1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 6 REPORTER'S TRANSCRIPT 7 MAY 24, 2016 8 9 10 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 11 APPEAL OF 12 EMERSON PROPERTIES, INC., 871652 13 STANLEY R. EMERSON AND KATHLEEN EMERSON, 871809 14 CHRISTOPHER B. EMERSON AND VALERIE M. WADE, 871819 15 DALE R. EMERSON AND CAROLYN K. EMERSON, 871825 16 MICHAEL EMERSON AND MARIA NOVO, 871826 17 PATRICK EMERSON, 871832 18 CRAIG J. COOMBS AND TRICIA EMERSON, 871833 19 20 AGAINST PROPOSED ASSESSMENT OF 21 ADDITIONAL INCOME TAX 22 23 24 25 26 27 Reported by: Kathleen Skidgel 28 CSR No. 9039 1 1 P R E S E N T 2 For the Board of Equalization: Fiona Ma, CPA 3 Chairwoman 4 Diane L. Harkey Vice Chair 5 Jerome E. Horton 6 Member 7 Sen. George Runner (Ret.) Member 8 Yvette Stowers 9 Appearing for Betty T. Yee, State Controller 10 (per Government Code Section 7.9) 11 Joann Richmond 12 Chief Board Proceedings 13 Division 14 For Board of 15 Equalization Staff: Grant Thompson Tax Counsel IV 16 17 For Franchise Tax Board: Carolyn Kuduk Tax Counsel 18 Ciro Immordino 19 Tax Counsel 20 For the Appellant: Silvio Reggiardo III 21 Attorney 22 23 ---oOo--- 24 25 26 27 28 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 MAY 24, 2016 4 ---oOo--- 5 MS. MA: Okay, Ms. Richmond, please call 6 the next item. 7 MS. RICHMOND: Our next item is B3a Emerson 8 Properties, Inc., B3b Stanley R. Emerson and 9 Kathleen Emerson, B3c Christopher B. Emerson and 10 Valerie M. Wade, B3d Dale R. Emerson and Carolyn K. 11 Emerson, B3e Michael Emerson and Maria Novo, B3f 12 Patrick Emerson, and B3g Craig J. Coombs and Tricia 13 Emerson. 14 MS. MA: Okay. Mr. Thompson, will you 15 please introduce the issues in this case? 16 MR. THOMPSON: Yes. Again, only one issue 17 in this appeal, and that is whether appellants have 18 shown error in respondent's determination that they 19 recognized taxable boot income in a like-kind 20 exchange under Internal Revenue Code section 1031. 21 MS. MA: Thank you. 22 Mr. Silvio Reggiardo, welcome to the Board 23 of Equalization. You have ten minutes to make your 24 initial presentation, and you will have an 25 additional five minutes on rebuttal. 26 Please introduce yourself for the record 27 and please commence your presentation. 28 MR. REGGIARDO III: I am Silvio Reggiardo; 3 1 I'm an attorney. And you just heard what I think 2 are complicated factual cases with fairly easy legal 3 issues. This is a different one. This case 4 involves complicated legal issues and, I think, 5 fairly simple facts. 6 Our taxpayer, main taxpayer, Emerson 7 Properties, Inc. is an S Corporation. It's got 8 flow-through income, which is one of the reasons why 9 the shareholders are involved. And it entered into 10 a real estate transaction where it received 11 $2 million of deposits. Those deposits were treated 12 as option payments, held open as to taxation under 13 the open transaction doctrine because we didn't know 14 how they would ultimately be handled. 15 And when it was clear that there would be a 16 closing, there was an exchange opened, an 17 intermediary hired. The intermediary received all 18 of the proceeds other than the deposits. 19 Right before the closing on the target 20 property -- so we're at the end of the exchange 21 period -- Emerson Properties put $1 million of the 22 deposits into the escrow and used those funds to 23 acquire target property in a like-kind exchange. 24 The intermediary never touched those funds. 25 The intermediary had the other funds, but the 26 intermediary never touched any of the $2 million of 27 deposits. 28 The issue is whether we have $2 million of 4 1 boot or $1 million of boot under section 1031(b). 2 Emerson Properties kept 1 million; there's no 3 question that was boot. The Franchise Tax Board 4 argues that all 2 million would be boot. 5 You'll see in the briefs of the Franchise 6 Tax Board the word "sale" many times. This is not a 7 sale. This is a like-kind exchange. It was never 8 questioned whether it was a like-kind exchange. 9 To the extent that there is cash or other 10 property, boot, it would be under 1031(b). And this 11 is not just nit-picking. This is an important legal 12 distinction because there's a big difference between 13 a sale and reinvestment as opposed to a like-kind 14 exchange where there's boot. 15 There's no authority that I could find 16 relating to the interplay of the open transaction 17 doctrine, funds held under the open transaction 18 doctrine, and a like-kind exchange like this. 19 What we're dealing with -- the like-kind 20 exchange, deferred exchanges have existed for 21 decades. It's typical. It's the rule that in these 22 transactions there will be deposits or option 23 payments that are held open. And yet, it's 24 surprising. I've looked hard, haven't found 25 anything. There's nothing in section 1031. There's 26 nothing in the regulations. No cases that I've 27 located. No revenue rulings. No private letter 28 rulings. Nothing that I could find. 5 1 And the Franchise Tax Board cites various 2 authorities, but they don't apply. There's nothing 3 mentioning the open transaction doctrine. There's a 4 revenue ruling the Franchise Tax Board cites, but 5 all of the funds were -- or some of the funds were 6 retained. None were put into the exchange in that 7 ruling. 8 So I haven't located anything right on 9 point, which is surprising. And the Franchise Tax 10 Board has not published any guidance on this issue, 11 at least not that I've seen. 12 It appears the Franchise Tax Board's making 13 two arguments: 14 One, on page 12 of its opening brief, it 15 talks about how the taxpayer had actual receipt of 16 funds during the exchange period. Well, actually 17 Emerson Properties had the funds well before the 18 exchange period. The exchange period starts at the 19 time the relinquished property is transferred, and 20 then ends either at the end of a period described in 21 the regs or at the acquisition of target property. 22 On page 12 of its opening brief, we get 23 some insight where the Franchise Tax Board says that 24 the -- at the first closing the funds were, quote, 25 converted from an option payment to sales proceeds. 