State Agency Rivals IRS in Toughness
California has a state income tax machine that puts a collar on cheats and keeps state coffers full, but a growing number of individual taxpayers, corporations and tax attorneys complain that the agency’s efficiency too often is tainted by arrogance and a stubborn unwillingness to compromise.
With 6,500 employees and tax collections that top $34 billion, the Franchise Tax Board is second in size and scope only to the Internal Revenue Service--and by all accounts the state agency is the more efficient, more aggressive and more relentless of the two.
But while the IRS came under fire two years ago for alleged abuses of power, an inquiry that prompted new controls and oversight, the Franchise Tax Board has received far less scrutiny. Among recent developments that are raising questions about the agency:
* For two years in a row, corporate tax executives have ranked California’s among the toughest, least fair and least predictable state tax agencies in the country.
* The agency’s refusal to compromise led recently to a rare but important loss in the courts when it was ordered to refund at least $250,000 to a Newport Beach couple after the state Court of Appeal ruled the agency had made up a tax bill “out of thin air.”
* The state auditor has questioned the cost-effectiveness of the agency’s aggressive audit squad.
* Until recently, the Franchise Tax Board rejected 96% of settlement offers by tax-strapped taxpayers as well as most pleas for installment agreements so tax bills could be paid off over time.
Tarzana accountant Michael Rozbruch makes his living battling tax agencies for clients: protesting assessments, arranging payment plans, negotiating for penalty waivers. But when it comes to the Franchise Tax Board, he concedes defeat before he even starts.
“You can always negotiate with the IRS,” said Rozbruch, a certified public accountant and principal of Tax Resolution Services Co. “I tell my clients to beg, borrow and steal if they owe the state.”
The Franchise Tax Board and its defenders say the agency has become more service oriented and taxpayer friendly in the past year, though some conflict is inevitable given California’s size, huge economy and complex tax laws.
“Our typical audit is a corporate audit or a very wealthy taxpayer with very sophisticated professional representation,” said Gerald H. Goldberg, who has been the agency’s top executive since 1980. “Aggressive taxpayers are forever going to be challenging the limits.”
Even some top state tax officials, however, say the agency occasionally lets its vigilance go too far. State Treasurer Kathleen Connell, who serves as chairwoman of the Franchise Tax Board, and Board of Equalization member Dean Andal have raised such concerns.
“The FTB probably has the most competent staff of any state tax agency, but they’re brutal,” said Andal, who also served as one of three board members of the agency last year. “They tend to look at every audit as a battle. In the gray areas, they push the envelope rather than work out a reasonable compromise.”
State Is Ranked Most Aggressive
Many corporate taxpayers agree. In both 1997 and 1998, company tax executives ranked California at the top of a “worst offenders” list compiled by CFO magazine to rate the tax agencies of the 50 states. The magazine polled 300 of the nation’s 1,000 largest companies, and 91 tax managers responded.
These corporate financial officers ranked California as the most aggressive of the states during audits. The state was described as among the least predictable in administering tax policy and among the most likely to take a black-and-white stance on unclear areas of tax law.
By contrast, the Franchise Tax Board has a lower profile with individual taxpayers, who are far less likely to have contact with the state tax agency than with the IRS. About one in five taxpayers gets some kind of routine contact--typically an automatic penalty or request for more information--from the IRS each year. About five in 1,000 people are audited.
The Franchise Tax Board contacts fewer than one in 20 state residents for administrative matters, and its audit rate is about half that of the IRS. In addition, most state agency audits of individuals are merely follow-ups on IRS audits. IRS leads account for the preponderance of the agency’sindividual taxpayer audits.
Nonetheless, some taxpayers and business leaders say that when the Franchise Tax Board does strike, it is hard and sometimes arbitrary.
The agency admitted it didn’t have enough information when it made up a tax bill for John and Barbara Wertin, a Newport Beach couple whose 1983 return was audited by the IRS.
The Franchise Tax Board had destroyed the Wertins’ return, but rather than waiting for them to dig up their copy, the state agency levied taxes and interest using erroneous electronic information. The Wertins argued successfully that the agency had to base assessments on an actual return.
The Franchise Tax Board “loitered,” “dawdled” and then “panicked” as the statute of limitations on the case began to run out, Court of Appeals judges said in a case brought by the couple. “Instead of seeking an extension of the statutory period from the Wertins, who were under a duty to produce their returns, the Franchise Tax Board ignored statutory directives and computed their tax deficiency out of thin air,” the judges wrote.
The Wertins’ attorney, M. Edward Mishow, said they offered to settle before going to trial. Now, the Wertins are expected to get more than $600,000 from the state. The Franchise Tax Board appealed but the state Supreme Court refused to hear the case.
The agency “didn’t get a dime,” Mishow said. “I said, ‘If you guys lose, it’s going to make an untenable precedent. . . .’ You have to wonder why they didn’t have a better assessment of the risks.”
Johan Klehs, chairman of the State Board of Equalization and a Franchise Tax Board member, said the case was a rare loss for the state, which he said wins 90% of the cases that go to trial.
But critics say such cases add to suspicion that the agency is trying to wring out the maximum amount of tax regardless of circumstances.
