1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 6 REPORTER'S TRANSCRIPT 7 MARCH 25, 2015 8 9 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 10 APPEAL OF 11 B6a RAGO DEVELOPMENT CORPORATION 12 B6b FREDRICK M. WOOSTER and MARY L. WOOSTER 13 B6c PAUL H. VERRIERE and PATRICIA R. VERRIERE 14 B6d MICHAEL J. SMITH and LYNN M. SMITH 15 B6e LOUIS RAGO and JUNE E. RAGO 16 B6f MARTIN BRAMANTE and ESTATE OF VELIA BRAMANTE 17 B6g FRANK SABELLA 18 B6h LOUIS LA TORRE LIVING FAMILY TRUST, LOUIS 19 LA TORRE TRUSTEE 20 AGAINST PROPOSED ASSESSMENT OF 21 ADDITIONAL INCOME TAX 22 23 24 25 Reported by: Kathleen Skidgel 26 CSR No. 9039 27 Juli Price Jackson 28 CSR No. 5214 1 1 P R E S E N T 2 For the Board Jerome E. Horton of Equalization: Chairman 3 4 Sen. George Runner (Ret.) Vice Chairman 5 6 Fiona Ma, CPA Member 7 8 Diane L. Harkey Member 9 10 Yvette Stowers Appearing for Betty T. 11 Yee, State Controller (per Government Code 12 Section 7.9) 13 Joann Richmond 14 Chief Board Proceedings 15 Division 16 For Board of 17 Equalization Staff: John Johnson Tax Counsel III 18 19 For Franchise Tax Board: David Gemmingen Tax Counsel 20 Ciro Immordino 21 Tax Counsel 22 For the Appellants: Edward Kaplan 23 Attorney 24 Donald L. Feurzeig Attorney 25 Melvyn I. Mark 26 Attorney 27 28 ---oOo--- 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 MARCH 25, 2015 4 ---oOo--- 5 MR. HORTON: Ms. Richmond. 6 MS. RICHMOND: Our next matter is item B6a 7 Rago Development Corporation; B6b Fredrick M. 8 Wooster and Mary L. Wooster; B6c Paul H. Verriere 9 and Patricia R. Verriere; B6d Michael J. Smith and 10 Lynn M. Smith; B6e Louis Rago and June E. Rago; B6f 11 Martin Bramante and the Estate of Velia Bramante; 12 B6g Frank Sabella; and B6h Louis La Torre Living 13 Family Trust, Louis La Torre Trustee. 14 MR. HORTON: Thank you. 15 As the taxpayer settles in, would Appeals 16 introduce themselves for the record. I can't tell 17 which one of you -- oh, okay. 18 MR. JOHNSON: Good afternoon, Chairman 19 Horton, Members of the Board. John Johnson with 20 Appeals. 21 MR. HORTON: Mr. Johnson. 22 MR. JOHNSON: The issue we have in this 23 appeal is whether Appellants have shown error in 24 Respondent's determination to deny the claimed 25 deferral of gain pursuant to attempted IRC Section 26 1031 transaction. 27 Interest abatement was previously an issue 28 on this appeal. But prior to the appeal, Respondent 3 1 has conceded to the requested period of abatement 2 for all the taxpayers. So it appears to be no 3 longer an issue. 4 We would also note that this is a Section 5 40 appeal. 6 MR. HORTON: Thank you. 7 Welcome to the Board of Equalization. We 8 appreciate your patience. You have ten minutes to 9 make your presentation. Please be advised that we 10 will return and allow you five minutes on rebuttal. 11 We would ask that you introduce yourself for the 12 record. 13 MR. MARK: My name is Melvyn Mark and I 14 represent three of the taxpayers known as the 15 Bramante group. We don't represent the other five, 16 the so-called Rago group; and they are represented 17 by Mr. Kaplan, to my right. 18 When I came here at 10:00 o'clock, I 19 thought I'd welcome you by say "good morning." And 20 then after lunch I thought it might be "good 21 afternoon." 22 MS. HARKEY: It's "good evening." 23 MR. MARK: But it is "good evening," and 24 it's been a long day for all of us. 25 This is another 1031 case. I imagine -- 26 I've been sitting here all day and after hearing 27 what has occurred earlier, you probably have had 28 your fill about 1031. But we've got one more case 4 1 to address. 2 I'll try to adjust my remarks because I was 3 very impressed by what I heard this afternoon and 4 your knowledge of 1031. And I'm going to try to 5 avoid repeating anything that I think you already 6 know. 7 But there are two points I'd like to make; 8 somewhat general. I'm here because I sincerely hope 9 that we can help you reach a fair, reasonable, 10 business-like decision, and a decision that will 11 allow a reasonable precedent. 1031 is a really, 12 really important provision in the law. There are 13 hundreds of millions of dollars of transactions 14 structured on it every year. 15 My comments are, first, just a small bit of 16 background, and then a little bit of guidance. The 17 background I want to convey is that, to the best of 18 my knowledge, and it's important to go forward 19 recognizing, that I believe that the Franchise Tax 20 Board is out of step with the federal law and the 21 law in every other state. 22 I go to a lot of seminars. I'm both a real 23 estate lawyer and a tax lawyer. And at all 24 seminars, whether it's New York to San Francisco, 25 they will address 1031, they'll address Magneson, 26 they'll tell you what the law is and they'll say 27 "but in California they seem to have a different 28 agenda." 5 1 The California approach is highly 2 aggressive. They seem to go out of their way, 3 hoping to find a flaw, a crack, anything, do 4 anything almost, say anything in order to defeat 5 1031. And that's very, very unfortunate. 6 Just on 1031 for a second longer. To some 7 extent the value of property in California is 8 reflected by the availability of 1031. The fact 9 that people can do what 1031 says, and buy and 10 exchange and reinvest and defer tax, definitely 11 gives it more value. A policy that throws -- that 12 casts doubt on that is not to be encouraged; it's 13 unfortunate. 14 The second point I'd like to make is that 15 in a little while you'll hear a lot of talk about 16 the technical rules and about a lot of cases, 17 Magneson and others. The lawyers will disagree on 18 Magneson. I'd like to share with you my approach 19 and hope that you will see the forest through the 20 trees. 21 Mr. Feurzeig and I, you can tell by looking 22 at us that we've been at this for a while. Together 23 we have practiced tax law for more than a hundred 24 years. Mr. Feurzeig started with the Internal 25 Revenue Service and I started in the tax division of 26 the Justice Department. 27 In a hundred years we've learned that a 28 case like this really turns on whether or not the 6 1 courts, the Board, believes that the taxpayers have 2 done something wrong. If they have, they should 3 lose. If they haven't, they should win. 4 The taxpayers constructed transactions 5 where they dot all their i's and cross their t's. 6 But nevertheless, if the nature of what they've come 7 up with is deemed to violate the principle of the 8 law or the purpose or its intent, then the courts 9 have established means of avoiding bad results, 10 finding against the taxpayer. 11 The way they do this is by employing a 12 judicial remedy. It's not in the law. It's 13 something that courts have established in order to 14 allow them to reach the right results in a case 15 where they think the taxpayer has done something 16 wrong. 17 So when we talk about no business purpose 18 or form over substance or step transaction, those 19 are just tools that your Board or any court can use 20 when they think a taxpayer has done something wrong. 21 So having said that, in the few minutes I 22 have left, let's just look at what these taxpayers 23 did. Imagine if you had done this, would it be 24 wrong? 25 Our group of taxpayers started out by 26 owning an apartment house in San Rafael. They owned 27 it long. It was successful. It was time to sell 28 it, and they sold it. Okay, that's not wrong. 7 1 They wanted to do a tax-free exchange; 2 that's not wrong. They employed a qualified 3 intermediary and they met every technical 4 requirement; and that's not wrong. 5 They looked for replacement property. And 6 what they came up with was a shopping center, much 7 bigger investment than they could make, and they 8 were put together with another group of investors. 9 They closed the purchase and they closed it 10 buying real estate; no question about it. They sold 11 the shop, they sold the apartment house real estate, 12 and they bought the shopping center real estate. 13 From the day they bought it, they did 14 everything an owner of real estate would do. They 15 made leases in their names as owners of real estate. 16 They hired a management company. They did 17 everything the local law required for property 18 owners to own a shopping center. 19 They bought insurance. They paid taxes. 