California state tax agencies do not primarily select audit targets at random; they mainly rely on data matching, analytics, and known compliance issue-driven campaigns, though they may occasionally randomly choose audit targets simply for compliance studies. The state’s three central tax agencies use data matching, analytics, and issue-driven campaigns to identify which businesses / individuals warrant closer scrutiny. For income tax, the Franchise Tax Board focuses on completeness of income, residency, and sourcing, as well as high-risk adjustments on business returns. For sales and use tax, the California Department of Tax and Fee Administration focuses on whether taxable sales were reported correctly and whether claimed exemptions or credits are adequately supported. For payroll tax, the Employment Development Department focuses on worker classification and wage reporting. The specific triggers differ by agency, but the pattern is the same: compare what third parties reported to what you filed, measure your filings against peers in your industry, and prioritize audit targets based on where the numbers or the story do not line up.
Who Audits What in California, and Why the Selection Criteria Differ by Agency
- Franchise Tax Board (FTB) audits income tax for individuals, corporations, partnerships, and S corporations. Selection focuses on underreported income, aggressive adjustments, residency, and sourcing for multistate owners, and pass-through items that do not reconcile to K-1s.
- California Department of Tax and Fee Administration (CDTFA) audits sales and use tax. Selection focuses on industries with cash sales or complex exemptions, recurring refund or credit claims, and leads that indicate use tax was not accrued on purchases.
- Employment Development Department (EDD) audits payroll taxes. Selection focuses on businesses that issue Forms 1099 to people who may be employees, non-filers, or under-filers of payroll returns, and cases where benefit claims suggest misclassification.
Because each agency enforces a different set of laws, what gets selected as a return in one program might be irrelevant in another. Understanding the agency that contacted you is step one in understanding why your company was picked.
The FTB Playbook: How Business Income Tax Returns Get Picked
The FTB relies on several stable inputs to build an audit inventory. First, information matching compares what your vendors, customers, and financial institutions reported on Forms W-2, 1099 series, and K-1 to the totals on your California return. Significant or repeated mismatches move a file up the list. Second, FTB receives data on federal changes. If the IRS increases federal taxable income for your business or owners, California state selection often follows to conform state entries to the final federal result. Third, FTB uses risk screening to identify patterns that have historically led to adjustments. Common examples include significant Schedule C losses without support, flowing-through losses to owners who lack basis or are subject to passive or at-risk limits, big year-over-year swings in apportionment or California sales, and sizable credits or net operating loss carryovers that do not reconcile with prior filings.
Residency and sourcing are core California tax audit priorities. For owners who moved in or out of the state, or who work in multiple states, FTB screens for return positions that reduce California taxable income while third-party data suggest the owner still has significant California ties. For multistate companies, FTB compares the sales you assigned to California with customer lists and contracts to see whether market-based sourcing was applied correctly. Returns that cannot be tied back to books, bank and merchant statements, and K-1s with clean math are more likely to be selected.
The CDTFA Playbook: Sales and Use Tax Selection and Why Some Industries See More Audits
CDTFA builds audit leads from several directions. Ratio analysis compares reported taxable sales to purchase patterns, industry norms, and prior filings. Files that consistently report low taxable sales relative to purchases of inventory, or that claim high percentages of exempt sales without adequate documentation, tend to draw attention. Large or repeated refund or credit claims are routinely reviewed. CDTFA also cross-checks income tax filings, business licenses, and resale certificates to identify sellers that should be registered or that appear to be under-reporting taxable sales. In use tax, CDTFA screens capital asset purchases, out-of-state vendor invoices, and procurement records to find untaxed items that should have been self-assessed.
Specific industries are audited more frequently because their risk profile is higher or their documentation is more complex. Restaurants, groceries, convenience stores, liquor and tobacco retailers, automotive shops, construction contractors, medical and dental offices with mixed taxable and nontaxable sales, and e-commerce sellers commonly appear on campaign lists. Where books are thin or cash sales are material, CDTFA may rely on sampling, purchase markups, or observation tests. Prior audit history also matters. If a previous audit found a material error, CDTFA often schedules a routine follow-up for later periods to confirm changes were implemented.