26 Again, this is not a sale, so that reference to 27 sales proceeds is not relevant or appropriate. But 28 the word "converted" is important because nothing 6 1 physically happened. Emerson Properties, Inc. held 2 the cash in its pocket the day before the 3 relinquished property closing and the day after. 4 Physically, nothing happened. If anything happened, 5 it would have to have been a tax event. 6 So it appears that the Franchise Tax Board 7 is asking this Board to deem a tax event to have 8 occurred. And Congress knows how to do that. Most 9 famously it's done that in connection with the 10 distribution of the property from a corporation 11 where it's deemed to be sold at market value. You 12 see that in Internal Revenue Code section 311 and 13 336. 14 And there are other instances when Congress 15 has stepped in and said, "We will deem a transaction 16 to have occurred." Didn't do it here, and yet it 17 appears that Franchise Tax Board is asking this 18 Board to basically write the law rather than 19 interpret it. 20 The second argument it appears that the 21 Franchise Tax Board is making relates to language in 22 the deferred exchange regulations. The language 23 essentially says -- and it's in a couple of 24 places -- that if the taxpayer either has actual 25 receipt or constructive receipt of cash during the 26 exchange period, before the acquisition of target 27 property basically, then the taxpayer has boot. 28 Well, that would take the regs right out of context. 7 1 Stepping back, we had Starker and some 2 other cases. But mostly Starker was the lead case 3 on deferred exchanges. Then Internal Revenue Code 4 section 1031 was amended to allow deferred exchanges 5 within certain parameters. And then the regs 6 followed and fleshed that out. 7 Those regs do not mention anything about 8 the pre-exchange period. They do not talk about 9 option payments or deposits received before the 10 exchange ever starts. So that would take the regs 11 out of context. 12 And, as I've acknowledged in the brief, had 13 this been a case where the exchange intermediary had 14 held these funds and if Emerson Properties, Inc. so 15 much as had the ability to draw on them, there would 16 have been constructive receipt. But that's not our 17 case. We're dealing with funds received before the 18 exchange ever started, under the open transaction 19 doctrine, and those regs just don't apply. 20 And so it appears the Franchise Tax Board's 21 asking this Board to stretch the regs beyond their 22 bounds. 23 I think there's a practical solution here. 24 The Franchise Tax Board occasionally issues notices; 25 it's issued one this year that I'm aware of, nothing 26 last year, a couple the prior two years. And they 27 go years and years issuing notices to the public, 28 advising taxpayers and their advisors regarding how 8 1 it might view a transaction. 2 If the Franchise Tax Board were to issue a 3 notice saying, "It is our view that, for example, 4 any deposits or option payments received must go to 5 the intermediary, even if it's far from clear that 6 there will ever be an exchange, set up an exchange, 7 put the funds into the intermediary's hands or we 8 will consider them boot." 9 Or, if it were to take the position that 10 you have to get the funds back into the 11 intermediary's hands before the closing of the 12 relinquished property, which I think would have been 13 the position here. I believe that if that had 14 happened, this case would never be before the Board. 15 If those are the positions of the Franchise 16 Tax Board, it should issue a public notice. Because 17 what would happen as a practical matter is, the 18 exchange intermediaries who, for the most part, run 19 these transactions and are very attuned to the 20 developments in the law, would immediately send 21 e-blasts. It happens all the time. Lawyers and 22 accountants would write articles; I'd be one of the 23 first ones to write, I understand the area. 24 The news would spread very quickly, and 25 taxpayers and their advisors would get right into 26 line. It wouldn't matter whether there are 27 technical flaws in the Franchise Tax Board's 28 analysis, which I think there are. It wouldn't 9 1 matter. What would happen is taxpayers' advisors 2 and intermediaries would be cautious, and they would 3 essentially say if this is what -- if you don't want 4 to pick a fight with the Franchise Tax Board, this 5 is how you behave. 6 So that's the solution. Rather than 7 attacking a taxpayer without notice, without any 8 federal guidance, without any Franchise Tax Board 9 guidance or published notice, attacking a taxpayer 10 and making arguments that just don't legally hold 11 water, issue a notice, put taxpayers on notice as to 12 the position and this problem will be solved as a 13 practical matter. 14 MS. MA: Thank you. 15 Franchise Tax Board, you have ten minutes. 16 If you would introduce yourself and begin your 17 presentation. 18 MS. KUDUK: Good morning, Chairwoman Ma, 19 Members of the Board. My name is Carolyn Kuduk. To 20 my right is Ciro Immordino. We represent the 21 Franchise Tax Board in this appeal. 22 This case involves the execution of a 23 section 1031 exchange. Appellants exchanged 24 property in Oakley, California for property in 25 Scottsdale, Arizona. 26 As my friend across the aisle stated, FTB 27 is not challenging the validity of the section 1031 28 exchange. The legal question in this appeal is, Do 10 1 appellants have to pay taxes when they actually 2 receive $2 million in cash during a section 1031 3 exchange? 4 Emerson Properties was a company that 5 appellants were shareholders of. It was an 6 S Corporation. Emerson Properties owned property in 7 Oakley, California. In December 2006, Emerson 8 Properties signed a Sales Agreement to sell that 9 property in Oakley, California. According to the 10 Sales Agreement, Emerson Properties would do a 11 section 1031 exchange and the buyers of the Oakley 12 property would give Emerson Properties $2.5 million 13 in three charges. 14 Emerson Properties would be able to keep 15 that $2.5 million if the buyers did not buy the 16 property. However, if the buyers did buy the Oakley 17 property, then the $2.5 million would be counted 18 towards the purchase price. It would be a buyer's 19 credit. 