20 And what's really interesting here is, in the year 21 they bought it, they then filed federal and state 22 tax returns, all of which were reported by people 23 who owned real estate and had come through a 1031 24 exchange. They didn't step up the basis. There was 25 no adjustment; that was a disadvantage, but they had 26 done a 1031 and they honored it. 27 So -- oh, they did one more thing. In the 28 next year, they converted their ownership of real 8 1 estate into a limited liability company. 2 I told you I'm also a real estate lawyer. 3 Dozens and dozens of my clients have converted the 4 direct ownership of real estate into a limited 5 liability company. It's, uh -- it's done for good 6 business reasons, limited liability. 7 And what's interesting is that when they do 8 it, you'd think the State of California would 9 complement them because now they're subject to the 10 limited liability gross receipts tax that didn't 11 exist before. So, in a sense, the State is better 12 off. 13 But, as we know, at a certain point the 14 Franchise Tax Board determined that by reason of 15 converting to the limited liability company they -- 16 they blew, they messed up. They -- they did not 17 qualify for the tax-free exchange. 18 So those are my comments. Now I'll let my 19 associates direct themselves to the -- some of the 20 technical issues and the cases. 21 Thank you. 22 MR. KAPLAN: Good evening. I'm Ed Kaplan. 23 I represent the other five Appellants of this 24 consolidated group of eight; seven individuals and 25 one corporation. 26 In June 2003, the eight Appellants each 27 acquired an ownership interest in four parcels known 28 as the Sand Creek Shopping Center in order to 9 1 complete their own like-kind exchanges. The 2 Appellants entered into a tenancy in common 3 agreement to spell out their ownership relationship 4 and to make clear that they were not creating a 5 partnership. 6 The Appellants fully understood that 7 acquisition of their respective interests in this 8 property as tenants in common would be like-kind to 9 the property they relinquished, qualifying them for 10 tax deferral under Section 1031. 11 For seven years during the audit and all 12 through the protest stage, Respondent argued that 13 the tenancy in common agreement was in reality a 14 partnership agreement and disallowed the claimed 15 exchange treatment on that basis. 16 In its determination letter, however, 17 Respondent finally acknowledged that the tenancy in 18 common agreement fully complied with the guidelines 19 published by the IRS in Revenue Procedure 2002-22 20 and that it did not create a partnership and 21 Appellants' tenancy in common interests were to be 22 respected as such. 23 The inordinate amount of time taken by 24 Respondent in reaching this result has lead to its 25 agreeing to suspend interest for over two years on 26 any tax that may ultimately be determined to be 27 owing. 28 Unfortunately, Respondent's acceptance of 10 1 Appellants' position did not bring this to an end. 2 The determination letter went on to state that 3 through application of the step transaction 4 doctrine, their tenancy in common interests were, in 5 substance, member interests in an LLC and continued 6 to disallow the Appellants' exchange. 7 Respondent claimed that the TIC interest 8 should be ignored and given no effect. The theory 9 supporting the disallowance before this Board was 10 never raised at any time prior to the issuance of 11 the Notices of Action. It did not come up once 12 during the seven years the issues were being 13 discussed with the auditor or at protest. 14 Because the Appellants were never afforded 15 the opportunity to contest or even discuss this 16 theory prior to the filing of their briefs of this 17 matter, we feel somewhat disadvantaged and I'm not 18 sure we would be here had we had that opportunity 19 earlier on. 20 Respondent now bases its disallowance of 21 exchange treatment on the fact that Appellants 22 transferred their tenancy in common interests into 23 two LLCs seven months after their acquisition. Two 24 of the parcels were subject to a loan encumbrance 25 with one of the loan's terms calling for such a 26 transfer into a single asset bankruptcy remote 27 entity. The other two parcels were not subject to 28 any similar provision, although the Appellants did 11 1 transfer their interests in them into a separate LLC 2 at the same time. 3 There are two requirements of Section 1031 4 that are relevant to these cases. First, is whether 5 the Appellants acquired like-kind property to 6 complete their exchanges and, second, whether they 7 intended to hold those interests in the like-kind 8 property for investment. The facts in the law show 9 that Appellants have met these requirements. 10 We would all agree that if the subsequent 11 transfers into LLCs did not occur, Appellants would 12 qualify for tax deferred exchange treatment under 13 Section 1031. They acquired like-kind property in 14 the form of their tenancy in common interests and 15 held them for investment; something they continue to 16 do to this day, 12 years later. 17 Respondent's position, though, requires 18 acceptance of the fact that the transfer of those 19 interests seven months later caused a qualified 20 exchange to become unqualified; that turns like-kind 21 property into unlike-kind property. But if the 22 property qualified as like-kind without a subsequent 23 transfer, there cannot be a legitimate question that 24 the Appellants did in fact acquire like-kind 25 property when they acquired their tenancy in common 26 interests. 27 If Respondent is serious in its assertion 28 that the only issue is whether the property 12 1 Appellants acquired was like-kind, we can go home 2 now. They acquired like-kind property when they 3 bought their interests in the shopping center as 4 tenants in common. 5 Although Respondent fails to understand it, 6 its position depends on whether the subsequent 7 transfers of their like-kind tenancy in common 8 interests negates their intent to hold those 9 interests for investment. 10 Case law, starting with Magneson, 11 continuing through Bolker, Maloney, Marks, among 12 others, establishes that changing the form in which 13 one's investment is held does not violate 1031 as 14 long as the intent to hold the property for 15 investment purposes remains. There is no case that 16 holds otherwise. 17 The fact that Appellants continue to hold 18 their interests in the Sand Creek Shopping Center in 19 precisely the same percentage interests as when 20 first acquired in 2003, coupled with the fact that 21 not a single Appellant has ever cashed out even $1 22 of equity in their investment, leads to the obvious 23 result that Appellants acquired their interests in 24 this property for investment and continue to hold it 25 for investment, albeit now in the form of member 26 interests in two LLCs. 27 The Respondent argues that the step 28 transaction doctrine produces a different result, 13 1 but that is not the analysis applied by the courts 2 when faced with this issue. 3 There is no reported case that holds that 4 like-kind property converts to unlike-kind property 5 through use of the step transaction doctrine. A 6 step transaction analysis, which is a subset of the 7 substance over form doctrine, is not appropriate in 8 Section 1031 cases. That's most easily seen by 9 recognizing that its application would negate every 10 deferred exchange where a qualified intermediary is 11 used as the placement of an intermediary into the 12 middle of what is otherwise a pure sale and a pure 13 acquisition would certainly cause it to fail. 14 Further, the Internal Revenue Service has 15 instructed its own personnel not to contest 16 exchanges such as those here and raise the issues 17 that Respondent is pursuing. In a 1999 field 18 service advice memorandum, the IRS's employees were 19 instructed to no longer pursue the position that an 20 immediate transfer of property pursuant to a 21 prearranged plan evidenced a taxpayer's failure to 22 hold that replacement property for the purpose of 23 investment. 24 Here, we don't even have an immediate 25 transfer, nor do we have even an argument that the 26 transfer of the two unencumbered parcels was part of 27 a prearranged plan. 28 The difficulty of accepting Respondent's 14 1 argument is that it requires this Board to ignore 2 entirely the seven-month period in which the 3 Appellants owned and operated the shopping center as 4 tenants in common, exposed to unlimited liability. 