1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 5901 GREEN VALLEY CIRCLE 3 CULVER CITY, CALIFORNIA 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 SEPTEMBER 22, 2009 10 11 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 12 APPEAL OF 13 TAKASHI WATANABE AND MARCIA WATANABE 14 NO. 461159 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 4 Bill Leonard Member 5 Michelle Steel 6 Member 7 Marcy Jo Mandel Appearing for John 8 Chiang, State Controller (per Government Code 9 Section 7.9) 10 Diane G. Olson Chief, Board 11 Proceedings Division 12 For Board of Amy Kelly 13 Equalization Staff: Staff Counsel 14 15 16 For Franchise Tax Mark McEvilly Tax Counsel: Tax Counsel 17 Karen Smith 18 Tax Counsel 19 For Appellant: Stehen G. McKee 20 Attorney 21 Marcia Watanabe Taxpayer 22 23 24 ---oOo--- 25 26 27 28 2 1 5901 GREEN VALLEY CIRCLE 2 CULVER CITY, CALIFORNIA 3 SEPTEMBER 22, 2009 4 ---oOo--- 5 MS. OLSON: Our next item is B2, Takashi 6 Watanabe and Marcia Watanabe. 7 Please come forward. 8 MR. MC KEE: Yes, good morning, Stephen 9 McKee -- 10 MS. YEE: Hold on one second. 11 Let me have Appeals introduce your case. 12 Miss Kelly? 13 MS. KELLY: The issues in this appeal are 14 whether attorney's fees awarded to Appellant wife as 15 part of an arbitration award are excluded from 16 California gross income and whether Appellants may have 17 attorneys' fees included in their California adjusted 18 gross income that have already been reported by their 19 attorney as part of his California adjusted gross 20 income. 21 MS. YEE: Very well, thank you very much. 22 Good morning, if you'll both introduce 23 yourselves for the record? 24 You have ten minutes. 25 MR. MC KEE: Yes, this is Stephen McKee, 26 attorney for the Appellant Marcia Watanabe, who is here 27 with me. 28 MS. YEE: Okay. 3 1 MS. WATANABE: And I'm Marcia Watanabe. 2 MS. YEE: Thank you. If you will pull that my 3 microphone right up towards you. 4 Okay, thank you. 5 MR. MC KEE: First, Members, I submitted two 6 exhibits this morning, I presume you have them. 7 MS. YEE: We do, yes, thank you very much. 8 MR. MC KEE: Thank you very much. 9 The cases we'll be citing today -- 10 Commissioner versus Banks, 453 US 543 2005; Sinyard 11 versus Commissioner, 268 F. 3d 756, 9th Circuit, 2001; 12 and Flannery versus Prentice, 26th Cal 4th 572 2001. 13 First of all, the Banks case we believe is 14 irrelevant to this case's outcome, does not apply here. 15 Banks -- the Banks court held that money paid to a 16 litigant's attorney per a traditional contingent fee 17 agreement is income to the litigant. The justices in 18 that case expressly refused to decide whether the same 19 rule applied to cases like Watanabe involving fee 20 shifting statutes. 21 In our second case, the Sinyard case, the 22 statutory attorney fees belonged to the litigant. In 23 such circumstances, the litigant's attorney must create 24 a security interest in the litigant's prospective 25 recovery to perfect his claim to the fees. 26 When the defendant pays the attorney fees 27 directly to the litigant's attorney, the payment 28 satisfies the litigant's debt. 4 1 In Flannery, however, statutory attorney fees 2 belong to the litigant's attorney. In such 3 circumstances, the litigant's attorney need not create a 4 security interest in the litigant's prospective recovery 5 to perfect his claim to the fees. Therefore, payment 6 does not discharge the debt because the debt does not 7 exist. 8 The former is a taxable event, the latter is 9 not. 10 In Sinyard the taxpayer was part of a federal 11 A. D. E. A. class action against his employer. He had a 12 traditional contingent fee arrangement in which he 13 agreed to pay his attorneys one-third of the amount 14 obtained in the lawsuit, whether by settlement or jury 15 award. The parties settled the case for 33.5 million. 16 And the employer agreed to pay one-third of the total 17 settlement amount directly to class counsel for 18 attorney's fees recoverable pursuant to the 19 A. D. E. A.'s fee shifting provisions. 20 The court held that the payment was income to 21 Sinyard. 22 "If A owes B a debt and C pays the debt on A's 23 behalf, it is elementary that C's payment is 24 income to A as well as to B. The discharge by 25 a third person of an obligation to the litigant 26 is equivalent to receipt by the person taxed." 