Analysis of the 2004-05 Budget Bill Legislative Analyst's Office February 2004

Franchise Tax Board (1730)

The Franchise Tax Board (FTB) is one of the state's two major tax collection agencies. The FTB's primary responsibility is to administer California's personal income tax (PIT) and corporation tax (CT) laws. The FTB also administers the Homeowners' and Renters' Assistance Program, the Political Reform Act audit program, and the Household and Dependent Care Expense Credit. In addition, the FTB administers several non-tax-related programs, including the collection of child-support payments and other court-ordered payments. The FTB is governed by a three-member board, consisting of the Director of Finance, the Chair of the Board of Equalization, and the State Controller. An executive officer, appointed by the board, administers the daily operations and functions of the FTB.

The Governor's budget proposes $560 million ($442 million General Fund) and 5,890 positions in support of FTB operations. Compared to the current-year budget, the level of support represents an increase of $28 million (5.3 percent) and a General Fund increase of $9 million (2.1 percent).

The change in funding is due almost entirely to an increase in support for the California Child Support Automation System (CCSAS). This program is funded largely through reimbursements from other departments but also receives General Fund support. The increase in child-support automation activities is partially offset by decreased support for other FTB activities, including reductions for its core tax administration efforts. Elsewhere in the Analysis we discuss shifting responsibility for CCSAS and related child support collection activities to the Department of Child Support Services (see "Health and Social Services" chapter).

Abusive Tax Shelters

In recent years, there have been significant concerns raised at the state and federal levels regarding the use of abusive tax shelters (ATSs) by taxpayers. The FTB indicates that ATS activity has resulted in billions of dollars of state revenue losses over the last four years, and has the potential to cause even more revenue losses in the future. Both the FTB and the Internal Revenue Service (IRS) have taken some recent steps to curb the growth of ATS transactions through statutory changes and administrative policies. However, given the seriousness of the problem, additional steps will need to be considered. We discuss issues related to the growth of ATSs and provide various recommendations regarding them in the Perspectives and Issues, "Part V."

Fees for Franchise Tax Board Services

We recommend that the Legislature adopt legislation to allow the Franchise Tax Board to collect fees for certain special tax services currently provided free of charge to taxpayers and tax practitioners. This action would provide General Fund savings of roughly $3.9 million in the budget year. ( Reduce Item 1730-001-0001 by $3.9 million and increase reimbursements by an identical amount.)

Background on FTB Fees. In carrying out its administrative responsibilities with respect to the PIT and the CT, FTB provides certain special services to taxpayers and professional tax practitioners. These services are distinct from typical tax administrative and processing activities of the agency and often represent a substantial commitment of resources for the benefit of individual taxpayers. While these services benefit FTB to some degree in allowing it to carry out its administrative tasks, most of the benefits of such services accrue to individual taxpayers and businesses. Special services provided by FTB include, for example, the tax practitioner hotline, the expedited processing of certain tax forms, and the execution of installment agreements for the payment of back taxes.

The IRS has rather extensive charges for many of its own services. Charges levied by the IRS range from rather modest amounts of less than $50 for copies of tax returns and expedited processing, to several thousands of dollars for providing various administrative requests, letter rulings, and opinions.

Currently, the FTB levies a limited number of fees for particular services and products. For example, it charges cost recovery fees for entity-status letters, copies of tax returns, as well as for certain publications (for example, the Tax Forms Catalog and the FTB Tax News). In many other cases, however, special services are paid for out of the General Fund. We believe this should be changed, based on the unfairness of requiring some taxpayers to subsidize others or private businesses. Since these activities benefit private entities, it is appropriate that the costs of such services be borne by them.

Potential New FTB Fees. In previous years, we have recommended that the FTB begin charging tax practitioners for their use of the tax practitioner hotline. This service provides a high level of technical tax expertise to professional tax practitioners. The FTB has raised concerns that a fee for this service would result in merely rechanneling tax practitioner inquiries to either the toll-free line used by all taxpayers or to district offices. Given the technical nature of some tax practitioner requests, however, we are not convinced that the rather general information available to them through the toll-free number or the substantial commitment of time involved in physically appearing at a district office represent realistic alternatives for professional tax practitioners.

We continue to think that a fee for professional tax information is justifiable and appropriate. In addition to charging for the tax practitioner hotline, the imposition of cost-recovery fees would constitute appropriate policy for several other services as outlined below.

