1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 MARCH 16, 2009 10 11 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 12 APPEAL OF 13 MARLENE D. CANTER 14 NO. 421269 15 AGAINST PROPOSED ASSESSMENT OF 16 ADDITIONAL TAX 17 18 19 20 21 22 23 24 25 Reported by: Juli Price Jackson 26 CSR No. 5214 27 28 1 1 P R E S E N T 2 For the Board Betty T. Yee of Equalization: Chair 3 Judy Chu 4 Vice-Chair 5 Bill Leonard Member 6 Michelle Steel 7 Member 8 Marcy Jo Mandel Appearing for John 9 Chiang, State Controller (per Government Code 10 Section 7.9) 11 Diane G. Olson Chief, Board 12 Proceedings Division 13 For Board of Lou Ambrose 14 Equalization Staff: Staff Counsel 15 16 For Franchise Tax Daniel Biedler 17 Tax Counsel: Tax Counsel 18 William Hilson ` Tax Counsel 19 20 For Appellant: Marlene D. Canter 21 Christopher Whitney Representative 22 Barry Edwards 23 Representative 24 25 ---oOo--- 26 27 28 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 MARCH 16, 2009 4 ---oOo--- 5 MS. OLSON: Our next item is B1, Marlene D. 6 Canter. The Appellant in this case has asked for an 7 additional fifteen minutes. So, we will have 25 minutes 8 time of presentation. 9 MS. YEE: Actually, I think it was a total of 10 fifteen minutes. 11 MS. OLSON: Oh, it was a total of fifteen 12 minutes? 13 MS. YEE: Yes. 14 MS. OLSON: Oh, okay. 15 They will have fifteen minutes to present. 16 MS. YEE: Okay. 17 MR. WHITNEY: Just one point of clarification, 18 it was my understanding that I had 25 minutes to 19 present, which had been confirmed via e-mail. 20 MS. OLSON: He did -- we did notify him of 25 21 minutes. 22 MS. YEE: Okay. I'm sorry, Mr. Whitney, that 23 was not -- my consent was for fifteen minutes. 24 But, let me do this, let me have Appeals 25 introduce the case. We'll give you fifteen minutes to 26 present. I'm sure there will be lots of questions that 27 we'll cover a lot of ground with. 28 MR. WHITNEY: Okay. 3 1 MS. YEE: So -- and then if we need additional 2 time, we'll proceed from there. 3 Appeals -- 4 MR. WHITNEY: Thank you. 5 MS. YEE: -- if you can introduce the case, 6 please? 7 MR. AMBROSE: Good morning, Madam Chair, 8 Members of the Board. 9 This is the appeal of Marlene D. Canter. And 10 the questions presented are whether Appellant has shown 11 that Respondent erred in using the maximum stated amount 12 payable under Appellant's 1998 installment sale of her 13 business in calculating the interest due under Internal 14 Revenue Code Section 453A. 15 Second issue is for purposes of calculating the 16 interest under Section 453A, whether Appellant has shown 17 that Respondent erred by not reducing the gain from the 18 sale by payments made by Appellant to Appellant's former 19 spouse and former employees. 20 MS. YEE: Okay, thank you very much. 21 Good morning, Mr. Whitney. Please introduce 22 yourself formally for the record and also the others who 23 have joined you this morning. 24 MR. WHITNEY: Yes, thank you. 25 Madam Chairwoman, Members of the Board, my name 26 is Chris Whitney. And I represent the Appellant, 27 Marlene Canter in this appeal. 28 Miss Canter is sitting to my immediate left and 4 1 to her immediate left is Mr. Barry Edwards, 2 Miss Canter's attorney, who also represents Miss Canter 3 and who is deeply involved in the -- negotiating 4 the transaction which is the subject of this appeal. 5 This appeal is from the action of the FTB in 6 denying Appellant's protest against the notices the FTB 7 issued for tax years '98 through 2000. 8 And, as stated, the issue is whether a 453A 9 interest charge can be applied to a contingent earn out 10 with no minimum and no maximum amount payable. 11 As I will discuss in greater detail, Appellant 12 was required to pay 10 percent of the proceeds to her 13 ex-husband and 55 percent of the proceeds to the certain 14 officers of the business, who, along with Appellant, 15 were required to sign an employment contract with Sylvan 16 as a condition of closing. 17 After deducting these amounts, which totaled 18 65 percent of the proceeds, as well as other expenses of 19 sale, the Appellant received a net amount 10.8 million 20 with respect to the contingent earn out over a 21 three-year period. 22 The central issue in this appeal is whether and 23 how a 453A charge can be applied. 24 It is FTB's position that Appellant must pay a 25 453A interest charge beginning with the year of sale on 26 a presumed maximum face value of 50 million, without any 27 reduction for the 55 percent payment obligation to the 28 executives. 5 1 It should be noted at the outset that there are 2 some areas of agreement between the Appellant and the 3 FTB. For example, the FTB did audit the returns and 4 concluded that the income tax reported on the returns 5 was correctly reported, which included a deduction for 6 the 65 percent payment made to the ex-husband and 7 officers. 8 That said, there is no specific authority to 9 support FTB's contention that a 453A charge applies in 10 case. 11 And with that, I will proceed with the facts. 12 The facts are not in dispute. Appellant and her 13 then-husband founded the Canter Companies, whose mission 14 was to improve the quality of education by enhancing the 15 knowledge and instructional techniques of teachers. In 16 the mid-'90s, Miss Canter and her team seized upon the 17 idea of adapting the companies' course material using 18 computer, videostreaming and internet technology into a 19 distance learning base master's degree program, which 20 would allow working teachers to pursue higher education 21 without having to take a leave of absence from work. 22 This idea had the potential to be very 23 lucrative. The key challenge was whether the Canter 24 Companies would be able to raise sufficient capital. It 25 was in this context that Sylvan approached Miss Canter 26 to discuss a possible acquisition. 27 While Sylvan saw the same potential which 28 Miss Canter did with respect to the new strategic 6 1 direction, it was concerned that it had no experience in 2 this area and that the future success of the business 3 would depend, in large part, on keeping Miss Canter and 4 the current executive team in place. 5 To address these concerns, Sylvan proposed to 6 acquire the stock of the companies for a combination of 7 25 million paid up front and a contingent earn out to be 8 paid only in the event that certain earnings levels were 9 achieved over a three-year period. The latter earnings 10 levels were set extremely high. For example, in 1998 11 alone, the company's earnings had to double -- no small 12 feat for a company with a 2 to 3 percent historical 13 growth rate prior to 1997. And the fact that it was 14 dealing with a largely unproven strategic plan, at a 15 time when it would be integrating with a public company. 16 In addition, Sylvan demanded that as a 17 condition to closing the transaction, that Miss Canter, 18 as well as the key officers, sign employment contracts 19 with Sylvan and immediately cancel their employment 20 contracts with the companies. 21 Since under the existing employment contracts 22 these officers were entitled to a 55 percent asset sale 23 bonus payment in the event of sale, in order to induce 24 the officers to sign the employment agreements with 25 Sylvan and to incentivize them to strive for maximum 26 results, Appellant agreed to pay out a 55 percent payout 27 of the proceeds to them. These payout and employment 28 agreements were a key element in order to close the 7 1 deal, which was structured by Sylvan to reward 2 Miss Canter and the officers for high performance during 3 the three years after the transaction and not for prior 4 services performed. 5 And, now, Mr. Edwards will add a few comments 6 regarding the nature and purpose of the employment 7 contracts. 8 MR. EDWARDS: Thank you, Chris. 9 As you can imagine, this was an extremely 10 complicated transaction. And Sylvan required new 11 employment agreements for Miss Canter and all of her 12 executive team for a three-year period that ran 13 throughout the earn out period. This was a condition of 14 closing the transaction. 15 Sylvan made it very clear to me that at the 16 time they had no interest in assuming the obligations of 17 the Canter Companies under the employment agreements. 18 It was then determined that we needed -- meaning 19 Miss Canter -- needed to cancel the existing employment 20 agreements that she had -- that the company had with the 21 named officers and also, therefore, cancelling any 22 rights that these officers had to any asset sale 23 bonuses. 