If you run an out-of-state business and find yourself facing a California tax audit, it’s critical to understand your rights, the scope of California’s authority, and how to respond effectively. California state’s tax agencies – the Franchise Tax Board (FTB) for income taxes, the California Department of Tax and Fee Administration (CDTFA) for sales and use taxes, and the Employment Development Department (EDD) for employment/payroll taxes – aggressively enforce California’s tax laws even against businesses with no physical presence in the state.
California Income Tax Audits (FTB) for Out-of-State Businesses
When California Can Tax You
Under Rev. & Tax. Code § 23101, you’re “doing business” if you exceed the annually-indexed economic-nexus thresholds (≈ $735k CA sales or 25 % of total, any CA payroll/property, commercial domicile, or active solicitation). Market-based sourcing means revenue from services or intangibles is California-source when the customer’s benefit is here. P.L. 86-272 protects only pure solicitation of tangible goods.
How FTB Audits Start & What They Want
Triggers include unfiled CA returns, IRS data matches, or sales/payroll above thresholds. The FTB can audit four years after a return is filed—or indefinitely if none was filed—and subpoena records. Expect requests for federal returns, financial statements, California sales lists, payroll records, and apportionment work papers.
Exposure
Back tax for every open year + interest + penalties: 25 % “demand-to-file,” 5 % + 0.5 %/month late penalties, 75 % civil fraud, and potential felony prosecution for willful tax evasion. FTB often issue an estimated return that more often than not overstates tax unless you prove otherwise.
Defense Playbook
Verify nexus with a formal analysis; challenge market-based sourcing where benefit occurred outside CA; supply only requested documents, in writing, through counsel; negotiate issue-by-issue; and seek penalty abatement for reasonable cause. Experienced, dual-licensed Tax Attorneys and CPAs are vital for integrating legal and accounting arguments.
Appeal Paths
Protest a Notice of Proposed Assessment within 60 days; escalate to the Office of Tax Appeals if needed; consider FTB settlement bureau or pay-and-sue refund action as a last resort.
Multi-Agency Domino Risk
FTB shares findings with IRS, CDTFA, and EDD—so an income-tax audit can spawn sales-tax or payroll-tax audits. Coordinate defenses across agencies from day one.
California Sales- & Use-Tax Audits of Remote Sellers – Core Principles
Nexus Rules
Under Rev. & Tax. Code § 6203 (AB 147), a remote seller must register and collect tax once California sales exceed $ 500k in the current or prior year—no transaction count test. Even businesses without a physical presence in California may still be required to collect sales tax if their economic activity meets the 500K threshold.
Any physical presence (inventory in an Amazon warehouse, in-state salesperson, trade-show booth, drop-ship agent) also creates a nexus. The threshold applies to district taxes, so you must collect local rates for each delivery address.
Audit Mechanics
The CDTFA opens audits when marketplace data, credit card information, freight records, or IRS/FTB matches indicate unregistered California sales. Auditors compare gross receipts to reported taxable sales examine invoices, shipping docs, resale certificates, bank statements, and federal returns. Incomplete books allow the CDTFA to estimate tax using sampling, mark-ups, or industry ratios—often resulting in the worst-case scenario for the seller. The look-back period is 3 years if returns were filed within the last 8 years or more or if none were filed (unless a Voluntary Disclosure caps it at 3 years).
Exposure & Penalties
Uncollected tax plus interest, 10 % late-file/payment penalty, 25 % civil fraud penalty for intentional evasion, and 40 % “collected-but-not-remitted” penalty if you charged sales tax but kept it. Responsible officers can be held personally liable, and willful sales tax evasion can trigger misdemeanor or felony prosecution.
Defense & Mitigation
Verify nexus period; argue below-threshold years or non-CA deliveries; document exempt/resale sales; challenge sampling or mark-up methods; seek Voluntary Disclosure if contacted late; and request penalty abatement for reasonable cause. Engage an experienced California Tax Attorney-CPA to control records who can negotiate look-back and, if needed, appeal a Notice of Determination within 30 days to CDTFA/OTA.
Penalties and Exposure (CDTFA)
California’s sales tax penalties can be severe and cumulative. Key penalties include:
Late Filing / Late Payment Penalty
10% of the tax due for failing to file a return or pay on time. This applies as soon as a return or payment is late. If you never filed returns for years, each period could get a 10% penalty.
Late Prepayment Penalty
6% for quarterly taxpayers who miss a required prepayment (for larger sellers, if applicable).
