The California Supreme Court reversed the appellate court’s decision regarding the Franchise Tax Board’s (FTB) authority to conduct an audit to determine whether a taxpayer is entitled to an enterprise zone hiring credit. DiCon Fiberoptics, Inc. v. Franchise Tax Bd., Case No. S173860 (Apr. 26, 2012).

California’s Enterprise Zone Act (the Act) permits a taxpayer that employs a “qualified employee” in an enterprise zone to claim a tax credit for five years. To be a “qualified employee,” at least 90% of the employee’s services must “directly relate[ ] to the conduct of the taxpayer’s trade or business located in an enterprise zone,” and the employee must perform at least 50% of his or her services in the enterprise zone. Cal. Rev. & Tax. Code § 23622.7(b)(4)(A). In addition, the employee must fall within one of several categories that demonstrate the employee is disadvantaged or endures some form of employment barrier. Cal. Rev. & Tax. Code § 23622.7(b)(4)(A)(iv). To claim the credit, taxpayers are required under the Act to: (1) obtain from the local zone government authority a certification (or “voucher”) that provides the qualified employee meets the eligibility requirements; and (2) retain a copy of the certification and provide it upon request to the FTB. Cal. Rev. & Tax. Code § 23622.7(c).

At the Court of Appeal, DiCon successfully argued that the specific statutory voucher requirements under the Act took priority over the FTB’s general statutory audit authority and that the FTB should not be permitted to displace the judgment of a local zone authority with expertise the FTB lacks. To wit, the Court of Appeal held that vouchers issued by local zone authorities are prima facie proof that a worker is a “qualified employee,” which shifts to the FTB the burden of proof to demonstrate that an employee is not a qualified worker for whom no voucher should have been issued.

The Supreme Court, however, disagreed. In reversing the Court of Appeal, the Supreme Court reasoned that the statutory voucher requirements under the Act supplement but do not supplant the FTB’s general audit authority with regard to the vouchers. The Supreme Court ultimately concluded that the FTB’s general authority to review returns and ascertain the correct amount of tax gives the FTB authority to conduct an audit to determine whether a taxpayer is entitled to the enterprise zone hiring credit.

Taxpayers intending to claim hiring credits in California enterprise zones are well-advised to retain, as part of their normal books and records, the supporting documentation to establish that employees meet the qualified employee requirements under the Act. Taxpayers who historically have claimed hiring credits should examine potential assessment exposure for taxable years with an open statute of limitations if they failed to maintain the appropriate supporting documentation for the claimed hiring credits. DiCon Fiberoptics is also a stark reminder of the FTB’s broad investigatory power as it relates to the examination of returns and its determination of the correct amount of tax.