By Mayer Nazarian and Geoffrey A. Weg

As discussed in our previous post, the California Franchise Tax Board recently announced the most common tax audit issues affecting Individuals, Pass-Through Entities and Corporations.  Last week we highlighted personal income taxpayers.

This week, we will review the top issues for Pass-Through Entity Taxpayers.

1. Disposition of Real Estate - IRC Section 1031 and 1033 issues: specifically with respect to deferred gain, incorrect treatment of cancellation of debt (COD) income within short sales or deeds in lieu, and failure to report California-source income by nonresident taxpayers . 

2. Final Year of Limited Liability Companies (LLC) or Partnerships - In the final year of an LLC or Partnerships, verification of proper gains or losses, reconciliation of negative capital accounts, distributions of installment notes, and COD income.

3. Apportioning Trust Income - When trust income is from sources within and without California, the apportionment of income to California and the residency status of the trustee must be appropriate. (A trust will be subject to taxation in California if the fiduciary or a noncontingent beneficiary is a resident of California.)

4. Other State Tax Credits - Verification of taxes paid to the other states is another audit priority.

5. Shareholders Basis - Review of shareholder's basis to determine correct flow through income, losses, deductions, credits, as well as taxability of distributions, debt repayments, and dispositions.

6. Built-in Gains - The recognition period and the basis of the disposed asset must be properly reported.  (If an S corporation that was formerly a C corporation sells an appreciated asset (such as real estate) and the appreciation occurred during the time the corporation was a C corporation, the S corporation will probably pay C corporation taxes on the appreciation--even though the corporation is now an S corporation. This Built In Gain (BIG) tax rate is 35% on the appreciated property, but is only realized if the BIG asset is sold within 5 years (starting from the first day of the first tax year of conversion to S-Corp status.))

Please contact our Tax and Wealth Planning attorneys for consultation or assistance in the identification, clarification or resolution of these issues.