5 If Appellants had been sued for an accident 6 occurring on the property during that time, they 7 certainly could not have defended themselves by 8 staying that their -- by stating that their 9 liability was in fact limited because under a loan 10 provision they might be transferring their TIC 11 interests into a limited liability company in the 12 future. 13 During the seven months Appellants held 14 their TIC interests, they managed the property as 15 tenants in common, they opened bank accounts in the 16 name of the tenants in common, they entered into 17 leases and marketing contracts as tenants in common, 18 and they filed their tax returns reflecting their 19 ownership of the property in this form. How can 20 these very real economic and business transactions 21 be set aside, ignored and pretend they never 22 happened? Because a lender asked them to later 23 transfer those interests into an LLC for its own 24 business purposes? 25 The step transaction doctrine cannot 26 properly be applied to situations where there are 27 real economic risks, burdens and benefits of what 28 Respondent has referred to as a transitory holding. 15 1 Here, we have seven months and no potential for 2 abuse. 3 The transfer to the LLCs was tax-free. 4 Appellants' basis in their tenancy in common 5 interests, their holding period in the property and 6 all the like, all carry over to their member 7 interests in the LLCs. Only the form of their 8 ownership has changed. 9 Perhaps most importantly, accepting 10 Respondent's position would create a conflict 11 between the federal law as interpreted by the courts 12 and by the Internal Revenue Service with 13 California's interpretation of those same 14 authorities. Doing so would put California out of 15 conformity with the federal law, something which 16 California's prohibited from doing. 17 Oregon recognized this when it issued its 18 opinion in the Marks case. Applying the same 19 federal law in the context of the same state laws as 20 those enforced in California, Oregon's tax court 21 issued a well-reasoned analysis of the 22 inappropriateness of applying the step transaction 23 doctrine to a 1031 case and the continued vitality 24 of Magneson, Bolker and Maloney. 25 If California wants to remain in conformity 26 with the federal law and the rest of the country, it 27 must follow those authorities and the IRS's 28 interpretation of them. 16 1 For those reasons as well as those laid out 2 in the numerous briefs that you've been reviewing 3 over the last few days, filed with this Board, 4 Appellants respectfully request their appeals be 5 granted. 6 MR. HORTON: Thank you. 7 Members, let us go to the Department. The 8 Department has ten minutes to make their 9 presentation. We'd ask that you commence with your 10 introduction for the record, please. 11 MR. MR. GEMMINGEN: Good evening, Board 12 Members. My name's David Gemmingen with the FTB. 13 And with me is Ciro Immordino, also with the 14 Franchise Tax Board. 15 To execute a valid 1031 exchange and be 16 able to defer the gain realized in the sale of 17 property, a person must satisfy each of the 18 requirements set forth in the section as well as the 19 Legislative intent of the statute. 20 Membership interest in a limited liability 21 company are personal property and may not be 22 exchanged for real property. Appellants' 23 transactions fail Section 1031's deferral provisions 24 because Appellants acquired nonlike-kind property, 25 limited liability company interests, as contemplated 26 at the time of the exchange after selling real 27 property. 28 The step transaction doctrine embodies 17 1 substance over form principles and it treats the 2 series of formerly related separate steps as a 3 single transaction. The steps are, in substance, 4 integrated, interdependent and focused toward a 5 particular result. Where the steps are taken to 6 achieve a particular result, the tax consequences 7 are determined not by viewing each step in 8 isolation, as Appellants suggest, but by considering 9 all of them as an integrated whole and acknowledging 10 the end result. 11 Appellants acquired the Sand Creek property 12 in conjunction with the $36 million loan. And 13 before the Appellants acquired the property, they're 14 aware of the loan's provisions and elected to 15 continue with the purchase under the loan's terms. 16 As your Board's hearing summary noted, on 17 June 2nd, 2003, within the 45-day identification 18 period to identify alternative real property to 19 complete a tax deferred exchange, the ability to 20 acquire different replacement property, Appellants 21 entered into a loan agreement with Greenwich Capital 22 for more than $36 million. 23 In accordance with the deed of trust and 24 the loan's terms, Appellants contributed the 25 property to a separate legal entity in return for 26 limited liability membership interest. 27 Appellants' own counsel in earlier 28 correspondence -- earlier correspondence to 18 1 Respondent, one of which is the first exhibit you 2 have, acknowledged that the loan's provisions 3 required that the property be conveyed away, 4 demonstrating and admitting the causal relationship 5 between the events at the time of the exchange and 6 Appellants' acquisition of disqualifying intangible 7 interests in the LLC. 8 Moreover, a press release was issued in 9 September 2003 naming Sand Creek Crossing, LLC as 10 the property's purchaser, and the lender issued a 11 prospectus in 2003 stating that Appellants were 12 required to contribute the property to a separate 13 entity. These are not independent events. 14 Thus, the FTB has applied the step 15 transaction doctrine in accordance with Appellants' 16 anticipated and required result to acquire 17 intangible personal property rather than real 18 property as required by Section 1031. 19 Moreover, several courts, including a 20 decision reviewing and invalidating a 1031 exchange, 21 have declared that existence of a valid business 22 purpose prompting one of the steps does not bar 23 application of the step transaction doctrine. 24 The validity of an exchange in its 25 compliance with Section 1031 is tested at the time 26 of the exchange, and Appellants' obligations and 27 intended actions at the time of their June 2003 28 transactions demonstrate that they're required 19 1 during the exchange to contribute the property in 2 return for LLC membership interests. 3 Thus, Appellants contemplated and agreed to 4 obtain disqualifying property during the testing 5 period, and their actions are properly viewed 6 together to recognize that Appellants knew going 7 into the exchange at the end -- at the end of their 8 associated transactions that at exit was 9 disqualifying personal property. Respondent is not 10 attributing to Appellants anything other than what 11 they agreed to do and what they actually did. 12 Moreover, the courts and your Board have 13 consistently held that taxpayers, while free to 14 structure their affairs, are bound by the resulting 15 tax consequences, whether contemplated or not, and 16 may not enjoy the tax benefits that some other 17 course might have provided. 18 In addition, only one side of the 19 transaction has to involve a partnership interest in 20 order for 1031's benefits not to apply. That is to 21 say, a taxpayer only has to receive a partnership 22 interest in order to lose eligibility from 1031's 23 deferral provisions. This principle's been upheld 24 in various cases using 1031's like-kind rules and 25 demonstrates that the Oregon decision in Marks is 26 wrongly decided. 27 The Marks Court mistakenly applied the 28 effect to the 1984 amendments to Section 1031's list 20 1 of disqualified property. The Marks Court 2 incorrectly concluded that only a partnership 3 interest for partnership interests exchange was 4 disqualified. Rather, taxpayer cannot obtain a 5 partnership interest as replacement property for 6 real property as they are not like-kind, as the 7 Court in MHS Company versus Commissioner held, even 8 where the underlying assets of the partnership 9 constituted real property. 10 However, Section 1031's list of property 11 ineligible for like-kind treatment was considered 12 completely differently in Magneson, in contrast to 13 Marks. 