California tax auditors start with a simple objective: Does the return fairly report taxable income under California law? The answer is developed through third-party data matching, targeted document requests, and issue-by-issue testing. For income tax, the Franchise Tax Board focuses on completeness of income, correct adjustments and credits, and proper residency and sourcing. For payroll tax, the Employment Development Department tests worker classification and wage reporting. For sales and use tax, the California Department of Tax and Fee Administration examines sales records, exemption documentation, and use tax on purchases. The themes are consistent across tax agencies: compare outside data to your return and books, reconcile any differences, and expand on areas where the facts do not line up.
How FTB Selects Returns and What the Initial Letter is Trying to Confirm
Most FTB exams begin with one of four triggers:
- Information matching to W-2, 1099, K-1, and broker reports;
- analytics that flag high-risk patterns, such as significant losses without support;
- referrals from the IRS or other California state tax agencies; and
- focused campaigns on residency, sourcing, or specific credits.
The first contact identifies the tax years, issues, and auditor, and often includes an Information Document Request with a response date. Typical initial asks include the filed return package, workpapers, bank and brokerage statements, merchant processor statements, general ledger extracts, and schedules that connect books to return entries. If the audit follows an IRS change, FTB will request the federal report and the tie-out to California entries. If residency or sourcing is the issue, expect a request for travel calendars, domicile indicators such as homes and family ties, and employer documents showing where services were performed.
Individuals: the Issues Most Often Tested and the Proof that Moves the Needle
Auditors Begin with Income Completeness
They match information returns to the return, then test bank deposits and transfers to see if gross receipts or other income were missed. Schedule C is a frequent focus. Expect requests for invoices, bank and merchant statements, mileage and home office logs, and proof that expenses were ordinary and necessary. For capital gains, FTB wants basis and holding period documents that connect the purchase, improvement, and sale to the reported gain. For rental real estate, they examine passive loss limits, depreciation records, and whether a short-term rental was truly a business or personal use.
Equity Compensation is a Standard California Adjustment
California sources stock compensation based on workdays performed in and out of California during the grant-to-vest or exercise period. Auditors request grant documents, vesting schedules, and proof of the work location to determine how much is owed to California. Charitable contributions must be fully substantiated. Cash gifts need bank records and contemporaneous acknowledgments that meet federal conformity rules. Noncash gifts need proper valuation documentation. For residency, FTB weighs the pattern of your life, including where you own or lease a home, where your spouse and children live, where you vote and hold licenses, where your business interests are managed, and how often you are physically present in California. Former residents claiming nonresidency should be ready to show that they established a home elsewhere and broke California ties, and that any safe harbor truly applies.
Note: If a residency issue arises, your electronic footprint cannot be faked and shows on a purchase-by-purchase basis your physical whereabouts. i.e. Where were you buying our tacos on taco Tuesday? Where were you buying gas? Paying utilities?
Businesses and Pass-Throughs: Where FTB Commonly Finds Adjustments
For corporations, partnerships, and S corporations, FTB tests gross receipts, cost of goods sold, and whether the books reconcile with the filed returns. Expect requests for trial balances, sales journals, purchase records, inventory roll forwards, and bank statements to test revenue recognition and COGS support. Related party transactions draw attention. Auditors request intercompany agreements and evidence that management fees or cost-sharing reflect real services and arm’s-length amounts. Owners of pass-throughs should expect questions about partner or shareholder basis, at-risk and passive loss limits, and whether losses that flowed to the individual were actually allowable under California law.
Apportionment and allocation are central for multi-state businesses. California uses market-based sourcing for most services and sales of intangibles and uses a single sales factor apportionment for most taxpayers. Auditors compare reported California sales with customer lists, contracts, and billing records to determine where the service benefit was received. Credits also receive scrutiny. The state examines documentation for the other state tax credit, research credits, motion picture credits, and carryovers to verify eligibility and computations. When a federal change is in effect, FTB confirms that corresponding state adjustments were made and that Schedule CA (for individuals) or Schedule R (for businesses), along with any applicable credit limitations, were recalculated correctly.
How Auditors Build Cases When Records are Thin and What Procedural Rules Matter
California tax auditors try to confirm your story with your records first. If books are incomplete or inconsistent with bank activity, they can use indirect methods such as bank deposits, net worth, or markup analyses. For cash-heavy businesses, they compare merchant processor statements to reported sales and test cash skimming by comparing purchases and inventory movements to recorded revenue. For investors, they request detailed broker activity to verify the basis and wash sale effects. In residency matters, they may request flight records, employer location records, leases and deeds, and other third-party proof of where you lived and worked.
