The California Franchise Tax Board (FTB) just released the list of “hot” audit issues they are encountering in the process of examining returns filed by California taxpayers. The FTB is responsible for administering two of California’s major tax programs: Personal Income Tax (PIT) and the Corporation Tax. The FTB regularly receives and processes more than 17 million Personal Income Tax (PIT) returns and 1.4 million Business Entity (BE) returns. Over 75 percent of PIT returns are filed electronically.
The FTB employs more than 5,300 permanent and 2,000 seasonal and intermittent employees nationwide. Headquartered in Sacramento, the California FTB office locations include Los Angeles, Oakland, San Diego, San Francisco, San Jose, Santa Ana, Van Nuys, and West Covina. Their out-of-state office locations include Houston, Chicago, and Manhattan.
PERSONAL INCOME TAX
Some of the most common tax audit issues affecting personal income taxpayers include:
Like-Kind Exchange (IRC Section 1031) – Audits related to IRC Section 1031 continue to assert noncompliance in the following areas:
•Gain computation errors (taxable boot due to debt netting; non-exchange expense items included in the computation).
•Invalid identifications (failing the 3-property 200%:95% tests; not acquiring substantially the same property that was identified; identifying a partial interest and acquiring a higher percentage interest).
•Including the cost of property improvements made after the exchange closed in the exchange (boot) calculation.
•Withdrawing cash out of the proceeds from the relinquished property.
Other State Tax Credit (OSTC) – The FTB uses use third party data to verify tax payments were made to other states and to disallow credits claimed to those states which do not have a reciprocal agreement with California.
Head of Household (HOH) Filing Status – Common errors include:
•The qualifying individual’s income exceeds the gross income test of $3,700.
•Taxpayers who do not meet the requirements to be considered unmarried or considered not an RDP.
Expired Credits –Some of the expired credits disallowed by the FTB include the Ridesharing, Recycling Equipment, Solar Energy, Political Contribution, Employer Ridesharing, and Water Conservation credits.
Employee Business Expenses – The FTB may ask taxpayers claiming unreimbursed employee business expenses to provide documentation to substantiate their employer’s reimbursement policy to determine if their expense is allowable.
PASS THROUGH ENTITIES
Some of the most common tax audit issues affecting pass through entities and related flow through to owners include:
Partnership/LLC Property Dispositions – Issues involving property dispositions reported by partnerships and LLC’s include like-kind exchanges (IRC Section 1031), foreclosures of real estate, and cancellation of debt (COD) income.
Termination of Partnership/LLC – Issues include partnership and LLC liquidations reported by both partnerships and partners.
Transfer of Partnership Interest – Issues include disposition of partnership and LLC interests by the partners/members of partnerships and LLCs. The FTB continues to identify taxpayers who transfer partnership interests between related entities to create a higher basis.
Shareholder/Partner/Owner’s Basis in a Pass-Through Entity – The FTB will verify shareholder’s basis to determine the correct flow-through income, losses, deductions, and credits. The FTB will use the correct basis to determine taxability of distributions, debt repayments, and dispositions.
S Corporation Liquidations – Common S corporation liquidation issues include:
•S corporation taxpayers that do not accelerate the recognition of installment gain for California purposes in the final year.
•S corporation shareholders that do not report the gain recognized under IRC Section 331(a).
•Nonresident shareholders that do not report their share of the gain that was recognized by the S corporation on the sale of intangible assets.
Charitable Deductions for Trusts – The FTB willverify that the amount donated is from the gross income of the trust and is paid pursuant to the terms of the governing instrument.
Charitable Remainder Trusts – The FTB will verify that the trust is operated pursuant to the terms of the governing instrument and that the trust meets statutory requirements. A charitable remainder trust that is not operated correctly may lose its tax-exempt status, and the previously untaxed income may be subject to income tax. In some cases, a disqualified charitable remainder trust will be treated as a grantor trust and the income of the trust will be reported on the grantor’s individual tax return.
Apportionment of Trust Income – A trust will be subject to taxation if the fiduciary is a California resident or a beneficiary whose interest in such trust is noncontingent is a California resident. When trust apportionment of income is within and without California, the FTB will look at how the income is sourced to California and the residency status of the trustee.
Some of the most common tax audit issues affecting corporations include:
Cost of Performance and Sourcing of Intangible Sales – For tax years beginning before January 1, 2011, sales from intangible sales and services are assigned based on the cost of performance. The complex rules of identifying income-producing activities and documentation necessary to do a cost-of-performance analysis may result in incorrect assignment of sales from intangibles and services. For tax years beginning on or after January 1, 2011, taxpayers who elect a single sales factor for apportioning business income to California will use market rules for assigning sales from intangibles and services instead of cost of performance rules.
Sales Factor and Gross Receipts – The FTB continues to see items in the sales factor denominator that do not meet the definition of “gross receipts” or that result in distortion.
Abusive Tax Shelters – The FTB is continuing to identify “abusive tax shelters” in a variety of situations that appear designed to avoid state or federal tax. These types of transactions often involve the creation of entities or deductions without economic substance or a business purpose.
Credits – The FTB will verify that credits, such as Enterprise Zone and Research and Development Credits, are reported correctly. In addition, they will verify that the assignment of credits is properly reported by the assignor and the assignee.
For further information see https://www.ftb.ca.gov/professionals/taxnews/2014/April/Article_6.shtml