20 Prior to the closing of the Oakley 21 property, the buyers paid appellants $2 million in 22 two payments. Appellants took actual possession of 23 the money. As your Board's attorney notes in the 24 hearing summary and as appellants state, they were 25 in actual receipt of the money. They had unfettered 26 use of the money. There was no limitation of what 27 appellants could do with that $2 million that was in 28 their possession. 11 1 In July 2008, Emerson Properties signed an 2 Exchange Agreement. In that Exchange Agreement they 3 committed to replace the Oakley property with a 4 like-kind property in Scottsdale, Arizona through a 5 section 1031 exchange. The Exchange Agreement made 6 clear that as part of the section 1031 exchange, 7 Emerson Properties could not receive money from the 8 Oakley property before they received the Scottsdale 9 property without paying taxes on that money. 10 Either in July or August of 2008, the 11 qualified intermediary received $500,000 for the 12 section 1031 exchange. This $500,000 can be 13 contrasted with the $2 million that Emerson 14 Properties received before the section 1031 exchange 15 began. 16 The full $2.5 million that the buyers 17 contributed to escrow before the Oakley property was 18 sold was reflected in the closing statements as part 19 of sales proceeds; it was called an early release of 20 funds. 21 On August 29th in 2008, the Oakley property 22 was sold for over $13 million. In violation of the 23 rule that appellants cannot receive cash in a 24 like-kind exchange, appellants received and kept 25 over $2 million until November 3rd, 2008, one day 26 before the Scottsdale property was bought. At that 27 time appellants placed $1 million of that $2 million 28 in escrow to purchase the Scottsdale property, which 12 1 closed one day later on November 4th, 2008. 2 Appellants then kept the other $1 million. 3 As we have stated, the FTB is not 4 challenging the section 1031 exchange. In fact, 5 appellants were able to defer taxes on over 6 $10 million of gain on the sale of the Oakley 7 property under section 1031. FTB is only 8 challenging the tax treatment of the $2 million that 9 appellants took actual receipt of during the section 10 1031 exchange period, in violation of the strict 11 rule that taxpayers could not take actual receipt of 12 cash during the section 1031 exchange. 13 As stated in your Board's hearing summary, 14 any money received in a section 1031 exchange is 15 taxable. Your Board's hearing summary notes in 16 footnote 11 there's no relaxation of the 17 requirements that appellants cannot receive cash 18 during a section 1031 exchange. 19 Your Board hearing summary also cites to 20 law which states even if the cash is reinvested in 21 replacement property, once appellants take 22 possession of that cash during the section 1031 23 exchange, it's taxable. 24 In this appeal Emerson Properties was in 25 actual receipt of over $2 million of sale proceeds 26 during the section 1031 exchange. Appellants 27 violated the specific requirement of section 1031, 28 and this cash cannot receive tax-deferred treatment 13 1 under the specific requirements of section 1031. 2 Therefore, the law requires that appellants must pay 3 taxes on this money that they actually received. 4 In conclusion, FTB respectfully requests 5 that you sustain its action in this matter. 6 Thank you. 7 MS. MA: Thank you. 8 Mr. Reggiardo, five minutes on appeal. 9 MR. REGGIARDO III: I counted six times 10 when Franchise Tax Board counsel referred to 11 receiving funds either during or in a section 1031 12 exchange. That is not what happened here. 13 Emerson Properties, Inc. received the funds 14 well before the like-kind exchange was ever certain 15 to occur; that's -- that's the essential difference 16 here. 17 These funds were received under the open 18 transaction doctrine. Taxpayers can have unfettered 19 use of funds during that period when they're held 20 under the open transaction doctrine. The issue is 21 whether funds received under the open transaction 22 doctrine can be used in a like-kind exchange. 23 Emerson Properties retained 1 million and 24 treated it as boot and transferred 1 million into 25 the exchange. Those funds were not received in the 26 exchange or during the exchange. 27 So what the Franchise Tax Board appears to 28 be asking this Board to do is to deem a transaction 14 1 to have occurred, to deem Emerson Properties to have 2 received the funds during the exchange. 3 It appears the Franchise Tax Board is 4 saying that at the time the first closing occurred, 5 Emerson Properties received the funds for tax 6 purposes, because we know that did not happen 7 physically. It received the funds long ago. So 8 there seems to be a disconnect between what the 9 Franchise Tax Board is saying happened and what 10 actually happened. 11 And, again, there are legal problems with 12 the Franchise Tax Board's analysis, but the problem 13 can be solved, if it is a problem, by simply giving 14 notice to taxpayers and their advisors. Everybody 15 will get right into line. 16 MS. MA: Ms. Stowers. 17 MS. STOWERS: Quick question. To the 18 appellant, $2.5 million was received and you're 19 saying it was part of an open transaction. 20 MR. REGGIARDO III: Two million. The other 21 $500,000 -- 22 MS. STOWERS: It's 2 million, okay. Two 23 million was part of the open transaction. 24 MR. REGGIARDO III: Correct. 25 MS. STOWERS: And 1 million, the 26 appellants, you all paid taxes on. 27 MR. REGGIARDO III: Correct. One million 28 was used in the exchange; it was transferred into 15 1 the main escrow immediately prior to the closing on 2 the target property. The intermediary did not touch 3 those funds. 4 MS. STOWERS: But the 1 million that was 5 not, they did pay tax on that. 6 MR. REGGIARDO III: Yes, they reported -- 7 MS. STOWERS: And they paid tax on that 8 because it was boot? 9 MR. REGGIARDO III: Correct. Because they 10 didn't ever use that in the exchange. They simply 11 retained it. 12 MS. STOWERS: So, how could that be boot, 13 meaning it was part of the 1031, and the remaining 14 1 million was not part of the 1031? 