27 That's Sinyard at 758. In other words, 28 A. D. E. A. statutory of fees belong to the litigant and 5 1 his attorney has no independent right to recover his fee 2 from the defendant. Therefore, to get at his court 3 awarded fees, the attorney must create a security 4 interest in the litigant's prospective recovery. He 5 must go through the plaintiff in order to get paid. 6 That is what Sinyard's attorneys did. His 7 counsel used a contingent fee agreement to secure an 8 anticipatory assignment of plaintiff's recovery. 9 Why? Because the A. D. E. A., a federal 10 statute, makes attorney's fees available litigants, not 11 to counsel. 12 The resulting assignment created a security 13 interest or a debt that ran from Sinyard, who owned the 14 damage award and any court awarded fees to his lawyers. 15 When a third party, the defendant, paid the lawyer, the 16 plaintiff's debt was extinguished and the resulting 17 discharge of indebtedness, satisfaction of the attorney 18 litigant's security interest was income to the 19 plaintiff. 20 Now we turn to Flannery, a California Supreme 21 Court case, in which the court held under California law 22 F. E. H. A. attorney fees belong -- and this is a quote, 23 "Absent an enforceable agreement to the 24 contrary, to the attorneys who labored to 25 earn them." 26 And that's Flannery at 590. In other words, 27 California law gives the F. E. H. A. attorney an 28 independent right to recover his fee from the defendant. 6 1 He does not need to create a security interest in the 2 litigant's prospective recovery. Why? Because he can 3 go directly to the defendant to collect his 4 court-ordered fee. This is the inverse of what the 5 court decided in Sinyard. 6 In the analysis here, the Franchise Tax Board 7 ignores the distinction that I've described above. 8 Instead it treats Sinyard and Flannery fees as two sides 9 of the same coin. In its briefs the Franchise Tax Board 10 goes so far as to mischaracterize Sinyard as a case 11 involving, "payment of attorney's fees pursuant to a 12 fees shifting statute such as Government Code Section 13 12965 b." In other words -- and that's unquote -- in 14 other words, the Franchise Tax Board argues that Sinyard 15 should control the Watanabe matter because it contends 16 the underlying statutes A. D. E. A. and F. E. H. A., 17 contains sufficiently similar fee shifting provisions. 18 But as I have noted above, the relevant case 19 law tells us that the statutes are not similar. In 20 fact, the fee shifting provisions are clearly 21 distinguishable. 22 In Flannery the California Supreme Court 23 explicitly rejected an attempt to analogize California 24 F. E. H. A.'s fee shifting provisions to sister 25 provisions in federal statutes. Writing for the 26 majority, Justice Werdegar noted, 27 "Plaintiff urges us to construe Section 12965, 28 the F. E. H. A. fee shifting provision, in the 7 1 light of federal cases construing certain 2 federal statutory attorney fee provisions. We 3 are, of course, not bound by lower federal 4 appellate decisions. And while the high 5 court's pronouncements regarding fees awarded 6 under federal statutes may be instructive, they 7 do not control our construction of 8 F. E. H. A's attorney fee provision. As has 9 been recognized, the federal decisions urged by 10 Plaintiff are, to some extent, based on federal 11 legislative history, which is without 12 California parallel." 13 And that's Flannery at 579 and 80. 14 The court went on to reject comparisons between 15 California F. E. H. A. and 42 U.S. Code Section 1988, 16 the well-known federal civil rights statute. 17 By contrast, the Sinyard court relied on 1988 18 and cases interpreting it to hold that A. D. E. A. 19 attorney's fees belonged to the plaintiff and not his 20 attorney. And that's Sinyard at 759. 21 The Franchise Tax Board ignores this 22 fundamental distinction between F. E. H. A. and A. D. A. 23 and, in the process, confuses the issue. 