14 Appellants here have attempted to only 15 focus on the holding requirement of 1031 and ignored 16 the equally applicable like-kind requirement which 17 they've plainly failed. Even the Magneson case, 18 which Appellants rely on, supports the FTB's 19 position and approves the application of the step 20 transaction doctrine in these appeals now that 21 Section 1031 has been revised of our partnership 22 interests as well as stock. 23 At the time of the Magneson transactions, 24 partnership interests were not included in the list 25 of ineligible exchange property, but corporate 26 stocks were listed. 27 The Magneson Court specifically stated the 28 parenthetical clause of Section 1031(a) expressly 21 1 excludes stock as property eligible for exchange, 2 but there is no such prohibition on exchange of 3 partnership interests. 4 The Court went on to consider the situation 5 whether a like-kind exchange of real property for 6 real property fouled by a transfer to a corporation 7 for stock under Section 351 continued to qualify for 8 nonrecognition under Section 1031. In considering 9 that situation, the Magneson Court stated: "A 10 like-kind exchange followed by a Section 351 11 transfer, viewed as a whole, results in the exchange 12 of property for stock." 13 Thus, the Magneson Court was willing to 14 apply the step transaction doctrine to disqualify a 15 multi-transactional exchange. Obviously only one 16 side of the transaction proposed by Magneson Court 17 involved a disqualifying transfer of stock. So the 18 Marks Court's determination that the 1984 amendments 19 required both sides of the exchange to be 20 disqualifying property is clearly wrong and that 21 decision should not be followed by your Board. 22 Thus, the Magneson Court approved the use 23 of the step transaction doctrine and its substance 24 over form principles to view, as a whole, that the 25 associated transfers resulted in exchange of 26 property for stock just like Appellants' 27 disqualifying exchange of real property for LLC 28 membership interests here. 22 1 For the step transaction to apply, a 2 taxpayer is not to be nefarious or doing something 3 wrong as strongly suggested by Appellants. As 4 demonstrated by the case of Crenshaw in which a 5 widow received a liquidating distribution from her 6 partnership, attempted to do a 1031 exchange and 7 that exchange was invalidated notwithstanding her 8 attempt to -- to, um, affect the exchange and there 9 was no determination of wrongfulness or nefarious 10 action on her part. 11 Furthermore, in the case of True versus 12 United States, which was an attempted 1031 case 13 where deferral was disallowed, the taxpayers 14 attempted to argue that their business transaction's 15 independent economic significance, the bono fide 16 business purposes, which precluded application of 17 the step transaction doctrine. The Court stated the 18 following in reply: 19 "We acknowledge the Trues' evidence of 20 business purpose and economic effects. 21 However, we do not agree with their 22 conclusion that business purposes and 23 economic effects relating to the individual 24 steps in each series of transactions 25 preclude application of the step 26 transaction doctrine in this instance. 27 The substance over form inquiry is not as 28 nearly as narrow as Trues suggest. To 23 1 ratify a step transaction that exalts form 2 over substance merely because the taxpayer 3 can articulate some business purpose 4 allegedly motivating the indirect nature of 5 the transaction or point to an economic 6 effect resulting from the series of the 7 steps, would frequently defeat the purpose 8 of the substance over form principle. 9 Events such as the actual payment of 10 money," transfer -- "legal transfer of 11 property, adjustment of company books, and 12 execution of a contract all produce 13 economic effects and accompany almost any 14 business dealing. Thus, we do not rely on 15 the occurrence of these events alone to 16 determine whether the step transaction 17 doctrine applies." 18 Moreover, in the case of Associated 19 Wholesale Grocers, the Court declared that the 20 existence of a valid business purpose does not 21 preclude application of the step transaction 22 doctrine, explaining that a legitimate business goal 23 does not grant a taxpayer carte blanche to subvert 24 congressionally mandated tax patterns. 25 In conclusion, the ability to point to 26 economic risk or business conditions does not bar 27 application of the step transaction doctrine in 28 these appeals. To find otherwise would allow 24 1 taxpayers to freely bargain with third parties and 2 create linked transactions that fail to satisfy 3 Legislative criteria under the rationale that 4 business conditions or third party requirements 5 dictated noncompliance with statutory provisions. 6 Allowing private contracts and understandings to 7 justify noncompliance with exchange criteria and 8 exemptions from taxation, benefits that courts have 9 long required full compliance with, effectively 10 would allow taxpayers and their business partners to 11 usurp and supercede congressional requirements. 12 In these appeals taxpayers freely agreed to 13 the requirement to contribute their property to an 14 LLC and obtain an eligible nonlike-kind property. 15 They engaged in a series of transactions to achieve 16 that particular result; and they in fact did so, 17 satisfying the alternative test of the step 18 transaction doctrine. 19 Taxpayers could have satisfied their 20 obligation to contribute the property in LLCs on 21 July 1st. They had -- that would have satisfied the 22 obligation. And so they just negotiated and 23 bargained for a date into January of the following 24 year to attempt to lag the transaction into the 25 following year for reporting purposes. But, to be 26 sure, the tax principle that a taxpayer cannot do 27 indirectly would have statutorily prohibited in a 28 direct manner, that's to say they could not directly 25 1 acquire LLC interest, applies in these appeals to 2 find that Appellants failed to satisfy 1031's 3 like-kind requirements. 4 Thank you. 5 MR. FEURZEIG: Mr. Feurzeig -- 6 MR. HORTON: On rebuttal. 7 MR. FEURZEIG: -- for the three 8 appellants. 9 First of all, I think the last statement 10 that Mr. Gemmingen said is not correct because in -- 11 in, uh, Magneson, they said the step transaction 12 does not apply if there's an alternative method to 13 do the same thing that was done in Magneson. 14 And here we could -- we could have had an 15 alternative method. We could have had a situation 16 where they could have created single member LLCs and 17 there's a -- there's a private letter ruling that 18 says if they would have -- if they would have 19 created eight -- eight single member LLCs, they 20 would have had the same number of steps. 21 Moreover, the recent cases have shown that 22 if there's an economic risk, then the step 23 transaction doesn't apply. So in the Holman and 24 Gross cases we had a situation they were gift tax 25 cases, and there's a regulation in the gift tax law 26 that says if you have an indirect gift on the same 27 date -- so, in other words, if you create an entity 28 and then in the same day you transfer, you make 26 1 gifts of -- of the interest in that entity, it's an 2 indirect gift and then all the -- the property that 3 was put into the LLC is really a direct gift, so you 4 can't get a -- a discount for lack of marketability 5 and for minority interest. 6 So in the Holman and Gross cases what 7 happened was they -- they created the entity and 8 then they transferred interest six days and eleven 9 days later. And the courts held that because of the 10 economic risk during that time, the stocks could 11 have fluctuated, anything could have happened. 12 Our case is so much better. We have a 13 situation where you have seven months have passed. 14 We had tremendous economic risk. We had unlimited 15 liability during that time. 16 The other thing that I think Mr. Gemmingen 17 fails to understand, because I know he doesn't -- he 18 doesn't agree with the Marks case and -- but he 19 still misunderstands, I think, the 1984 amendments 20 which was clearly enunciated in Marks. And it's 21 very clear that when they created the -- when they 22 published the 1984 amendments, they did it for 23 burned out partnerships. And it was for partnership 24 interests transferred for partnership interests. 25 I think Mr. Gemmingen misses the boat. He 26 thinks that any time you have a partnership that 27 then the 1984 amendments apply. In fact, if you 28 look at the Notice of Assessment, the NOA, they cite 27 1 that section and it's not applicable. We did not 2 have a partnership interest for a partnership 3 interest. 