United States: Limitations Period — California State Personal Income Tax Deficiency Not Revived by Belated Federal Tax Adjustments

The Court of Appeal of the State of California recently concluded that a taxpayer’s state personal income tax deficiency may not be revived by belated federal tax adjustments. See Ordlock v. Franchise Tax Bd., No. B169465 (2nd App. Dist. July 28, 2004).¹

In May 1984, the taxpayers, as husband and wife, filed joint federal and state tax returns for the 1983 tax year. The California Franchise Tax Board ("FTB") never audited the taxpayers’ 1983 state tax return or took any action to extend the four-year limitations period. In 1994 and 1996, the IRS issued reports of income tax examination changes for the 1983 tax year. The taxpayers did not report those changes to FTB. In May 1998, FTB issued against the taxpayers a notice of proposed assessment for the 1983 tax year.

The issue presented to the Court of Appeal was, under relevant California statutes, whether state personal income tax deficiency could be revived by belated federal tax adjustments.

Generally, FTB must issue a notice of proposed deficiency assessment within four years after a return is filed. Cal. Rev. & Tax. Code § 19057. If any item on the return is subsequently changed by the IRS, the taxpayer must report such changes to FTB within six months. Cal. Rev. & Tax. Code § 18622. "If the taxpayer is required by ... Section 18622 to report a change ... and does report the change," the statute of limitations will be extended for at least two more years from the date when the notice is filed. Cal. Rev. & Tax. Code § 19059. "If a taxpayer fails to report [the] change ... as required by Section 18622," a notice of proposed deficiency assessment resulting from the federal adjustment may be mailed to the taxpayer "at any time." Cal. Rev. & Tax. Code § 19060. As an exception to this report requirement, the last sentence of Section 18622, subdivision (a), provides that "[f]or any individual subject to [the personal income tax,] changes or corrections need not be reported unless they increase the amount of tax payable ...." Cal. Rev. & Tax. Code § 18622.

FTB and the taxpayers disagreed on the application of these statutes. FTB argued that, since the taxpayers failed to report the changes in their 1983 return to FTB, Section 19060 afforded FTB an "unlimited period within which the FTB can issue a notice of proposed assessment." The taxpayers took the position that they were not required to report the federal adjustment to FTB under Section 18622 because they believed that there was no additional state income tax payable in 1994 and 1996, as the four-year period for assessing additional income taxes had expired in 1988.

The court ruled for the taxpayers. The court held that, based on the last sentence of section 18622, subdivision (a), the taxpayers "need not have performed an idle act, namely, reporting to FTB the change or correction by the federal government when the statute of limitations barred FTB from assessing any tax deficiency." "Because section 19060 incorporates Section 18622," the court found that "the last sentence of section 18622, subdivision (a), is applicable." Furthermore, the court held that "[t]hat sentence permits the taxpayer to apply the four-year statute of limitations in determining whether the federal changes increase the amount of tax payable." FTB’s argument was flawed because "FTB fails to afford any import or meaning to [that sentence.]"

In general, a change in the federal or state return should put a taxpayer on notice to adjust the other return. If the federal change results in a higher state tax, the taxpayer should immediately file an amended state return to avoid paying needless interest and possible penalties. If the federal change lowers taxable state net income, the taxpayer should claim a refund promptly.

This opinion has created a taxpayer-friendly exception to this general rule of prompt reaction to federal adjustments, at least for some taxpayers in California. If a California taxpayer receives from the IRS a report that increases her income tax for a previous tax year, she needs to check the statute of limitations before taking any further actions. If the statute of limitations has run (in other words, more than four years have passed since she filed a return for that tax year), she need not report the federal changes to FTB, and FTB is barred from issuing a deficiency assessment for that year.

However, it is unclear whether this exception applies to business taxpayers. Sections 18622, 19057, and 19060 are applicable to both personal income tax and corporate income tax, "unless otherwise provided." See Cal. Rev. & Tax. Code § 18401. The court did hold that "there is no language in section 18622, subdivision (a)or section 19060, subdivision (a) expressing the Legislative’s intent to revive a time-barred tax deficiency assessment." But the last sentence of Section 18622, subdivision (a), specifically provides that "[f]or any individual subject to tax under Part 10 ..., changes or corrections need not be reported unless they increase the amount of tax payable under Part 10 ...." Cal. Rev. & Tax. Code § 18622. "Part 10" governs only personal income tax, while corporate income tax is governed by Part 11. See generally Cal. Rev. & Tax. Code, Division 2, Other Taxes.

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