24 To get the executives to agree to cancel 25 bonuses that they were entitled to without having to 26 perform any additional services, Miss Canter agreed to 27 personally pay -- make payouts to these individuals out 28 of the Sylvan proceeds in the event that any were 8 1 received. 2 She did this by entering into extremely heavily 3 negotiated cancellation agreements with these named 4 officers in which their employment agreements were 5 terminated, the companies and Miss Canter were released 6 from any past obligations, and the named officer payouts 7 were now personal obligations of Miss Canter -- tied 8 directly to the future earnings of the Canter Companies. 9 MR. WHITNEY: Thank you. 10 Mr. Edwards assisted Miss Canter throughout the 11 negotiations with Sylvan and was able to secure an 12 unusual concession from Sylvan, namely, that if 13 Miss Canter and her team were able to deliver results in 14 excess of the targets that they'd be compensated on a 15 two-for-one basis. For every dollar of earnings above 16 the amount of the target, $1 of cash would be paid and 17 $1 of restricted stock. 18 Subsequent to close, and despite the extremely 19 high targets, Miss Canter and her executive team met the 20 target in 1998. And in 1999 an earn out payment of 21 24.1 million was received, roughly half in restricted 22 stock, which was issued to Miss Canter and the officers, 23 and half in cash, which was paid into a special account 24 set up for this purpose with wiring instructions to 25 immediately transfer the appropriate payments to the 26 respective accounts of the various officers and Lee 27 Canter. 28 After subtracting the 65 percent payable to 9 1 these individuals and other expenses of sale, 2 Miss Canter's net payment was 6.8 million. 3 In 2000, although Appellant believed an earn 4 out payment had been earned, Sylvan indicated that it 5 would make no payment, requiring Miss Canter to engage 6 the Law Firm Gibson Dunn. 7 Under the threat of litigation, Sylvan settled 8 the entire remaining earn out via cash payments of 9 9 million and 13 million in 2000 and 2001, respectively. 10 After deducting imputed interest, the 65 11 percent payable to the officers and Lee Canter and other 12 expenses of sale, Miss Canter received net payments of 13 1.3 and 2.7 million in these years. 14 Miss Canter reported each of the payments 15 received as income in the year received and -- on 16 Schedule B, and deducted the payments to the officers as 17 non-employee compensation on Schedule E. 18 As the FTB has noted in its briefs, installment 19 sale forms were not included, although such method would 20 have had substantially similar effect of reporting 21 income in the year in which payments are received. 22 Attached is Exhibit A of your handouts, it is a 23 schedule which summarizes the manner in which Appellant 24 reported the income from the contingent earn out, as 25 well as how the income might have been reported had the 26 installment sale been used. 27 As you can see, the sole difference between the 28 two methods is that the initial basis of 724,00 would be 10 1 recovered rabidly under the installment sale method, 2 with no effect on overall income over the entire period 3 concerned. 4 As previously discussed, the contingent earn 5 out was completely open-ended with no minimum and no 6 maximum. And the payments to Lee Canter and the 7 executives was open as well. 8 It was thought that reporting the payments as 9 income in the year received and deducting the payments 10 in the year made was a straightforward way of reporting 11 the income from the transaction, given the open nature. 12 In Appellant's mind, no income under the 13 contingent earn out was deferred, but was rather earned 14 by her and the officers over time, based upon the 15 performance of the companies during the earn out period. 16 As a result, she never believed for a moment 17 that something like 453A interest could apply on -- and 18 there is no regulatory guidance to this day that says 19 that definitively it does. 20 Miss Canter will add a few comments now 21 regarding her thought process and how she filed the 22 returns. 23 MS. CANTER: Thank you. I've always prided 24 myself on doing the right thing. And we had to work 25 really, really hard for the earn out. 26 We also worked really hard to report it 27 accurately and correctly, with the kind of professional 28 advice that you seek when you do these kinds of 11 1 transactions. 2 It's been a really long and arduous and 3 upsetting process for me. And I just really appreciate 4 the time that you're taking today to help resolve it. 5 MR. WHITNEY: Thank you. 6 FTB commenced an audit of Appellant's tax 7 returns in 2002. At the end of the audit, FTB made no 8 adjustment to the manner in which income tax had been 9 reported. 10 Stated differently, FTB concurred with the 11 manner in which Appellant reported its income tax 12 liability, including the deduction of 65 percent of the 13 payments to officers and Lee Canter. 14 However, in addition to the nearly $1 million 15 of income taxes paid on the earn out by Miss Canter, the 16 FTB asserted the second tax on the same transaction, the 17 453A interest charge. 18 Included in Exhibit B of the handouts is a high 19 level summary of the FTB's assessment under the presumed 20 maximum face value method. As reflected in the 21 attached, the FTB asserted that the charge was due on a 22 presumed maximum face value of 50 million. Further, 23 while the FTB allowed reduction in this amount for the 24 contractual obligation to pay 10 percent of the proceeds 25 to Lee Canter, it failed to match these payments with 26 the payments received by delaying the deduction of these 27 amounts until the years paid, while at the same time, 28 treating the entire 50 million as if it were received up 12 1 front in 1998 for purposes of computing the deferred tax 2 liability. Finally, FTB refused to allow any of the 3 55 percent of the proceeds which was paid to the 4 officers. 5 During audit and protest, Appellant explained 6 that the payout was highly contingent and that since 7 453A applies only to installment obligations with a face 8 amount greater than 5 million, it didn't seem to 9 Appellant that 453A was applicable to contingent earn 10 outs with no minute and no maximum. 11 However, in a good faith effort to resolve the 12 matter, after more than three years of attempting to do 13 this at audit, Appellant obtained a fair market value 14 appraisal of her net 35 percent interest in the 15 contingent earn out as of the date of sale. 16 And in the professional opinion of Higgins, 17 Marcus and Lovett, the fair market value of her 18 35 percent interest was 10.3 million. 19 It should be noted that this appraisal was very 20 close to the value that Sylvan itself placed on the 21 transaction. Attached is Exhibit C, it's an as excerpt 22 from the B. T. Alex Brown report discussing that Sylvan, 23 at the time, expected total consideration of the three 24 years to be 55 to 60 million, which when you back out 25 the 25 million that was paid up front, would yield a 30 26 to 35 million on a future value basis attributed to the 27 earn out. 28 This is very close to the 29.5 million gross 13 1 value determined by Higgins before applying the 2 65 percent reduction for the payment obligations. 3 It should also be noted that the actual net 4 amount that she received over the period on the earn out 5 was 10.8 million, after deducting 65 percent, and other 6 expenses of sale. 7 FTB's refusal to consider the fair market value 8 method as the more appropriate approach has led to this 9 appeal. 10 There is substantial authority to support 11 Appellant's tax return position that 453A doesn't apply. 12 And I wanted to spend a few minutes talking about this. 13 The Appellant reported the payments as income 14 as they were received and relayed payments as they were 15 deducted. In Appellant's mind there was no tax deferred 16 on the transactions since nothing was earned until it 17 was received. 18 The IRS never selected Appellant's returns for 19 audit on this or any other basis. 20 While the FTB viewed the transaction as an 21 installment sale in its audit, it made no change to the 22 underlying income that was reported, other than a 23 favorable basis adjustment. 24 But, nevertheless, it assessed a 453A interest 25 charge without considering the possibility that if this 26 isn't an installment sale, then 453A doesn't apply. 27 While the installment sale rules apply broadly 28 to transactions with one or more payment received after 14 1 the year of sale, the US Supreme Court, in Burnett 2 versus Logan, did apply the open transaction doctrine to 3 a transaction involving the sale of stock under a 4 contingent arrangement with no minimum or maximum. And 5 the installment regulations to this day recognize the 6 possibility of applying this method in unusual cases. 