24 To sum up, the 9th Circuit has held that the -- 25 that A. D. E. A. attorney fees belong to the successful 26 plaintiff, not his attorney. As a result, an A D. E. A. 27 attorney must create a security interest in his 28 plaintiff's prospective attorney fee award. If he fails 8 1 to do so, he could forfeit any legal claim to those 2 fees. 3 When an unsuccessful A. D. E. A. defendant pays 4 attorney fees to a successful A. D. E. A. attorney, the 5 payment discharges the bailiff's indebtedness and should 6 be considered income to the plaintiff. 7 By contrast, the California Supreme Court, our 8 state's highest appellate tribunal, has held that 9 F. E. H. A. attorney fees belong to the attorney who 10 labored to earn them and not to the plaintiff. Because 11 the F. E. H. A. attorney owns the fees, he does not need 12 to create a security interest in his client's 13 prospective recovery. He may collect his fees directly 14 from the defendant. In such circumstances, no debt runs 15 from the plaintiff to his attorney and, thus, when an 16 unsuccessful defendant pays attorney fees to a 17 successful F. E. H. A. attorney, he does not discharge 18 the plaintiff's indebtedness. Why? Because there is no 19 debt to discharge. Consequently, the fee payment should 20 not constitute income to the plaintiff. 21 And in this case, as you have in one of your 22 exhibits, attorney Michael Faber obtained $150,000 in 23 attorney's fees from the defendant directly through the 24 arbitrator pursuant to Government Code Section 12965. 25 And my client had nothing to do with that award. 26 We also have an equitable argument to make in 27 this case. The reason we've here, quite frankly, is the 28 application of the alternative minimum tax. In normal 9 1 situations the taxpayer would be able to deduct her 2 legal fees against her income. In this case, because of 3 other issues, she has not been able to because the 4 alternative minimum tax eliminates this. 5 In her dissent in Sinyard, Judge McKeown 6 commented on the perverse consequences of treating 7 statutory attorney's fees as income for a successful 8 litigant. 9 "The taxation to a plaintiff of attorney's 10 fees, combined with the operation of the 11 A. M. T., sometimes leaves the victorious civil 12 rights plaintiff with a net after tax loss. 13 The draconian result under the Tax Code can 14 only undermine our civil rights laws." 15 And that's Sinyard at 762 and 63. 16 Just as Kennedy made a similar observation in 17 Banks, 18 "Sometimes as when the plaintiff seeks only 19 injunctive relief or when the statute caps 20 plaintiff's recoveries or when for other 21 reasons damages are substantially less than 22 attorney's fees, court awarded fees can exceed 23 a plaintiff's monetary recovery. Treating the 24 fee award as is income to the plaintiff in such 25 cases can lead to the perverse result that the 26 plaintiff loses money by winning the suit." 27 And that's Banks at 438. 28 And, finally, Congress finally got it right in 10 1 the year following the year where our client filed her 2 discrimination action. In 2004 Congress enacted the 3 American Jobs Creation Act at 118, statutes 1418 and 4 that law permits taxpayers to deduct attorney's fees and 5 court costs paid on behalf of the taxpayer in connection 6 with any action involving a claim of unlawful 7 discrimination as we have in this case, even when the 8 alternative minimum tax applies. 9 I would simply submit to you -- to the Members 10 that because of the age of this case, No. 1, this would 11 be the last case you'll probably ever hear on this issue 12 because of the law that changed in 2004, but we clearly 13 have a strong legal argument in the differentiation 14 between Flannery and Sinyard and the way these cases are 15 interpreted between the federal courts and the State 16 courts. 17 MS. YEE: Thank you very much, Mr. McKee. 18 Ms. Watanabe, do you have any comments at this 19 point? 20 MS. WATANABE: Nothing. 21 MS. YEE: Okay, we will give you time on 22 rebuttal. Thank you very much. 23 Franchise Tax Board? 24 MR. MC EVILLY: Yes, good morning, Madam 25 Chairwoman and Members of your Board, I am Mark 26 McEvilly, appearing for the Respondent Franchise Tax 27 Board. 28 And to my left is Karen Smith, also appearing 11 1 for the Respondent. 2 The real issue in this appeal is whether an 3 amount Appellant wife recovered as attorney's fees in an 4 arbitration award is excludable from Appellant's gross 5 income. 6 In 2003, Appellant wife received $399,000 in an 7 arbitration award for employment discrimination. 