4 Do you have anything? 5 I think that's it for me. 6 MR. KAPLAN: I think, in addition, there 7 are no partnership interests on either side of any 8 of these exchanges. They exchanged out of 9 individual ownership of various properties and they 10 acquired tenancy in common interests in the -- in 11 the Sand Creek Shopping Center. They did not 12 acquire an interest in a partnership. 13 The -- the Franchise Tax Board's position 14 is, somehow, you take this like-kind property that 15 did receive and you convert it to unlike-kind 16 property by virtue of subsequent transfer. None of 17 the cases in this area support such an idea. 18 You can't make like-kind property 19 unlike-kind property. You can -- you can exchange 20 like-kind property for unlike-kind property. But if 21 you have like-kind property, it is like-kind 22 property. What you do with it may change or 23 evidence your intent in why are you holding it. But 24 it doesn't change the fact that it was like-kind. 25 So, I mean, the -- the -- the entire 26 discussion about, you know, do you need one side or 27 two sides with a -- with a partnership interest 28 really is -- is quite irrelevant to what we have 28 1 here. 2 I also want to make two more quick points. 3 One is the press release that has been introduced as 4 an exhibit -- I don't have it right here in front of 5 me; I'm not sure exactly what it is -- Mr. Gemmingen 6 presented that to us when we met a couple of months 7 ago. And we told him at that time we have no idea 8 who these people are, where this press release came 9 from. And the -- the purpose of presenting it to 10 the Board seems to be that it uses the name of Sand 11 Creek Crossing, LLC as the buyer of the property. 12 Well, at the time of the press release there was no 13 such entity. There was no such entity for another 14 four or five months. 15 The question of who purchased the property 16 cannot be in dispute. It's -- it's crystal clear 17 that it was purchased by the individual Appellants 18 as tenants in common. They had a tenancy in -- 19 tenancy in common agreement that explained their 20 relationships. For seven years Franchise Tax Board 21 argued it was a partnership. They finally came 22 around to understand that it was not. 23 I think the only purpose of putting that -- 24 that press release in front of you is to try to 25 confuse the reality of what's -- what's going on 26 here. 27 MR. HORTON: Thank you. 28 Member Ma. 29 1 MS. MA: Okay. So thank you very much. I 2 think this is a very enlightening conversation, 3 education in 1031. I've had to brush up on my 1031 4 courses as well. 5 But I want to ask you about the bank loan. 6 As I understand, this is common practice with many 7 lenders if they're going to lend to a group in a 8 1031 situation, that they require them to form a 9 single entity LLC for security purposes, right? 10 Because, for the bank, it's more secure to loan to 11 one entity; they don't have to worry about personal 12 issues for, let's say in this case, the eight 13 different Appellants, whether they got divorced, 14 whether they went through a bankruptcy, whether 15 someone was suing them. And so as I understand the 16 bank's practice in these type of large dollar LLC 17 transactions for commercial property is to have the 18 group form an LLC. 19 MR. MARK: There really are -- are two 20 parts to the -- to the answer, and neither is really 21 relevant to this lawsuit. But let me address them 22 both quickly. 23 The forming a bankruptcy remote entity came 24 about, about 15 years ago, when the real estate 25 industry -- excuse me, when the lenders of real 26 estate got tired of real estate that was going bad. 27 And what the owners would do, instead of just 28 allowing the foreclosure to go forward, is that they 30 1 would start a bankruptcy proceeding, sort of to tie 2 up the lender, frustrate the lender, buy some time 3 and, uh -- and eventually try to work out some kind 4 of a deal with the lender. 5 So they managed to get Congress to change 6 the bankruptcy law so that if it turns out that the 7 entity that goes into bankruptcy is a single entity, 8 single entity, they only have one business, then 9 there's an expedited procedure. So instead of the 10 owner being able to frustrate the lender, now the 11 lender can go into the bankruptcy court and get 12 relief very quickly and then proceed to foreclose. 13 So that's the portion of the bankruptcy -- of the 14 single purpose. 15 The other point is that back when this loan 16 was being made, it was really the beginning of the 17 securitization world on Wall Street when all sorts 18 of real estate loans were being securitized. 19 Eventually it led to part of the -- the collapse 20 that occurred in '07-'08. 21 So what that means is that a lender -- it 22 could be Bank of America, it could be anyone -- 23 they -- they put together a package of loans and 24 don't hold them. They make money putting the loans 25 together and then they would send them to Wall 26 Street and Wall Street would sell interest in the -- 27 the entity. 28 In order to do that, when you're taking a 31 1 lot of different loans, you have to have a uniform 2 standard so that all of the loans have the same 3 profile. 4 So that's the combination when we say 5 "bankruptcy remote" and "single purpose," it's to 6 try to fit everyone in. And they did it by making 7 everybody form a limited liability company, just -- 8 just as you're suggesting. But that all had to do 9 with -- with -- with what lenders wanted to do. 10 In this case, the, uh -- the lender did 11 what was just common at that point. 12 MS. MA: Right. So the -- the parties, the 13 Bramante group and the Rago group, came together, 14 identified the property, secured the loan, which 15 required them to form a single entity LLC some 16 months later. 17 MR. MARK: Well, that is and isn't quite 18 right. 19 In law school one of the things you learn 20 in this area is the difference between a covenant 21 and a condition. If I borrow money from the bank, I 22 promise to pay it back. If I don't, they can sue 23 me. Okay. That's -- that's a covenant. 24 But the terms in the deed of trust are a 25 condition. It says that if the borrower does not do 26 certain things -- and there's a long -- a laundry 27 list of things in a deed of trust. I'll get back to 28 the list in a second. But if you don't do what's in 32 1 there, that can be an event of default. And if it 2 can be an event of default, then that can lead to a 3 foreclosure. 4 But these trusts routinely, including this 5 case, but routinely have a laundry list of po- -- of 6 conditions that, if they're not met, can be an event 7 of default. A commercial property may have to 8 maintain a certain occupancy level. It may have to 9 have a certain square foot rental. It cannot commit 10 waste. 11 Often times the death of a -- of a borrower 12 will be an event of default. So any one of those 13 could trigger -- if it occurred -- and in this case 14 if the parties did not put the property in, then 15 that could have triggered this option of an event of 16 default. 17 Another common event of default is 18 submitting an annual accounting. It's not at all 19 uncommon in commercial real estate for something to 20 have occurred that's an event of default. Or maybe 21 somebody even died. But while it's in there, that 22 isn't what happens in the real world. I mean the 23 lender looks at his position. If a loan is being 24 paid, they're making money on it, then they take one 25 course of action. But theoretically, they could 26 initiate a foreclosure. 27 What would happen if that happened here? 28 Well, what would have happened then is what happened 33 1 eventually. Eventually this loan that we're talking 2 about was a ten-year loan and was paid off, so they 3 refinanced. So if this event of default had 4 occurred in year two or three and if the lender, not 5 likely, but if they had declared an event of 6 default, then these people would have refinanced, 7 which they have done. The current loan on the 8 property is not what was there at the time that the 9 property was bought. 10 MS. MA: Well, I think one of the arguments 11 is that the Appellants initially, as tenants in 12 common, entered into this transaction to exchange 13 their interest for LLC interest. 14 MR. MARK: No, that's not quite right. 15 What they did is they said we're going the 16 buy it as tenants in common and in the next year 17 we're going to look at our options. 18 All sorts of things could have happened. 19 The interest rates could have dropped and they would 20 have walked away from the loan. All sorts of things 21 could have happened. 22 But when the next year came, they decided 23 they would pursue the conversion; one, because of 24 what it says in the deed of trust; two, because it's 25 really good business, limited liability. As -- as 26 you heard, they had adjoining property which wasn't 27 subject to the mortgage at all, and they put that 28 into a limited liability company. 34 1 So there were a lot of things that could 2 have happened between the day they bought the 3 property and when they put it into a limited 4 liability company. 5 MS. MA: Okay. So they weren't forced by 6 the bank, so that was just an option if they -- 7 MR. MARK: That's a good way to put it. 8 MS. MA: -- wanted to continue -- 9 MR. MARK: Yes. 10 MS. MA: -- the loan. 11 MR. MARK: It was discretionary on their 12 part. 13 ---oOo--- 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 35 1 MS. MA: Okay. So, the same investors that 2 invested initially as tenants in common, are they 3 still the same ones -- 4 MR. MARK: They are still -- 5 MS. MA: -- in the LLC? 6 MR. MARK: -- 12 years later, they still 7 own the shopping center. 8 And the only difference is instead of 9 owning it directly, they own a limited liability 10 company that owns it directly. 11 MS. MA: Has -- so, nobody's cashed out any 12 cash? No new LLC members have entered? 13 MR. MARK: Several of the people -- the 14 names are behind you, several have died. 15 But aside from that, nobody -- nobody has 16 cashed out. 17 MR. KAPLAN: Two -- only two. 18 MR. FEURZEIG: Two have died. 19 MS. HARKEY: Two have died. 20 MS. MA: Okay. 21 MR. FEURZEIG: At 98 and 102. 22 MS. MA: And, so, their rights, 23 responsibilities, liabilities before as tenants in 24 common are still the same -- 25 MR. MARK: Well, yes and no. 26 MS. MA: -- as today? 27 MR. MARK: If you own property in a limited 28 liability company, then you're subject to different 36 1 rules. You have limited liability, you know. So -- 2 so, that would be different. 3 MS. HARKEY: I think what she's asking is 4 about the percent ownerships and things like that. 5 MR. MARK: Pardon me? 6 MS. HARKEY: The percent -- 7 MS. MA: The percent ownerships. 8 MS. HARKEY: -- ownership and things like 9 that. 10 MS. MA: There hasn't been a change 11 substantially -- 12 MR. MARK: No, no. 13 MS. MA: -- from -- except a couple of 14 people passed from the initial to today? 15 MR. MARK: Let me just say one more time, 16 that that provision in the deed of trust, if the 17 owners did not convert, they could not have been 18 sued. 19 It wasn't like they said we're going to do 20 it, if we don't do it, sue us. 21 It wasn't that, it was a condition. And it 22 could have triggered an event of default, subject to 23 all of those rules. 24 MS. MA: I think those are my questions. 25 MR. HORTON: Members, let me go to the 26 Department and have them address the Holman versus 27 -- the Holman and Gross case, as well as the 28 Magneson case, when they -- all three seems to speak 37 1 to economic risk. 2 And yet still the Department's conclusion 3 is that economic risk doesn't -- doesn't prevent you 4 from employing the step transaction. 5 MR. GEMMINGEN: Well, as I discussed 6 earlier, the True case -- 7 MR. HORTON: No, no, no. 8 MR. GEMMINGEN: -- I'm sorry, what -- 9 because -- 10 MR. HORTON: Holmes -- Holman -- 11 MR. GEMMINGEN: Well, Holman -- 12 MR. HORTON: Gross. 13 MR. GEMMINGEN: -- Gross and Magneson was 14 just a -- Magneson was only a holding issue, not 15 a like-kind issue. 16 We're are discussing a like-kind issue. 17 And, so, as far as the Holman and Gross concepts, 18 that's a question of valuation and really what 19 was -- what was gifted to the children in those 20 cases. It's a question of what was gifted and how 21 should that be valued? 22 And what was gifted in those cases were 23 limited lia -- limited partnership interests that 24 have substantial restrictions on alienability. In 25 other words, the idea there was to tie up the funds 26 in those partnerships so the children could not 27 spend the money. 28 So, there were substantial restrictions 38 1 imposed by the parents before the children received 2 the property, which detrimentally affected the value 3 of those limited partnership interests because they 4 were basically -- couldn't be freely sold for the 5 same value at the same time that the underlying 6 stock could be. 7 And, so, as far as the valuation there or 8 the economic risk, the court took that into 9 consideration in the value. 10 At the end of the day what the court was 11 really valuing was not the underlying stock, but 12 rather it was the limited partnership interest, 13 which is completely different, a different asset 14 here. 15 And, actually, the Holman and Gross courts 16 found that the daughters acquired intangible 17 ownership interests, limited partnership interests. 18 And, so, it is completely different, it's 19 like an apples and oranges comparison. 20 MR. HORTON: Well, I would think the 21 Appellant -- maybe -- well, let me just go to the 22 Appellant. 23 Your views? 24 MR. FEURZEIG: We -- I think we disagree 25 with the way the facts have been presented by 26 Mr. Gemmingen, because it wasn't -- it's true that 27 it was a valuation case, but the question was 28 whether there was an indirect gift. 39 1 So, the -- the IRS was taking a position 2 that the -- mainly stocks, but there were stocks and 3 real estate and some bonds -- that those were 4 directly made to the children. 5 So then there wouldn't be any discounts 6 because you can't discount items that are not in an 7 entity. 8 And the taxpayer in Holman and Gross argued 9 that -- that when they made -- when they made the 10 gifts, it was an economic risk because the stocks 11 could have fluctuated in value. And, so, therefore, 12 the step transaction should not apply. 13 And the court -- the court, of course, in 14 those two cases agreed with the taxpayer. 15 MR. HORTON: Appeals. 16 MR. JOHNSON: As to the question of whether 17 economic risk defeats the step transaction, parts of 18 the step transaction, there are even ones that can 19 last several years and, so, it would be very 20 difficult to imagine a situation where you've locked 21 something down for several years with absolutely no 22 economic risk. 23 So, I don't think you can say that economic 24 risk by itself is going to defeat the step 25 transaction. However, as you and Appellants noted 26 in Holman and Gross, they definitely looked at the 27 economic risk, even though it was six and 11 days 28 and determined that that was significant enough to 40 1 defeat a step transaction. 2 MR. HORTON: Back to the Department. 3 It appears that the -- the loan -- the loan 4 requirement to establish an LLC was a condition 5 subsequent to an act on the part of the tenants in 6 common, that -- and it was conditioned subsequent, 7 which they could have changed, could have modified, 8 didn't necessarily have to implement. 9 Given that that is -- that was the case for 10 seven months and it appears that they seemed to have 11 made significant decisions during that period of 12 time, which includes transferring not only one piece 13 of property into the LLC, but transferring both 14 properties into it. 15 And then I'd like to hear from both parties 16 as to what they -- how they would define a managing 17 partner in the LLC. 18 MR. GEMMINGEN: As far as the conditions, 19 the exchange is tested at the time of the exchange, 20 not -- you can use subsequent events to determine 21 what the parties' intent was going into the 22 exchange, but this idea that it's a discretionary 23 contribution, really they're saying that the 24 taxpayers then would not have the intent to hold the 25 property. They might not have been willing to hold 26 the property. 27 But, really, the requirement with realty in 28 all of the cases is that you test the exchange at 41 1 the time of the exchange. And at the time of the 2 exchange the taxpayers had the requirement to do 3 that contribution. 4 MR. HORTON: Seems to me that would negate 5 all that we've discussed, if only at the time of the 6 exchange while that process is taking place if 7 subsequent actions have nothing to do with the 1031 8 exchange. 