Office of Tax Appeals

OTA Releases 41 Opinions, Including Precedent on Qualified Small Business Stock

OTA with State Seal

The Office of Tax Appeals released 41 opinions April 3, including one marked pending precedential – a 3-0 decision upholding the Franchise Tax Board’s position in a dispute over the taxpayers’ gain from the sale of qualified small business stock (the Appeal of R. Nag and S. Rudd).

The precedential opinion involved a former stockholder in a corporation that built and licensed software for mobile infrastructure providers and mobile content owners. When the corporation was acquired by another company in 2010, the appellant-husband received sales proceeds totaling more than $25 million, as well as two distributions totaling $5.18 million.

The taxpayers reported a stock basis of $1.6 million and claimed a 50 percent qualified small business stock (QSMS) gain exclusion of $14.5 million, for a total taxable gain of $14.5 million.

After auditing the return, the FTB concluded that the two distributions were not part of the gain from the sale, but rather were non-dividend distributions that should be treated as return of capital in excess of the basis in the original company’s stock.

The FTB determined that the capital gain in excess of basis from the special dividends was $3.5 million (reducing the appellant-husband’s basis in the stock to zero) and the realized capital gain from the sale was $25.4 million. The FTB also ruled that the QSBS gain exclusion was limited to $5 million.

Under the FTB’s calculations, the total taxable gain was $24 million – almost $10 million higher than the gain calculated by the taxpayers.

The OTA rejected the taxpayers’ argument that in substance, the two distributions were part of the consideration received in the sale, and were one step in a multi-step sales transaction.

“The evidence presented, including the Agreement, does not show that the Special Dividends were considered or intended by the parties to be part of the sale …,” the OTA wrote. “In addition, the Special Dividends had independent legal significance from the sale. The parties chose to structure the transaction so that: (1) the Special Dividends were legally independent from the sale; and (2) the cash distributed by the Special Dividends was excluded from the sale and purchase price.”

The two distributions “were legally binding irrespective of the outcome of the sale,” the OTA ruled. Thus, in substance and form, they were separate from the consideration received in exchange for stock in the acquired company.

In a footnote, the OTA added: “This conclusion is based on the facts and circumstances in this specific appeal; it does not mean that a corporation can never, under any circumstances, distribute cash prior to the sale and have such distribution treated as part of the subsequent sale.”

On the issue of whether the QSMS gain exclusion should be $14.5 million or $5 million, the OTA acknowledged the taxpayers’ argument that the Legislature intended the exclusion to benefit small businesses through tax benefits, but added that “the plain language of the statute and Legislative history of the California statute and similar federal statute do not indicate that the exclusion should, or was intended to, be calculated as appellants contend.”

“Statutes granting exemption from taxation are strictly construed to the end that such concession will not be enlarged nor extended beyond the plain meaning of the language employed,” the OTA wrote. “An exemption will not be inferred from doubtful statutory language; the statute must be construed liberally in favor of the taxing authority, and strictly against the claimed exemption.”

The only consolation for the taxpayers was that during the appeal, the FTB agreed to abate almost two years’ worth of interest.

The taxpayers asked for a rehearing, but were denied. The petition for rehearing was based on “the same arguments that were previously considered and addressed” in the original opinion, the OTA ruled.

Other notable opinions from the 39 franchise and income tax decisions and two business tax rulings posted to the OTA’s website this week:

OTA Ruling Gives an Isley Brother Something to Shout About. Ronald Isley of the Isley Brothers likely wanted to kick his heels up and shout when the FTB said it will concede two of the three years at issue in a dispute over residency. Isley, in turn, conceded that he was a California resident during the remaining year.

The concessions were made during the OTA’s November hearing of the appeal – the FTB referenced witness testimony for its decision – and were cemented in the Appeal of R. Isley opinion released this week.

The dispute dated back more than 25 years – to the tax years 1997, 1998, and 1999 – but was triggered by the taxpayer’s untimely filing of returns in 2010. Isley testified that the late filing was prompted by an FTB notice received in 2006, while the FTB testified that its first contact with the taxpayer was in 2012.

During the appeal, Isley conceded that he was a resident in 1997, and the FTB conceded all tax liability, penalties, and interest for the 1998 and 1999 tax years. The tax agency also conceded penalties that had been imposed for failure to furnish information for all three years.

OTA Sides With FTB in Dispute Where Interest Was Five Times More Than the Tax Liability. The Appeal of F. Kiss illustrates the importance of responding to FTB notices in a timely manner. The dispute dates back to the 1991 tax year, when the taxpayer filed a timely return that reported an overpayment. The FTB subsequently learned that during a deposition in connection with a lawsuit, the taxpayer gave sworn testimony that he had unreported income of $50,501.

In 1995, during the early years of the Clinton administration, the FTB issued a notice of proposed assessment for $3,858 plus interest. The taxpayer did not file a protest.

After failing to respond to FTB notices or participate in the state’s amnesty program, the taxpayer eventually filed an amended return in 2008, excluding the income added by the FTB. After various attempts at resolving the dispute, in 2021 the taxpayer paid the balance due for the 1991 tax year – now more than $24,000 due to penalties and interest – and filed a claim for refund.

The OTA denied the refund, finding that the tax, interest, and penalties were properly imposed. The breakdown of the $24,026 paid by the taxpayer (rounded to the nearest dollar): $3,898 in tax, $116 in collection fees, $3,240 for the amnesty penalty, and $16,772 in interest.