Here’s something we will be seeing more of in the near future: Do It Yourself tax return audits.

I was reading the January 2022 Tax News from the California Franchise Tax Board and saw this announcement of a new tactic they are starting to use.

“Select taxpayers who reported large Schedule C expenses will receive self-correct letters

Beginning the week of January 10, 2022, Franchise Tax Board (FTB) will begin an outreach effort by sending self-correct letters to selected taxpayers who reported large Schedule C expenses on their 2019 tax returns that are “significantly higher than expected.”

The purpose of the self-correct letters is to encourage these taxpayers to review their 2019 tax return, and current tax years, for any discrepancies. The letter informs the taxpayers to file an amended tax return to correct any discrepancies.

This self-correct letter does not constitute an audit. The tax returns remain subject to audit until the expiration of the statute of limitations. The taxpayer should maintain documentation to substantiate their deductions are in line with their business activity.

We will start the outreach effort by sending a small volume of self-correct letters in January, and increase the volume over the next several months. Our goal is to expand future outreach efforts to include other issues and tax years.”

What this sounds like is that there will be a cursory review by FTB of tax returns with large Schedule C expenses, with letters going out to those taxpayers threatening full blown audits if they don’t “voluntarily” file amended returns to reduce those expenses. Obviously the threat will be implied, but it will be real.

While this may be starting in California, that State and its FTB have a long running reputation as a test-bed for tax administration and enforcement tactics by other States, as well as by the IRS. We can be sure that the head honchos at IRS and other State tax agencies will be monitoring the results of this FTB experiment very closely. With the current huge shortage of IRS auditors, this approach has to be very tempting as a means to cover many more tax returns than is possible with their limited resources.

In its latest Tax News newsletter, the California Franchise Tax Board stated the following.

We noticed a large number of taxpayers who claim unreimbursed employee business expenses (EBE) on Schedule A that appear questionable.

In August, we will increase the number of audits for taxpayers deducting EBE on personal income tax returns, starting with the 2011 and 2012 tax years.

There appears to be a bit of scare strategy at work here.  Normally, FTB doesn’t do many actual audits of items on income tax returns.  Instead, as with most other States, they just let IRS do the bulk of the examination work and then use the IRS results to make changes to the State tax returns.   They are explicitly encouraging people who don’t think they will survive an examination to file amended tax returns and do their job for them.

Your clients can file amended tax return(s) if their business expenses do not qualify.

Notice that they mention going back to 2011, highlighting the fact that the Statute of Limitations for California income tax returns has long been Four (4) years, compared to the long-standing Three (3) years with IRS.

Also, notice that the focus of this concern is just deductions on Schedule A of individual income tax returns.  It doesn’t mention any problems with expenses claimed on business forms (i.e. Schedule C) or corporate tax returns (hint hint).