The chief financial officer for a large Silicon Valley company, a former Franchise Tax Board auditor, said the state’s auditors increasingly focus on big assessments, bypassing areas in which a company might be owed a refund.
“We overpay a lot and we underpay a lot; that’s what happens when you’re filing in so many different states,” the executive said. “We really want them to do a fair, complete audit and not ignore the areas where we might get a refund.”
The president of California Taxpayers Assn., which represents more than 600 companies that do business in the state, said such fears about the Franchise Tax Board are common.
“They won’t talk for fear of retribution . . . [but] we hear a lot of complaints from members that they think decisions are made by auditors based on a revenue result,” Larry McCarthy said.
Other corporate executives, however, suggest that complainers merely resent getting caught after taking too many tax shortcuts.
“I think that’s probably sour grapes,” said Larry W. Berlant, head of Ernst & Young’s state and local tax division in Los Angeles.
Franchise Tax Board member Klehs agreed.
“The head of a corporation’s finance division has one job: to make sure the corporation pays as little as possible,” Klehs said. “The tax agency’s job is to collect the correct amount of tax, and therein lies the rub. It’s a healthy although stress-filled relationship that has gone on since the beginning of time.”
State Official Defends Agency
Meanwhile, Lynette Iwafuchi, head of the Franchise Tax Board’s auditors and a 24-year employee, said the mandate for audits hasn’t changed and that, unlike the IRS, the agency has never rewarded auditors based on their assessments against taxpayers.
Iwafuchi said the agency has largely switched from general audits to more focused versions in an effort to be less intrusive, not to raise revenue.
But she acknowledges that auditors do get more pleasure from big assessments than small ones.
“I can tell you to this day how many audits I did and what they were about and the great issues I uncovered,” Iwafuchi said. “That’s where I got my satisfaction.”
The power of Franchise Tax Board auditors has unnerved some taxpayers who have been targets of audits initiated by the state.
Gerald M. Steiner, whose home was damaged in the 1993 Anaheim Hills landslide, said he has spent $20,000 so far in attorney and accountant fees to defend a casualty loss deduction worth about $70,000 to the state. The IRS, meanwhile, accepted the $727,000 deduction on his federal return, according to Steiner and his accountant, Gary Capata.
“I feel like I’ve been raked over the coals,” Steiner said. “I’ve never experienced anything like it in my life. They’re relentless.”
The auditor in the case rejected the contention that Steiner’s home had sustained significant damage, even though the Small Business Administration estimated repairs would cost $98,000 and an engineer hired by Steiner said that restoring stability to his land would cost millions. More than 40 families, including Steiner’s, were evacuated from the neighborhood of million-dollar homes in January 1993.
Steiner said he has been willing to compromise, but so far the agency has rejected his efforts.
The cost-effectiveness of the agency’s approach to audits recently came under scrutiny after state Auditor Kurt R. Sjoberg questioned whether a burgeoning audit staff had resulted in greater revenues to the state.
The agency added 362 auditors between 1992 and 1996, promising the Legislature that the new positions would boost collections. Although audit revenues rose by $558 million during that time, the additional auditors weren’t responsible, Sjoberg said. (Sjoberg’s complete report is available on the Bureau of State Audits’ Web site at https://www.bsa.ca.gov/bsa/.)
Instead, the increased revenues came from cases that the agency would have pursued anyway--follow-ups on IRS audits and cases with potential for large assessments, Sjoberg said. When Sjoberg looked at more marginal cases where he expected the new auditors would be assigned, he found that collections in those categories actually dropped by $128.6 million between 1992 and 1996.
The Franchise Tax Board vigorously protested the audit’s conclusions, disputing the way that Sjoberg made his calculations.
But now the situation is evolving in other ways. Changes at the IRS mean the Franchise Tax Board is starting to lose some of its best audit leads.
The agency’s most profitable audits come from following up on cases in which the IRS has assessed extra taxes. Such audits generally result in $30 to $50 of state tax for every dollar spent in auditing. Audits from IRS leads account for 71% of the additional personal income taxes assessed each year, Sjoberg found. Initiating its own audits generally returns $4 to $12 in assessments for each dollar the agency spends. But the number of IRS leads has dropped 40% since March 1998.
The Franchise Tax Board estimates that each 10% drop in leads costs the state $41 million.
Critics worry that the dearth of “easy money” may lead to even more aggressive audits.
Sacramento tax attorney Eric J. Miethke believes there is little to stop the agency from becoming more aggressive. Most members of the Legislature turn a blind eye to its excesses rather than risk losing revenue, he said.
“It’s like ‘Heart of Darkness.’ As long as the ivory keeps coming in, we don’t care what you’re doing up at the headwaters,” Miethke said.
Klehs, a former state legislator who was elected to the State Board of Equalization in 1994, said that criticism is unfair.
“Every tax official is elected, from the members of the board . . . to the county tax collectors,” he said.
Times staff writer Liz Pulliam can be reached at liz.pulliam@latimes.com.
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
State Audits Declining
Tax assessments from Franchise Tax Board audits of both individual and corporate returns have declined in recent years. Additional assessments from state audits of individual tax returns peaked in 1995-96, while corporate audit assessments peaked the next year. In millions of dollars:
