1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 MAY 27, 2015 10 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 11 APPEAL OF 12 MICHAEL D. RUDD and PATRICIA J. RUDD 13 NO. 794298 14 AGAINST PROPOSED ASSESSMENT OF 15 ADDITIONAL INCOME TAX 16 17 18 19 20 21 22 23 24 25 Reported by: Juli Price Jackson 26 CSR No. 5214 27 Kathleen Skidgel 28 CSR No. 9039 1 1 P R E S E N T 2 3 For the Board: Sen. George Runner (Ret.) Vice-Chairman 4 5 Fiona Ma, CPA Member 6 7 Diane L. Harkey Member 8 9 Yvette Stowers Appearing for Betty Yee, 10 State Controller (per Government Code Section 11 7.9) 12 Joann Richmond 13 Chief, Board Proceedings Division 14 Claudia Lopez 15 Manager II, Acting Clerk 16 For Board of Linda Frenklak Equalization Staff: Staff Counsel 17 18 For Franchise Tax Kristen Kane Board: Tax Counsel 19 Ciro Immordino 20 Tax Counsel 21 For Appellants: Mark A. Loyd 22 Attorney 23 Marcy Jo Mandel 24 Attorney 25 26 ---oOo--- 27 28 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 MAY 27, 2015 4 ---oOo--- 5 MR. RUNNER: What's next on our agenda? 6 MS. RICHMOND: Our next item is item B3, 7 Michael D. Rudd and Patricia J. Rudd. 8 Please come forward. 9 MR. RUNNER: Okay. Everybody in their 10 place? Coming soon. There you go. Thank you. 11 Okay, Appeals? 12 MS. FRENKLAK: Good afternoon, Members of 13 the Board. My name is Linda Frenklak with the 14 Appeals Division. 15 The issue in this appeal is whether 16 Appellants have shown error in the Franchise Tax 17 Board's adjustment of Appellants' claimed other 18 state tax credits. 19 MR. RUNNER: Okay. Taxpayers, 20 representatives? 21 MR. LOYD: Hi, I'm Mark Loyd, with Bingham 22 Greenebaum Doll of Louisville, Kentucky. With me is 23 Marcy Jo Mandel of counsel with Winston & Strawn. 24 And Mr. Mike Rudd is in the gallery. 25 The -- this case is really about a 26 relatively narrow issue. It's about whether Revenue 27 and Tax Code 18 -- Section 18001, which provides a 28 California other state tax credit for, quote, "net 3 1 income taxes imposed by and paid to another state," 2 end quote, and whether or not Mr. Rudd should get a 3 tax credit for Kentucky individual income tax 4 imposed on Mr. Rudd for his income from Rudd 5 Equipment, which is an S corporation, which was 6 satisfied by an amount paid to Kentucky by Rudd 7 Equipment as Kentucky limited liability entity tax. 8 So, this is an issue of first impression, 9 from what I can tell. It's not been addressed by 10 California. So, I think the most appropriate place 11 to start is the California statute. 12 And it's a pretty narrow little section of 13 it, you know, it basically says, you know, quote, 14 "net income taxes imposed by and paid to another 15 state." 16 So, No. 1, you look at another state must 17 impose a net income tax. And No. 2, that tax must 18 be paid to that other state. It's pretty 19 straightforward. 20 To us the real question is going to be what 21 is a payment? I mean, that's really what you get 22 down to. And, you know, I think that a payment is 23 an amount paid to a state, you know, 'cause that's 24 consistent with what the statute says. I think it's 25 that simple. 26 So, as it relates to 18001, Kentucky 27 imposed a net income tax on Mr. Rudd on his income 28 from Rudd Equipment. So, the tax imposed is an 4 1 income tax. It's not a gross receipts tax. It's 2 just an income tax. So, the first part of that test 3 is met. 4 The second test is -- is really the 5 question for the Board. And that is, is this 6 payment to Kentucky by Rudd Equipment, which 7 satisfied Mr. Rudd's Kentucky net income tax 8 obligation, an amount -- quote, "an amount paid to 9 another state" under 18001? 10 To us, at least as it relates to Mr. Rudd, 11 18006, which talks about, you know, a tax that's 12 paid by an S corporation, like you might have in 13 Tennessee -- you know, Tennessee doesn't have an 14 income tax. So, if you're an S corporation in 15 Tennessee, they tax the S corporation directly. So, 16 we don't have that situation here. 17 California -- it says -- as far as relevant 18 background, you know, California imposed its income 19 tax on all of Mr. Rudd's income from Rudd Equipment, 20 an S corporation. 21 And Kentucky imposed its income tax on 22 Mr. Rudd's Kentucky source income from Rudd 23 Equipment. Mr. Rudd's Kentucky income tax liability 24 was satisfied in part from withholding, which had 25 been paid to Kentucky by Rudd Equipment, and that 26 piece is not in issue here. 27 But I think it's interesting because when 28 you look at that, you can compare that to Rudd 5 1 Equipment -- the other amount that Rudd Equipment 2 paid to Kentucky and that was the amount that Rudd 3 Equipment paid which satisfied the other portion of 4 Mr. Rudd's Kentucky source income from Rudd 5 Equipment, which was the limited liability entity 6 tax, for which Mr. Rudd received a credit. 7 So, our position is, as to Mr. Rudd's 8 Kentucky net income tax liability, that Kentucky tax 9 amount paid by Rudd Equipment is an amount paid to 10 another state, Kentucky, and, thus, it's a allowable 11 as a California tax credit. 12 I think a little bit of background as to 13 limited liability entity tax night be helpful to the 14 Board. 15 The limited liability entity tax and the 16 credit -- and the corresponding credit for income, 17 you know, to the income tax, is -- is all contained 18 in KRS, Chapter 141 of the Kentucky Revised 19 Statutes, specifically in KRS-141.010. 20 Kentucky treats tax paid at the entity 21 level, and, as far as I'm concerned as Kentucky a 22 practitioner, as if it were paid by the individual, 23 to the extent of the individual's distributive share 24 of income is included in income to be taxed by 25 Kentucky. 26 So, you get a dollar for dollar offset. 27 And it's only available for amounts paid to the 28 state. So, it looks likes a credit. 6 1 Now a little bit of local flavor, you know, 2 why do you have somebody from Kentucky here talking 3 about this, you know, as opposed to my co-counsel 4 Ms. -- distinguished co-counsel from California? 5 It's 'cause I practice in Kentucky. 6 So, I'm very familiar with this tax. I was the 7 Chair of the Kentucky Society of CPAs Tax Committee 8 from 2005 to 2007, when the Kentucky General 9 Assembly enacted the Kentucky statutes that provide 10 for pass-through entity -- for this pass-through 11 entity tax that would require out-of-state owners to 12 pay a portion of each owner's in -- Kentucky 13 individual income tax. 14 At that time the Kentucky Society of CPAs 15 Tax Committee was very involved in talking with 16 legislators, as well the Governor's budget office, 17 about their concerns about tax proposals in the 18 context of tax modernization. 19 In the mid-2000s, Kentucky perceived a 20 problem, particularly the budget office did, with 21 nonresident pass-through owners who were not paying 22 Kentucky income taxes. 23 And there was a case that's not cited in 24 the -- in the materials, but it's an example case, 25 really, it's called Kentucky Department of Revenue 26 versus Asworth, which is 2007-CA-002549-MR and 27 2008-CA-00023-MR, which is an unpublished decision 28 of the Kentucky Court of Appeals in 2010. And all 7 1 that really does is show that -- is demonstrate that 2 it was an issue. It just -- and that's all it does. 3 It's not relevant to the immediate -- to the 4 immediate issue. 