8 $48,100 of this amount was reported as an arbitration 9 award, but excluded from her gross income. And $150,000 10 of the amount was excluded and those are the fees that 11 were paid to Appellant wife's attorneys. 12 At audit Respondent adjusted the reported gross 13 income to include the $48,100 and the $150,000 amount 14 that Appellant had excluded from income. 15 Respondent added the amounts back into gross 16 income and allowed the Appellant a miscellaneous 17 itemized deduction for the attorney's fees subject to 18 the 2 percent adjusted gross income limitation. The 19 adjustment resulted in excess itemized deductions that 20 were subject to the statutory alternative minimum tax. 21 The adjustments resulted in an additional tax amount of 22 $11,904, of which 500 -- $5,554 was alternative minimum 23 tax. 24 Appellants have agreed to all issues except the 25 treatment of the attorney fees amount, $150,000. The 26 Appellants have maintained that that amount was paid as 27 attorney's fees and is includable within the attorney's 28 gross income, but not appellants'. 12 1 The law in this issue is very clear. The 2 treatment of attorney's fees was addressed by the United 3 States Supreme Court in Commissioner versus Banks. 4 Appellants' counsel is right, it did -- did not address 5 this exact issue and refrained from addressing the exact 6 issue where a contingency fee is involved. But that 7 doesn't mean that they were siding with the principal 8 that the amount was not includable within gross income. 9 They just did not address it. 10 The Appellants have asserted that Banks is 11 distinguishable. And they cite the Flannery case, as 12 you have heard. 13 Respondent's opening brief had explained that 14 the application of the Flannery case to facts as those 15 in this case was not appropriate. In the cases of 16 Sinyard, the 9th Circuit Court of Appeals and the Tax 17 Court cases of Vincent versus Commissioner, Green versus 18 Commissioner and Sanford versus Commissioner, the courts 19 ruled that payment of attorney's fees from judgments, 20 settlements and awards, the taxpayer in these cases is 21 entitled -- is entitled to not shift the tax obligation 22 from the award recipient to the actual amount that was 23 eventually paid to the attorney. 24 In the Vincent and Green cases the Tax Court 25 found the Flannery case not to be applicable. It was 26 stated that Flannery dealt with entitlement to fees, not 27 taxability. 28 Appellant wife's arbitration award, as 13 1 submitted as Respondent's Exhibit R, clearly states on 2 page 13 -- and Appellant has been so kind as to provide 3 this as an exhibit today -- page 13, at the first 4 paragraph, line 1, 5 "In addition to the above, Marcia Watanabe is 6 entitled to recover her attorney fees and 7 costs of the suit and costs of the 8 arbitration." 9 She was entitled to recover her attorney's 10 fees, not the attorney was entitled. 11 Additionally submitted as an exhibit is 12 something that was not submitted by Respondent and is 13 new to Respondent's eyes, but the plaintiff's brief re 14 attorney's fees declaration of Michael J. Faber. And on 15 the last page, 16 "In conclusion for those -- for these reasons 17 and for such other and additional reasons as 18 may be presented at oral hearing on the motion, 19 plaintiff," which is Ms. Watanabe, "plaintiff 20 requests an attorney fee award." 21 It's not the attorney requesting an attorney 22 fee award. It was Appellant wife that was entitled to 23 the amounts paid by the defendant, not her attorney. 24 The attorney had a right to be paid by Appellant wife 25 pursuant to their contingency fee agreement. 26 Respondent's position is legally correct and 27 supported by all applicable tax law. Respondent 28 requests that your Board sustain its action. 14 1 And Respondent would also like to note that the 2 reading I read from Appellant's submissions today and 3 this conflicts with the statement that was made by 4 Appellant's counsel, the client had nothing to do with 5 the payment to her attorney. Yes, she did. The -- this 6 was not an award from Toyota to the attorney, it was an 7 award to -- from Toyota to Appellant. Appellant was 8 obligated, pursuant to a contingency fee agreement to 9 pay the attorney. 