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Contingent attorney fees + non-compliance = audit

The best business ideas are often those that require minimal resource investment, yet generate substantial returns. If people are educated along the way, all the better. The audit program's "Attorney Fees Study" is a good example of an uncomplicated, effective way to shrink the tax gap.

Although FTB's tax audit, collection, and filing enforcement systems are among the most effective in the nation, conservative estimates show California loses more than $6.5 billion a year to tax cheating. You may recognize this $6.5 billion figure as the "tax gap," which is defined as the difference between the tax that is due and the tax that is paid.

In the Attorney Fees Study, auditors are investigating noncompliance associated with attorney contingency fees resulting from lawsuits. Damage awards or settlements are often taxable, and cannot be excluded from the taxpayer's gross income. When taxable, attorney fees associated with the settlement must be taken as a miscellaneous deduction, subject to a two percent limitation.

When damage awards are excludible from gross income, the attorney fees associated with the settlement cannot be deducted.

Using creative sources like legal periodicals and newspapers, FTB auditors contact taxpayers to determine whether they correctly followed the law.

The study's early results show a high ratio of non-compliance. Based on these results, we expect to conduct more of this type of audit.