5 The Kentucky General Assembly enacted this 6 LLET, Limited Liability Entity Tax, as a part of 7 this comprehensive tax modernization in 2007 and in 8 2006 to make sure that nonresident owners paid their 9 Kentucky income tax, which why is the LLET tax 10 payment is the first credited -- it's the first 11 credit to be against the tax. 12 And the reason why it was that is because 13 the budget office wanted the LLET credit to be 14 nonrefundable and they felt like if they could make 15 it the first application against the tax that that 16 would be -- would be -- would be fair. 17 But the intent was all -- was for this to 18 be like a payment -- for it to be a payment, not -- 19 you know, although it is, you know, it is, I guess, 20 the nomenclature of a credit and thus, we're talking 21 about this. 22 So, the credit -- the credit for the LLET, 23 or the limited liability entity tax, must be 24 distinguished from other credits. Like, for 25 example, you have credits to incentivize 26 expenditures. You know, they're for buying 27 manufacturing equipment, for example, or expanding a 28 plant. 8 1 This is a -- this is what you get -- a 2 credit here is what you are getting for an amount 3 paid to Kentucky. It's kind of like a withholding. 4 You know, withholding is paid by an employer. And, 5 in theory, the employee gets a credit for the 6 amounts paid by the employer. 7 And this is no different, really, in 8 substance, because the amounts that would have went 9 into the owner's pocket, don't go there. They 10 went -- 'cause they were paid to Kentucky. 11 So, the purpose of the California -- of the 12 state tax credit, is to make sure that income 13 sourced to another state is taxed only once and it's 14 not subject to unconstitutional double taxation. 15 That is, it's supposed to go to a state. 16 And the Board could avoid any 17 constitutional problem by construing the California 18 law, in this case the California tax credit, so as 19 to allow that. 20 Now, you know, California's not the first 21 state facing this. Neighboring states of Kentucky 22 had to deal with this as well. And the population 23 center in Kentucky is Louisville -- which you all 24 pronounce Louisville. And there there's a sizeable 25 group of people who live in southern Indiana and 26 they casually refer to that as the sunny side of 27 Louisville, which we might take issue with, but 28 that's okay. 9 1 Anyway, Indiana's right across the river, 2 so, they have dealt with this issue. This was a big 3 issue to Indiana -- much bigger than it is to 4 California because of the amount of commerce that 5 goes back and forth across the river. 6 Indiana's statute -- Indiana's other tax 7 credit statute is virtually identical to that of 8 California's. And after studying it, 9 contemporaneously at the time, you know, they issued 10 their directive, which the Board has a copy of, 11 which was provided a few days ago. 12 It basically says that Indiana will give 13 credit for not only amounts that are withheld, but 14 also for amounts that are paid via the limited 15 liability entity tax. 16 So, in other words, the only state that's 17 addressed this particular issue that we have, you 18 know, before the Board, has found for the taxpayer's 19 position, which is that it's a -- it's a payment, 20 essentially, and, therefore, it's creditable because 21 it was for an amount -- because the amounts at issue 22 were paid to Kentucky to satisfy Mr. Rudd's Kentucky 23 net income tax liability. 24 So, in sum, that's why Mr. Rudd is due a 25 California tax credit under 18001. 26 And I'll yield my remainder. 27 MR. RUNNER: You will have chance to return 28 -- to respond. 10 1 Okay, FTB. 2 MS. KANE: Good afternoon, Vice Chair 3 Runner, Members of the Board. 4 My name is Kristin Kane. Sitting with me 5 are Ciro Immordino and Cheryl Akin. I apologize for 6 the 1980s version of Power Point. This is what we 7 have. 8 So, this case deals with both Kentucky and 9 California law. There are two separate Kentucky 10 laws that we're concerned with today. 11 Under one Kentucky law limited liability 12 entities are subject to a gross entity tax. This 13 tax is neither a net tax nor an income tax. 14 A separate Kentucky law gives S corporation 15 shareholders a nonrefundable personal income tax to 16 -- equal to the shareholders' pro rata share of the 17 limited liability entity tax paid. The credit is 18 called the limited liability entity tax credit. 19 So, there's both a tax and a credit. 20 California law at issue in this case 21 relates to the other state tax credit, or the OSTC. 22 There are several types of OSTC. At issue we have 23 two, the personal OST for a California resident and 24 an S corporation OSTC for members of flow-through 25 entities, such as Appellants' S corporation. 26 Some facts of the appeal, Mr. Rudd was 27 shareholder in an S corporation that did business in 28 Kentucky, among other states. During 2007 and 2008 11 1 taxable years, Appellants' income from the S 2 corporation was subject to taxation in both Kentucky 3 and California. 4 On Appellants' original returns, they 5 claimed the OSTC for only the payment of net tax to 6 Kentucky. 7 During audit they claimed additional other 8 state tax credit for the amount of Kentucky net tax 9 and for the Kentucky limited liability entity tax 10 credit. 11 Respondent allowed the OSTC which related 12 to Kentucky's net income tax paid, but disallowed 13 that portion which related to the limited liability 14 entity tax credit. 15 So, at issue in this appeal is whether 16 Appellants can claim the limited liability entity 17 tax credit as an income tax imposed and paid for 18 purposes of the other state tax credit. 19 Appellants argue that the limited liability 20 entity tax credit should be treated as a payment of 21 tax for OSTC purposes, while Respondent says the 22 limited liability tax credit is just a tax credit 23 and doesn't qualify as tax imposed and paid for 24 purposes of the other state tax credit. 25 There are considerable problems with 26 Appellants' attempts to use the limited liability 27 entity tax credit as a payment of their personal 28 income tax. 12 1 First, it's unprecedented under the law to 2 treat a tax credit as a payment. 3 Second, assuming that the credit is a 4 payment, the payment in question was for a tax which 5 is not eligible for the other state tax credit. 6 And, third, Appellants attribute the S 7 corporation's payment to themselves with no 8 authority under the law to do so. 9 The OSTC is not for generating credits. 10 It's for net income taxes imposed and paid. And, as 11 such, the -- in order for the limited liability 12 entity tax credit to qualify under Section 13 18001 (a), it would need to be considered a payment 14 of Appellants' net income tax. 15 As stated, there is no precedent under the 16 law for treating a nonrefundable tax credit as 17 payment. 18 Treating a nonrefundable income tax payment 19 would go against findings of the IRS, the United 20 States Tax Court, and Respondent's pub list 21 guidance. 22 Despite the fact that a credit is not a 23 payment, the Appellants argue that the limited 24 liability entity tax credit should be treated as 25 one. Substance and not form is controlling when 26 determining how a tax item should be treated. 27 And under the law we analyze how a tax item 28 functions to determine how it should be treated. 13 1 However, Respondent believes that the limited 2 liability entity tax credit is properly identified 3 as a credit because it functions in every way as a 4 tax credit. 5 Here are some functions of a tax credit 6 versus a tax payment. Credits are used as part of 7 the calculation of tax to reduce total tax and 8 arrive at net tax, while payments are a satisfaction 9 of that net tax. 10 Generally law lists what is considered a 11 credit and what is considered a payment. A 12 nonrefundable credit, not fully utilized as income 13 tax, may not be refunded as a payment can. 14 And income tax credits cannot be used 15 against other tax liabilities, such as sales or use 16 tax. And credits must be applied in the order 17 prescribed by law. 18 When we apply these functions to the 19 limited liability entity tax credit, we see that it 20 meets all of them. The credit is used as part of 21 the calculation of Kentucky tax to reduce total tax 22 and arrive at next tax. Kentucky law lists it as a 23 nonrefundable business incentive credit against the 24 income tax imposed by that state. If the credit is 25 not fully utilized against tax, it may not be 26 refunded. The credit cannot be used against 27 Kentucky use tax. And, finally, the credit must be 28 applied against tax in the order prescribed by 14 1 Kentucky law. 2 In every way the limited liability entity 3 tax credit functions as a tax credit. The fact that 4 the credit is generated in relation to an unrelated 5 entity's payment of gross tax does not change its 6 fundamental nature as a credit. 