Business Estate & Tax Attorneys, P.C.
Federal v California business tax audits: key differences
Although the Internal Revenue Service (IRS) is the revenue service for the United States federal government, business tax laws vary from state to state. California is subject to some of the highest tax rates in the nation, and some of its tax laws can seem unnecessarily complex if you're unfamiliar with them.
Below, we break down the procedural differences between the Californian and federal business tax audits, and how you can prepare for them.
Why you might be facing a tax audit
A tax audit is a way for taxing authorities to check that your tax return is accurate and that you're paying the tax you properly owe. Authorities look to ensure that you've correctly reported your income, deductions, losses, and expenses, and that you haven't made any errors in your reporting.
Typically, a tiny percentage of small businesses--between one and two percent--are audited in the U.S. each year. If you're one of the unlucky few who get chosen, it's probably because there are inconsistencies or errors in your tax reporting.
In California, the California Franchise Tax Board (FTB) is responsible for enforcing the state's income tax laws. The FTB works very closely with the IRS, and if the IRS audits your tax return, it's likely you'll hear from the FTB shortly afterward.
Furthermore, the FTB may wish to perform a further tax audit to check for problems that are specific to California state tax law, or they may perform their own audit before passing the results to the IRS. Don't worry, though. The differences aren't as hard to understand as they may seem at first.
The key differences between IRS and California business tax audits
The main differences between IRS and California business tax audits fall under these broad categories:
Let's take a closer look at each of these differences in turn.
Statute of limitations to audit
The statute of limitations determines how long the IRS and the FTB have to audit your tax returns. There are two relevant statutes here. First, the statute of limitations of assessment, and second, the statute of limitations on collection. In both cases, the FTB has far longer to audit your taxes than the IRS.
When it comes to assessment, the FTB has wider powers than the IRS. Generally speaking, the IRS has only three years from the date of filing to assess more taxes on this filed return. The FTB, on the other hand, has four years.
The IRS has 10 years to collect any past due accounts from your business. In contrast, the FTB has 20 years. In practical terms, this means that even if you're no longer a California state resident, the FTB can still challenge you for tax within this 20-year period.
The FTB often performs its own audits following IRS audits. However, the FTB has its own unique selection criteria for selecting which businesses to audit. This criteria is more demanding than the IRS selection criteria.
For example, the FTB considers ancillary evidence such as state property tax bills and the records held at the Department of Motor Vehicles. Put simply, there's more chance of the FTB flagging your business for an audit than the IRS.
Generally speaking, California uses the same rules for net operating loss as IRS federal laws. The main exception involves carrybacks. Unlike with the IRS, the FTB rules around carrybacks fluctuate annually and you should always check the most up-to-date position before filing your returns.
In federal law, there's no requirement for businesses earning less than $5,000.00 in gross income to apply for tax exemptions. In contrast, the FTB demands that all such businesses and non-profits apply for exemption and obtain a determination acknowledgment letter from the body. A failure to do so will likely result in fines.
Foreign earned income
Federal law makes allowances for foreign earned income that FTB regulations don't. If you're taxed in California, you're taxed on all income, whatever the source. So, for example, if your business generates income from foreign companies, you'll pay tax on it if you're a California resident.
Statute of limitations to appeal an audit
If you disagree with an IRS audit, you have 90 days from receiving a statutory notice of deficiency, also known as a 90-day letter, to either agree to the government’s adjustments or file a petition with the Tax Court for a redetermination of the deficiency. If the letter is addressed to you outside the United States, the period is 150 days. Failing to agree to the adjustments or timely file a petition will result in the assessment of the tax and actions to collect it.
In contrast, if you disagree with an FTB audit, you must submit an appeal with the Office of Taxpayer Assistance (OTA) not later than the date shown on your Notice of Action, or 30 days from the date the FTB mailed the notice, whichever is later. If you disagree with the OTA's determination after your decision becomes final, you may file a claim in the Superior Court.
Penalties for non-compliance with California-specific rules
Even if you make an honest mistake on your tax return, it can still be costly. If you fail to regard the differences between California and federal tax laws, you could find yourself paying hefty fines to the FTB.
If you're facing a tax audit, or you're concerned about any aspect of tax return compliance, never hesitate to contact a licensed tax attorney for help and advice. Professional guidance can be the difference between avoiding a tax audit and thousands of dollars in fines.
Even honest typos and errors are still subject to fines. Ignorance is not an excuse. Double and triple-check your figures before sending them out. If you're unsure, invest in some tax preparation software, or speak with a tax advisor.
Avoid rounding numbers excessively
Where possible, use precise numbers on your tax return. When you're rounding up or down, round to the nearest dollar, not the nearest $10.00 or $100.00. For example, if you're submitting an expense of $318.21, round to $318.00, not $320.00.
Don't make home office deductions or similar deductions if you can't support them
Chances are you'll need to provide accurate measurements of any space in your home that you've set aside for work purposes and claim deductions on. For example, don't claim your lounge as a home office deduction if you answer emails on your sofa a few hours per day. The lower your home office deduction, the less chance you'll have of the IRS or FTB challenging it. The same goes for any deductions--don't make them unless they're strictly necessary for you to perform your job.
Never falsify donations
This one should go without saying, but don't claim you've made donations to charity that you can't support. If you can't provide the paperwork, don't mention it as a charitable deduction.
Don't hide income
It doesn't matter where it comes from--income is income. A failure to report income is an easy way to secure yourself an IRS or FTB audit.
As is clear, there are substantial differences between how the IRS and the FTB perform their tax audits on your business. So long as you keep on top of your paperwork and make every effort to complete your tax returns honestly and on time, you should have nothing to fear from an audit by either authority.
A final note--if you're subject to an IRS audit, and your tax return changes, you must notify the FTB within 6 months of the changes. It doesn't matter whether this change falls outside the 4-year statutory limit. You must still tell the FTB, which will claim its own share of any tax owed.