9 And, quite frankly, I think it would sort 10 of negate the Congressional intent to establish a 11 basis where an individual can have the same economic 12 risk that they had from the beginning to -- in the 13 subsequent case. 14 Therefore, we're going to allow them to 15 defer because it's basically the same people, same 16 investment, same results. 17 MR. GEMMINGEN: Well, I think looking at 18 that economic risk, if you're looking at just the 19 overall investment, these people wanted to be 20 invested in a shopping center in a desirable 21 neighborhood. They're looking for a return. 22 How that investment is -- is -- it's 23 malleable as to whether it's going to be a TIC 24 interest or an LLC interest. They're looking for a 25 return on their investment. What profits will it 26 produce? 27 The question here is -- that we're looking 28 at -- is it's not same in the sense it's the same 42 1 kind of property. 2 'Cause as discussed in an earlier case 3 today, mobilia doctrine says that intangible 4 interests which are owned by a nonresident are 5 sourced differently. 6 So, the LLC interests here are a different 7 type of property than the TIC interest. 'Cause TIC 8 interest in California, the sale of that would be 9 sourced to California. 10 But as discussed in an earlier appeal 11 today, a person holding an intangible interest, who 12 is a nonresident, the sale of that interest would 13 not be sourced in California. 14 So, they're very different types of 15 property. And, that's what we're looking at here is 16 these are not like-kind property. 17 Taxpayers knew going into this transaction 18 that that they were going to end up with not 19 like-kind property. And that's one of the tests. 20 There's many tests in 1031. There is a 45-day 21 identification period in all this. 22 MR. HORTON: Are you arguing that it's not 23 the same form or it's not investment property for 24 investment property? 25 MR. GEMMINGEN: It's not -- it's not real 26 property. 27 They did not, at the end of the day, intend 28 to acquire real property. At the end of the day 43 1 they contemplated and were required to receive 2 intangible personal property by virtue of -- 3 MR. HORTON: Which is the LLC? 4 MR. GEMMINGEN: -- the LLCs, yes. 5 And they knew that in early June before 6 they even acquired -- when they even signed the loan 7 documents, before they acquired the property. 8 MR. HORTON: The basis for the Department 9 establishing the intent is a loan that -- that 10 clearly is -- doesn't appear to be binding by virtue 11 of the acts of the parties where subsequently seven 12 months they could have refinanced the loan? 13 MR. GEMMINGEN: Actually, may I address 14 that? 15 MR. HORTON: Yes. 16 MR. GEMMINGEN: I have as one of exhibits 17 here, Exhibit D, refinancing was not an option. 18 Refinancing was prohibited by the terms of the loan. 19 It was a ten-year balloon note. And, so, 20 they could not simply walk away or change if -- if 21 interest rates dropped as is suggested. 22 Rather it's at page D11 here, it says, 23 "There is no right of prepayment." So, it's -- they 24 were going into the transaction with this loan, no 25 right of prepayment and this what really should be 26 judged and the end results, interrelationship of 27 this loan, it's being a part of their ability to get 28 into that overall investment to get that rate of 44 1 return shows the interrelationship -- ship of this 2 loan with the acquisition of that property and their 3 ultimate acquisition of the LLC interest, which are 4 not like-kind property. 5 The whole point in the step transaction 6 doctrine is to link related transactions, which -- 7 MR. HORTON: No, I don't know -- 8 MR. GEMMINGEN: -- that's what we've got 9 here. We've got a linkage with the desire to 10 ultimately get non like-kind property. 11 MR. HORTON: Let me have the Appellant 12 respond to the same question. 13 MR. KAPLAN: Yeah. First of all, the 14 notion that the Appellants intended or desired to 15 acquire partnership interest is rather absurd. 16 They understood what Section 1031 required. 17 They knew that if they did acquire interest in a 18 partnership, their transaction would not qualify as 19 a tax deferred exchange. 20 As -- as Chairman Horton mentioned, 21 taxpayers are free to arrange their financial 22 affairs in manners which are within the law which 23 are most advantageous to them. 24 The Appellants were advised. They 25 understood what was law was. They knew that if they 26 acquired tenancy in common interests that would 27 constitute like-kind property. It would complete 28 their tax deferred exchange. And under the 45 1 established case law they were free to transfer 2 those interests into LLCs the next day, certainly 3 down the road. 4 I think we've also lost sight of the fact 5 that there are four parcels here and only two of the 6 four are subject to this loan. 7 It's not clear to me whether Franchise Tax 8 Board is focused on this requirement and it's the 9 requirement that somehow defeats the 1031 10 transaction for the Appellants. 11 Because if that's the case, then certainly 12 a portion of the exchange would qualify because 13 there was such -- no such requirement. 14 Mr. Gemmingen also mentioned that you look 15 to later events to help determine the taxpayer's 16 intent. 17 Well, now we're back to intent again. 18 We're not talking about like-kind property. We're 19 talking about the intent that the taxpayers had in 20 holding the property. 21 The purpose of Section 1031, whether you 22 agree with the policy behind it or not, is to allow 23 for continued investment in qualified property. 24 The minute you take money out of that, 25 you're subject to tax. But as long as your 26 investment continues, there's no current taxation. 27 It comes down the road. 28 MR. MARK: I hear Mr. Gemmingen to be 46 1 saying something else, which is really disturbing. 2 I hear him saying that if on the day I buy 3 a property, I own it. But if I contemplate that 4 in -- in the future, I buy replacement property, but 5 if I contemplate it on the day I buy it that I may 6 put it into an LLC, then that queers the 1031. 7 That kind of policy is so divisive, so 8 unbusinesslike, so inappropriate. 9 If I buy replacement property, I own a 10 hotel, now I own a shopping center, me, but I 11 want -- but at some point I contemplate, I may very 12 well put it into a limited liability company. Why 13 shouldn't I? It's done every day. 14 He's saying if you contemplated it and then 15 you do it, you queered your 1031. 16 But that's -- that's more than sad. 17 MR. HORTON: Okay. Well, the one point 18 that I would caution Appellant on, that if you 19 transfer it the same day, the Aries -- we'd take a 20 look at the Board's decision in the Aries case and 21 so forth. 22 I mean I do believe economic risk has a 23 value. And when there is economic risk, it 24 establishes not only the intent, but in transferring 25 it from tenant in common -- tenants in common to 26 tenants in common and maintaining a level of 27 economic risk, a level of economic risk, a level of 28 decisions, a level of management during that process 47 1 is somewhat extensive. 2 And then if you -- if you look at the Hart 3 case, which may not necessarily follow, but it is 4 informative to this body, the Hart case is 5 informative to this body as to the form, where the 6 form -- basically, the intent of the party was to 7 maintain similar. 8 The loss of risk that occurred seven months 9 later by moving the property into a TLC at that 10 point, if that had occurred at an earlier stage and 11 then not been an economic risk by the virtue of the 12 time at which it was transferred, there may be some 13 challenge here. 14 But -- let me just leave it alone, I guess. 15 Member Harkey. 16 MS. HARKEY: Yeah, I don't have a whole lot 17 to add to that. 18 I just -- I thought you -- you transferred 19 from a tenants in common to a tenants in common. It 20 was held for seven months. Then you changed the 21 structure. 22 So, in my mind, 1031 was completed. The 23 fact that the -- you had subsequent dealings, I 24 think you were probably -- we've established you -- 25 you have a right to have -- the ten-year hold on the 26 loan really isn't -- isn't of issue here because you 27 did that seven years -- or seven -- seven months 28 later you procured that, even though you may have 48 1 had it tied up sometime earlier. 