7 If your Board were to find that a credit 8 could be a payment, the problem arises that 9 Appellants did not make that payment. It was made 10 by a separately legal entity, the S corporation. 11 There is no process under 18001 (a), which allows 12 the taxpayer to claim an other state tax credit for 13 a tax imposed on a different entity and paid by a 14 different entity. 15 Appellants say there's no requirement under 16 18001 (a) that they make the payment in order to 17 take the OSTC. However, there is a requirement that 18 the taxpayer make the payment when you read the 19 statute in its totality. 20 In 18001 (b), it states that certain 21 payments of net income tax made by other entities 22 may be treated, and as I quote, "paid by the 23 taxpayer." 24 If there was no requirement that the 25 payment be made directly by the taxpayer, then there 26 would be no need for 18001 (b). 27 If the legislature had intended Appellants 28 be able to claim credits for payments made by other 15 1 entities, they would have explicitly stated so in 2 18001 (a) as they did in 18001 (b). 3 Since the Appellants did not pay the 4 payment, there is no process to attribute the 5 payment to them under 18001 (a), as there is under 6 18001 (b). They are not entitled to the credit. 7 If your Board were to find that the 8 nonrefundable credit can be treated as a payment and 9 find there is a process for Appellants to claim that 10 payment as their own, Appellants still may not claim 11 the other state tax credit for the limited liability 12 entity tax because the limited liability entity tax 13 is not a qualified tax for purposes of the other 14 state tax credit. 15 In order for a payment to qualify for the 16 other state tax credit it must be a payment of net 17 income tax. The limited liability entity tax is 18 neither a net tax nor an income tax. It's a gross 19 tax on limited liability entities. As such, the 20 payment of this tax is not qualified for the OSTC. 21 Appellants essentially argue that one 22 payment is just as good as the other, and we should 23 overlook the difference between the two and 24 attribute the payment to Appellants' income tax. 25 However, the differences between the two 26 payments cannot be overlooked. And a nonqualified 27 tax cannot be transmuted into a qualified tax. 28 And, finally, I would like to respond to 16 1 Appellants' argument regarding the Indiana 2 directive. The Indiana directive is simply a 3 process to allow, quote, "Residents proportionate 4 share of taxes paid by a limited liability entity," 5 for purposes of the Indiana OSTC. 6 California allows the same treatment under 7 not just a directive, but a statute, 18001 (b) and 8 180016 (verbatim). However, California law 9 restricts the qualifying taxes to net tax. Net 10 taxes are defined as income that remains after gross 11 income, reduced by deductions and exemptions, and, 12 importantly, credits. 13 Unlike California, Indiana allows an OSTC 14 for gross income taxes that can include tax before 15 it is reduced by credits. 16 As a result, the Indiana directive can 17 never be implemented in California because it is 18 directly contrary to California law, which does 19 allow for a proportionate share of taxes paid by an 20 S corporation to be included in the OSTC calculation 21 as the directive, but limits that OSTC to net taxes. 22 Indiana having no such -- has no such net 23 tax restriction. So, the directive fits comfortably 24 in their law, where it would actually negate a 25 portion of our law. 26 Because California imposes tax on net 27 income only, allowing an OSTC for gross taxes would 28 be to allow a credit for more tax than California 17 1 would impose under its law, that is, more income 2 that was subject to double taxation. 3 Because of the significant differences 4 between Indiana and California law, the directive is 5 inapplicable. Furthermore, this type of directive 6 cannot be issued by a California agency because it 7 may be considered an underground regulation pursuant 8 to Government Code 11340.5. 9 In conclusion, Respondent respectfully 10 requests that its action is sustained. 11 MR. RUNNER: Thank you. 12 Rebuttal? 13 MR. LOYD: Sure, I'll just kind of flip 14 through the Franchise Tax Board's slides. 15 As to the LLET and the LLET credit, under 16 Kentucky law it's all in the same statute. It's in 17 KRS 01 -- KRS 0141.0401. 18 Under California law, we're only looking at 19 18001 (a), we're not looking at 18001 (b). 20 It seems to me that the -- as it relates to 21 positions, you know, the -- it seems to me that our 22 position is that a payment of tax is -- that the 23 LLET credit is a payment of tax because the 24 substance of it is a payment of tax because it is an 25 amount paid to the government. 26 As it relates to Franchise Tax Board's 27 position, it seems to me that it's the label that 28 controls. And the label really can't control under 18 1 Beamer, which is cited in the -- in our briefs, the 2 Beamer case. 3 There really isn't any problem with our 4 argument. Interestingly, when -- when the Franchise 5 Tax Board says that the payment it isn't a qualified 6 payment, they're almost admitting that it's a 7 payment. So, I mean, it is a payment. 8 And the fact that it was made -- that the 9 payment was made -- not made by -- directly by 10 Mr. Rudd doesn't convert it to a nonpayment simply 11 because it was made by the S corporation. It was an 12 amount paid to Kentucky. It's out of his pocket, 13 just like it -- just like withholding tax is out of 14 my pocket or any other employee's pocket. 15 As it relates to the Internal Revenue 16 Service authority cited by the Franchise Tax Board, 17 Internal Revenue -- there is no other state credit 18 in the federal tax -- in the Internal Revenue Code 19 of which I'm aware, so, that's really just not of 20 any help. 21 And as it relates to, you know, what -- the 22 functions of a credit, I think the real fundamental 23 issue for the Board is what's a payment? You know, 24 is a payment -- is a payment an amount paid to a 25 government? I mean, to me that's really the 26 fundamental difference. 27 A credit is an amount paid to somebody 28 other than the government, you know, that you're 19 1 getting a credit for that reduces your -- your 2 income tax liability down to your net tax liability. 3 And the other thing is, I think that since 4 this is -- since this is a statute that we're 5 looking at, the statute doesn't talk about what's a 6 payment versus what's a credit. It just talks about 7 what's a payment. And under the statutory language 8 it says, "an amount paid to another state." 9 So, from that standpoint, whether it's 10 refundable or not -- and we could go through this -- 11 we named this credit legally, whether it's named a 12 credit or not, the Franchise Tax Board admits the 13 substance controls over the form or the label, 14 whether it's nonrefundable or not really doesn't 15 matter. In a lot of states, you can't get your 16 money back, you know, after the statute of 17 limitations expires and under certain conditions. 18 So, from that respect -- in that respect, a 19 lot of payments are not refundable. There's no 20 requirement that the payment be refundable. 