10 Noteworthy is the fact that Appellant's counsel 11 has not addressed the Green versus Commissioner. He 12 cites Banks, Sinyard and Flannery. Noteworthy, in Green 13 versus Commissioner, which was reviewed, a Tax Court 14 decision reviewed by the 9th Circuit in an unpublished 15 decision, but reviewed and not overturned, the Court of 16 Appeals stated, 17 "We agree with the Tax Court that Marcia Green 18 is required to pay income tax on statutory 19 attorney fees awarded under F. E. H. A., 20 although factually different, the reasoning of 21 Sinyard controls the outcome in this case, 22 allocating a third of the settlement for 23 payment of statutory attorney's fees pursuant 24 to the U.S. Code Section cited. This Court 25 reasoned that the payment by the employer to 26 the attorney satisfied Sinyard's contractual 27 obligation." Contractual obligation I might 28 emphasize. "And, thus, was income to Sinyard 15 1 as a discharge of indebtedness." 2 Again, Respondent's position is legally 3 correct, supported by the law. Flannery is not -- 4 applies to taxability, it applies to the fee shifting 5 arrangements and contingency fees, not taxability. 6 Respondent would be willing to entertain any 7 questions from your Board. 8 Thank you. . 9 MS. YEE: Thank you very much, Mr. McEvilly. 10 Mr. McKee, Ms. Watanabe, you have five minutes 11 on rebuttal. 12 MR. MC KEE: Yes, Members, in relation to the 13 issue of the fees belonging to the attorney versus my 14 client, it's clearly the attorney who labored for these 15 fees. That's what Flannery v Prentice says. 16 He specifically petitioned the court. And 17 that's one of the exhibits I provided you with. Item 18 after item after item justifying his fee in this case. 19 When I said that my client had nothing to do 20 with that, she did not know what was going on with the 21 arbitrator and with Toyota in terms of the final award 22 of the attorney's fees. She was not part of that 23 discussion. 24 Essentially, Toyota sent the check directly to 25 the attorney. There was no amount of attorney's fees 26 that went to my client. In fact, as you probably know, 27 two separate 1099s were sent. My client received a 1099 28 for $249,000 for the full award, which is in the 16 1 arbitration award. The attorney received a 1099 for 2 $150,000 for his fee. So, she had no knowledge that she 3 was supposed to put $399,000 on her tax return until she 4 was notified by the Franchise Tax Board. 5 Furthermore, what an arbitrator or, in fact, 6 what a personal injury lawyer says in a brief to the 7 court in terms of obtaining attorney fees can not change 8 California law from the Supreme Court in terms of who is 9 entitled to own the fees. 10 And as I submit, ownership and laboring for 11 those fees means that that attorney is required to put 12 that on his tax return, not my client's tax return. 13 As far as the contingent fee agreement that a 14 client -- my client had with Mr. Faber, it was in the 15 alternative and I submit the attorney was simply being a 16 good business person by putting in the alternative, 17 "I am going to go for my fees pursuant to 18 12965. And if I get $500,00 in fees, you're 19 not going to be able to share in that. Those 20 are my fees." 21 That -- in fact, that's what happened in 22 Flannery. That's why there was a case in Flannery, the 23 attorney fees awarded in Flannery were over a million 24 dollars and the plaintiff, the client, said, "Wait a 25 minute, I want to get those fees." 26 And, in fact, the court said, "No, you are not 27 entitled to that because you didn't have an agreement 28 that said you would get those fees." 17 1 There was no such agreement between my client 2 and her attorney that if he were to receive 500,000 or 3 700,000 in attorney's fees, there was no agreement that 4 she would get to share in that whatsoever, she would not 5 see that at all. 6 Further, as far the Green case is concerned, 7 it's an unpublished decision, of course, but other than 8 that, it's simply part of the same progeny of Sinyard. 9 And, in fact, you know, the fact that Green is 10 attempting to interfere itself in California law and 11 trying to interpret a statute without actually analyzing 12 the statute just seems totally irrelevant. And I think 13 the Members should totally forget about the Green case 14 completely. 