15 MR. REGGIARDO III: So the 1 million that 16 was retained and not used in the exchange was 17 treated as section 1031 boot. The 1 million that 18 was used in the exchange to acquire target property 19 was treated as part of the exchange and deferred. 20 MS. STOWERS: Okay. But what my question 21 is that the 1 million that you treated as boot, 22 you're saying that you have a like-kind exchange. 23 So how could the money that your client received, 24 the $2 million from this transaction, how could one 25 part be like-kind exchange and another part is not 26 like-kind exchange? 27 Whether it's taxable or not, it seems to me 28 that as one it is one transaction. 16 1 MR. REGGIARDO III: Section 1031 solves 2 that problem. 3 MS. STOWERS: Yes, so it's 1031. So if -- 4 if -- if it's 1031 and they had control over the 5 2 million, you're violating the rules that you 6 cannot have control over the cash proceeds. One 7 point -- 1-1 -- 1.1031 little (k), saying that -- 8 MR. REGGIARDO III: Two separate issues. 9 One, there can be boot in a like-kind exchange, and 10 section 1031(b) allows for that. So it is a 11 like-kind exchange transaction, but there is cash or 12 other property received and that's treated as boot 13 under section 1031(b). 14 It is exactly the same thing we see with 15 corporate reorgs where section 356 does the same 16 thing. The dash (k) regs are deferred exchange 17 regulations and, again, different because they are 18 regulations that apply during the exchange period. 19 And so, had Emerson Properties received the funds 20 during that period from the intermediary, no 21 question, it would have been boot. But this is a 22 different case. 23 Those funds were received under the open 24 transaction doctrine before the exchange ever 25 started. There appears to be no legal authority out 26 there; the IRS, Congress, nobody's issued authority 27 on this, Franchise Tax Board hasn't. It's a very 28 different thing. 17 1 So you can absolutely have boot, and 2 Emerson Properties received and kept $1 million and 3 reported it as 1031(b) boot. That's the proper 4 treatment. It transferred $1 million into the 5 exchange and deferred that. 6 MS. STOWERS: Thank you, sir. 7 To the Franchise Tax Board. 8 MS. KUDUK: Yes. May I -- may I clarify 9 something? 10 MS. STOWERS: Yes, please. 11 MS. KUDUK: Actually, Emerson Properties 12 didn't pay taxes on $1 million in boot. They paid 13 taxes on $808,000 of boot. So I don't know what the 14 difference is, but my friend across the aisle is 15 saying $1 million, but in actuality it's 808,008 -- 16 808,812. 17 MR. REGGIARDO III: I stand corrected. 18 MS. STOWERS: I'm just going to round up to 19 200. It's easier for me. 20 MR. REGGIARDO III: I was focusing on what 21 was kept. 22 MS. STOWERS: Okay, that's fine. 23 MR. REGGIARDO III: Didn't mean to mislead 24 you. 25 MS. STOWERS: To the Franchise Tax Board, 26 when are you seeing that the like-kind exchange 27 period started and end? 28 MS. KUDUK: The like-kind exchange period 18 1 starts with the sale of the Oakley property and when 2 the Scottsdale property is bought. 3 MS. MA: So what are the dates? 4 MS. STOWERS: What's the dates? Thank 5 you. 6 MS. KUDUK: Oh, sorry. It is August 29th, 7 2008 and November 4th, 2008. 8 MS. STOWERS: August 29th, 2008? 9 MS. KUDUK: Mm-hmm. 10 MS. STOWERS: That's the Oakley property? 11 MS. KUDUK: Right. 12 MS. STOWERS: And the replacement property 13 is when? 14 MS. KUDUK: November 4th, 2008. 15 MS. STOWERS: 2008? 16 MS. KUDUK: Mm-hmm. 17 MS. STOWERS: Do you agree with that time 18 period, sir? 19 MR. REGGIARDO III: I don't have the exact 20 dates, but I do see on page 10 of the opening brief 21 where the Franchise Tax Board says that on 22 August 29th, 2008 the funds were converted from 23 option payments to sales proceeds. Again, it's not 24 a sale, but that is the date that was cited, so I'll 25 assume that that was correct. 26 MS. STOWERS: When was the -- give me -- to 27 you, sir, the date that you guys received the 28 $2 million? 19 1 MR. REGGIARDO III: Long before that. 2 MS. STOWERS: That's the '06 date. 3 MR. REGGIARDO III: Long before that. 4 MS. STOWERS: To the Franchise Tax Board, 5 in your experience have you seen cases where earnest 6 money deposit is received years in advance, or a 7 year in advance, two years in advance, of the actual 8 sale of the property? And if so, how is it normally 9 treated? 10 MR. IMMORDINO: Well, there are 11 transactions or structures where you'll have options 12 for -- it could be years before a property's either 13 purchased or the option's allowed to lapse. In 14 those cases, when a 1031 is attempted, the option 15 payments are always put into escrow before the 16 relinquished property closes. And in this case that 17 would be on August 29th, 2008. 18 Of course here they never put the money 19 back into the escrow. They kept it until one day 20 before they purchased the replacement property. But 21 in that situation that's the way it's generally 22 done; it's not clear if that violates 1031. So if 23 they had done it, you know, what's considered the 24 proper way? There's no clear authority as to 25 whether that is a valid 1031 or not a valid 1031. 26 But, of course, here they went way beyond, 27 you know, that structure when they put in before 28 escrow closes and they kept it during the 1031 20 1 exchange period. And so now we go into very clear 2 authority that they had actual receipt of cash 3 during the exchange period and it's all going to 4 have to be taxable boot. 5 MS. STOWERS: So had it just kind of -- for 6 me, had they put the $2 million in escrow by August 7 28th, we would not be here. 8 MR. IMMORDINO: Well, yeah, the law is not 9 clear on that. But -- 10 MS. STOWERS: Okay. The law is not clear. 11 So you're -- that's been what the Franchise 12 Tax Board has seen in the past where there's been 13 options and the option would end up going into 14 escrow, the entire amount goes into escrow? 15 MR. IMMORDINO: That's correct. You know, 16 before the relinquished property closes, the funds 17 are put back into escrow. 