This article was reprinted with permission from the author.
By Joon Cha – State and Local Tax Senior Manager at Moss Adams LLP
According to USA Today, California is one of the top three least tax friendly states in the nation. Last week, California’s top tax authorities took steps toward making California friendlier. The five-member board of the State Board of Equalization decided (3-to-2) to make a previous decision, involving a 1031 like-kind exchange transaction, precedential. By doing so, they hope to provide both taxpayers and the Franchise Tax Board (FTB) guidance to be relied upon for similar pending disputes and future tax returns.
Earlier this March, the Board decided unanimously in favor of the taxpayers Rago Development Corp. et. al. Taxpayers originally held an interest in two adjacent real properties in California. They sold the properties and used a third-party qualified intermediary to acquire a Tenant-in-Common (TIC) interest in the replacement property (two parcels and a shopping center). Later, the properties were transferred to two separate Limited Liability Companies (LLC).
FTB argued that the exchange was not valid due to the appellants essentially exchanging real property for intangible assets (i.e., LLC interests). FTB argued that step transaction theory (where multiple steps are collapsed and viewed as one) and substance-over-form (where the form of the transaction is ignored and the essential substance of the transaction is analyzed) should be applied. Taxpayers’ representatives argued that various courts had allowed subsequent tax-free transfers of replacement properties and that 1031 exchanges in their very nature are form-over-substance and not the other way around. That is to say, selling one property to one person and later buying another similar property from someone else is by no means a true “exchange”. However, so long as the permitted form of the transaction is followed, the separate transactions will be treated as a tax-deferred exchange. The taxpayers performed all of the permitted steps, and so they argued the tax benefit should be allowed. Board members agreed with the taxpayers.
More than a Taxpayer Win
Not only did the Board members decide in favor of the taxpayers, the Board members were very concerned about the volume of 1031-exchange-related appeals in the pipeline. They wanted to set a precedent to end a repeat of similar disputes going forward.
It is important to note that the Board members are not in the business of giving away state revenues. On the same day, another appellant also had an appeal involving a 1031 exchange. The members voted in favor of the FTB in this case. It is important to note that FTB is also not in the business of being unfair to taxpayers. In instances where an issue is gray and there is not clear precedential guidance or tax authority, FTB employees vigorously argue the state’s case despite their personal views on the issue – not unlike the taxpayers’ representatives and tax counsel. This is the way it is supposed to work. However, this system only the highlights the need for the Board to settle certain tax disputes by providing precedential decisions. As the California Taxpayers Association observed (CalTaxLetter, June 26, 2015), this is the first precedential appeal decision since NASSCO Holdings, Inc. in 2010. The Board ended this long drought of authoritative decisions with this case.
Thanks to the Board
This is not the only instance where I’ve witnessed such concern for the fairness of taxes in California by this Board. For this and the other instances, Jerome Horton, George Runner, Fiona Ma, Diane Harkey, and Yvette Stowers (Deputy State Controller for Taxation, on behalf of Controller Betty Yee) should be commended about their active and diligent exercise of their authority as the top administrative tax authorities in the state. This one action does not completely change the tax environment in California, but it’s a step in the right direction.