21 As a matter of fact, if you make payments 22 to Kentucky under tax amnesty, you can't get your 23 money back. And it's definitely a payment. A 24 payment made under tax amnesty is nonrefundable. 25 You cannot get it. It doesn't convert it into a 26 credit. A credit can't be -- payment -- well, a 27 credit cannot be used against other tax liabilities. 28 Well, you can't use a payment against other 20 1 tax liabilities either because a payment for income 2 taxes, unless it's a -- unless it's a payment for 3 income taxes, unless it's statutorily allowed, like 4 withholding. 5 And credits used in the order prescribed by 6 law, again, you know, by making it first, the intent 7 of the Kentucky General Assembly was to make sure 8 that that payment got -- was applied against the 9 tax, the net liability -- at least, we would -- we 10 would say, at least in California parlance. 11 And in sum, at the -- at the end, the focus 12 again, I think, has got be on 18001 (a), 'cause that 13 really holds the key to the Board's -- to the 14 Board's decision in this case. 15 And if you look at the language of the 16 statute, you know, one payment is as good as 17 another. And in this case we've got an amount that 18 was paid to Kentucky. I don't really know how much 19 more you could ask 'cause how could that not be a 20 payment? 21 Thank you. 22 MR. RUNNER: Okay. Questions from Members? 23 MS. STOWERS: I will go. 24 MR. RUNNER: Member Stowers. 25 MS. STOWERS: I was going to put on 26 Mr. Horton's hat and ask Ms. Mandel, is this your 27 first time here? 28 MS. MANDEL: Technically, no. 21 1 MR. RUNNER: No, that's right, the right 2 answer. 3 MS. STOWERS: So, anyway, to Appellant, 4 you're saying the focus should be on subdivision (a) 5 and not (b)? 6 MR. LOYD: Yes. And that's -- go ahead, 7 I'm sorry. 8 MS. STOWERS: But to focus on (a), are you 9 -- wouldn't it have to be that Mr. Rudd, excuse me, 10 paid the tax? 11 MR. LOYD: No, because it doesn't matter -- 12 there's no requirement in the statute, it doesn't 13 say by the taxpayer. 14 So, in other states, you know, where they 15 have requirement that the taxpayer pay the tax, it's 16 got to be paid by the taxpayer. 17 So, for example, if you're an employer, 18 okay, let's say I'm an employee in Kentucky -- or 19 let's say Mr. Rudd was an employee in Kentucky of 20 Rudd Equipment and Rudd paid him a salary. And they 21 paid him -- and they paid withholding tax. 22 It's -- in Kentucky the obligation is on 23 the employer to pay withholding tax. So, that 24 payment is being made by Rudd Equipment. And he 25 would still get a tax credit for it, an other state 26 tax credit, even though Mr. Rudd didn't actually 27 make that payment himself. 28 Likewise, I mean, you know, I could pay his 22 1 tax liability, in theory, 'cause there's really no 2 prohibition in -- in California from somebody else 3 having made that -- made the tax liability, as long 4 as it's paid. 5 And the other thing about the Kentucky 6 limited liability, the credit that you get, if the 7 entity does not pay the tax, the individual does not 8 get the credit. And they will assess the individual 9 for the tax. 10 MS. STOWERS: Franchise Tax Board, when 11 would subdivision (b) apply? 12 MS. KANE: Subdivision (b) would apply at 13 any time there -- are you asking why it's not 14 applying to their S corporation payment? 15 MS. STOWERS: Yes. 16 MS. KANE: It's not applying to their S 17 corporation payment because we treat the payment as 18 if it were made by the taxpayer, per 18001 (b). 19 So, if the payment -- if this payment was 20 made by the taxpayer, it would be a disqualified 21 payment for purposes of the other state tax credit 22 because it's on a gross tax and not a net tax. 23 The fact that the tax paid is a 24 disqualified tax disqualifies them under both (b) 25 and (a). 26 MS. MANDEL: If I might? 27 MS. STOWERS: Ms. Mandel. 28 MS. MANDEL: Thank you. 23 1 The -- it gets a little confusing, I think 2 that it can get a little confusing because of the 3 limited liability entity tax characterization. 4 But the tax that the Rudds are looking at 5 for a other state tax credit in California is the 6 personal income tax, the personal net income tax 7 that they -- was imposed by the State of Kentucky, 8 that they owed the State of Kentucky. 9 A part of that -- what Mr. Loyd is saying 10 is that a part of that tax was covered by this 11 credit. The credit was -- was a result of this 12 other tax scheme that Kentucky put in that he 13 explained. 14 And Kentucky allows this credit for a 15 payment to Kentucky of an amount, a dollar figure, 16 that they then treat as paid on the income tax 17 return, the net income tax return. 18 The credit they're trying to get other 19 state credit for -- or the tax they're trying to get 20 an other state credit for is the individual income 21 tax payment. 22 The fact that it was paid via a credit that 23 Kentucky had got in its pocket over here through 24 this other tax scheme that Kentucky put in to make 25 sure that everybody was paying on their income from 26 a -- from an S corp in Kentucky. 27 I think when Mr. Loyd was talking, he went 28 over it a little fast, but there are other types of 24 1 taxes in other states that fit under (b). 2 Tennessee was the example that he gave. 3 Tennessee does not -- hit me if I get this wrong -- 4 Tennessee -- 5 MR. LOYD: Tennessee is right. 6 MS. MANDEL: -- okay, Tennessee does not 7 have a personal income tax, but they do tax S 8 corporations at the entity level. And it's a net 9 income tax at the S corporation level. 10 So, as a person in California if you had -- 11 if Mr. Rudd's company was not in Kentucky, but was 12 in Tennessee, he would not have paid an individual 13 net income tax in Tennessee because they don't have 14 one. 15 But the S corp would have paid an S 16 corporation entity level tax. And it was a net 17 income tax in Tennessee. 18 For California purposes, then that's under 19 (b), because when would put file his California 20 personal income tax return, he would be seeking to 21 get an other state tax credit on his California 22 personal income tax return for the Kentucky S entity 23 level tax. 24 And California would say, "Okay, we're 25 going to treat that like it was paid by you." 26 Here he's trying to get a credit for -- he 27 believes he's entitled to a credit for the net 28 income tax paid to Kentucky by virtue of the special 25 1 feature they have in their tax system, which is a 2 credit for an entity level tax. 3 But whatever the entity level tax 4 characterization is, that's not technically the tax 5 for which he's seeking the other state tax credit. 6 See, I still talk long. 7 MS. STOWERS: Yes, Franchise Tax Board? 8 MS. KANE: May I respond to that? 9 MS. STOWERS: I don't want to take up 10 anyone's time, but go right ahead. 11 MR. RUNNER: Go ahead. 12 MS. HARKEY: I'd like the hear it. 13 MS. KANE: So, what Appellants are asking, 14 though, is that this credit be treated as a payment, 15 that because it's a payment of this limit -- for a 16 payment of the limited liability entity tax, they'd 17 like us to disregard that it's a credit and treat it 18 like a payment. 19 And then we look and see that that payment 20 is disqualified. 21 If they don't want us to look to that 22 payment and they want us to treat it just as a 23 credit, then a credit is not a payment and it cannot 24 be used against -- for calculation of the OSTC. You 25 can't have it both ways. 26 MR. LOYD: The credit is based -- 27 MR. RUNNER: I think we're okay. 28 MS. STOWERS: I'm okay. 26 1 MR. RUNNER: Member Harkey. 2 MS. HARKEY: Yeah, I would like Ms. Mandel 3 to expand on that because this just seems to be the 4 crux of the issue. 5 It's S corporation taxes that he paid. 6 They went through his personal income tax, so, you 7 do file S corporation, personal? 8 And regardless of the configuration, those 9 were taxes paid. 10 So, you're applying then for a credit in 11 California for personal income taxes, regardless of 12 how they were configured in California. 