Electronic Payment (EFT) Penalty
10% if you were required to pay electronically (due to size) but didn’t.
Civil Fraud or Intent to Evade Penalty
25% if the CDTFA finds any part of the deficiency was due to intentional fraud or evasion. This is a big one – it not only quadruples the base penalty, but if CDTFA has evidence to assert fraud, they likely have enough evidence to refer a criminal case for prosecution. Fraud penalties typically come into play if you knew of your obligation and took steps to conceal sales (for instance, keeping two sets of books or willfully ignoring nexus).
“Collected But Not Remitted” Penalty
40% if you actually collected sales tax from customers and failed to remit it. This penalty punishes the breach of fiduciary duty (since sales tax is considered trust funds you hold for the state. Out-of-state businesses sometimes charge California customers “sales tax,” thinking it covers use tax, but if you didn’t register and send it in, you’re in this category.
Personal Liability for Officers/Owners
Importantly, if your business is a corporation or LLC that doesn’t pay its sales tax, California law allows the state to hold responsible persons (e.g., officers, directors, owners with control) personally liable for the unpaid taxes (under certain conditions). The CDTFA can issue a dual determination against individuals, meaning your personal assets are on the hook for the company’s tax debt. This typically occurs when a company has collected tax but not paid it or when the business dissolves with unpaid taxes.
California Employment Tax Audits (EDD) for Out-of-State Businesses
When EDD Has Jurisdiction
One California worker (employee or contractor) is enough. AB 5’s ABC test presumes employee status unless you prove (A) freedom from control, (B) work outside your usual business, and (C) an independently established trade. Remote staff, installers, sales reps, or gig workers in CA all create a payroll-tax nexus. Misclassification complaints, UI claims, 1099 data, or referrals from CDTFA/FTB routinely trigger audits.
Audit Mechanics
EDD reviews the last 3 years (up to 8+ for non-filers/fraud). Focus: were all CA wages reported on DE-9/DE-9C? Records demanded include payroll registers, W-2/1099 lists, general ledger “contractor” accounts, Form 941s, and contractor agreements. Auditors interview owners and sometimes workers about control and integration. Poor records let EDD reclassify by assumption.
Financial Exposure
Back UI, SDI, ETT, and PIT-withholding, plus
- 15 % late-deposit penalty on withholdings
- 10 % late-return penalty per quarter
- 25–50 % fraud/misclassification penalty for willful cases
- CUIC § 1735 personal liability for responsible officers
- Interest accruing quarterly. Civil audits can expose criminals who use cash payrolls or falsified records.
Defense Strategy:
The moment an EDD audit notice lands—whether a phone call, “Inquiry Regarding Records,” or Pre-Audit Questionnaire—treat it as a high-stakes event: first inventory every person who has performed work in California, onsite or remotely, and determine whether each truly satisfies the ABC test or a statutory exemption; if any clearly belong on payroll, engage a dual-licensed Tax Attorney-CPA immediately to craft a corrective strategy (which may include a §1088(c) voluntary settlement that swaps prospective compliance for reduced back-penalties). Complete all EDD questionnaires with counsel, answering honestly yet precisely to avoid inadvertently conceding employee status, and assemble solid documentation—independent-contractor agreements, proof of multiple clients, business licenses, invoices, and tools of the trade—that support contractor positions. Where workers do fail the ABC test, focus on mitigating exposure by demonstrating good-faith misunderstanding (especially amid AB 5’s evolving rules) and negotiating to confine the audit’s scope; never let the auditor assume every 1099 is misclassified without challenge. In short, proactive classification review, strategic disclosures, and seasoned legal representation are indispensable to keep an EDD examination from ballooning into crippling assessments.
Appeal Rights
A Notice of Assessment may be protested by filing a petition with CUIAB within 30 days. ALJ hearings allow evidence, cross-examination, and legal arguments; further appeal to the Board or courts is available. Skilled Tax Attorney-CPAs present both tax and employment-law defenses and pursue penalty abatement.
Ripple Effects
EDD shares reclassification data with FTB, CDTFA, IRS, Workers’ Comp, and Labor Commissioner—expect inquiries on income tax, sales tax, or labor violations. Coordinated, multi-agency defense is essential.