7 The open transaction method is similar to the 8 installment sale method in that income is reported as 9 payments are received, but does so under the theory that 10 some transactions are so speculative that they're not 11 fully realized or income is not fully realized at the 12 time of sale. 13 Here there were both contractual uncertainties 14 as well as substantial business uncertainties. The deal 15 was contingent upon signing employment contracts and 16 future services. There was no minimum, no maximum. 17 The companies were embarking on a new and 18 largely unproven business strategy, which existed 19 largely in the minds of Appellant and her executive 20 team. 21 Further, substantial expenses of sale, the 22 65 percent contractual obligations for themselves, were 23 contingent upon future payments, if any. 24 With all these uncertainties, Appellant's 25 original filing position was reasonable. And if this 26 transaction is best reported under the open transaction 27 method, there is no 453A. 28 Despite FTB's determination that this is an 15 1 installment sale, it's still far from clear that 453A 2 would apply. 453A applies where the face amount of 3 obligations exceeds 5 million. 4 What is the face amount of the contingent earn 5 out which has no minimum and not maximum amount payable 6 and which is subject to significant uncertainties? 7 Some commentators have speculated that such 8 should be the fair market value estimated at the time of 9 the transaction. Such speculation in the form of Law 10 Review articles and passages and treatises, for example, 11 were more common in the late '80s and early '90s when 12 the provisions were relatively new and the hope of 13 regulations coming around the corner, which would 14 explain these things, may have generated more interest 15 in this area. 16 As we stand here today, some twenty years after 17 the enactment the provisions and still no regulatory 18 guidance, it may be time to stop speculating about how 19 these rules might apply, particularly with respect to 20 contingent earn outs without any minimum or maximum 21 amount and simply be guided by the plain wording of the 22 statute. 23 Since a contingent earn out with no minimum or 24 maximum can not be said to have a face value, 453A on 25 its face is inapplicable. This conclusion would be 26 consistent with your Board's recent ruling in the Appeal 27 of Bengard. 28 Even if it's found that 453A applies to a 16 1 contingent earn out like this, the FTB's method is 2 inappropriate and unfair. 3 First, the FTB's proposed use of a presumed 4 maximum face value is inappropriate because there isn't 5 the maximum face value. 6 Second, even if there were, your Board has 7 rejected that in the Appeal of Rawlings. 8 While the FTB, in computing the interest 9 charge, has allowed a 10 percent payment to Lee Canter, 10 there's also a problem with the years that these are 11 allowed. They delayed the allowance of those until the 12 later years when they're paid, while at the same time 13 treating the payment as if it were received up front, 14 which would have triggered the payment for the 15 10 percent. That approach is inconsistent and fails to 16 match the payments. 17 Finally -- 18 MS. OLSON: Time has expired. 19 MS. YEE: Finish your thought, Mr. Whitney, and 20 then we'll go to the Franchise Tax Board. 21 MR. WHITNEY: Okay. Finally, the FTB's 22 disallowance of the payment of 55 percent of the 23 proceeds seems to be based on the theory that we're 24 trying to claim a double deduction, which we're not. 25 We're trying to claim consistent treatment for 26 two types of taxes that the FTB is imposing and that the 27 payments to the executives are selling expenses, which 28 the IRS publication defines very broadly as any expense 17 1 that relates to a sale of property. 2 And also the fact that they were reported on 3 Schedule E, as opposed to Schedule D. 4 But as we'll discuss, the key here is if it is 5 applied, it should be based upon the fair market value 6 of her net interest, so as not to apply the charge on 7 amounts that she did not receive and didn't have a right 8 to. 9 MS. YEE: Thank you very much. You'll have 10 time on rebuttal. 11 Franchise Tax Board, you have fifteen minutes. 12 MR. BIEDLER: Thank you, Madam Chairwoman. 13 Members of the Board, my name is Daniel 14 Biedler, representing Respondent. 15 To my right is Mr. Bill Hilson, also 16 representing Respondent Franchise Tax Board. 17 Appellant Miss Canter was always the majority 18 owner of the Canter Companies, with an ownership 19 interest of at least 90 percent. And the Canter 20 Companies had no more than two shareholders, the other 21 one being Mr. Canter. 22 Beginning in 1993, Appellant entered into a 23 series of employment contracts with key employees which 24 contained particular provisions. 25 There is two important things to remember: The 26 corporations did not own any of their own stock. This 27 would be important in the case of a stock sale because 28 the corporations would not receive the proceeds of the 18 1 sale, the stockholders would. 2 Appellant signed on to the employment contracts 3 that we're discussing personally with respect to a 4 specific provision, that's the bonus provisions 5 regarding the sale of the company by stock or asset 6 sale. She did not sign these employment contracts as a 7 representative of the corporation. 8 In 1997 Appellant and Sylvan entered into 9 negotiations for the sale of the companies. The 10 documents show Sylvan did want to keep the companies 11 operating as they had been. They obviously saw value. 12 To that end, they wanted them -- Appellants and the key 13 employees to remain on and not change anything else. In 14 fact, they agreed not to merge or otherwise change the 15 structure of the companies until the end of the 16 installment sale term. 17 What Appellant -- what Sylvan did not want was 18 to take on a continuing obligation, essentially letting 19 the bonus provisions renew when they took control of the 20 Canter Companies. The sale to Sylvan triggered the 21 timing and the amount of the payments due to the key 22 employees. But those obligations to receive them -- to 23 pay them and the right to receive them had been fixed 24 when the employment contracts were entered into. The 25 employment contracts noted that they were for both past 26 and future employment. 27 So, these bonuses, paid by Miss Canter, 28 directly from her own accounts, represented compensation 19 1 to employees for past services by the time of the sale. 2 If there are documents to show, as I believe 3 has been alleged in the briefs, that Sylvan would have 4 been willing to pay less if Miss Canter hadn't agreed to 5 formally, in writing, assume the obligations that she 6 already had personally, that they might have paid less. 7 Well, we haven't seen any documents to that effect. 8 When the structure of this deal became clear to 9 Miss Canter, she faced a decision. She could proceed 10 with the sale on the terms offered by Sylvan and honor 11 her promises to the key employees and their employment 12 contracts or, if she found the terms unpalatable, she 13 could have moved on. She was running a successful 14 business. 15 And as Exhibit C, on the second page of 16 Appellant's additional materials today, indicates, there 17 was recognition that estimated revenues for the Sylvan 18 Companies was already $27 million. That's not the same 19 as (unintelligible) and I don't mean to equate it, but 20 clearly they are successful and they're doing well. 21 The expectation that each party held as of that 22 year is, of course, what we're looking at as far as was 23 there in existence a continuing installment sale? 24 Well, payments were received in more than one 25 year. That fits the statutory definition. Appellant 26 chose to sell and keep her personal promises. Again, we 27 know that these are personal promises because she signed 28 the contracts as to these specific terms as an 20 1 individual and not as a representative of the companies. 2 Sylvan paid all of the monies that it was 3 obligated to directly to the Appellant. And she made 4 payments to Lee Canter and to the key employees out of 5 her own accounts. We have copies of checks for 1998 and 6 we also have 1099s issued for 1999 and 2000 from 7 Miss Canter to the key employees. 