The EDD Playbook: Worker Classification and Payroll Audit Selection
EDD selection often begins outside the audit division. The most common trigger is a benefits claim. When a person who paid on a 1099 applies for Unemployment Insurance or State Disability Insurance, the benefits office may flag a status question and refer the matter for a worker classification audit. Other common triggers include non-filing or under-filing of payroll returns, inconsistencies between payments shown on Forms 1099 and wages reported on Forms DE 9 and DE 9C, and the absence of required Reports of Independent Contractor(s) on Form DE 542. EDD also receives referrals from the IRS, FTB, and CDTFA when those agencies identify facts suggesting payroll noncompliance.
Once selected, EDD applies the ABC test in Labor Code sections 2775 to 2787, with a presumption of employee status unless the hiring entity proves all three prongs or fits a statutory exemption. Where an exemption applies, the Borello multi-factor test governs. Files are prioritized when contractors appear to perform the same core function as W-2 staff, when contracts and actual practice do not match, or when other clients and independent business indicia are missing.
Practical Ways to Lower Selection Risk Without Guessing the Algorithm
You cannot make yourself audit-proof, but you can make your file a poor target. The following steps reduce selection risk across California tax agencies and put you in a better posture if you are selected:
Match Third-Party Data to Returns Before You File
Reconcile W-2, 1099, and K-1 totals to what will appear on your California return. For sales tax, reconcile sales journals, merchant processor statements, and exemption documentation to reported taxable sales.
Document Positions That Tend to Trigger Questions
For residency and sourcing, keep travel calendars, domicile and work location proof, and customer location support. For sales tax exemptions, maintain executed resale certificates and contemporaneous exemption files. For contractors, retain business licenses, insurance certificates, invoices, and evidence of other clients.
Report Federal Changes on Time
If the IRS changes your federal taxable income, report the final change to FTB within the six-month window where it affects California tax. Timely reporting narrows the scope of any California follow-up and avoids keeping the changed items open indefinitely.
Avoid Avoidable Filing Defects
Non-filer and late-filer lists are common selection pools. File required returns, pay current estimates, and correct obvious math or identity errors before the state points them out.
Be Consistent Across Tax Agencies
Payroll, sales tax, and income tax filings that tell different stories about the same facts invite selection. Align your narratives and numbers so EDD, CDTFA, and FTB see the same picture.
Contact the Tax Law Offices of David W. Klasing if You Were Selected for a California State Tax Audit
Selection is only the first step. What happens next depends on how quickly you stabilize the file and how well your records support your positions. At the Tax Law Offices of David W. Klasing, every matter is attorney-led, and our CPAs are employees of the firm who work as part of the legal team. That structure lets you speak openly while we build the examiner-grade record each agency actually credits. From day one, we file your California power of attorney, take over communications with FTB, CDTFA, or EDD, and map the statute posture and deadlines for each year so the process stays on schedule and under control.
Our dual-licensed California Tax Attorneys and CPAs rebuild the schedules an auditor will prepare anyway, then tie them back to source documents: books and bank for income tax, cash register and merchant data for sales tax, and payroll and contractor matrices for worker status. For residency and sourcing, we prepare documented timelines and customer location analyses that comply with California law. For sales and use tax, we defend exemptions with complete certificate files and challenge sampling and projection methods that overstate liability. For worker classification, we test your facts against Labor Code sections 2775 to 2787 and, where an exemption applies, present a Borello analysis that reflects how work was actually performed.
If the audit advances to a proposed assessment, we prepare focused protests, pursue the appropriate settlement path when warranted, and litigate before the Office of Tax Appeals or the California Unemployment Insurance Appeals Board when necessary. Throughout, we quantify interest and penalties precisely, advise on targeted remittances that stop interest on amounts you place on account, and coordinate federal and state positions so one fix does not create a new problem elsewhere. If you received an initial contact letter, an information request, or a proposed assessment, call 800-681-1295 or book a confidential, reduced-rate consultation online with the Tax Law Offices of David W. Klasing. We will stabilize the file, protect your rights, and drive the case toward the best outcome the facts allow.
