Key Takeaways: FTB Audits

• Most FTB audits are conducted through correspondence by issuing written Information Document Requests (IDRs) seeking supporting documentation for items reported on a tax return.
• The FTB typically relies on IRS audit results instead of re-auditing the same issues, but it may conduct its own examinations or adjust returns based on IRS reports.
• California’s statute of limitations for assessment is generally four years – compared to the IRS’ 3-year statute – though it may remain open indefinitely in certain circumstances.
• Disputes may proceed through several stages, including an FTB administrative protest, appeal to the California Office of Tax Appeals (OTA), and in some cases, litigation in California courts.
• The FTB is known for relatively aggressive and fast enforcement and collection practices once a liability becomes final.
• Early strategic representation can be critical. Understanding how the FTB develops audit issues and evaluates disputes can help taxpayers respond effectively and mitigate potential liabilities.

Introduction

The California Franchise Tax Board (“FTB”) administers and enforces California’s personal income tax and corporate franchise tax laws. To ensure compliance, the agency conducts thousands of examinations each year involving individuals, businesses, and pass-through entities.

Understanding how the FTB selects returns, conducts examination, and resolves disputes is essential for California taxpayers.  California’s tax enforcement framework differs in several important respects from the federal system, including longer statutes of limitation, aggressive residency enforcement, and extensive conformity with federal audit adjustments.

This article provides an overview of the FTB audit process, common audit issues, and the procedural options available when a taxpayer disagrees with a proposed assessment.

How the FTB Selects Returns for Audit

The FTB uses several methods to identify tax returns for examination. One of the most common sources of audit leads is the Federal/California Information Sharing Program, through which the FTB receives federal audit reports and other information from the Internal Revenue Service (“IRS”). When a federal audit results in adjustments, the FTB frequently reviews the federal findings to determine whether corresponding California tax adjustments are required.

California law also requires taxpayers to report federal changes to the FTB within six (6) months after the final federal determination. If a taxpayer fails to report federal adjustments as required, the statute of limitations for the FTB to assess additional tax remains open indefinitely.

Beyond federal audit reports, the FTB relies on internal screening criteria and data analysis.  Common triggers include:

• Residency changes involving high-income taxpayers
• Large capital gains transactions
• Significant loss deductions or carryovers
• Inconsistencies between state and federal filings
• Information obtained from third-party sources or public records

Through these selection methods, the FTB examines tens of thousands of returns filed by individuals and businesses each year.

The FTB Audit – Correspondence Audits

The FTB conducts audits using several formats, but most examinations are handled as correspondence (desk) audits. In these cases, the auditor communicates with the taxpayer (or their representative) through written requests for information for information focused on specific issues identified through return screening or information matching. Many of these audits are resolved through the exchange of documentation and written explanations.

Information Document Requests (“IDR”) and Audit Issue Presentation Sheets (“AIPS”)

Once an examination begins, FTB auditors request information through IDRs. These requests typically seek financial records such as bank statements, accounting records, contracts, and supporting documentation for items reported on the return.

Throughout the audit, the auditor develops proposed adjustments using internal analysis and information provided. These adjustments are often summarized in Audit Issue Presentation Sheets (“AIPS”), which outline the factual findings, legal analysis, and computation of proposed changes to the taxpayer’s liability.  Taxpayers and their representatives have the opportunity to respond to proposed adjustments by providing additional documentation or legal arguments before the audit is finalized.

Possible Outcomes of an FTB Audit

At the conclusion of an examination, the FTB will notify the taxpayer of the audit results. Possible outcomes include:

• No-Change Letter: A determination that the return was correctly filed, and no additional tax is owed.
• Notice of Proposed Assessment (“NPA”): A notice proposing additional tax, penalties, and interest based on the audit findings.
• Notice of Proposed Overassessment: A determination that the taxpayer overpaid tax and is entitled to a refund or credit.
• Proposed Adjustment to Carryover Items: An adjustment that affects tax attributes such as net operating losses (“NOL”) or credit carryovers without immediately resulting in additional tax for the audit year.

Interest continues to accrue on unpaid tax liabilities during the audit and protest process unless the taxpayer pays the disputed amount.

Disputing an FTB Assessment

Taxpayers and their advisors should be familiar with the main stages for challenging FTB assessments.