13 So, could you explain what you were about 14 to say in response? 15 I'm just trying to -- trying to get through 16 this. 17 MS. MANDEL: It's -- let me back up just a 18 little bit. 19 It's -- you know, I hear unprecedented and 20 I -- that's to me a little bit pejorative. Of 21 course, we say say it's an issue of first 22 impression, that's just the difference in the 23 verbiage. 24 This credit in Kentucky is -- as was 25 explained by Mr. Loyd -- it's unlike other kinds of 26 credits. 27 The Kentucky law, they set up a particular 28 tax scheme in Kentucky, as he explained, to try to 27 1 make sure that -- that that Kentucky tax was being 2 paid on all of these nonresidents and everything, I 3 think he explained they wanted to make sure they 4 were getting their tax. 5 But people who are filing in Kentucky on 6 their Kentucky-sourced income have a personal income 7 tax liability to Kentucky. The income from the S 8 corp comes down onto their Kentucky return. 9 Kentucky doesn't want to tax it twice. 10 Kentucky says, you, person, individual, have to pay 11 tax on this income, but we're going to give you a 12 credit, you know, you can say it's two different 13 laws, but it's really part of one entire scheme of 14 how they're going to look at making sure that they 15 got the incomes tax that they're due in Kentucky on 16 the Kentucky source income. 17 And, so, they give a credit on the Rudds' 18 return for an an amount of tax, just as if we had 19 written a check for, you know, part of Mr. Rudd's 20 taxes. That would have been tax paid to Kentucky 21 for his individual income tax. 22 This is an amount of dollars that Kentucky 23 got, paid to Kentucky, happened to be paid by the S 24 corp. 25 And the way Kentucky set up their system, 26 they just said, "S corp, you're going to pay us at a 27 certain level." 28 But it's an amount that he claims on his 28 1 return for this payment that had been made to 2 Kentucky. It's a claimed as a credit. Mr. Loyd 3 explained why Kentucky set it up that way, as a 4 credit. 5 And if he did not have that payment to 6 Kentucky on his -- reflected on his return as a 7 credit, he would have owed that amount as net income 8 tax, additional net income tax, to Kentucky, which 9 is why when you get over to the California return 10 and he has to include in his California return his 11 income from Kentucky because he was resident in 12 California and California says, "Put all your income 13 on the return." 14 He puts it on the return. But 15 California -- the whole purpose of the other state 16 tax credit is if you have -- if you're a resident 17 here and you have income that's sourced in another 18 state, California doesn't want to tax it again. 19 They say, "Okay, you're only going to have 20 one level of state income tax on that, if you -- if 21 there was tax that was imposed on it in another 22 state, and that tax was paid to the other state, 23 California will give you a credit for it." 24 And Mr. Rudd has his Cal -- his 25 Kentucky-sourced income on his California return. 26 He looks at his -- his Kentucky income -- net income 27 tax return, how much was paid to Kentucky for tax 28 that would have been -- was imposed on his Kentucky 29 1 source -- Kentucky income and that was the amount of 2 tax payments through with -- withholding, net of his 3 refunds, and this credit amount, because it was an 4 amount paid to Kentucky. 5 MS. HARKEY: Okay. I have -- so, does 6 Kentucky require an S corp filing and paying of 7 taxes and that's how the credit comes into being on 8 the personal? 9 How does that work? 'Cause right now -- 10 MR. LOYD: It's a -- 11 MS. HARKEY: -- in California our S corp's 12 all folded into the personal income tax. That's how 13 it's paid. 14 MR. LOYD: That's how it works in Kentucky. 15 MS. HARKEY: So, then how do we -- 16 MR. LOYD: It's a -- it's a -- it's a 17 somewhat unique animal, I mean -- 18 MS. HARKEY: I understand that. 19 I am just trying to break it down to -- 20 MR. LOYD: So -- 21 MS. HARKEY: -- kind of ducky, bunny, so 22 that -- 23 MR. LOYD: Gotcha. 24 MS. HARKEY: -- it's not so complex. 25 I want to see -- he paid the taxes when and 26 how did he receive the credit? 27 MR. LOYD: Sure. As to Mr. Rudd, he would 28 have income from Rudd Equipment, you know, for, 30 1 let's say -- 2 MS. HARKEY: Through the S corp? 3 MR. LOYD: -- through the S corp. 4 So, let's say that amount of income was, 5 you know, $100,000, so that -- and it's a 6 percent 6 rate, roughly. So, he's going to owe $6,000 in 7 Kentucky tax. 8 That will be satisfied, in part, by LL -- 9 the Limited Liabilty Entity Tax amounts that were 10 paid by Rudd Equipment to Kentucky. 11 MS. HARKEY: So, you pay those -- you pay 12 those like a quarterly payment or how -- how does 13 that happen? 14 MR. LOYD: They're paid annually. It's an 15 annual return. 16 MS. HARKEY: They're paid annually. 17 So, is that a return you file? 18 MR. LOYD: It's a return. 19 On the Kentucky S corp return, you would -- 20 the S corp has a K1 set up, so the amounts are -- 21 MS. HARKEY: Okay. 22 MR. LOYD: -- distributed to -- the 23 $100,000 income would be distributed to Mr. Rudd. 24 And then on that K1 there would also be the 25 amount listed of limited liability entity tax that 26 was paid by Rudd Equipment to Kentucky. 27 And as long as that amount was actually 28 paid to Kentucky -- because if they didn't pay that 31 1 amount, that wouldn't be listed on the return and 2 they would -- and Mr. Rudd would get no credit. 3 MS. HARKEY: Okay. So, I'm trying to 4 compare this -- pardon, I just want to compare this 5 to California, the we way account for it. 6 So, if we have an S corp, we fold 7 everything into the personal. 8 In Kentucky they actually pay like an LLC, 9 kind of, they do it on a K1, and they actually then 10 pay something on that K1? 11 MR. LOYD: It's a -- there's a reflected 12 amount on the K1. 13 MS. HARKEY: And that's because they want 14 to get the money first and they want to be sure it 15 doesn't flow through and get written off on your 16 personal income tax when you do all of the -- 17 MR. LOYD: They want to make sure it's paid 18 first. And, so, if it's -- 19 MS. HARKEY: Right. 20 MR. LOYD: -- paid then you're -- 21 MS. HARKEY: You can't write it off against 22 your PIT because it's already taken out? 23 MR. LOYD: Yeah. You don't get to take 24 the -- you don't get to reduce -- it doesn't satisfy 25 your personal income tax unless it was actually 26 paid. 27 So, let's say there was $1,000 of -- 28 MS. HARKEY: Okay. I don't want to -- I 32 1 don't want to go into it too much. 2 I'm just trying -- I'm trying to figure 3 this out, how my a little brain will work, is that 4 you got -- you've got an S corp that's paid 5 something through an entity? 6 MR. LOYD: Yes. 7 MS. HARKEY: Okay. So, then when you do 8 your -- your personal income taxes, you report the S 9 corp earnings again -- 10 MR. LOYD: Yes. 11 MS. HARKEY: -- but because you've already 12 paid a portion of that -- 13 MR. LOYD: Yes. 14 MS. HARKEY: -- then you take a credit for 15 that? 16 MR. LOYD: Yes. 17 MS. HARKEY: Okay. And you can never get 18 that back from Kentucky because once they've got 19 you, they've got you? 20 MR. LOYD: Yes. 21 MS. HARKEY: Okay. So, okay, comparing 22 that to California then, California you just report 23 everything through your personal income tax. 24 There'd be no credit. We don't pay S corp 25 taxes or entities or any -- 26 MS. MANDEL: There's a separate -- there is 27 a entity level tax on the S corp. 28 MS. HARKEY: Okay. 33 1 MS. MANDEL: But it's not -- it's just a 2 separate entity level tax. There's no relationship 3 of it down to the individual returns. 