8 As I mentioned before, because the S 9 corporations, even though they continued in business, 10 they continued in existence, now owned by Sylvan, the 11 monies that were eventually paid to the key employees 12 never went to the companies for the companies to pay, 13 they went to Miss Canter. Granted that was the form 14 chosen, but, again, that was an existing obligation. 15 With regard to Mr. Canter, in order to obtain 16 the last 10 percent of the stock that she did not 17 already own, she entered into a redemption agreement, 18 which also happened to be a dissolution agreement, or 19 part of a dissolution agreement, for their marital 20 estate. So, she was accomplishing this purpose, which 21 already existed again, an obligation to divide her 22 personal -- their marital estate, and she managed to tie 23 it into the sale. 24 But the funds from the sale did come from the 25 acquisition by Sylvan. But the obligation did not come 26 from that sale to pay Lee Canter. This is the form that 27 she chose. 28 As structured -- and as we've mentioned -- this 21 1 deal is clearly an installment sale because the payments 2 were received in more than one year. No matter what the 3 expectation was as of the end of the year, there was a 4 possibility, and a fairly strong one, although there 5 were uncertainties, and money was, in fact, received by 6 Miss Canter before she filed her return for 1998. So, 7 she knew that there -- that this was an installment sale 8 before she filed her return, which was filed in October 9 of 1998 -- payments being received, I believe, as early 10 as April of 1999 -- excuse me, October of '99 for the 11 '98 return. 12 Appellant did not indicate and opt out on her 13 returns, nor did she indicate treating the installment 14 sale as such. We know this because she did not did not 15 return -- did not report and pay tax on all of the gain 16 in 1998. And if she had opted out for '98, she would 17 have had to present a calculation present valuing every 18 aspect of the compensation called for in the contract, 19 including the contingent terms. 20 As we can see from Appellant's own expert 21 valuation, which indicates itself it was looking from 22 the perspective of the date of the sale in February of 23 1998, there was a substantial value beyond the 24 $25 million already received up front in cash 25 compensation. 26 So, it seems a bit disingenuous to say that 27 given that a payment was received in 1999, based on the 28 economic performance of '98 before the returns were 22 1 filed, and the valuation itself that there was no 2 expectation that she would get anything more. 3 What Appellant did do, instead of filing -- 4 paying tax or filing form 6252 and then calculating and 5 paying the interest charge and the deferred tax, she 6 simply reported an amount of gain without explaining how 7 she calculated her basis or how the calculation of the 8 gain was derived, although there was discussion of that 9 at audit and protest later. 10 Pardon me -- lost my thought. 11 And at audit we discovered the failure to 12 report. So, instead of doing either an opt out and 13 following the forms and the requirements of that or 14 recognizing that she remained in the installment sale 15 provision, she did something different. 16 Mr. Whitney has made several comments about our 17 agreement to the income tax being correctly reported. 18 We wouldn't be here if the income tax had been correctly 19 reported. 20 We certainly don't agree on the tax reporting. 21 We do agree that the deductions taken currently for the 22 payments to the employees as she made them was 23 appropriate. These were again compensation, wages paid 24 for compensation in the form of bonuses for past 25 services. That was -- it was Miss Canter's business. 26 She owned it 90 to 100 percent, that seems like a very 27 reasonable position for her to take. 28 And because that was a pre-existing obligation, 23 1 it was appropriate to put it on Schedule E instead of 2 Schedule D, where the gain from the sale is reported. 3 So, by her own reporting, she's acknowledging a 4 disconnect between the sale. 5 Also I'd like to point out a distinction 6 between the way Franchise Tax Board responded -- took 7 the approach to the key employees and Mr. Canter. 8 Mr. Canter had stock in the corporations. Appellant 9 obtained that stock and we granted her basis in that 10 stock, which did have the effect of reducing her gain 11 and would also reduce the amount of deferred interest 12 that she would be liable for. 13 However, the employees didn't have stock. And 14 the employment contracts did not go so far as to give 15 them stock that she owned or to give them a lien against 16 her stock. Her promises were not secured by the stock 17 she owned. The only claim that the employees had was 18 the services that they had rendered. 19 And because those were pre-existing obligations 20 before the sale, if anticipating a sale, they are not in 21 the same nature as attorneys' fees or bankers' fees, 22 which are necessary at the time of sale to accomplish 23 it. So, there is a disconnect again between the sale 24 and these amounts paid to the employees. 25 So, we weren't inconsistent between 26 Mr. Canter -- payments to Mr. Canter and the payments to 27 the key employees because they were, in their very 28 nature, different. 24 1 We're faced now here at appeal -- and we dealt 2 with somewhat at protest -- with the two claims -- at 3 least two claims by Appellant. The idea that the 4 interest on the deferred tax can't be calculated because 5 there isn't a value because there's no guaranteed 6 minimum or guaranteed maximum would seem to allow the 7 taxpayer to wait until all events had occurred and then 8 look at what actually happened and then what the present 9 have value calculation would be and then choose which 10 one was lower and then report that for past years. 11 Well, in fact, the taxpayer Appellant did 12 receive nearly $75 million, just over 73 million, of 13 which over 4 million was imputed interest, so, that 14 would be reported as ordinary income, and the rest would 15 be gain after subtraction for basis and legitimate costs 16 of sale, such as brokers' fees, which we did allow. 17 The statutory scheme provides, across 453, 18 453A and 453B, a way for taxpayers to be able to enter 19 into sales and then not pay tax on all of the amounts of 20 gain, although it would otherwise be called for under 21 the Code, until money came in. They could elect out 22 under 453 and, if so, they would have to pay tax on all 23 of the gain that was recognized from that deal up front. 24 And if the -- there were no contingencies as to 25 the amounts, such as with an earn out, then that would 26 be easy -- straightforward, face amount. Where there's 27 contingencies, they have to present value, do a fair 28 market value of those contingent terms. 25 1 And then in calculating a loss under 453B, 2 again a present valuation is done to compare what was 3 actually received against what was anticipated. But for 4 453A, the government is to be compensated for the loss 5 of deferred tax revenues. 6 To follow Appellant's argument that they 7 shouldn't have to do it until they see what happens and 8 then they can choose doesn't accomplish that statutory 9 end. 10 Respondent is not asserting that there is a $50 11 million gain on top of the $25 million already received, 12 unlike Mr. Whitney's characterizations. In calculating 13 the interest, we assert that you look to what the 14 maximum discernible price is. And on the face of the 15 contract the numbers that were capped were a couple of 16 tiers, which is the term used in the valuation report, 17 that said, 18 "If this, then this, if this, then this and 19 then, if both that and the best case scenario, 20 you'll get even more. And we don't know how 21 much that would be because that depends." 22 Well, to say that just because there's an "it 23 depends" provision, which could be added with a sentence 24 or two to any contract, would allow the nonapplication 25 of 453A, would be to defeat the statute by simple 26 drafting. 27 With regard to allowing or not allowing the 28 payments to the key employees as costs of sale, as we've 26 1 said, these area pre-existing obligations. Tying them 2 into the sale, saying, somehow, "but for the sale, 3 they -- Miss Canter wouldn't have had to pay," well, she 4 already had the obligation to pay under her personal 5 signature to the employment contracts. The assumptions 6 formalized that. 7 But, as I said before, the sale to Sylvan, or 8 to whomever it might have been, triggered the timing and 9 the calculations of the amount. But the obligation to 10 pay already existed. 