18 MS. STOWERS: Okay. Okay. That's it. 19 MR. REGGIARDO III: May I respond to that? 20 MS. STOWERS: Sure. 21 MR. REGGIARDO III: That is not my 22 experience at all. 23 One of the first transactions I did 25 24 years ago when starting to practice law involved 25 option money that went into the exchange. 26 I recently talked to some very 27 sophisticated intermediaries, explained my case, and 28 they said, "Oh, yeah, that ought to work." 21 1 They did not say, "Well, we advise that the 2 funds get transferred into the escrow." That is 3 simply not my experience. In fact, there's just 4 simply no authority out there. This is not a hot 5 issue. When I get called on exchanges it's about 6 swap-and-drops and things -- drop-and-swaps. It's 7 not this issue. 8 MS. STOWERS: Let's not go there. Let's 9 not go there. 10 MR. REGGIARDO III: Well, I'm just saying 11 that this is not a hot issue. My experience is not 12 that. 13 And the statement about clear authority, 14 receiving the exchange, again, those are deferred 15 exchange regs. They do not address funds received 16 before the exchange period under the open 17 transaction doctrine. 18 MS. STOWERS: All right. Thank you. 19 Helpful. Thank you. 20 MS. MA: Mr. Runner. 21 MR. RUNNER: Yeah, just a quick question 22 again on the procedure. So let me see if I get this 23 right, from FTB. 24 Again, in this kind of a structured -- this 25 unique structure of this particular deal, there was 26 some deposits made. Deposits were made well before 27 escrow, correct? 28 MR. REGGIARDO III: Correct. 22 1 MR. RUNNER: And -- and if -- did I just -- 2 see if I heard this correctly. This would have 3 qualified if those deposits then would have been 4 transferred into the escrow prior to the sale? 5 MR. IMMORDINO: No. 6 MR. RUNNER: Did I -- 7 MR. IMMORDINO: I'm saying -- 8 MR. RUNNER: -- maybe I misunderstood 9 that. 10 MR. IMMORDINO: No, if the -- if the funds 11 had been transferred to escrow before the 12 relinquished property closed -- 13 MR. RUNNER: Yes. 14 MR. IMMORDINO: -- then the law is more 15 gray. 16 MR. RUNNER: Okay, okay, okay. 17 MR. IMMORDINO: It's undefined. But one -- 18 MR. RUNNER: Okay, it's undefined. So 19 there -- obviously there's room -- more room for 20 interpretation. What you're bringing us is 21 something that has -- in your opinion, has no room 22 for interpretation, correct? 23 MR. IMMORDINO: That's correct. 24 MR. RUNNER: Okay. So that would be -- 25 that would be -- if indeed the seller did -- or the 26 buyer -- well, the taxpayer did that, then it would 27 be a little different set of facts that would have 28 to be talked about. And then we'd have to work 23 1 through a murkier part of law; is that fair? 2 MR. IMMORDINO: That's correct. 3 MR. RUNNER: Okay. But your premise is the 4 fact that it doesn't qualify because he had -- they 5 had control of the money, right? 6 MR. IMMORDINO: That's correct. 7 MR. RUNNER: But wouldn't they have had 8 control of the money prior to putting it into escrow 9 too? 10 MR. IMMORDINO: That's the exact reason why 11 the structure, you know, may not work. And so, you 12 know, when -- I think when people tie in -- 13 MR. RUNNER: When you say "may not work," 14 when you say "may not work," what does that mean? 15 Does that mean -- does that mean the FTB would 16 actually then disallow it? 17 MR. IMMORDINO: We have not had one of 18 those cases, you know, come up at appeal. We 19 haven't seen where the IRS has had a case in which 20 it's come up on that. And so there's no clear cases 21 out there or no clear authority from the IRS where 22 they're saying how to treat it. 23 MR. RUNNER: There's got to be a -- it 24 seems to me there's got to be a lot of very 25 complicated exchanges out there that have dollars 26 that -- that flow prior to an identification in 27 escrow. That can't be unusual. 28 MS. KUDUK: May I? May I -- 24 1 MR. RUNNER: Yes. 2 MS. KUDUK: -- address your question? 3 There are cases where -- where taxpayers do 4 take money out of a 1031 exchange before the 5 exchange begins and that money is taxable boot. 6 There are cases like that: Long, Garcia. 7 MR. RUNNER: Well, the difference is that 8 this was not identified at that time as an exchange. 9 Is that -- 10 MS. KUDUK: That is -- 11 MR. REGGIARDO III: Right. Those cases 12 involved taking money out of -- out of an exchange 13 that's actually occurring. These funds were 14 received long before the exchange ever started. 15 MR. RUNNER: Right. So these facts are, I 16 think, a little different than what you're 17 illustrating. 18 MS. KUDUK: But in December 2006, Emerson 19 Properties signed a Sales Agreement identifying that 20 they were going to be doing a section 1031 exchange. 21 So they knew well before they got the $2 million 22 that they were going to be doing a section 1031 23 exchange. 24 MR. REGGIARDO III: Nobody ever knows 25 they're going to do an exchange. A lot of reasons 26 why an exchange could fall out of bed. And even 27 Starker says the fact that money might actually be 28 retained doesn't defeat an exchange. 25 1 I don't recall exactly what the nature of 2 the language in that document was, but you never 3 know whether you're going to do an exchange. I mean 4 things -- 5 MR. RUNNER: Is the assumption that people 6 do that in order to just keep their options open? 7 MR. REGGIARDO III: Correct. But typically 8 what happens is you enter into a purchase, a Sale 9 Agreement -- 10 MR. RUNNER: Yeah. 11 MR. REGGIARDO III: -- and then you assign 12 your rights and delegate your duties under the 13 agreement to the exchange intermediary. And that 14 happens once you know there's actually going to be a 15 closing. That's how it works in the real world. 16 MR. RUNNER: Well, and again, that's what 17 I'm trying to figure out if what we've got here is 18 a -- is what could be a fairly common practice. 19 MR. REGGIARDO III: Very common. As 20 counsel indicated, in many cases option proceeds are 21 received years before you know whether there's even 22 going to be a closing. A lot of times it happens 23 when developers are trying to pick up property and 24 get entitlements. 