4 MS. HARKEY: Okay. So, how does that work 5 then? 6 MS. MANDEL: It's just a -- just a 7 percentage of gross, the legislature put it in at 8 the -- 9 MS. HARKEY: Percentage of gross and does 10 it -- there's no credit for it? 11 MS. MANDEL: There's no credit for it. 12 It's a separate tax. 13 MS. HARKEY: You pay percentage of gross, 14 separate tax. 15 MS. MANDEL: It's a -- 16 MS. HARKEY: Now when you file your return, 17 though, you have the entire S corp? 18 And you -- I mean, whatever your profit was 19 or whatever on the other side? 20 MS. MANDEL: Right. The S corp in 21 California is a flow-through, just like -- 22 MS. HARKEY: Right. 23 MS. MANDEL: -- it's a flow-through for 24 federal purposes. 25 But my recollection is when the legislature 26 finally decided to allow S corps in California, 27 which was later than a bunch of other places, just 28 like they did when they did the LLCs, they were 34 1 concerned about a loss of tax at the entity level 2 that they were getting at the time from things being 3 in corporate form. 4 And that's my recollection of part of why 5 then we wound up with an entity level tax. 6 But it's not -- it's not this -- this 7 Kentucky system. And as he explained the Kentucky 8 system, Kentucky adopted that system to -- because 9 they had -- they thought they had a tax gap problem 10 with people from out of state who had investments 11 and businesses in Kentucky that were not reporting. 12 And, so, what it sounds like to me, from 13 his explanation, was that this was a mechanism for 14 Kentucky to make sure that it got its tax -- 15 MS. HARKEY: Got some taxes. 16 MS. MANDEL: -- by getting -- 17 MS. HARKEY: But yet it didn't penalize 18 anybody who was a resident -- 19 MS. MANDEL: Right. 20 MS. HARKEY: -- and was paying tax? 21 MS. MANDEL: Right. 'Cause you would still 22 have to -- it was still flowing through to your 23 return and they he only want to get the tax -- 24 MS. HARKEY: But in California -- 25 MS. MANDEL: -- once. 26 MS. HARKEY: -- we do have an entity level 27 tax, we just don't give credit on it? 28 MS. MANDEL: Right. It's just a different 35 1 system. It's a different system. 2 MS. HARKEY: Okay. Thank you. 3 MR. RUNNER: Okay. 4 MS. HARKEY: Go ahead. 5 MS. STOWERS: I just wanted to know -- 6 MR. RUNNER: Member Stowers. 7 MS. STOWERS: -- on the S corporation, it 8 is subject to a California income tax at one-third, 9 33 percent? 10 MS. HARKEY: Yeah. 11 MS. STOWERS: The tax rate? 12 And then on the shareholders, all that 13 income will flow back to the shareholders. 14 MS. HARKEY: Okay. 15 MS. STOWERS: So, there is - two sides. 16 We don't have a credit. But on the flip 17 side, let's say that the S corp generated an R & D 18 credit, we see it a lot, that S corporation will be 19 entitled to the credit. 20 MS. HARKEY: Right. 21 MS. STOWERS: And then that same credit 22 will come down to the shareholders. 23 MS. MANDEL: Yeah, that's a particular 24 feature. 25 MR. RUNNER: Okay. 26 MS. HARKEY: Okay. Then I understand this 27 a little bit better. 28 And I guess my question then for the FTB is 36 1 what makes this not a paid tax in California 2 where -- because it would -- it would have flown 3 through his personal income tax. 4 I mean, he would -- he paid it, even though 5 it was S corp entity level, it was still paid. 6 What makes this not a function of taxes 7 paid? 8 MS. KANE: When you're speaking 9 specifically about the limited liability entity 10 tax -- 11 MS. HARKEY: Well, I'm not. 12 I'm speaking about -- I'm speaking about 13 the tax. It seems like that's a mechanism to be 14 sure the money stays there. 15 And then, you know, minus that -- if we 16 didn't have that, we would have had income taxes 17 paid in total for which -- here and here, they were 18 paid, here at the entity level and here on the 19 personal level there was a credit for what was paid 20 on the entity level, but it was still paid. 21 What makes that not -- 22 MS. KANE: Because that entity level 23 payment is not a qual -- it's not that it's not a 24 payment, it's not a qualified payment for purposes 25 of the other state tax credit. 26 Because California restricts the other 27 state tax credit to net taxes. And that tax is a 28 gross tax. 37 1 MS. HARKEY: Okay. Mary Jo, what's your 2 statement on that? 3 MS. MANDEL: Again I think that's where 4 they're looking at the wrong level. 5 The -- the tax -- the tax figure on his 6 return -- you know, you get down and you get to your 7 taxable income, and then, what's my tax? 8 There's a tax amount on his personal income 9 tax return that if he's got nothing else on there, 10 he owes that amount of money to Kentucky as 11 personal -- net income personal income tax. 12 This credit, just like in other types of 13 credits, but this credit, which is a peculiar credit 14 because it's -- it represents a payment to the State 15 of Kentucky -- this credit is then allowed against 16 what he would have to pay for net income tax. 17 And as Mr. Loyd said, if -- if for some 18 reason an entity doesn't pay at the entity level, he 19 doesn't get that credit, he owes tax. 20 That's what Indiana was like this is his 21 personal liability. If his credit was $100, he has 22 a personal liability to the State of Kentucky for 23 $100. 24 He gets to apply this credit against his 25 net income tax for an amount that was paid to 26 Kentucky. 27 The credit under the other state credit is 28 for the purpose of making sure that income on his 38 1 individual return that's already been taxed on his 2 individual return in Kentucky is not taxed again. 3 And this is a payment, just like if, you 4 know, if you had written a check for him or 5 whatever, it's a payment. 6 Yes, it -- it's, at some level in the 7 scheme, it's a reflection of the fact that there was 8 a payment by the entity at this entity level tax. 9 But he is being allowed a credit, dollar -- 10 dollar credit, against his net income tax liability 11 to Kentucky. 12 It's -- Kentucky's basically treating it as 13 a payment to them. "You don't have to pay me the 14 $100, Mr. Rudd. We already got it." 15 And, so, he's saying for California now, if 16 you want to tax me on this $100 of income that I had 17 in Kentucky, you're taxing me twice at the state 18 level because I already was taxed on it in Kentucky 19 and had a payment. I want a credit for my net 20 income tax payment to Kentucky, which was covered by 21 this credit, which is unlike all these other kinds 22 of credits that you see where they're just sort of 23 credits for, you know, incentives and -- 24 MS. HARKEY: But the FTB is saying it's 25 disallowed under our statute. 26 MS. MANDEL: FTB is saying it's disallowed 27 under a different provision, which is the provision 28 for a tax which we say is like the Kentucky -- I 39 1 mean, sorry, the Tennessee S corp tax. 2 Because there you're saying -- in 3 California, if I have to take in my S -- the 4 flow-through from my Tennessee S corp onto my 5 California return, I don't have a personal income 6 tax return in Tennessee -- there's no such thing. 7 But the S corp did pay a tax in Tennessee and it was 8 a net tax. And I get a pro rata share. 9 California will say we're going to treat 10 your pro rata share of that tax as your tax credit 11 in California for it. 12 (Ms. Lopez replaced Ms. Richmond.) 13 MS. MANDEL: But that's where they're 14 really trying to take a credit for the entity level 15 tax. 16 And the point here, and why Mr. Loyd 17 started with this, is this an amount that was paid 18 to Kentucky. 19 He noted that the California statute only 20 says imposed by and paid to the other state, not 21 imposed by and paid by the taxpayer to another 22 state, which some states have it that way. 23 California doesn't. 24 If -- if -- if California had it that way, 25 we probably -- we might not be here, because it's a 26 different -- different statute. 27 But California just says was there an 28 income tax -- net income tax -- was there an income 40 1 tax imposed by another state on you? And was that 2 income tax paid to the other state? 