11 And to allow them to be included as a cost of 12 sale, reducing the amount of gain calculation for 453A 13 purposes and to allow a present deduction as an ordinary 14 cost of doing business, is to render these costs -- 15 expenses to be both capital and current expenses at the 16 same time. 17 And now we're not talking about dollar for 18 dollar comparisons, we're not talking about reducing her 19 gain if you do the current expense deduction, although 20 there is an interplay there. 21 But for purposes of this case, all we're saying 22 is you can't reduce her gain by the amounts -- in 23 calculating the interest deferred on the deferred tax 24 and allow her a current expense. 25 You can't let it be a current expense and 26 capital at the same time. To the extent that that 27 creates a double dip, that's what we're referring to. 28 And we, by no means, intend to characterize 27 1 anything done here as intentionally inappropriate. It's 2 very complex. 3 Do you have anything you'd like to add? 4 MR. HILSON: No. 5 MR. BIEDLER: All right. I'd be happy to take 6 your questions. 7 MS. YEE: Okay, thank you very much. 8 You have five minutes on rebuttal. 9 MR. WHITNEY: Okay, thank you, Madam 10 Chairwoman. 11 Just a couple of points of clarification. The 12 FTB did, in fact, audit the returns and conclude that 13 the income tax was appropriately paid. 14 We're not here because of the income tax, we're 15 here because of the 453A interest charge. 16 Second of all, I still haven't heard addressed 17 the Appellant's return position and the position at 18 audit and protest, which is that 453A doesn't apply. 19 Again, they treated this as an open transaction on the 20 returns as filed. It wasn't that this was a question of 21 opting out of the installment sale method, their 22 position was -- her position was that these amounts were 23 earned as they were received, that the entire 24 transaction was too speculative to be considered 25 realized. They were subject to a subsequent employment 26 contract that required work, the new business plan and 27 uncertainties around hitting the high hurdles, the 28 payment obligations themselves being contingent upon the 28 1 amounts received -- that was the position taken on the 2 return and I haven't heard that addressed. 3 Nor have I heard the point about the face value 4 being greater than 5 million. What is the face value of 5 a contingent earn out that has no maximum or no minimum? 6 What I've heard is that taxpayers could try to 7 game the system by putting trivial amounts that, you 8 know, theoretically could come in, but without providing 9 a specific amount. I would say that a two for one 10 payment obligation that was a hard, hard -- we heartily 11 fought, a negotiated item during the negotiations was 12 not a trivial amount put in for them to somehow defeat 13 453A. This had real significance as part of the deal 14 and, potentially, you know, a lot of money could have 15 been received on that. 16 So, with that, in terms of the 55 percent 17 payments, again FTB is adopting too narrow a view of 18 what a selling expense is. 19 The other point I wanted to make is that 20 Sylvan would not accept buying these companies subject 21 to the 55 percent asset sale bonus arrangement. They 22 did not want to have that liability. And that, among 23 other reasons, is why they demanded that the existing 24 employment contracts be cancelled. And they demanded 25 that new employment contracts be entered into with 26 Sylvan. 27 This required her to -- the 55 percent payout 28 in order to close the deal. There was no way that the 29 1 executives would walk away from a 55 percent asset sale 2 bonus without her doing at least that. 3 These were not the same employment contracts 4 and the same bonus arrangements that they had 5 previously, which did not require subsequent work. This 6 was a completely different deal, which required them to 7 work during the entire period of the earn out. And they 8 might not see another dime after the date of the 9 transaction. These were different agreements. 10 And certainly in every basic sense of the word, 11 the 55 percent amount that she paid out reduced the 12 amount that she realized. She did not have this money 13 on the transaction. 14 If you look at the definition that the IRS 15 gives to selling expenses, they define it broadly as any 16 expense related to the sale of assets. I think under 17 that broad definition we easily meet that definition. 18 In terms of the fair market value and the 19 maximum face value, the Appellant did not receive 20 75 million. Besides the imputed interest, there's also 21 the 20 percent discount on restricted stock, not to 22 mention the 65 percent payments that she had to make out 23 to Lee Canter and the named executives. 24 What she received, net of all of the expenses, 25 was the $10.8 million figure that we talked about and 26 that's in contrast with the $50 million that she's being 27 asked to pay this 453A interest charge on. 28 And the FTB indicated that what the Appellant 30 1 is doing is waiting until the very end and picking which 2 method is better. 3 We've already stated what the position on the 4 original return was. It wasn't a guessing game or 5 gaming the system, but doesn't, at some point, the 6 agency have an obligation to issue, after twenty some 7 odd years, what the rules are and explain that if 453A 8 is to apply to a contingent earn out with no minimum and 9 maximum, what's the rationale? 10 Is it based on the fair market value rationale 11 or some other rationale? We don't know the answers to 12 this. And I think at some point it's the agency that I 13 think we need to hold to the letter of the law. 14 And if it says maximum face value of more than 15 5 million and we don't have that, I think there's more 16 than a reasonable basis that this doesn't apply. 17 In terms of the fair market value appraisal 18 that Appellant obtained, it's consistent with the value 19 that Sylvan itself placed on the transaction. Included 20 in the materials is an excerpt from an analyst's report, 21 a third party analyst, B. T. Alex Brown, at the time. 22 It's a good valuation. The end result is very similar 23 to what she, on a net basis, received after all expenses 24 were paid. 25 And we think that, again, her original position 26 on the return was reasonable. She's offered, in 2006, 27 to resolve this on the basis of the fair market value 28 appraisal obtained. 31 1 If your Board decides to apply 453A to this 2 case, we think that the fair market value basis is the 3 more appropriate, more reasonable measure of her net 4 35 percent interest in the payments. 5 And we have attached as Exhibit E a computation 6 of what the fair market value calculation would look 7 like in this case. 8 I appreciate the time for rebuttal. 9 MS. YEE: Thank you very much. 10 Questions or comments, Members? Dr. Chu? 11 DR. CHU: Question -- question for the FTB. 12 What authority do you have for establishing 13 that $50 million is the maximum face value under the 14 stock purchase agreement, particularly in light of the 15 earnings requirements contained in the earn out 16 provisions? 17 MR. BIEDLER: Well, as I mentioned, the 18 statutory scheme provides for mechanisms for handling 19 the eventualities of installment sales, taxpayers opting 20 in, taxpayers making money, taxpayers losing money. 21 The statutory scheme intending to compensate 22 the government requires a compensation mechanism. And 23 there's a similarity between 453 and 453A in that you 24 need to calculate what is the measure of gain for gain 25 reporting on 453 and for measuring deferred gain under 26 453B. 27 Under 453, the regulations specifically apply a 28 valuation scheme to contingent terms. And that 32 1 valuation scheme is maximum discernible face value. And 2 that has been upheld in a variety of formats. 3 MS. MANDEL: And I think her question was, how 4 did you get a maximum discernible face value for the 5 $50 million? 6 MR. BIEDLER: Because those were the maximums 7 that were stated on the face of the contract. And 8 that if the earnings were met, then they would receive 9 those set amounts. 10 There was a portion that if they exceeded all 11 of those earnings goals, they could get even more and 12 there was no cap set on that. 13 But in applying the statute, which requires the 14 government be compensated for deferred tax, rather than 15 taking the low end, such as, no, this doesn't apply, in 16 which the government would not be compensated and 17 taxpayers who had opted out would be unfairly 18 disadvantaged, maximum discernible on the face of the 19 document. 