25 MR. RUNNER: Yeah. Because, again, I 26 assume that this is a typical kind of a -- of a 27 transaction to where, you know, somebody is wanting 28 to sell a piece of property and somebody is wanting 26 1 to buy a piece of property. The seller's wanting to 2 see how serious and protect themselves and so they 3 get some money up front, whether it's a deposit, may 4 not be refundable. It keeps the buyer then serious 5 about this -- about this sale. If the buyer 6 sells -- backs out, the money then becomes -- goes 7 back -- is -- belongs to the -- to the seller and is 8 then just regular income at that point, correct? 9 MR. REGGIARDO III: That's how it works. 10 MR. RUNNER: And this case what you're 11 doing is you're getting that money in advance in 12 earnest money in order to do that. The deal went 13 through, and now you're wanting to -- and now -- 14 but -- but the idea was that it was then be 15 structured then into this exchange. 16 MR. REGGIARDO III: Correct. 17 MR. RUNNER: Okay. I may come back. 18 MS. MA: Mr. Horton. 19 MR. HORTON: Thank you, Madam Chair. 20 Members, we may want to go to Appeals. 21 There seems to be a mixing of laws, if I may. I 22 mean this is very common. Very common. But there 23 are different set of laws that apply. 24 When you have a simultaneous 1031 exchange 25 and the funds are in escrow, the open transaction 26 doctrine clearly applies to that because the escrow 27 is still open and so you have an opportunity to move 28 funds in and out of the escrow, as long as you do it 27 1 before it closes. 2 However, if you move the funds outside of 3 escrow and they stay outside of escrow, escrow 4 closes, that transaction is finished. And that act 5 in and of itself triggers a taxable transaction. 6 That's when the tax is triggered. Then you open up 7 a -- I mean you open up a 1031 deferred exchange and 8 you identify the property within the limited amount 9 of time, extended to the 180 days. That's the 10 subsequent transaction. 11 But if you take funds from a previous 12 transaction and move it into the subsequent 13 transaction, it doesn't change the taxability when 14 it was originally triggered. 15 So this is common, you know, and it happens 16 all the time. But it doesn't change the 17 implications of the tax. 18 And so if you -- I can't remember the case, 19 but I think it's Davis versus the United States or 20 something like that, that sort of speaks to this 21 issue. 22 You know, I don't want to be the one 23 putting it on record. I'd rather Appeals -- 24 MR. THOMPSON: Well, yeah. I just wanted 25 to comment. You know, we have a transaction in 26 front of us and I wanted to try to stick to the 27 facts of that transaction. 28 Both parties maybe have different 28 1 experiences about what they're seeing at audit, in 2 FTB's case, and in the appellant's private practice. 3 And certainly in many cases they're earnest money 4 deposits, obviously that's the case. 5 I would question whether it is typical for 6 an advisor to take earnest money and advise their 7 taxpayers that they can retain actual receipt of 8 that money through -- through and during the 9 exchange period. It would be an odd result if a 10 taxpayer who received money prior to the exchange 11 period was in a better position than a taxpayer who 12 had control of the money constructively during the 13 exchange period. 14 Let me -- let me restate that. 15 A taxpayer that had control over money 16 during the exchange period would unquestionably, 17 under the regulations, recognize taxable boot. 18 Here, the taxpayer had actual receipt, not 19 constructive, not deemed, uncontestedly had actual 20 receipt of the cash during the exchange period. 21 And I'd also note that the regulation on 22 point doesn't refer to the receipt of cash during 23 the exchange period. It refers to the receipt of 24 cash prior to obtaining the replacement property. 25 "Prior to obtaining the replacement property," 26 that's the language in the regulation. 27 MR. REGGIARDO III: May I address -- 28 MR. HORTON: Thank you. 29 1 And -- and you know, I mean, if you look at 2 the intent of the 1031 exchange, Congress is 3 relatively clear that their intent is to provide the 4 taxpayer an opportunity to make this exchange. 5 However, at no point in the transaction shall the 6 taxpayer retain possession of the funds and be able 7 to control those funds in such a way to deposit them 8 into their personal bank account, use them however 9 they will, and subsequently make a decision to now 10 reinvest it back into the -- into the 1031 exchange 11 property. That's a conscious act and conscious 12 control. 13 And so, you know, I mean I get the -- I 14 commend you for the argument. But they're, you 15 know, two different bodies of law. And the first 16 time when it happened, as soon as you pulled those 17 funds out, you know, you trigger a taxable event. 18 MR. REGGIARDO III: I'd like to address 19 several points. Number one, it was referenced to 20 two transactions. This is all one transaction, one 21 like-kind exchange. 22 MR. HORTON: In that case you're 23 contradicting yourself. 24 MR. REGGIARDO III: Not at all. No. It's 25 a single transaction and 1031(b) governs. It's not 26 two transactions at all. The tax laws treat this as 27 one, and that's why we have section 1031. 28 Second, taxpayers do in fact retain funds 30 1 all the time under the open transaction doctrine. 2 Third, the regulations do not say that you 3 cannot receive property before the exchange period. 4 Those regulations, to apply them to transact -- to 5 funds received before the exchange period takes them 6 completely out of context. 7 Again, there was Starker, there was an 8 amendment to 1031. And then the regs came along, 9 and they deal only with the deferred exchange 10 period. 11 So to say that there's a better result, it 12 seems odd that there's a better result if you 13 actually receive funds and have them in your pocket, 14 it's a better result than you would otherwise get is 15 true. And yet, to get a different result you 16 actually have to make a policy decision and draft 17 something into the tax law that doesn't exist. 