• Installment Agreements. These are agreements that allow certain taxpayers to schedule periodic partial payments on a balance due of under $10,000 that can be fully paid within 36 months.
• Refund Stop Payment. The purpose of this processing activity is to prevent a refund warrant to be cashed by an unauthorized individual.
• Transcript Preparation or Tax Computation. These activities require the preparation of a document or report showing annual activity on a taxpayer's account, including: filings, tax amounts, penalty amounts, interest amounts, payments, assessments, credits, and refunds.
• Lien Release or Subordination. This service requires the review and analysis of extensive documentation in order to determine whether the removal or subordination of a state tax lien from a specific piece of property is appropriate, prudent, and justified.
• Rush Services. These services provide 24-hour "turn-around" for various actions including corporation reviver (brings a corporation out of suspension), escrow demand (used to process lien releases), entity exemption (for tax-exempt corporation status), and estate income tax certificate (certification of taxes paid).

In each of the above cases, the provision of the service represents a level of activity that is used under special circumstances and thus is not a part of the agency's regular course of business. In most of these cases, the IRS charges fees for similar services. Furthermore, many of the services provided by FTB have a counterpart in the private sector, requiring the payment of a fee to the lender, bank, or other financial institution providing the service.

Figure 1 indicates the volume of services, proposed fee level, and estimated potential revenue relating to various service fees. Our proposal assumes that fees should cover the full cost of services, since these services are directly linked to individual taxpayers. The fees indicated and the revenue impacts shown are based on a FTB cost-recovery model that incorporates an estimate of the number of minutes necessary to produce each of the specified services. The cost per service uses an annual salary at the mid-range point, plus benefits, and overhead. The number of transactions is based on the volume of such requests in the current year, adjusted for a potential decline resulting from the imposition of a fee.

Administrative Considerations. While it is difficult to levy fees on the provision of certain types of services—due to administrative considerations—levying fees on particular other services would be administratively straightforward. For certain service items, the FTB would be required to establish administrative procedures and technical capabilities for the effective levying of the fee. For example, an annual fee for the tax practitioner hotline would require that a database of tax practitioners in the state be established in order to identify subscribers and track usage. In addition, the FTB may need to develop a method for tracking the receipt of service fees through modifications to its existing accounting system. The costs of such improvements could be built into the fee structure. Finally, FTB would need to develop various policies that address issues such as at what point the fees should be charged.

General Fund Savings. We estimate that implementing our recommendations to shift funding for various special tax services to fee-based support would result in General Fund savings of about $3.9 million annually. We therefore recommend that the Legislature make corresponding reductions in General Fund support for FTB and increases in reimbursements based on the new fee structure.

Revenue Acceleration and Tax Compliance Efforts

We recommend that the Franchise Tax Board report at budget hearings regarding (1) the budgetary costs and estimated revenues that would result from the continuation of the department's existing revenue acceleration program, and (2) the viability of a program to require tax withholding on payments to independent contractors.

Revenue Acceleration Program Generates Benefits

As a component of the 2002-03 May Revision, FTB's collections staff budget was augmented by $3.7 million on a limited-term basis for the purpose of accelerating the payment of delinquent tax accounts. The revenue acceleration program (RAP) was established through legislation that allowed FTB to waive the payment of penalties and interest for taxpayers owing balances, in exchange for their immediate payment of unpaid taxes.

The agency was responsible for establishing the eligibility criteria for participation in the program and for contacting potential participants. The program was targeted to taxpayers who had not responded to notices, liens, levies, and telephone or personal contacts for at least two years. Without the RAP program, such accounts would largely be considered noncollectable; no accounts that were deemed to be collectable through other channels were included in the program. The year-long RAP—running from October 2002 through October 2003—resulted in additional tax revenues of $32 million.

Based on preliminary estimates we have received from FTB, the department believes that the cost of extending the RAP for an additional year would be in the range of $1.5 million to $2 million, and result in additional revenues of $23 million, for a net return in excess of $20 million. The agency indicates that the program could be reestablished in less than a month.

LAO Recommendation. At the time this analysis was written, detailed information was not available to estimate the net fiscal benefit to the state of the RAP. Given the potential for substantial additional revenue from this program, we recommend that the FTB report at hearings regarding final cost and revenue results of the initial RAP program as well as provide estimated costs and revenues to the state resulting from extending the RAP for an additional year.

Independent Contractors—Bridging the "Tax Gap"

The IRS has identified a federal income-tax gap—defined as the difference between "true" tax liabilities and taxes actually remitted on a timely basis—of approximately $310 billion in 2001. The IRS has indicated that about $81 billion of this amount is the result of nonreported income earned by self-employed individuals and independent contractors. This nonreporting can occur because payments to independent contractors do not require the withholding of taxes. Thus, if the independent contractor does not report the income, it can remain untaxed.