20 DR. CHU: Except that theoretically they could 21 have earned more, correct? 22 MR. BIEDLER: Precisely, they could have earned 23 more. 24 DR. CHU: But you didn't state that as the 25 maximum value? 26 MR. BIEDLER: We couldn't discern a maximum 27 value beyond the 50 million maximum that was stated for 28 the earnings goals. 33 1 It could have been unlimited in the best of all 2 worlds. Revenue Ruling 58-402 clearly indicates the 3 IRS's dealing with in the past and it states that there 4 is almost no circumstances, just the rarest of 5 circumstances, where no value can be discerned. 6 And we were not trying to create something out 7 of whole cloth. We went with the form of the documents 8 chosen -- and the form of the transaction chosen by the 9 taxpayer. 10 She didn't have to do the deal. 11 MS. YEE: Can I follow on that? 12 DR. CHU: Okay. 13 MS. YEE: So -- so, okay. 14 So, you believe that where no maximum value can 15 be discerned that you can look at the stated amounts 16 that were in the agreement, even though there were parts 17 of the agreement that did allow for additional payments 18 that could exceed the stated amounts? 19 MR. BIEDLER: If I understand your question 20 correctly, I would like to restate my position to say -- 21 not to change it but to clarify -- that the maximum we 22 can discern that could be received, from zero to 23 infinity, is, in this case, the 50 million that was 24 specifically capped for the earnings targets. 25 Now there was a potential for an amount beyond 26 but we could not discern what that maximum was. So, we 27 did not go beyond what we could discern. 28 MS. YEE: Okay. And I guess when I look at 34 1 maximum, I'm thinking about what can be determined, 2 including those additional payments. And I'm looking 3 at, I guess what was cited, the temporary Treasury reg, 4 which at least suggests that these proceeds have to be 5 able to be determined. 6 And it seems to me there's -- 7 MR. BIEDLER: Well, the valuation report from 8 Appellant's own expert clearly found as of the date of 9 the sale, February 1998, that there was a value beyond 10 zero, because they assigned a value of approximately 11 30 million. That's more than 25 million that she -- 12 that Appellant got up front. 13 So, clearly, it was discernible, at least to 14 that amount. So, it doesn't -- it doesn't jive with 15 logic, to my mind, to say that there was no value that 16 was discernible. 17 MS. YEE: Although I think the report may not 18 have been speaking to that point. 19 Mr. Whitney, can you clarify? 20 MR. WHITNEY: I'm not a qualified appraiser, 21 but it took into account the statistical chance of 22 meeting, you know, certain hurdles and how much income 23 would be reported based on the past and growth rates. 24 And it projected out what would be the probability of 25 earning, you know, the different amounts. 26 But the 50 million was only payable in the 27 event that the exact target earnings amount was earned. 28 A dollar less, it was zero; a dollar more, it would be 35 1 two for one; and, really, anything above that amount, 2 you know, it could be anything. 3 So, there really wasn't a maximum value -- it 4 was zero to infinity, depending upon the results. 5 MS. YEE: Dr. Chu? 6 DR. CHU: You haven't commented on the fair 7 market appraisal. And, so, I want to know if you 8 dispute the assumptions, methodologies or valuations in 9 it? 10 MR. BIEDLER: Well, as Mr. Whitney conceded, I 11 also must concede that I am not a valuation expert. 12 In my experience, the discount of 20 percent 13 seems a bit high for the restricted stock, considering 14 the restrictions -- Sylvan was a strong company and the 15 restrictions ended just a few years later. So, it seems 16 high to me, but I can't say expertly. 17 And then the 14 percent discount rate seems 18 also a little bit high considering what the federal 19 discount rate was at the time. But, again, I am not a 20 valuation expert. 21 I do take exception to reducing the amount of 22 the value to Miss Canter by the amount of expenses that 23 she obligated herself to pay. In running her business, 24 she chose her form, she did her deal. She did 25 everything that she thought was best to accomplish her 26 ends. 27 And to allow her to reduce the gain -- and 28 we're only talking about the measure of deferred gain 36 1 here, we're not talking about the total -- her total 2 income tax right now, by amounts that, you know, are 3 essentially, in some ways, equivalent to inventory 4 because they were current expenses for -- not inventory, 5 but papers and pens. 6 For the employees' wages, why should that be a 7 cost of sale that would somehow reduce the valuation? 8 So, on those grounds, I do. 9 DR. CHU: Well, that brings to mind this 10 question that I had for the Appellants and, that is, 11 what legal authority do you rely on for your opinion 12 that the payments made to the former spouse and 13 executive officers should be both deductible as ordinary 14 expenses, as well as capital expenditures added to your 15 basis to reduce your gain on the stock sale? 16 MR. WHITNEY: Okay, thank you, Dr. Chu. 17 Just for clarification, the Lee Canter payments 18 were deducted as an adjustment to basis. So, they were 19 treated as capital on the return. 20 And the payment of the 55 percent payouts to 21 the executives was reported as ordinary on Schedule E. 22 I just -- 23 DR. CHU: Right. So, actually we're talking 24 just about the executive officers? 25 MR. WHITNEY: Yeah. 26 DR. CHU: Yes. 27 MR. WHITNEY: So, our view, you know, again 28 with the original return, was open transaction 453A 37 1 doesn't apply. 2 But if it is an installment sale and 453A is 3 germane, then what we've done is turned to the IRS 4 installment sale publication to look at the definition 5 of what selling expenses are. And the definition there 6 is very broad, it's any expense related to the 7 transaction of selling the property. 8 In this case we had to agree to make that 9 payout in order to close the deal. If she didn't do 10 that, then the executives would not sign the employment 11 contracts with Sylvan. And if they didn't sign the 12 employment contracts with Sylvan, there would be no 13 transaction. So, this, in a very real sense, was a 14 necessary cost in order to close the transaction. 15 Sylvan did not care about past services. What 16 they wanted was future profits and future success. 17 That's why they demanded a future employment contract, 18 the old employment contracts be cancelled, they didn't 19 want have to anything to do with a 55 percent asset sale 20 bonus that was company's obligation. 21 They wanted that cancelled. And to do that, to 22 get the officers to sign -- to sign up for an agreement 23 like that, she had to agree to make that payout, but it 24 was a very different contract because it was based on 25 future performance of services under the employment 26 contract. 27 DR. CHU: But isn't this a double benefit? 28 MR. WHITNEY: I don't see how it's a double 38 1 benefit. 2 It's been allowed for income tax, which is 3 true, but now there is a second tax being imposed of a 4 453A interest charge tax, which is purportedly on the 5 tax on the transaction. 6 The FTB has allowed this as a deduction in 7 determining the tax on the transaction. It's been 8 allowed. 9 So, if it's been allowed for purposes of the 10 determining the income tax, why wouldn't it be relevant 11 in determining the interest charge on the allegedly 12 deferred income tax on the transaction? 13 MS. YEE: Okay. Well, then another question 14 that I have is, I understand why you definitely don't 15 believe that the maximum value is 50 million since you 16 did not receive it, but then there's a question of fair 17 market value versus wait and see, and, obviously, you're 18 arguing fair market value. 19 So, why do you think that the valuation should 20 be fair market value versus wait and see? 21 MR. WHITNEY: Well, the fair market 22 value method, I mean, one of the things that's unique 23 about this transaction is we did sell to a public 24 company that corroborated the fair market value. So, 25 it's not just the word of our appraiser firm, but also 26 the word of Sylvan, they estimated the same value. So, 27 that was one factor. 28 The other one was it seemed to comport most 39 1 with the way the FTB set up the assessment. The FTB 2 didn't base the assessment on payments received in the 3 future in treating that under a wait and see approach, 4 what they said is it's based on a value approach, 5 whether or not you get any payment in the year at all. 6 So, they went back to 1998, a year where there 7 was no payment, and assessed 32,000, but not 2001, a 8 year when there was a payment. 