15 MS. YEE: Okay, Ms. Watanabe, anything else? 16 MS. WATANABE: (Whereupon she shakes her head.) 17 MS. YEE: Very well, thank you very much. 18 Questions? Yes, Ms. Steel? 19 MS. STEEL: To FTB, how did the IRS treat the 20 attorney fees at this point for this case? 21 MR. MC EVILLY: To our knowledge, we have 22 checked federal records. We do not know, at this point 23 in time, how they treated the attorney fees. 24 MS. STEEL: Do you know? 25 MR. MC KEE: Yes, they excluded them. 26 MS. STEEL: Okay. I have a question, isn't 27 this a double taxation because they get two 1099s, one 28 for attorney, one for the taxpayer. Attorney already 18 1 said that attorney already paid taxes on that fee. So, 2 that's totally double taxation there -- for attorney for 3 $450,000 that we are asking taxpayer to pay it that -- 4 on the top of that attorney already paid income taxes 5 from that. 6 MR. MC EVILLY: Yes. Mrs. Watanabe contracted 7 for services from the attorney. And any time you 8 contract for services, like you and I were to go and 9 hire a attorney, we pay for the services. So, the money 10 it is still flowing to her, flows through her. 11 MS. STEEL: But she never got it because there 12 is two 1099 forms and attorney got paid by themselves 13 check and 1099 form. 14 And then additional question is when taxpayer 15 never got those amount on their 1099, how they know that 16 attorney got paid $150,000 she had to add on the top of 17 what, you know, they're reporting for the tax return? 18 That's doesn't make any sense. Because if I 19 have a case and if I get paid something and then 20 attorney got paid, you have to ask attorney how much you 21 got paid and what you got for 1099, so, let me report on 22 my tax return with addition to whatever you received 23 plus tax, the attorney fee and costs there? I mean cost 24 is not a fee. 25 MR. MC EVILLY: In many cases, such as marital 26 dissolutions or other legal matters, it's not infrequent 27 that plaintiffs do not engage a tax attorney to find out 28 how the actual amount should be treated. 19 1 And Mr. Faber did get a check, but his receipt 2 was of the amount in reporting to him on the 1099, the 3 courts have said that she constructively receives it 4 through -- through him. Essentially all rights to those 5 monies flow through her. 6 He would not have gotten -- 7 MS. STEEL: She never received it, though. 8 That was two separate checks. 9 MR. MC EVILLY: But the rights to the money, 10 the award. 11 MS. STEEL: But award came in for attorney fees 12 separate with what she got awarded. 13 MR. MC EVILLY: Right, I'm sure that the -- 14 MS. STEEL: So if the -- okay, let me rephrase 15 the question. 16 So, award came in saying that it didn't -- it's 17 -- attorney fees been awarded and taxpayer got awarded 18 certain amount. Then she doesn't have to do the report 19 with attorney fees? Is that what you are saying? 20 MR. MC EVILLY: No, the -- yeah, her award, the 21 original arbitration award left -- left the item of 22 attorney's fees still up in the air. So, these -- these 23 documents that have been submitted by Appellant were 24 subsequent to the original attorney -- attorney, the 25 arbitration award. 26 Subsequently to the arbitration award, the 27 amount of what the attorney's fees would be were settled 28 by the court. It required her counsel to submit a 20 1 listing of fees and costs to the court. And he 2 essentially, for instance, would have like a lien on the 3 amount that she was receiving. And she would have to 4 agree -- and in this instance, I think the arbitration 5 award was like $255,000. 6 MS. STEEL: Right. 7 MR. MC EVILLY: The dollar amount at the end, 8 $255,400, plus costs in the sum of 257. So, those 9 amounts were resolved between she and her attorney. He 10 did not actually receive those amounts. 11 MS. STEEL: That's not she and her attorney, 12 court and her attorney because they are submitting their 13 hours to the court, not through the taxpayer. 14 MR. MC EVILLY: Well -- 15 MS. STEEL: So, at that point she already got 16 awarded and she got her money. And attorney fees being 17 negotiated with the court and attorney fees. So, 18 that's -- that's different. 