2 The reason for the ten-year hold is what 3 we've gone back to, the syndicated loan, the 4 securitization syndicated loan. 5 The loan was syndicated, wrapped and the 6 lenders sold it. And the investors wanted to know 7 that there was some -- that they were going to have 8 a yield for a while, you know, interest for a while. 9 So, I don't think that really weighs into 10 this. I think the point is -- and the point that 11 was argued in the last transaction that we had -- 12 and this one seems to really fit the bill of the 13 1031, that it was like -- it was tenants in common, 14 went to tenants in common. 15 Subsequent didn't matter. It's where it 16 went. And, so, I think the loan documents, the 17 transactions that came into place, it's 18 just changing -- it didn't change the fact that 19 there was a legitimate 1031 document. 20 And you still -- there's -- the property's 21 still held now. So, the intent to hold was there. 22 The intent to keep the investment's there. 23 And I'm not even sure that matters except 24 for when you decide to sell and pay your taxes. 25 So, I'm -- and the fact that you split it 26 up, you know, you had one that was liened, one 27 that's not, but you put them both in the LLCs, which 28 is probably for -- to limit your liability, very 49 1 definitely to limit your liability. 2 So, that's -- that's all I have to say. 3 Thank you. 4 MR. HORTON: Ms. Stowers. 5 MS. STOWERS: Okay. Let's talk about the 6 other parcels. @@@ So, Appellant, you're saying 7 that your loan document did not require you to put 8 those into an LLC? 9 MR. KAPLAN: That's correct. The loan -- 10 there were four separate parcels that cumulatively 11 comprised the Sand Creek shopping center. 12 Two of the parcels were subject to the 13 loan. The other two parcels were purchased 14 outright -- were not financed, had no financing 15 requirements or elements to it at all. 16 MS. STOWERS: Okay. 17 MR. KAPLAN: So, it's only -- yeah, it was 18 the two -- two of the lots were subject to the loan. 19 The other two were not. 20 At the same time, or roughly the same time, 21 all four parcels -- these two subject to the loan 22 were put into one LLC, the two that were subject -- 23 that were not subject to the loan were put into a 24 separate LLC. 25 MR. MARK: But the reason it's obvious is 26 two -- two of the lots were the shopping center. 27 And the other two lots were just vacant lots. 28 So, the vacant lots -- the lender wasn't 50 1 interested in the vacant lots. 2 MR. GEMMINGEN: May I address that, 3 Mr. Chairman, please? 4 MS. STOWERS: Wait a second, I was going to 5 give you an opportunity. 6 MR. GEMMINGEN: Sorry, okay. 7 MS. STOWERS: So, I want to you address 8 what you want to say, but then also answer -- if two 9 was not required to placed into an LLC, are you 10 still -- is it still your position to look at the 11 step transaction doctrine? 12 Because they had -- well, it doesn't seem 13 like they had a requirement to put those into an 14 LLC. 15 So, why the step transaction with those 16 two? 17 MR. GEMMINGEN: Well, I'll answer that 18 question. 19 Beginning I'd like to just point -- this 20 will explain why we're looking at is that 21 Appellant's comment that the lender was not 22 interested in the adjoining pads is not correct, as 23 you will see at Exhibit B of our exhibits, page 4, 24 which talks about the pads and restrictions on the 25 use of the pads. 26 And the taxpayer is not entitled to -- the 27 Appellants are not entitled to commence any 28 construction activities on any pad 'til after the 51 1 single purpose entity transfer date. 2 So, there were restrictions on the pads by 3 the loan documents. 4 And, so -- and in addition, I have included 5 the -- the relevant portions of the tax returns for 6 the LLC companies for the pads. It's a separate 7 LLC, as well as the primary entity, The Crossing. 8 And the pads property was only valued at 9 $358,000. It's less than 1 percent. The overall 10 money going into this deal is 5 -- I mean, $50 11 million. So, you'll see that reflection of over $40 12 million on the -- the other tax return. 13 And, so, really the pads were restricted by 14 the deed of trust, but they're an insignificant 15 amount. But they -- they were -- no construction 16 activity could happen on them. 17 But we look again at the end result and the 18 pads formation was alongside the time of the 19 formation of the LLC Crossing, which held the 20 property worth over $40 million. 21 And, so, we say that those activities were 22 in harmony with one another. 23 MR. MARK: I really think that's a sad 24 response. 25 What you're saying is did the lender take a 26 lien on the lots? No, no. 27 The lender was interested in what was 28 happening on the adjoining property. They didn't 52 1 want a racetrack going up there. They were very 2 interested in what might happen. They made a big 3 loan on this shopping center and they were concerned 4 about what was going on around it. 5 But the lots were not subject to the deed 6 of trust. The lender did not have a lien on those 7 lots. 8 MS. STOWERS: Next question, I'm looking at 9 FTB Exhibit C -- it's late. 10 Could you have paid the loan off sooner? 11 Were you restricted from doing it? Could you have 12 paid off your loan sooner? 13 I think FTB said there was some prepayment 14 clause, that they could not prepay the loan. So, 15 therefore, you was locked into this loan and you 16 were going to have to drop it into the LLC? 17 MR. MARK: You can always prepay a loan, 18 but you might have to pay a fee. 19 MS. STOWERS: Okay. So, you could have 20 paid it off? 21 MR. MARK: You are not free -- you're not 22 free. 23 MS. STOWERS: It would have just had a 24 penalty, like so many other loans have? 25 MR. MARK: Just a business term. 26 MS. STOWERS: Okay, I just wanted 27 clarification on that. 28 MR. RUNNER: Prohibitive. 53 1 MS. HARKEY: You got to pay. 2 MS. STOWERS: I just -- I agree with so 3 many of the other Members that holding the property 4 and take interest for seven months, they had that 5 economic risk for seven months. 6 So, they, at that time, completed 7 a like-kind exchange. And the event to drop it into 8 an LLC, that's an event subsequent. 9 And I don't see that the requirement in the 10 loan document telling them that they shall do it and 11 if they don't do it, they may have a default -- I 12 don't see where that is justification to say that 13 they exchanged real property for an LLC property. 14 You're saying when they step together, 15 their intent was always to get an LLC property. I 16 can't ignore the fact that they held that property 17 for seven months. 18 Just my comment. 19 MR. HORTON: Further discussion, Members? 20 Is there a motion? 21 Moved by Member Runner to take the matter 22 under submission. Second by Member Ma. 23 Without objection, Members, such will be 24 the order. 25 Thank you very much for appearing before us 26 today. The Board will take your matter under 27 consideration later on this evening. 28 MS. HARKEY: Thank you. 54 1 MR. HORTON: And send you a written report 2 of our decision. 3 MR. GEMMINGEN: Thank you, Mr. Chairman. 4 MR. MARK: Thank you. 5 ---o0o--- 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 55 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, KATHLEEN SKIDGEL, Hearing Reporter for 8 the California State Board of Equalization certify 9 that on March 25, 2015 I recorded verbatim, in 10 shorthand, to the best of my ability, the 11 proceedings in the above-entitled hearing; that I 12 transcribed the shorthand writing into typewriting; 13 and that the preceding pages 1 through 35 constitute 14 a complete and accurate transcription of the 15 shorthand writing. 16 17 Dated: April 30, 2015 18 19 20 ____________________________ 21 KATHLEEN SKIDGEL 22 Hearing Reporter 23 24 25 26 27 28 56 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, JULI PRICE JACKSON, Hearing Reporter for 8 the California State Board of Equalization certify 9 that on March 25, 2015 I recorded verbatim, in 10 shorthand, to the best of my ability, the 11 proceedings in the above-entitled hearing; that I 12 transcribed the shorthand writing into typewriting; 13 and that the preceding pages 36 through 55 14 constitute a complete and accurate transcription of 15 the shorthand writing. 16 17 Dated: April 27, 2015 18 19 20 ____________________________ 21 JULI PRICE JACKSON 22 Hearing Reporter 23 24 25 26 27 28 57