9 So, I think that, you know, to try to resolve 10 this in 2006, they were working with the way the FTB had 11 set it up and effectively said, 12 "Instead of this $50 million figure, why not 13 consider using this appraised value, which 14 was close to what Sylvan estimated?" 15 DR. CHU: Thank you. 16 MS. YEE: Thank you. 17 Other questions or comments, Members? 18 Mr. Leonard? 19 MR. LEONARD: Just a comment, thank you, Madam 20 Chair. 21 I know you guys aren't the ones, but you could 22 take a message back -- 453A deserves a regulatory scheme 23 to implement this century. 24 I don't like us making it up case by case. The 25 taxpayer, I think, has a very reasonable proposal based 26 on what they knew at the time. And given the 27 regulation, it's hard to say it's -- that they erred, as 28 you're alleging, based on what they knew and what was 40 1 available to them in terms of tax knowledge. 2 And it would sure help to -- now that we have a 3 pretty good record of what comes up in contingent 4 installment sales, of how to put together a regulatory 5 scheme and let us all look at it ahead of time. 6 Thank you. 7 MS. YEE: Okay. Ms. Mandel? 8 MS. MANDEL: I think it might still be on the 9 IRS business plan, but maybe I'll ask them in May when 10 I'm back there what they're planning to do with it. 11 MR. LEONARD: Would you, please? 12 MS. MANDEL: Yeah. 13 MR. LEONARD: Ask what century? 14 MS. YEE: Let me follow onto Dr. Chu's -- some 15 of her questions. 16 I am -- I'm not convinced with respect to 17 looking at the maximum face value on Issue 1, but I do 18 want to follow on Issue 2. 19 And that is, what I'm troubled by is that for 20 the same expenditures -- and here we're talking about 21 the payout to the former employees -- so, Miss Canter 22 received an ordinary business expense deduction for 23 those payouts. And then also seeking then to reduce the 24 gain from the installment sale for the same 25 expenditures. 26 And I guess I'm -- that's where I'm stuck 27 because it seems to me that you claim this as a benefit 28 one way or the other, but not both. 41 1 And then the concept of actually then claiming 2 them as selling expenses in the year of the sale makes 3 no sense to me because they weren't paid in 1998. 4 So, I am just trying to -- and also 5 Miss Canter's a cash based taxpayer. So, I'm kind of 6 trying to reconcile, you know, what's appropriate here. 7 MR. WHITNEY: So, if -- just to analogize to 8 something else, if there was a commission, you know, 9 where somebody received a certain proceeds -- percentage 10 from the sale of the company that was dependent upon the 11 future receipt of amounts, would we agree that that 12 would be a selling expense, that that was a direct 13 expense in order to sell the company, not necessarily 14 all paid up in the year of sale, but something that 15 would be paid over time, depending on what is received? 16 And I think, you know, under that analogy, I 17 mean, if we agree that this was something that was 18 necessary to close the deal, you know, if she did not 19 accept this payout, there wouldn't be a deal. If it, 20 you know, comes from the proceeds received from the 21 transaction, does it matter for a 453A interest charge, 22 which is assuming that, effectively, everything under 23 the FTB's methodology and the fair market value, 24 everything is received up front, whatever that amount 25 is. 26 Well, if those amounts were received up front, 27 the 55 percent payment would be made up front and so 28 would the 10 percent payment up front. 42 1 So, it's not that we're claiming a double 2 deduction. There's the income tax, we don't want both 3 ordinary treatment and capital treatment. The income 4 tax has been reviewed. We paid the income tax. 5 But there's a separate charge under 453A that's 6 based on a hypothetical amount of tax deferred. So, if 7 we accept that there was something deferred, I mean, our 8 point of view is that it was earned over time, not 9 deferred, but if we take the view that something was 10 deferred, what was that? 11 Well, it would be what you -- what would you 12 have paid had you received everything up front? Well, 13 if we had received everything up front, we would have 14 paid the 55 percent and the 10 percent and that 15 amount -- that tax on that net amount is, I guess, 16 arguably what's been deferred under this method. 17 And if this interest charge applies at all, it 18 would be to that. 19 MS. MANDEL: Can I see if I understand what 20 you're saying? 21 When you talk about the income tax side having 22 been -- as reported, having been vetted, approved, not 23 changed on audit by FTB, that's the sort of straight up 24 capital gain determination and whatever expenses might 25 have been reported on the Schedule E. 26 That's what you're calling income tax side? 27 And when you talk about 453A, it's because 28 that's in addition to tax, in the nature of an interest 43 1 charge on deferred income off an installment sale? 2 And because FTB, in saying that she owed this 3 addition to tax, which you're calling the second tax, in 4 order to say that, they, FTB, had to treat this 5 transaction as an installment sale, which in their final 6 brief they then go off on she never treated it as in 7 installment sale as reported, so, she shouldn't get a 8 whole bunch of stuff -- which was a little confusing to 9 me because they're the ones, FTB's the ones, as I 10 understand it, who introduced installment sale into the 11 mix by asserting 453A addition to tax. 12 And so, you're -- what you're saying, 13 Mr. Whitney, as I understand it, is put aside -- for 14 purposes of the addition to tax, put aside the capital 15 gain as reported and validated by FTB because that's a 16 -- that's a separate item that's not been disputed. 17 Now FTB is bringing in 453A addition to tax, 18 and what that does is say, 19 "What if -- what if instead of reporting on an 20 as it came in basis, which was how she 21 ultimately reported, what if someone were 22 electing out of installment sale treatment?" 23 Which would mean assuming I really had an 24 installment sale, which you're willing to go with this 25 453A if the Board goes with 453A -- even though you did 26 talk today about maybe it doesn't even really apply -- 27 but if we had work using 453A, you'd with look at 28 what -- what income was deferred until later years and 44 1 then, under whichever method, fair market value or wait 2 and see or their "Let's just take what we consider the 3 total face of the earn out," method, the -- what if that 4 had been all received in the year of the sale? 5 And it wasn't, but assume that it was, under 6 whichever method, then figure out what the interest cost 7 of the deferred tax. 8 So, when -- so, when the FTB talks about an 9 inconsistency between taking the payout to the key 10 employees on the Schedule E as an ordinary expense and 11 then trying to get it for installment sale purposes on 12 453A, what I hear you saying is those are -- those are 13 separate things because FTB has not challenged the 14 correctness of the original reporting of the 15 transaction. 16 And all that's in dispute now is if 453A 17 applies, how do you do that -- and just look at 453A and 18 figure out what the gain. And, so, for those 19 purposes -- and now I am getting very confused and I'm 20 sure as is everybody -- but for those purposes you're 21 saying for 453A, because the payouts to the key 22 employees were a necessary part of the sale to Sylvan 23 and not because of some prior employment agreement, 24 although she would have to pay if she ever -- if the 25 companies were ever sold, but you're saying because the 26 new employment agreements were a necessary component of 27 the sale and you're trying to point out that the new 28 employment agreements had different terms to them, 45 1 specifically that the key employees had to stay employed 2 with Sylvan throughout this earn out period. 3 And it's just a -- that's -- that's what he's 4 saying. 