18 And this is federal tax law being 19 incorporated into -- by reference, into California 20 law. And what the Franchise Tax Board's asking this 21 Board to do is effectively draft something to solve 22 a perceived problem. The way to solve the problem 23 is not to attack on weak technical grounds but to 24 give taxpayer's notice. They will fall into line. 25 MR. HORTON: Yeah. I mean, I appreciate 26 your argument, but I think the Supreme Court 27 disagrees. I also think that there are a number of 28 cases where they just fundamentally disagree. 31 1 And so it's difficult for me to -- I 2 mean -- I mean I've done 1031 exchanges before, for 3 about five years before going to the Legislature. 4 And to advise the tax -- I wouldn't advise a client 5 to take money out of the process. That's not the 6 intent of the law. 7 And so, again, I can't remember the case 8 exactly, whether it's Logan, Bennet versus Logan, or 9 something like that, U.S. Supreme Court, that says, 10 you know, the value of the property is established 11 at the point -- anyway -- 12 MR. REGGIARDO III: The U.S. Supreme Court 13 has most certainly not addressed this issue. 14 MR. HORTON: Well, they've addressed the 15 open transaction doctrine. They've addressed when 16 the value of the property's established. They've 17 addressed the issue of deposit and pulling funds out 18 of a transaction. 19 And if this was a continuous transaction, 20 still, that bodes to the argument that you shouldn't 21 have pulled the funds out of that transaction even 22 if it occurred prior to opening the 1031 exchange or 23 commencing the 1031 exchange. 24 MR. REGGIARDO III: The funds were not 25 pulled out. 26 MR. HORTON: In the argument that it was 27 unknown is an argument that says that you had -- you 28 had finalized the transaction and then subsequently 32 1 decided to enter into a 1031 exchange, which is 2 somewhat inconsistent with the facts. 3 But this is not a -- it's just my opinion. 4 You still have four other Members to convince. 5 MS. MA: Ms. Harkey. 6 MS. HARKEY: Thank you. 7 Okay. Just to start out, to address your 8 taxpayer notice, we can take that up and maybe 9 establish that procedure at a later time. I 10 understand what you're saying, and I'm very 11 supportive of doing so. If the Board wishes to -- 12 wishes to do that, I'll be happy to take that under 13 consideration. 14 But it is true that tax -- that money 15 received as part of a purchase option is not taxable 16 until the option is exercised; is that correct? 17 Okay. 18 MS. KUDUK: Exercised or -- or lapsed. 19 MS. HARKEY: Yeah. And in this case the 20 option was exercised when the buyers bought the 21 property on August 29th, 2008; is that correct? 22 MR. REGGIARDO III: That's my 23 understanding, but I don't think that that's a 24 correct statement of the law that it becomes -- 25 MS. HARKEY: Okay. I'm not debating now. 26 I'm just asking a yes or a no. Okay. 27 In 2006 -- this is for the FTB -- there was 28 a Sales Agreement that noted there was going to be a 33 1 1031. 2 MS. KUDUK: Yes. Yes, that's true. 3 MS. HARKEY: Do you concur with that? 4 MR. REGGIARDO III: I -- I have not 5 reviewed the file to look at the language, but I'll 6 assume that that's correct. 7 MS. HARKEY: Thank you. 8 So I know we have said there's a bit 9 murkiness around, you know, when the option's 10 received, and the FTB will have to clarify that at 11 some point with us and probably in future cases. 12 But it would seem to me that with the 2006 Sales 13 Agreement it was kind of an understanding. You did 14 take -- your client did take the money out. And in 15 2008, once the option -- I used to work with a lot 16 of land purchases and publicly traded and private 17 home builders, so I understand the option element of 18 this. 19 But if this was, in fact, going to be a 20 1031, it would seem to me that the minute you had 21 resolved that, that money should have come back. 22 MR. REGGIARDO III: One thing I question is 23 whether the agreement simply had the standard 24 language saying that it may be a 1031. 25 MS. HARKEY: Okay. But on August 29th -- 26 so that's kind of enough there. You don't have it. 27 The FTB does, but I'm not going to ask for proof. 28 MR. REGGIARDO III: I don't think it was -- 34 1 MS. HARKEY: All I'm saying, on August 2 29th, 2008, did your client establish that there was 3 going to be a 1031? 4 MR. REGGIARDO III: No, I don't believe so. 5 I believe that language was the standard language 6 saying that a -- that the parties will accommodate a 7 like-kind exchange, as I recall now. It was a 8 standard Purchase and Sale Agreement with language 9 saying that there would be exchange accommodation. 10 That's typical language. It's boilerplate almost. 11 That doesn't mean that the parties are committing to 12 an exchange. 13 MS. HARKEY: Well, if there wasn't an 14 exchange, then the whole amount was taxable. 15 MR. REGGIARDO III: But there was an 16 exchange. And so the issue -- 17 MS. HARKEY: Okay. So there either was an 18 exchange -- 19 MR. REGGIARDO III: There was. 20 MS. HARKEY: -- and it was completed and 21 money was taken out earlier and money wasn't put 22 back once the agreement was made. Or you're saying 23 there wasn't an exchange; in that case, the tax bill 24 is much higher. 25 MR. REGGIARDO III: There was most 26 certainly a like-kind exchange, but the deposits 27 were received under the open transaction doctrine 28 and then the exchange occurred later. 35 1 MS. HARKEY: Yeah, the exchange occurred 2 August 29th, 2008, is what I have. 3 MR. REGGIARDO III: And the funds were 4 received well before that. And so $1 million of the 5 deposit funds were used in the exchange to acquire 6 target property, $1 million were retained. 7 So it wasn't clear whether there would even 8 be a closing. Then it was clear there would be a 9 closing and the property -- the transaction was then 10 structured as an exchange and an exchange occurred. 11 And so then there was some boot in the exchange. 12 And the issue is whether it's all 2 million or 13 1 million and change. 14 MS. HARKEY: Right, I understand that. 15 So why wouldn't they have put -- why 16 wouldn't your client have put the money in, the 17 million that is in dispute, in in August -- in 2008 18 once they realized and once they had a qualified 19 intermediary? Or better yet, why wouldn't they keep 20 the options somewhere that would not be under their 21 control? 