The Risk of Multi-Agency Consequences and Enforcement
As highlighted above, a California audit in one area often doesn’t stay confined. All three major tax agencies (FTB, CDTFA, EDD) communicate with each other and with federal authorities. California’s systems are designed to sniff out inconsistencies – for instance, the FTB compares income tax returns to sales tax filings and payroll reports. If any puzzle piece is missing, they will inquire. The phrase “one audit begets another” is very true in the state of California. For out-of-state businesses, this means approaching any audit with a holistic view of your overall compliance to avoid triggering new problems.
If you resolve a sales tax audit via a settlement or payment, be aware the FTB might get the data on your California sales and bill you for income/franchise tax on the profits from those sales (plus penalties for not filing). If you undergo an employment tax audit and end up registering for payroll, the FTB may ask why you had employees in California. Still, perhaps no corporate tax return was filed in those years – again raising nexus issues. Additionally, California occasionally conducts joint audits or criminal tax investigations, especially in egregious fraud cases (for example, a business not reporting cash sales and also not reporting income or paying workers under the table could get a task force of CDTFA, FTB, EDD, and even the Attorney General’s office looking at it from all angles).
Civil vs. Criminal
While the majority of audits are civil (resulting in bills for taxes, interest, and penalties), there is always a real-world risk of criminal tax enforcement if the agencies suspect tax evasion or fraud. California doesn’t hesitate to pursue criminal tax charges for tax cheats. We’ve mentioned some: FTB can refer felony tax evasion cases (with charges like filing a false return under RTC §19705) for prosecution, where one could face up to 3 years in prison per offense and hefty fines. The CDTFA collaborates with district attorneys to prosecute serious sales tax evasion, including instances where owners collect sales tax but fail to remit it, which may result in charges of grand theft. Even EDD has worked with prosecutors in cases of employers operating in the underground economy (paying workers off the books, workers getting injured with no insurance, etc., can lead to criminal charges for payroll tax evasion and workers’ comp fraud). If your business’s noncompliance appears willful and involves large sums, you must treat the audit as a high-stakes situation. Often, the first people to spot potential fraud are the civil auditors – they will then quietly involve criminal tax investigative units. Warning signs include auditors asking very detailed questions about records that don’t tie out or paying personal expenses from business accounts (which could indicate unreported income). If we sense a case might turn criminal, we immediately adjust strategy: for example, invoking your rights, being careful about providing information, and possibly negotiating a resolution before it escalates.
In summary, the worst-case scenario for an out-of-state business would be a cascade of audits: CDTFA finds unreported sales tax, which leads FTB to find unpaid income tax, which leads EDD to find unpaid payroll taxes – all of which piles up taxes, 25-50% cumulative penalties, and interest, plus the looming threat of criminal action. This nightmare can be avoided by staying ahead of nexus issues and proactively addressing any compliance gaps. If it’s too late for that, then tackling the audits with experienced representation is the next best course.
How The Tax Law Offices of David W. Klasing Will Help An Out-of-State Business at Every Stage
Facing a California tax audit from hundreds or thousands of miles away can be overwhelming. This is where the Tax Law Offices of David W. Klasing truly make a difference. Our firm is uniquely staffed with dual-licensed Tax Attorneys and CPAs who have decades of experience handling FTB, CDTFA, and EDD audits for out-of-state clients. Our blend of legal, tax and accounting skills enables us to devise comprehensive solutions that pure law firms or accounting firms might overlook. Here’s how we help at every stage:
Nexus Analysis & Compliance Review
Before an audit even begins (or at the first hint of one), we analyze your business activities against California state’s nexus standards. We’ll advise on whether California state actually has jurisdiction and explore exemptions, such as P.L. 86-272 or AB5 exceptions. If you haven’t been compliant, we’ll discuss options like voluntary disclosures or remedial filings to minimize exposure. Our goal is to either prevent an audit or make sure you’re prepared for one with no surprises.
Audit Response & Representation
Once an audit starts, we take over communications with the auditors so you don’t inadvertently say something harmful. We handle all correspondence, document submissions, and meetings. With former auditors on our team, we are familiar with the tactics they employ and the procedures they must follow. We’ll ensure the audit focuses on relevant issues and doesn’t stray out of control. If an in-person meeting or site visit is required, your Tax Attorney-CPA from our firm will be by your side (or even attend on your behalf), whether in California state or liaising remotely. We ensure your rights are protected under the Taxpayers’ Bill of Rights and that the agencies don’t overreach.