3 So, we say the focus is on Mr. Rudd's 4 individual income tax return. Was -- was this 5 income that's on his California return -- and the 6 income is indisputably on both returns -- was that 7 income -- was there -- did Kentucky impose an income 8 tax on it and did Kentucky get paid? 9 And we say yes, by virtue of the credit. 10 MS. HARKEY: Okay. So, what you're 11 basically saying is the FTB is caught up on the 12 semantics of the word "credit"? 13 MS. MANDEL: They're caught up on the 14 semantics of the word credit and -- and they're -- I 15 think there's a little distraction with the -- by 16 trying to focus on the -- what the entity -- what 17 kind of tax it is on the entity level. 18 MS. HARKEY: I don't want to beat this 19 totally dead, but I'm just trying to understand 20 where the big break is here and it seems to be on 21 the word "credit". 22 You are saying it's disallowed by our 23 statute, by language in the statute. 24 And they're saying that the language in the 25 statute was basically meant for where you don't pay 26 the tax. 27 Do you want to respond to that or -- 28 MS. KANE: So, I would start by saying a 41 1 credit is not a satisfaction of net tax. 2 So, you start with gross income. You 3 remove your deductions. You arrive at AGI. You 4 multiply it by your tax rate. You get total tax. 5 And then you apply tax credits to total tax 6 and you arrive at net tax. 7 After that you make a payment. 8 So, when they're saying this credit is a 9 satisfaction of net tax, that's just not how it 10 works. It's just -- that's not -- that's not how 11 the tax game works. 12 So, to get around that, they then say, 13 "Well, the credit really represents a payment." 14 But when you look at what that payment was 15 actually for, that payment was for the entity level 16 tax. It's not meant to be a distraction, it's meant 17 to show what it is really. 18 The limited liability entity tax is paid. 19 It's a gross tax, which does not qualify for OSTC 20 purposes. 21 If this -- if the -- if the S corporation 22 tax in Kentucky were a net tax, we wouldn't be here. 23 They would be completely qualified under 1800 (b) 24 (verbatim) and 18006. 25 So, basically, they're trying to fit, which 26 doesn't fit into 1800 (b) (verbatim) into 1800 (a) 27 (verbatim), because they know that they're 28 disqualified under 1800 (b) (verbatim). 42 1 So, what they're trying to say to disregard 2 the payment portion, but treat it as a payment. So, 3 disregard that the payment is disqualified but treat 4 the credit as a payment. 5 And I feel like you can't do both and have 6 the logic hold. 7 MR. RUNNER: Member Ma. 8 MS. MA: Okay. Please start one more 9 time -- sorry. 10 So -- okay. So, the limited liability 11 entity tax credit, is Mr. Rudd a sole S corp 12 shareholder? Does he have other shareholders? 13 MR. LOYD: There are other shareholders, 14 but he owns the vast majority. 15 MS. MA: Okay. So, you take the gross 16 income from his equipment company, you deduct the 17 expenses? 18 MR. LOYD: Yeah. 19 MS. MA: And then you charge the LLEC? 20 MR. LOYD: LLET, yeah. 21 MS. MA: LLET to the net income for the 22 entity? 23 MR. LOYD: It would arrive at net income, 24 yeah. 25 Is that -- 26 MS. MA: And it's tax based on the 27 shareholder's percentage in the S corp? 28 MR. LOYD: The amount of LLET that he would 43 1 get would be based on his percentage in the S corp. 2 So, if you owned 100 percent, you would 3 get -- 4 MS. MA: Right. But it's gross income at 5 the entity level, gross less the expenses, comes in 6 with a net income level. 7 Then if he's 51 percent, his tax is 51 8 percent on his allocated share? 9 MR. LOYD: On the individual -- his 10 individual income? 11 MS. MA: Yes. 12 MR. LOYD: Yes. 13 MS. MA: His individual income? 14 MR. LOYD: Yes. He would pay tax on -- on 15 his distributive net income from Rudd Equipment, 16 yes. 17 MS. MA: And then that number flows to the 18 S -- to the K1? 19 MR. LOYD: Yes. 20 MS. MA: That goes on his taxes? 21 MR. LOYD: Yes. 22 MS. MA: So then on his return he reports 23 whatever the net is net of this tax that he already 24 paid? 25 MR. LOYD: He reports -- his income would 26 be -- his -- he would have -- if he had -- I'm 27 trying to make sure I'm following you correctly. 28 So that I stay -- 44 1 MS. MA: Okay. On his K1, his Kentucky 2 K1 -- 3 MR. LOYD: Yes. 4 MS. MA: -- what does his Kentucky K1 look 5 like? 6 MR. LOYD: Well, Kentucky K1 would look 7 simply -- if -- if, let's say he -- let's say he 8 owned you all of Rudd Equipment just for the sake 9 of -- 10 MS. MA: All right. 11 MR. LOYD: -- you know, simplicity. 12 And Rudd Equipment had $100,000 of net 13 income. 14 MS. MA: Okay. 15 MR. LOYD: Then that $100,000 of net income 16 would flow through to his K1, and it would be on his 17 return. 18 So, he would report $100,000 of net income. 19 MS. MA: Okay. 20 MR. LOYD: Then the Kentucky tax would be, 21 let's say for simplicity purposes, 6 percent of 22 that. So, it would $6,000. 23 So, going back to the Rudd Equipment 24 return, it would compute whatever the limited 25 liability entity tax would be on that -- on Rudd 26 Equipment. 27 And they would -- and Rudd Equipment would 28 pay that limited liability entity tax. And if it 45 1 paid the limited liability entity tax, and let's say 2 it's $1,000, the net $1,000 would go on the K1 as 3 well. 4 And then on Mr. Rudd's income tax return, 5 he would satisfy that $6,000 liability with $1,000 6 that was paid to Kentucky by Rudd Equipment. 7 MS. MA: He paid it? 8 MR. LOYD: 'Cause it was paid, yes. 9 And he essentially paid it 'cause -- or at 10 least his portion of it -- 'cause he owns the 11 company. 12 MS. MA: Right. 13 MR. LOYD: And other $5,000 would have to 14 be paid, you know, by estimated payments, by 15 withholding, by some other mechanism. 16 MS. MA: Combined the 5,000 plus the 17 1,000 -- 18 MR. LOYD: Is the 6. 19 MS. MA: -- is the 6 -- 20 MR. LOYD: And it all got paid -- 21 MS. MA: -- based on net income? 22 MR. LOYD: Yes and it all got paid to 23 Kentucky. 24 MS. MA: Right, okay. 25 MR. LOYD: Yes. 26 MR. RUNNER: Okay. 27 MS. STOWERS: Clarification to Appeals. 28 The limited liability entity tax, based on 46 1 the statute, based on the example he gave you, is 2 that a gross tax or is that a net income tax? 3 ---oOo--- 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 47 1 ---oOo--- 2 MS. FRENKLAK: The Kentucky statute, which 3 is 141.0401, specifically provides that it is based 4 on either gross receipts or gross profits. And so 5 that is what the LLET is based on. And I would be 6 interested to hear how the parties look at the 7 regulation under 18001 that talks about gross 8 receipts as an exclusion for this credit. 9 So it is definitely calculated on gross 10 receipts or gross profits in Kentucky. 11 MS. STOWERS: So then if her reading of the 12 statute is correct, then that tax that you just 13 described in your example is not based on net 14 income, it's based on gross. 15 MR. LOYD: Yes, but that's the wrong -- I 16 mean, with all due respect, that -- the -- the focus 17 should be on Mr. Rudd's individual income tax which 18 is being satisfied by the payment that was made by 19 Rudd Equipment to Kentucky. 20 MS. STOWERS: And the payment that -- 21 MR. LOYD: And that's under -- 22 MS. STOWERS: -- that the S corp made, but 23 the actual payment was based on gross and not net. 24 MR. LOYD: Well -- 25 MS. STOWERS: I'm not -- I'm not 26 finished. 27 MR. LOYD: Oh, I'm sorry. 28 MS. STOWERS: And I'm looking at the actual 48 1 K-1 that you gave. And I don't want to disclose the 2 income, but on the backside we do see the credit. 3 MR. LOYD: Mm-hmm. 4 MS. STOWERS: So that's kind of the example 5 you were giving, but that credit is based on the 6 LL -- the tax that was paid at the entity level. 