FTB Legal Team Gets Aggressive in Appeal Over Like-Kind Exchange Involving Out-of-State Property

An April 24 personal income tax appeal hearing conducted by the Office of Tax Appeals had a tenor distinctly different from past appeals, as a team of three attorneys from the Franchise Tax Board aggressively challenged exhibits submitted by the taxpayer, objected to the qualification of the taxpayer’s expert witness and sought to force the taxpayer to provide the FTB with copies of notes she referred to while presenting her case.

The FTB’s protestations garnered mixed results from the three-member panel of OTA administrative law judges, comprised of Teresa Stanley (lead), Alberto Rosas and Michael Geary.

Stanley, the only one of the OTA’s 14 original administrative law judges who has not worked as an attorney for any of the state tax agencies, sustained the FTB’s objections on some exhibits, but overruled the objection to the expert witness – agreeing only to direct him not to testify about the meaning of various legal precedents that the panel already is expected to be familiar with.

Regarding the FTB’s request for copies of the taxpayer’s notes, Stanley asked if the FTB would allow the taxpayer to use her notes “since this is an administrative hearing and we like to give leeway.” The FTB’s legal team would not make this concession, arguing that since the taxpayer had been sworn in as a witness, any document she referred to must be admitted as an exhibit. The taxpayer’s attorney responded that the notes contain items protected by attorney-client privilege, and thus would not be turned over. After some back-and-forth, the FTB attorneys said they reserved the right to ask for copies after hearing the taxpayer’s testimony, and Geary told the taxpayer she would have to provide the documents to the FTB if she used them during testimony. At that point, the taxpayer resolved the issue by proceeding without her notes, instead referring to official exhibits when she needed to cite an exact date or sum of money. (Official exhibits were plentiful, as nearly 70 were entered into the official record.)

Did the Taxpayer Qualify for a Like-Kind Exchange?

The main issue in the Appeal of Sharon Mitchell was whether a Walnut Creek property was sold in 2007 by a partnership as the sole seller, or by the partnership, Mitchell and another tenant in common – and thus whether Mitchell qualified to conduct a like-kind property exchange under Internal Revenue Code 1031, and defer taxes on her capital gain.

The property had been owned by the partnership since 1969. Mitchell’s mother was a key partner, described as a savvy real estate investor and negotiator. Mitchell became a partner in 1991 when she inherited a partnership interest from her aunt.

Shortly before the sale of the property became final, Mitchell and her mother redeemed their partnership interests, and became tenants in common. After the sale, Mitchell deferred tax on her capital gain by purchasing replacement property in Arizona within the 45-day legal deadline.

The 1031 exchange was audited by the FTB, which alleged that the partnership was the true seller of the property, and Mitchell’s capital gain was taxable as partnership income.

The taxpayer said there were legitimate reasons for the timing of the partnership redemption, including differences between partners over whether to continue investing in property or cash out and retire, and growing lack of desire to remain in the partnership after original members died and willed interests to others who had not earned the same level of familiarity and trust.

Most importantly, the taxpayer’s attorney argued, there is no requirement in law that a person hold a property for any specified amount of time before being legally recognized as a seller. There are requirements that in a 1031 exchange both properties must be held for use in a trade or business or for investment, that they be the same nature, character or class, and that the purchase of the replacement property occur within 45 days of the sale of the relinquished property, but no requirement for how long the seller must have owned the relinquished property, the attorney noted.

Such a time requirement would be “bad tax policy … and certainly not in the law,” the attorney testified.

Additionally, the attorney noted that the taxpayer had engaged in many other 1031 exchanges and the only one that was challenged by the FTB was the one that involved a replacement property in another state. The FTB should not be allowed to strip the taxpayer of her legal right to a 1031 exchange “just because they don’t like the fact that she exchanged this property for property outside California,” the attorney told the OTA panel.

Other Issues

The FTB also disputed the step-up in basis calculation used by the taxpayer, and asserted that assignment of income doctrine should apply, so Mitchell would be required to pay tax on the gain as partnership income, even if the right to income was transferred.

Mitchell’s attorney said the FTB was “grasping at straws” with the assignment claim, and argued that the courts have not allowed the doctrine to be used to keep a taxpayer from being able to defer income. She stressed that Mitchell was “simply deferring gain, not evading tax.”

The expert witness agreed, stating that since a 1031 exchange involves a tax deferral, not tax evasion, the assignment doctrine would not apply.

The FTB’s Legal Tactics

The FTB’s three lawyers – David Gemmingen, Ciro Immordino and Michael Cornez – objected to the admission of exhibits that they argued were irrelevant.

After the testimony of expert witness Jeffrey Krajewski, a certified public accountant from Arizona, the FTB asked for copies of his complete files on the case, including his correspondence with the taxpayer’s attorney. Expert witnesses are not protected by attorney/client privilege, the FTB argued, and his files should be open to all parties.

Stanley denied the request for Krajewski’s files, calling it “an attempt at late discovery.”

The FTB’s opening argument was brief, but the agency spent considerable time cross-examining the two witnesses – Mitchell and Krajewski – and delivered a tag-team closing argument that lasted 80 minutes. The FTB did not call any witnesses of its own.

All three ALJs asked numerous questions during the hearing, and almost all were directed to the taxpayer and her expert witness.

Lengthy Hearing

The hearing, held in the Victim Compensation Board Hearing Room, began at 9 a.m. and ended at 4:30 p.m.

Stanley informed the parties that a decision will be rendered in 100 days or less.


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