Documentation & Record Reconstruction
Good documentation can make a difference in an audit’s outcome. We help you gather, organize, and, if necessary, reconstruct records to satisfy the auditors’ requests. For example, if you’re missing resale certificates or expense receipts, we can assist in obtaining secondary evidence or affidavits to substantiate your positions. We also carefully review all documents before they are sent out to redact irrelevant information and avoid disclosing data that could raise new questions.
Legal Argumentation & Technical Tax Analysis
Our dual expertise shines when it comes to crafting legal arguments grounded in tax law and regulations. Whether it’s demonstrating that a service’s benefit was received out of state (market-based sourcing rules), that a worker meets the ABC test’s exceptions, or that an estimate by CDTFA is unreasonable under the law – we articulate these points in writing and discussions with the agency. We cite statutes (e.g., California Revenue & Taxation Code provisions), regulatory guidelines, and even prior case precedents to advocate for your position. Auditors and their supervisors are more cautious when a skilled attorney is involved, often leading them to be more measured in their assessments.
Mitigating Penalties & Exposure
A crucial part of our representation is negotiating to reduce civil and criminal tax penalties. We present evidence of reasonable cause, good faith, or circumstances beyond your control to get penalties abated whenever possible. If there is exposure to multiple years or multiple agencies, we strategize a global approach – for instance, using a sales tax settlement to bar specific further claims or timing agreements that limit the scope of additional audits. We aim to limit your financial exposure and prevent a domino effect of liabilities.
Appeals and Protest Representation
f you disagree with an audit result, our firm seamlessly transitions to the appeals stage. We prepare protest letters to FTB, petitions to CDTFA, or appeals to CUIAB/OTA, as needed. Vigorous appeals can often result in a reduction or elimination of the proposed assessment, especially when we bring forth new evidence or legal interpretations that were overlooked. We handle all aspects of the appeals, including representing you in hearings or oral arguments.
Settlement Negotiation
At any stage – audit, appeal, or even litigation – we are open to and skilled in negotiating settlements. California state’s tax agencies have settlement bureaus (FTB and CDTFA) or the ability to compromise liabilities. We leverage this by highlighting the hazards of litigation for the government’s side, using our detailed knowledge of your case. Settlements can sometimes save you a significant percentage of the tax or allow payments over time with reduced or no penalties. We also explore voluntary disclosure agreements when appropriate (for example, if you come to us before the state does, we might proactively disclose and negotiate to avoid harsh penalties or criminal referrals).
Litigation (Tax Trials and Court)
If needed, we won’t hesitate to take your case to court. As licensed California Tax Attorneys, we can file suit in California Superior Court or defend you in any judicial proceeding. Our team’s CPA background also enables us to handle the complex calculations and expert testimony that may arise in tax litigation. Having one firm handle the matter from audit through court ensures consistency and deep familiarity with the facts – something a business would lack if it had to switch from an accountant to an outside litigator. We provide aggressive courtroom advocacy while constantly weighing whether a settlement is more advantageous.
Throughout every step, our dual-licensed team provides an integrated approach. You don’t have to juggle a CPA for numbers and a lawyer for legal – we simultaneously wear both hats, giving you cohesive and comprehensive representation. For example, if an auditor questions your accounting method, we, as CPAs, can address it on the spot; if they ask for a legal interpretation, we, as attorneys, can argue the law – all in one meeting. This efficiency can shorten the audit and control its scope.
Most importantly, we bring an “insider perspective” – our firm’s experience includes former government auditors, so we understand how the agencies think and operate. We use this to strategize proactively, preparing counterarguments for the likely challenges the state will raise. Our focus is not just on reacting to what the auditors do but on anticipating their next move and guiding the process toward a favorable resolution.
Experience with Out-of-State Clients
Over the years, our firm has represented numerous out-of-state businesses – ranging from small family-owned companies to large multi-state corporations – in California audits and disputes. We understand the concerns of a nonresident business owner: the shock of receiving a California notice, the complexity of dealing with unfamiliar laws from afar, and the fear of steep penalties or even criminal repercussions in a distant state. We take pride in being your boots on the ground in California. Clients often remark that having a single firm handle both the tax calculations and the legal defense was a game-changer for them. It not only provides convenience but also better outcomes because nothing gets lost in translation between separate advisors.
At the Tax Law Offices of David W. Klasing, we stand ready to assist at every turn – whether it’s conducting a nexus study to keep you off California’s radar, navigating an ongoing FTB/CDTFA/EDD audit, or fighting an unjust assessment in court. Call (800) 681-1295 or schedule a reduced-rate, attorney-client-privileged initial consultation today.