5 FTB having given me a squirrely look -- that's 6 what I understand he's saying about the employment 7 agreements. And that -- that because of that, it's not 8 the same. And if -- if, in fact, you know, the key 9 employees had thought, well, I want instead of -- I 10 forget what it added up to, 55 percent -- instead of 11 cumulatively adding up to 55 percent, if they'd managed 12 to negotiate with Mr. Edwards that it should be some 13 higher amount because they thought, well, maybe they'd 14 prefer to retire than keep working at this place, it'd 15 be more -- seems like it would be more distinct from the 16 prior agreement. The percentages just happen to be the 17 same. 18 Is that -- is that kind of what you're -- 19 MR. WHITNEY: Yeah. 20 MS. MANDEL: -- getting at and that you think 21 that the double deduction fuss is a red herring of some 22 kind -- 23 MR. WHITNEY: I think it's -- 24 MS. MANDEL: -- because we're just talking 25 about in addition to tax? 26 MR. WHITNEY: -- I think it's a complete red 27 herring. I think there's two different taxes at work. 28 Like you said, the income tax has already been 46 1 vetted, you know, right, wrong or indifferent, the FTB 2 concluded that the correct amount of income tax was 3 paid. 4 We did demonstrate that even if the installment 5 sale rules were applied, really what it would do is just 6 serve to rabidly defer some of the up front basis over 7 the four year period. 8 And we computed on Exhibit A the impact of 9 that, which is timing and cancels itself out over the 10 course of the contract. 11 So, the income tax has been vetted. So, the 12 question now is this 453A interest charge, does it 13 apply? 14 And we've stated our reasons why we don't think 15 it does. You are correct that in 2006 she offered the 16 fair market value appraisal as a way to try to resolve 17 this. 18 Then the question is, okay, if it does apply, 19 what does it apply on? And, I guess, it would apply to 20 the amount of deferred tax on the transaction. 21 Well, what's been deferred is the tax that 22 would have been paid if things had been received up 23 front, you know, based on what you knew in 1998 in 24 filing that return. 25 And the only way to logically apply that, if 26 that's the method that, you know, we're going with, 27 would be an appraised value of what you expect to get, 28 treat that as the amount that's received up front, 47 1 deduct anything that would be triggered by the receipt 2 of that payment that we know about, which would be part 3 of that fair market value estimate, the 65 percent 4 contractual payments, determine the net, the tax on that 5 and that, ostensibly, is what has been deferred through 6 the use of the installment sale -- if that's what method 7 we're in. 8 And, so, it -- you know, we think that basing 9 it on the net value of her 35 percent interest is a more 10 fair and consistent basis for applying that. 11 MS. YEE: Franchise Tax Board, do you have 12 comments on that? 13 MR. BIEDLER: Yes, thank you very much, Madam 14 Chair. 15 I'd like to note that our not addressing by not 16 adjusting an issue doesn't mean that we vetted it or 17 approved it. We didn't spend significant time -- for 18 whatever business decision reasons we didn't at the 19 time, the allegations of basis. 20 And the idea that an open transaction was the 21 method used to report is somewhat confusing because 22 there was no notation of that. 23 Installment sale treatment requires either you 24 opt out and pay tax or you form -- or file form 6252 and 25 report in accordance with the installment sale 26 treatment. 27 There was no indication on the return that this 28 was an open transaction reporting of an installment 48 1 sale. 2 And, again, there's no authority that I am 3 aware of for applying an open transaction approach to 4 installment sales and, in fact, contradicts the Revenue 5 Ruling 58-402 that I cited. 6 Again, I'd like to -- I appreciate the effort 7 put in by the taxpayer Appellant, but she chose the form 8 of her transaction and you can't have it both ways. 9 MS. MANDEL: Chose the form of her transaction? 10 MR. BIEDLER: With Sylvan, and whether to enter 11 it at all. 12 If I may add one more thing? I have not seen 13 the Sylvan employment contracts. So, to allege that 14 there was some requirement that they required -- that 15 the employees were required to stay on in order to get 16 the earn out -- excuse me, the bonuses that were part of 17 their prior contract seems a bit of a stretch. 18 They had a fixed right to receive the amounts 19 called for under the prior contract at the time of the 20 sale. And only if they were willing to give up that 21 right, would they enter into a contract that required 22 them to stay on in order to get the money they were 23 already entitled into. 24 MS. YEE: Mr. Biedler, you suggest you haven't 25 seen the employment contracts. 26 Were they not provided? 27 MR. BIEDLER: I personally have copies of the 28 previous contracts. I have seen references in this 49 1 stock purchase agreement to the Sylvan employment 2 contracts, but I don't -- I have not seen copies of the 3 Sylvan contracts. 4 I would also like make one further distinction 5 based on what Ms. Mandel was saying. 6 The -- if the taxpayers are allowed to take as 7 a cost of sale for the purposes of some conceptually 8 different second tax, then there would be need to be a 9 corresponding calculation adjustment, part of how you 10 account for 453A interest is you recognize how much gain 11 you received previously. 12 Well, the way that the calculations have gone, 13 we would need to make an adjustment to reduce the amount 14 of gain previously received for each year that a payment 15 was made to the key employees. We would have to -- have 16 less amount of gain actually received that carries more 17 gain further forward. 18 The net effect of doing as they asked with 19 regard to the cost of sale, just for the 453 interest, 20 would be roughly a $58,000 adjustment, reduction in tax. 21 And it's a very complicated thing, I'm happy to 22 submit additional briefing on it, but it's an important 23 thing to remember that it all doesn't go away just 24 because they're allowed the cost of sale -- the cost of 25 employees as cost of sale. 26 MS. YEE: Mr. Whitney? 27 MR. WHITNEY: Yeah, just a couple of comments. 28 It's not that an open transaction is a kind of 50 1 installment sale. There are open transactions, as the 2 US Supreme Court found in Burnett versus Logan, and is 3 referenced under the installment sale regs. And then 4 there are installment sales. 5 So, it wasn't somebody electing out of 6 something, it was a position that any future payments 7 that I get are going to be based on my efforts and under 8 the employment contract. 9 When you get to the -- you know, assuming that 10 it is an installment sale, for the sake of argument, the 11 second question is does 453A apply? 12 And the question there is does the face amount 13 of the obligation exceed 5 million or not? And before 14 you walk through our basis for -- there isn't the face 15 value. 16 With respect to reducing, under the fair market 17 value method, for payments received in subsequent years, 18 we factored that in in our calculation in and 19 Schedule E. It's not difficult to do, I mean as far as 20 these calculations are concerned. 21 It would include the fair market value up front 22 to determine a deferred tax for the first year upon 23 which you would compute an interest charge. And then 24 for each subsequent year, to the extent that you receive 25 a payment, you would subtract that from the remaining 26 balance. And we have demonstrated how you would 27 calculate the interest in each year until you have fully 28 received the full amount that you estimated. 51 1 Now, obviously, in some cases you may receive 2 and in some cases you may receive less. And that's just 3 inherent with using the fair market value method. 4 Same as if you would have if somebody were to 5 elect out of the installment sale method and include the 6 fair market value up front. 7 MS. MANDEL: Okay, very well. 8 Other questions or comments, Members? 9 Hearing none, is there a motion? 10 MS. MANDEL: Take it under submission. 11 MS. YEE: Okay, motion by Ms. Mandel to take 12 the matter under submission. 13 Is there a second? 14 MS. STEEL: Second. 15 MS. YEE: Second by Ms. Steel. 16 Without objection, such will be the order. 17 Thank you very much, we will take your matter 18 up for discussion later today and submit notice of our 19 decision. 20 Thank you. 21 ---o0o--- 22 23 24 25 26 27 28 52 1 REPORTER'SCERTIFICATE. 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, JULI PRICE JACKSON Hearing Reporter for the 8 California State Board of Equalization certify that on 9 MARCH 16, 2009 I recorded verbatim, in shorthand, to the 10 best of my ability, the proceedings in the 11 above-entitled hearing; that I transcribed the shorthand 12 writing into typewriting; and that the preceding pages 1 13 through 54 constitute a complete and accurate 14 transcription of the shorthand writing. 15 16 Dated: April 24, 2009 17 18 19 ____________________________ 20 JULI PRICE JACKSON 21 Hearing Reporter 22 23 24 25 26 27 28 53