1. Administrative Protest

IF the FTB issues an NPA, a taxpayer who disagrees with the proposed adjustments generally has 60 days from the date of the NPA to file a written protest. The protest should include:

• Identification of the disputed issues
• An explanation of the taxpayer’s position
• Supporting documentation
• A request for an oral hearing, if desired

Protests are reviewed by FTB personnel within the FTB’s Legal Division or by experienced auditors, depending on the nature and complexity of the issues.   The assigned protest hearing officer conducts an independent review of the proposed adjustments, and the taxpayer’s protest.  At the conclusion of the protest, the FTB issues a Notice of Action (“NOA”) that affirms, modifies, or withdraws the proposed assessment.

2. Appeal to the Office of Tax Appeals

If the taxpayer disagrees with the NOA, the next step is an appeal to the California Office of Tax Appeals (“OTA”), an independent state agency that replaced the former State Board of Equalization appeals function.  Taxpayers generally have 30 days from the date of the NOA to file an appeal with the OTA. Appeals are typically decided by a panel of three administrative law judges, and taxpayers may request an oral hearing.

3. Settlement Options

In appropriate cases, disputes with the FTB may be resolved through the agency’s Settlement Program, which is administered by the FTB Legal Division’s Settlement Bureau.  The Settlement Program allows cases to be resolved based on litigation hazards or factual uncertainty. Settlement may be requested at various stages, including during the protest, during an OTA appeal, or in connection with a claim for refund.

It is important to distinguish the Settlement Program from the Offer in Compromise (“OIC”) process. An OIC applies to undisputed tax liabilities and focuses primarily on the taxpayer’s inability to pay. By contrast, the Settlement Program applies to disputed tax liabilities and is driven by the parties’ assessment of the strengths and weaknesses of their positions.

4. Judicial Review

If a taxpayer disagrees with the final outcome of the administrative appeals process, further review may be available through the courts.  Unlike the federal Tax Court system, California generally requires taxpayers to pay the disputed tax first before seeking judicial review. After payment, the taxpayer may file a claim for refund with the FTB. If the claim is denied—or six months pass without action—the taxpayer may file a refund lawsuit in California Superior Court. Decisions of the Superior Court may ultimately be appealed to the California Court of Appeal.

Common Issues in FTB Audits

Certain issues arise frequently in FTB examinations and deserve particular attention.

• Residency and Domicile: Residency disputes are among the most complex and contentious areas of California tax enforcement. Taxpayers who relocate from California shortly before significant income events—such as the sale of a business or liquidation of stock—often face scrutiny regarding whether the move effectively changed their residency for tax purposes.
• Sourcing of Income: The FTB frequently examines whether income earned by nonresidents should be treated as California-source income, particularly for services performed for California businesses or the sale of business interests with California connections.
• Federal Adjustment Conformity: Another common audit issue arises when taxpayers fail to report federal audit adjustments to California within the statutory six-month period required under California law.
• Pass-Through Entity Issues: Audits involving partnerships, S corporations, and limited liability companies often focus on allocation and apportionment of income, nonresident withholding obligations, and characterization of income from business activities

Statute of Limitations

California generally has a four-year statute of limitations for issuing tax assessments. This period is longer than the three-year limitation period applicable to most IRS examinations.

However, the statute of limitations remains open indefinitely if a taxpayer fails to file a required tax return, or a taxpayer fails to report federal adjustments to the FTB.  These rules create significant exposure for taxpayers with unreported federal changes or filing gaps.

Conclusion

California’s tax enforcement environment presents unique challenges for taxpayers and their advisors. In many respects, the FTB’s audit and enforcement practices are widely viewed by practitioners as more assertive than those of the IRS, particularly when it comes to California specific issues such as residency, sourcing, and post-assessment collection activity.

The state’s tax system differs from the federal framework in several important ways, including longer statutes of limitation, extensive residency and sourcing examinations, and selective conformity with federal tax law. The FTB is also known for its quick and aggressive collection efforts, which may include wage garnishments, bank levies, liens, and other enforced collection actions once a liability becomes final.

Having previously served as tax counsel with the FTB for over 13 years, I have seen firsthand how the agency develops audit issues, evaluates taxpayer positions during the administrative process, and pursues collection of assessed liabilities. That experience underscores the importance of responding strategically and proactively when the FTB initiates an audit or proposes an assessment.

Taxpayers who understand the FTB’s procedures—and who respond promptly with well-supported legal and factual arguments—are in a stronger position to resolve disputes efficiently and mitigate potential liabilities. Careful navigation of the audit, protest, settlement, appeals, and collection processes can significantly affect the outcome of a California tax controversy.

For taxpayers facing an FTB audit, proposed assessment, or collection action, obtaining experienced tax counsel early in the process can often make a meaningful difference in protecting financial interests and achieving a favorable resolution.