Top Audit Issues
1. State Adjustments from IRS examinations – California law requires taxpayers to notify them within six months of receipt of a final federal determination. The IRS sends the FTB results of over 184,000 examinations each year and they issue notices to those individuals for all IRS adjustments to which California conforms.
2. Sale of property through an IRC §1031 exchange – The sale of property through an IRC §1031 exchange raises questions regarding basis and related party transactions. Taxpayers continue to report transactions as IRC §1031 exchanges that do not meet such basic code requirements (found here) which results in a tax-free exchange becoming taxable. There are also additional requirements for §1031 exchanges of CA property.
3. Sourcing of income and residency determination – The sourcing of deferred compensation, such as stock options, continues to be an audit issue. Another ongoing focus is determining whether a taxpayer actually changed their domicile and residency status shortly before receiving a large amount of income to avoid paying tax in CA. It is important for taxpayers who change their residency status to retain documentation to support their residency change as this is determined on facts and circumstances (i.e., there is no 'bright line' rule for determining status).
4. Bad debt/worthless stock – Taxpayers continue to take Schedule D losses where the debt reported was not worthless in the year claimed; was not a valid debt; payments were never received; and no attempt was made to collect the debt. Worthless stock is often not worthless in the year claimed, so it may become a timing issue with large tax implications. California will adjust this for you if done incorrectly which may result in a penalties and interest, plus a surprise tax bill mailed to you.
5. Personal Residence Issues – Reporting of sales of personal residences and the home mortgage interest deduction continue to be issues with high error rates. Many filers are making the assumption that the gain is less than the allowed exclusion and are not reporting the sale on the return as allowed under current law. Also, poor record keeping results in adjustments to the reported basis on these sales. Talk with a CPA who can work with you to get your facts correct and file your return right the first time.
Suggestions During an Audit
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CPA + Partner at Why Blu