Service (IRS) program was developed to identify taxpayers who underreport their income. FTB's CP-2000 audit program combines IRS and FTB information to assess taxpayers who have underreported their state income.
  • Federal Audit Reports: At the conclusion of a federal audit, the IRS forwards their Revenue Agents Report (RAR) to FTB, or the appropriate state taxing agency, after notifying taxpayers that a copy will be sent (see June 2007Tax News: "Notify FTB after a federal tax adjustment"). The RAR indicates the issues that were examined, and whether or not any federal adjustments were made. FTB uses this information to identify any similar state tax issues on the California tax return, and may also detect California-only tax issues during the examination.
  • Head of Household (HOH) filing status: Each year we ask selected taxpayers who claim the HOH filing status to substantiate that they qualify for it. HOH NPAs are issued to taxpayers who we determine are not qualified for HOH filing status. We change their filing status to single, or married filing separate, and assess the additional tax accordingly.

Total assessments for all PIT RAR audits in 2006, including CP-2000 audits, were $279 million.

PIT audit program

We are able to efficiently resolve many audit issues through the Special Audit programs, freeing our professional audit staff to examine the more complex audit issues. The PIT audit program is staffed by one hundred tax professionals located throughout California. This program primarily conducts audits of personal income tax, residency and sourcing determinations, substandard housing, and amended returns. In 2006, our auditors closed the books on $480 million in tax assessments.

We get audit leads from many sources, including the IRS. Information reporting is required for many financial transactions, and is a valuable tool for audit decision-making.

We use audit models to reveal inconsistencies on tax returns. Models detect inconsistencies when return data do not add up, and alerts audit staff that certain tax returns should be examined further. Some audit models are perennial workhorses: The Schedule C model for instance. Most audit models are continually adjusted to keep up with new developments in the financial world. Some of the models we are focusing on right now are:

  • Abusive tax shelters and transactions.
  • Passive activity losses.
  • Economic development areas.
  • Research and development credit.

"What happens next?"

Tax returns that fit audit model criteria go into a pool, from which they are assigned to specific auditors. Here are the steps that an audit generally follows:

Step 1

The auditor conducts a pre-audit analysis to analyze the case, and determine whether the taxpayer has been audited in the past for the same or different issues. The auditor uses this information to help determine the audit's potential for adjustment, and whether the time and effort required for conducting the audit are justified.

Step 2

If the pre-audit analysis shows that an audit is justified, the auditor makes note of all the material items that merit further investigation.

Step 3

The auditor retrieves the tax return from our data storage facility, and will typically request past year returns and examine them for the same audit issue. The auditor asks the taxpayer to supply documentation for the issue or issues that are under examination.

Example: Abusive tax shelter audit

If conducting an abusive tax shelter audit, the auditor will request many forms of documentation:

  • Books, records, documents, or other information to support the tax returns' correctness, or photocopies of these materials.
  • Specific information about the tax strategy, and the promoter of the tax strategy.
  • Any information provided by attorneys, accountants, brokers, promoters, and anyone involved in the tax strategy.

These are items we typically ask for, but the list is far from all-inclusive. We may ask for other information and documents depending on the type of transaction reported on the return. (California Revenue and Taxation Code Section 19504.)

Step 4

The auditor conducts in-depth research using FTB and IRS materials, and relevant court cases. During the course of auditing the original issue or issues, the auditor may identify and pursue additional audit issues.

Step 5

After thorough research, the auditor will notify the taxpayer of the audit findings by issuing the appropriate document:

  • A position letter, giving the taxpayer the opportunity to respond.
  • An NPA.
  • A refund of over-assessed tax.
  • A determination that there is no change to the tax return(s) as filed.

Step 6

The auditor will issue an NPA if the audit reveals that the taxpayer owes additional tax. The taxpayer must either pay the assessment, or file a written protest within 60 days of the date the NPA was mailed.

Post-audit

Protest and appeal: A taxpayer has 60 days from the date the NPA is mailed to file a written protest. Generally, if the protest questions the law that supports the NPA, it is a docketed protest, and is handled by an attorney in our legal department. If the protest challenges the facts supporting the NPA, it is an undocketed protest.

If no protest is filed the NPA is final at the end of 60 days. The law has no provision for extending the time for filing a protest.

If the taxpayer files a written protest, the auditor must act on the protest by affirming, revising, or withdrawing the NPA. If the taxpayer does not respond, we will send a formal Notice of Action (NOA) to affirm, revise, or withdraw the assessment. The department's action on the protest is final 30 days from the date of the NOA.

If the taxpayer disagrees with the protest determination, the taxpayer may appeal to the California State Board of Equalization in Sacramento, or pay the deficiency and file a claim for refund. Although the protest process does not stop interest from accruing, FTB does not issue a lien on a protested assessment, because it is not a final liability.

This is a very simplified sketch of the steps taken during an audit. These steps were described in terms of a PIT audit, but also generally fit the procedures followed for a corporate or pass-through-entity audit. Taxpayers and their representatives should carefully consider all aspects of an audit when responding to an audit notice, including complex tax law and statutes of limitation. Read more about tax audits, protests, and appeals in our Taxpayer Bill of Rights: A Guide for Taxpayers (FTB 4058 revised 04/2006) and our General Tax Audit Manual (now part of the Manual of Audit Procedures) on our website.