The federal National Taxpayer Advocate—a post established by Congress in 1998—released a report in January of this year recommending an active and vigorous presence in enforcing federal tax laws (see also our discussion in the Perspectives and Issues, "Part V" entitled "The Problem of Abusive Tax Shelters"). As a component of her report, the advocate recommended that federal legislation be adopted that would establish withholding requirements for certain categories of nonwage workers. The report indicates that such enforcement is necessary since noncompliant taxpayers implicitly impose a higher tax burden on compliant taxpayers. The report recommends a relatively low withholding rate of 3.5 percent to 5 percent for this purpose, in order to address those situations where an independent contractor experiences little or no tax liability.

The FTB formerly estimated the tax gap for California, but no longer makes such estimates. The federally identified tax gap represents about 15 percent of federal receipts. If this relationship of tax gap and tax receipts holds at the state level, California's potential tax gap would be in the low billions of dollars, with a substantial amount due to under-reporting by independent contractors and the self employed.

The FTB currently has a nonfiler enforcement program that incorporates information received from the IRS as well as certain state sources. The integrated nonfiler compliance (INC) system uses such information to identify nonfilers in order to commence tax enforcement measures. For example, the FTB receives approximately 6 million 1099 MISC forms annually (filed by companies to report payments to nonemployees) that are used by INC to identify nonfilers. However, if no 1099 MISC is issued by the company, the income may go unreported.

LAO Recommendations. Given the level of concern about the tax gap at the federal and state levels, we think it advisable to consider additional filing and enforcement measures, particularly with respect to independent contractors and self-employed individuals. In particular, we recommend that the Legislature consider that businesses hiring independent contractors be required to report payment amounts and withhold taxes for such payments. Furthermore, we recommend that FTB report at budget hearings with respect to the viability of a withholding proposal similar to that suggested by the National Taxpayer Advocate. The FTB should specifically address the estimated administrative costs and potential revenues from requiring such withholding at the state level.

District Office Consolidations and Reductions

We recommend that the Franchise Tax Board report at budget hearings regarding district office restructuring proposals, including the phasing in of such changes, budget savings, and revenue impacts.

The FTB operates 16 field offices throughout the state—Bakersfield, Fresno, Long Beach, Los Angeles, Oakland, Sacramento, San Bernardino, San Diego, San Francisco, San Jose, Santa Ana, Santa Rosa, Stockton, Van Nuys, Ventura, and West Covina—nine of which are located in privately owned buildings and the remainder of which are located in state-owned facilities. The district offices provide limited public access counters which allow taxpayers to address particular tax-related issues and obtain information and assistance regarding other programs administered by FTB. The district offices also house certain auditing and collections activities.

Taxpayer assistance (as well as assistance with various other programs) is currently available through four channels: (1) a centralized call center with automated and staffed responses, (2) written correspondence through the FTB central office, (3) walk-in accessibility through one of the 16 FTB field offices located throughout the state, and (4) Internet access through the department's Web site.

The department's call center provides the greatest number of personal responses to taxpayers, receiving approximately 3 million inquiries per year. Written correspondence is limited to less than 500,000 inquiries annually. The number of direct taxpayer contacts through public access counters typically ranges from 200,000 to 250,000 annually. In addition, electronic services (Internet and interactive voice response) receive over 25 million taxpayer contacts; however, such modes do not provide customized services to taxpayers but rather provide specified information based on taxpayers' selection of various "menu" options.

Shift Resources to Most Effective Channels. The public access counters remain the most expensive by far of the channels available for general taxpayer assistance. The FTB estimated that a call center response to a taxpayer inquiry cost an average of $6.07 in 2000-01, compared to $5.21 for a written response, and $11.15 for a field office contact. The FTB estimates that roughly 75 percent to 80 percent of inquiries received through the public access counters can be addressed though the Internet or the call center.

The FTB recently took action to close public access counters at all district offices except for Oakland, Los Angeles, Sacramento, San Diego, Santa Ana, and San Francisco. The department estimates that this will achieve personnel and lease savings of somewhat less than $1 million. After closure, approximately 75 percent of taxpayers are within a 50-mile radius of a public access counter (versus about 95 percent formerly).

In addition to public access, however, it is apparent that many auditing and collection activities now conducted through some field offices could be effectively carried out through alternative means—and at a substantially lower cost. Such alternative administrative venues include: telephone communication, shifts to other district offices, or the transfer of activity to the Sacramento main office. For example, while a physical presence may be required at certain stages of an audit, this presence might be just as effectively met by deploying resources directly from FTB's main office in Sacramento as it is by using staff from a district office.

LAO Recommendation. In view of the substantial commitment of resources required to maintain its district offices for public access and other activities, we recommend that the FTB present district office restructuring proposals at budget hearings including the phasing in of such changes, budget savings, and revenue impacts.