7 MR. LOYD: It was certainly computed based 8 on either gross receipts or gross profits at the -- 9 at the Rudd Equipment level, yes. 10 MS. STOWERS: Okay. And since he has this 11 credit for Kentucky, when he went and computed his 12 Kentucky tax liability, his Kentucky liability was 13 reduced for that credit. So that basically Kentucky 14 is not going to tax him twice, once at the entity 15 level, at the gross level, and then once at the 16 individual level, at the net level. 17 MR. LOYD: It was satisfied by that payment 18 that Rudd Equipment made, yes. Because if -- let's 19 say that Rudd Equipment -- the other portion of this 20 statute, of KRS 141.0 -- 141.0401, the credit 21 provision is in (3). And in (3), if the payment is 22 not made by the -- by the entity, in this case Rudd 23 Equipment, there is no credit. 24 MS. STOWERS: That makes sense. 25 MR. LOYD: Yeah. So in other words, if 26 there's no payment -- if there's no payment made by 27 the entity, there's no credit. And so in other 28 words, you have to make a payment in order to, uh -- 49 1 to get the credit. And, thus, on Mr. Rudd -- as to 2 Mr. Rudd's return, in his individual income tax 3 liability, that is a -- we say that the substance of 4 that is a payment. 5 MS. STOWERS: Although it was made by the 6 entity. 7 MR. LOYD: Yes. 8 MS. STOWERS: And although it was made on 9 the gross. 10 MR. LOYD: It was computed based on gross, 11 yes. 12 MS. STOWERS: Okay. 13 MR. LOYD: But we all -- 14 MS. STOWERS: What you're saying -- but it 15 was basically that was -- it was made on his behalf. 16 And then you're saying that it results to be net 17 income tax, regardless of the fact that California 18 statute says that the other state tax credit must be 19 paid and it must be based on net income and not 20 gross. 21 That's all I have. 22 MR. RUNNER: Member -- Member Ma, did 23 you -- 24 MS. MA: No, I'm done. 25 MR. RUNNER: Okay. 26 Member Harkey, are you done? 27 MS. HARKEY: I'm done. 28 MR. RUNNER: Okay. I have just a -- a 50 1 follow-up, and I think Member -- Member Mandel, 2 sorry. The taxpayer representative has a comment, 3 and then I have a follow-up in regards to that 4 question, too. 5 MS. MANDEL: Well, I -- I don't want to be 6 repetitive, so -- 7 MR. RUNNER: Okay. 8 Let me just ask -- let me go back to, 9 quickly, on the -- on the -- on the Indiana issue. 10 And that is, can you, real quickly again, tell us 11 why you think it's relevant to us? Because I'm 12 going to go back and ask FTB why it is that we -- 13 that does not give us -- again, it's not relevant. 14 Obviously it's not controlling, but is it -- again, 15 I think the arguments are that you would believe 16 that the Indiana statutes are very similar to the 17 State of California, therefore, there should be 18 some -- some ideas as to the application. Is that 19 what I'm understanding? 20 MS. MANDEL: Right. Right. The Indiana -- 21 as I understand it, the Indiana credit -- other 22 state credit statute -- 23 MR. RUNNER: Mm-hmm. 24 MS. MANDEL: -- is the same wording as 25 California. 26 Right? 27 MR. LOYD: I believe so, yes. 28 MS. MANDEL: Right. And what Indiana, 51 1 again being the neighboring state, decided that 2 this -- the very reason for them to allow the credit 3 was the whole purpose of the other state tax credit 4 is that the states don't want to all be taxing the 5 same income. 6 If it's sourced out-of-state and taxed to 7 the other state, they're going to allow the credit. 8 And Indiana decided that because an individual in 9 Mr. Rudd's type of position had a net income tax -- 10 I'm not saying that that's the net tax, but it's a 11 net -- the personal income tax is a net -- tax on 12 net income. So it's a net income tax. 13 He had a net income tax liability to the 14 State of Kentucky that was satisfied, in part, by 15 this credit. Indiana says, then we're going to 16 recognize that as a tax payment to Kentucky on the 17 income and we're going to give you another State tax 18 credit for it. 19 MR. RUNNER: Okay. 20 MR. LOYD: I think that -- if I may add. 21 MR. RUNNER: Quickly. 22 MR. LOYD: Quickly. On page two, it simply 23 says that, you know, pursuant to blank the amount of 24 the Indiana resident's credit for taxes paid to the 25 commonwealth of Kentucky is the lesser of the 26 Indiana -- of the resident's Indiana income tax 27 liability on the income derived from the Kentucky 28 sources, or the amount of nonrefundable Kentucky tax 52 1 credit claimed on the taxpayer's Kentucky individual 2 income tax return. 3 And thus, I think the main point of this 4 Indiana directive is the fact that Indiana 5 recognizes that it was a tax paid to the 6 commonwealth of Kentucky. 7 MR. RUNNER: Okay. 8 And just to the FTB now. Again, you 9 would -- the application of the -- the use or the 10 way that Indiana's applying is not consistent with 11 what we would believe California statute is? 12 MS. KANE: No. In fact, I would actually 13 say that the Indiana statutes and the California 14 statutes are significantly different. As we've 15 quoted from 18001, it's for taxes imposed and paid 16 by other states. The Indiana scheme, to quote from 17 the Indiana statute: 18 "The credit is the lesser of the amount 19 of income actually paid to the other state, 20 on income from that state, an amount 21 equal to two percent of the income from the 22 other state or the amount of Indiana state 23 taxes due." 24 Right. 25 And to that, with the Indiana directive, 26 they also added, or this -- the lesser could be this 27 limited liability entity tax credit. So it's the 28 series of either/or. It's either/or and you get the 53 1 lesser of all of them. 2 California law, under 18001, which is the 3 resident other state tax credit, just says that it 4 is -- let me see if I can quote directly from the 5 law for you. 6 "Subject to the following restrictions 7 a resident shall be allowed a credit 8 against the net tax for net income tax 9 imposed and paid to another state, not 10 including preference, alternative or 11 minimum tax comparable to the tax imposed 12 by Section 17042. The credit shall be 13 allowed only for taxes paid to another 14 state," and -- and goes so on. 15 And it's definitely not the series of 16 either/or. And most importantly, it has 1800(b) and 17 18006 as part of the scheme, which allow for the 18 treatment of S corporation shareholders to treat 19 payments as if they were their own payment, which 20 their law does not have. So they need the Indiana 21 directive or we don't need the Indiana directive, 22 and there's no net income limitation. 23 The net income limitation is huge and it's 24 specifically in our Legislature. Our Legislature 25 specifically put it in there to make sure that 26 there's not a credit allowed for more than 27 California with subject to tax. 28 MR. RUNNER: Okay. Okay. Thank you. 54 1 Any other questions? 2 Motion? 3 MS. STOWERS: Move to take it under 4 submission. 5 MR. RUNNER: Okay. Second somewhere? 6 MS. HARKEY: Second. 7 MR. RUNNER: Second, okay. 8 Without objection, okay. 9 Thank you. 10 MR. LOYD: Thank you. 11 ---oOo--- 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, JULI PRICE JACKSON, Hearing Reporter for 8 the California State Board of Equalization certify 9 that on MAY 27, 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 47 constitute 14 a complete and accurate transcription of the 15 shorthand writing. 16 17 Dated: July 6, 2015 18 19 20 ____________________________ 21 JULI PRICE JACKSON 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, KATHLEEN SKIDGEL, Hearing Reporter for 8 the California State Board of Equalization certify 9 that on May 27, 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 48 through 55 14 constitute a complete and accurate transcription of 15 the shorthand writing. 16 17 Dated: June 30, 2015 18 19 20 ____________________________ 21 KATHLEEN SKIDGEL 22 Hearing Reporter 23 24 25 26 27 28 57