22 MR. REGGIARDO III: I wasn't involved in 23 structuring the transaction, so I don't know their 24 thought process. But, as I said, when I first came 25 to town, one of the first transactions we did, 26 deposits and option money are often kept. 27 MS. HARKEY: Right. They are, but they're 28 not part of a 1031 if they're kept. 36 1 MR. REGGIARDO III: Not true, not 2 necessarily. That's the whole issue here is whether 3 they can be, or the extent to which they can be used 4 in an exchange. 5 And as I pointed out, there is no legal 6 authority dealing with the use of funds received 7 under the open transaction doctrine before the 8 exchange, the use of those funds in the exchange. 9 That's -- there's simply no authority on that. 10 MS. HARKEY: But I believe we're talking 11 about once the exchange occurred, which is August 12 29th, 2008. Is that when the exchange -- 13 MR. REGGIARDO III: Well, it was a deferred 14 exchange, so it was a process -- 15 MS. HARKEY: That was the process. 16 That's -- 17 MR. REGGIARDO III: -- that started. 18 MS. HARKEY: -- once you got to qualified 19 intermediary for the -- for everything, or your 20 client did. 21 MR. REGGIARDO III: That's when the first 22 disposition occurred. 23 MS. HARKEY: Right. And so at that point 24 in time when you were sure that it wasn't all 25 taxable, that you were trying to put some back in, 26 why didn't you put it back, why didn't you put it 27 back -- 28 MR. REGGIARDO III: Again, I was not 37 1 involved in structuring the transaction. 2 But what the Franchise Tax Board is asking 3 this Board to conclude is that the failure to put 4 all of those funds into the exchange at that time, 5 to put the money in the intermediary's hands, causes 6 a deemed receipt of the funds. Because the taxpayer 7 already held the money in its pocket. So Franchise 8 Tax Board's asking this Board to conclude that an 9 event occurred for tax purposes. Congress, the 10 Treasury, the IRS, they've never gone down that 11 path. 12 MS. HARKEY: Oh, I don't -- I'm not so sure 13 about that. All of my analysis seems to indicate 14 that if the -- even if the cash is reinvested in 15 replacement property after being received, either 16 actually or constructively -- and I think we've 17 ruled on something up here before, not the same 18 issue but very similar -- from the sale of 19 relinquished property, it will not be allowed under 20 IRC section 1031 if it was not done through the use 21 of a safe harbor. 22 MR. REGGIARDO III: If there is a sale and 23 reinvestment, that is a problem. This was not a 24 sale and reinvestment. This was a like-kind 25 exchange. 26 MS. HARKEY: Right. 27 MR. REGGIARDO III: Boot is tested under 28 1031(b). I mean we need to focus on the technical 38 1 issues, and that's how this works. 2 MS. HARKEY: I think we're trying to. But, 3 you know, you're trying to get this all around. And 4 I like to say ducky, bunny. 5 You had the money here. You knew about the 6 transaction here. You had an opportunity to 7 reinvest the money over here and we probably 8 wouldn't be sitting here. You did not. You took 9 some of it. Not you, but your client took some of 10 it. And then they put some in at the very end. 11 During that time between this ducky, this 12 bunny, and this ducky, we had constructive use of 13 the cash. You had. Your client did. 14 MR. REGGIARDO III: Actual use of the 15 cash. 16 MS. HARKEY: Actual use of the cash, 17 right. 18 MR. REGGIARDO III: And that's okay. 19 MS. HARKEY: Right. Actual use of the 20 cash. 21 Well, you're saying it's okay. 22 MR. REGGIARDO III: Yeah, open transaction 23 doctrine says -- 24 MS. HARKEY: And FTB is saying it's not 25 okay. Am I -- 26 MR. REGGIARDO III: And FTB can't cite to 27 any authority that -- 28 MS. HARKEY: Okay. 39 1 MR. REGGIARDO III: -- deals with the 2 interplay of the open transaction doctrine and 3 like-kind exchanges like this. This is -- 4 MS. HARKEY: Well, I think -- 5 MR. REGGIARDO III: -- an open area. 6 MS. HARKEY: I think these things are much 7 too complex. You had the money, you could have 8 taken it. You would have paid all cash on it, but 9 you didn't. You reinvested some of it, but you 10 didn't reinvest it at the time. You reinvested it 11 back probably when you finally knew what you really 12 had to have for the deal. In the meantime, there 13 was use of the money. And so that's boot in my 14 opinion. And I think legally it's very supportable 15 that it was boot. 16 So I appreciate your argument. I think 17 you've done a great job. But keeping it real 18 simple, which is really what this is. 19 MR. REGGIARDO III: This is actually not 20 simple. This is complicated tax law. 21 MS. HARKEY: Yeah, it is. Nothing is that 22 complex. 23 MR. REGGIARDO III: This is. 24 MS. HARKEY: Nothing in life is that 25 complex. You just got to break it down. You got to 26 break it down. What are the facts? You had the 27 money here. It was option money. You knew about 28 the transaction over here. You didn't put the money 40 1 in until over here and only part of it. So -- and 2 there was no qualified intermediary. That's where I 3 have a problem. Thank you. 4 MR. REGGIARDO III: Well, there was. The 5 intermediary just didn't handle these funds. 6 MS. HARKEY: Yeah, the intermediary didn't 7 handle the funds, I guess. Thank you. 8 MS. MA: Mr. Runner. 9 MR. RUNNER: No. 10 MS. MA: Okay. Is there a motion? 11 MS. STOWERS: Move to sustain the Franchise 12 Tax Board. 13 MR. HORTON: Second. 14 MS. MA: Okay. The motion is to sustain 15 the Franchise Tax Board by Ms. Stowers, seconded by 16 Mr. Horton. 17 Madam Clerk, please call the roll. 18 MS. HARKEY: Is there an objection? 19 MS. RICHMOND: Ms. Ma. 20 MS. MA: Is there any objection? 21 No objection. 22 MS. RICHMOND: Okay. 23 MS. MA: By consent. 24 Thank you, Mr. Reggiardo. Thank you, 25 Franchise Tax Board. 26 ---oOo--- 27 28 41 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 24, 2016 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 41 constitute 14 a complete and accurate transcription of the 15 shorthand writing. 16 17 Dated: June 6, 2016 18 19 20 ____________________________ 21 KATHLEEN SKIDGEL, CSR #9039 22 Hearing Reporter 23 24 25 26 27 28 42