Several procedural rules drive timelines and strategy. For most filed income tax returns, FTB generally has four years from the filing date to mail a Notice of Proposed Assessment. If your federal taxable income changes, you must report the final federal change to FTB within six months. Reporting on time starts a defined California assessment window on those items. If you report within six months, FTB generally has two years from your report to assess those changes. If you report after six months, FTB typically has four years from the date it was notified. If you never report, FTB may assess those federal change items at any time. There is no statute of limitations if you never file a required return or if a return is false or fraudulent with intent to evade tax.
If FTB proposes changes, it will issue a Notice of Proposed Assessment. You generally have sixty days from the notice date to file a written protest. Interest accrues from the original due date and compounds daily at the posted rate. To control carrying costs while you contest, you can remit all or part of the proposed amount. If you pay within fifteen days of the Notice of Proposed Assessment date, FTB stops interest on that paid amount as of the notice date. If you pay later, interest stops as of the payment date. If the protest does not resolve the case, FTB issues a Notice of Action, and you generally have thirty days to appeal to the Office of Tax Appeals.
Penalties, Interest, and Practical Steps that Keep Audits Civil and Contained
Common additions include failure-to-file and failure-to-pay penalties, as well as accuracy-related penalties for negligence or a substantial understatement. California offers a One-Time Penalty Abatement for eligible timeliness penalties if you have a clean, recent history and meet the criteria. Separate reasonable cause relief may be available where facts support it. You improve outcomes by delivering examiner-grade support. Rebuild the schedules an auditor will prepare anyway, reconcile bank, brokerage, and merchant data to reported income, and document deductions with the exact proof agencies expect. Align California entries with any federal changes to ensure your filings tell a consistent story. For residency and sourcing, assemble contemporaneous proof of travel and work locations before any interview. If you need more time, secure it before a deadline expires. Keep current compliance clean during an audit. New late filings or missed estimates undercut credibility and invite new issues.
Contact the Tax Law Offices of David W. Klasing if You Are Being Audited by the California FTB.
California FTB tax audits are optimally defended with a disciplined process, precise math, and examiner’s grade record keeping and documentation. At the Tax Law Offices of David W. Klasing, every matter is Tax Attorney-led, and our CPAs are firm employees working under attorney direction as part of the legal team. That structure keeps your communications protected while we do the hard work that reduces tax assessments by mapping statute posture and notice deadlines by year, filing your California power of attorney, taking over communications with FTB and rebuilding the schedules a reviewer will prepare anyway. We reconcile books, banks, brokerage, and merchant data to your filed returns, then tie those reconciliations to Schedule CA for individuals or Schedule R for businesses, so your file tells one coherent story that a California examiner will actually credit.
Substance and sourcing drive California adjustments, so we prepare the proofs that matter before the questions are asked. For residency and domicile, we build a documented timeline of travel, housing, family and business ties, and work location evidence. For equity compensation, we compute California sourcing using workday records for the relevant grant-to-vest or exercise period. For pass-through owners, we document basis, at-risk and passive limits, apportionment, and credit computations back to partnership or S corporation workpapers. Where a federal change is in the background, we correctly manage the six-month reporting rule, align state entries with the final federal report, and time any California amendment to preserve defenses while controlling interest. If a Notice of Proposed Assessment is issued, we file a focused protest that ties the controlling California authority to organized evidence. If the dispute continues, we prepare and file a timely appeal to the Office of Tax Appeals and present a clean, well-supported record ready for decision.
You also get a strategy that protects your wallet while you contest. We model interest daily, advise on targeted remittances that stop interest on amounts you place on account, and evaluate One Time Penalty Abatement or reasonable cause where facts support relief. When appropriate, we pursue the FTB Settlement Program or a closing agreement after a realistic analysis of litigation risks. If collections have started, we stabilize the file, address liens, levies, and garnishments, and secure a workable installment agreement. In limited situations where there is no realistic ability to pay, we evaluate a California Offer in Compromise. If you received an initial contact letter, an Information Document Request, a Notice of Proposed Assessment, or a Notice of Action, call 800-681-1295 or book a confidential, reduced-rate initial consultation online HERE 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 your facts allow.