19 She didn't ask that attorney fees being paid. 20 Yes, I am looking at the last sentence that she -- 21 MR. MC EVILLY: Yeah, "Plaintiff requests an 22 attorney fee award." 23 MS. STEEL: But it's Plaintiff attorney has 24 been requesting, actually, most of the cases. 25 Okay, let's move on to that, that emotional 26 distress, is that taxable? 27 MR. MC EVILLY: Yes. 28 MS. STEEL: So, pain and suffering is not 21 1 taxable, but emotional distress is taxable? 2 MR. MC EVILLY: It has to be a personal 3 physical injury and emotional distress is -- 4 MS. STEEL: Together it's nontaxable? 5 MR. MC EVILLY: It is not excludable from gross 6 income. It is taxable. 7 MR. MC KEE: And we agree with that provision. 8 MR. MC EVILLY: There's -- 9 MS. STEEL: I just wanted to know. 10 MR. MC EVILLY: -- no dispute as to that. 11 MS. STEEL: Okay. So, only the attorney fees 12 at this point? 13 MR. MC EVILLY: That's correct. 14 MS. STEEL: Okay, thank you. 15 MR. MC EVILLY: You're welcome. 16 MS. YEE: Mr. Leonard? 17 MR. LEONARD: Board Member Steel asked the 18 question about IRS. 19 Can you -- did the -- did the Watanabe return 20 go into the alternative minimum tax? And if it did, how 21 was -- how were the -- how was the deduction taken then? 22 MR. MC KEE: I did not prepare the tax return 23 or handle that matter with the IRS. I got involved 24 afterwards. 25 But I have seen the closing letter from the IRS 26 that indicates that the exclusion of the $150,000 in 27 attorney's fees was satisfactory with the IRS. 28 MR. LEONARD: Did the Watanabe return pay under 22 1 alternative minimum tax or were they not qualified on 2 the IRS return? 3 MR. MC KEE: They certainly would have been, 4 except for the fact with 150,000 never being included. 5 In other words, my client included the 249,000 6 award, but did not include the 150,000 and that, even 7 though they inquired, that never became a subsequent 8 issue. 9 MR. LEONARD: So, they filed the same return, 10 they didn't deduct it? 11 MR. MC KEE: Yes, exactly. 12 MR. LEONARD: They didn't report it? 13 MR. MC KEE: Exactly, they treated it as 14 excludable income. 15 MR. LEONARD: And I guess the FTB -- FTB found 16 out about the attorney's fees and raised this issue? 17 And I wish more of the debate had focused on 18 the A. M. T. because that's the real evil here, not 19 deductibility or the other income. And we're all stuck 20 with it. Nobody in this room did it. 21 But I'm trying to figure out what differences 22 between California A. M. T. and federal A. M. T. that 23 might have -- IRS treated this same transaction 24 differently than California. 25 And you say you haven't seen the returns. So, 26 I am kind of asking in the dark, what's your 27 speculation? 28 MR. MC EVILLY: Well, I've seen the individual 23 1 master file. This -- the federal return for this year 2 for the Appellants escaped examination. 3 MR. MC KEE: I believe it was examined. I beg 4 to differ. There was inquiry. There was examination at 5 least as to the emotional distress amounts. 6 MR. LEONARD: How did FTB pick up this -- the 7 fact that this income was not reported? 8 MR. MC EVILLY: Well, we have audit programs 9 and, most likely, it was the $48,100 that triggered 10 attention. 11 MR. LEONARD: That deduction? 12 MR. MC EVILLY: The initial exclusion of that 13 amount from gross income. 14 And, so, therefore, we asked for the 15 documentation connected to the award. 16 MR. LEONARD: The theory of alternative minimum 17 tax was to make sure that taxpayers with high incomes 18 did not avoid their income tax obligations by means of 19 over utilizing legitimate deductions, if I could 20 paraphrase my version of the law, with the prejudice 21 that that was a bad idea. 22 It seems, however, in this case the application 23 of that law results in a very unjust outcome. This was 24 not income that was subject to her control. Clearly -- 25 it would be okay to pass it through the Watanabes 26 because it was associated with their lawsuit -- the 27 lawsuit, and, therefore, it would also be appropriate to 28 deduct it as it is a legitimate business expense to 24 1 pursue the lawsuit. 2 To have that deduction eliminated on the same 3 grounds that somebody manipulated their incomes and 4 deductions to avoid a tax obligation is just an unjust 5 outcome. 6 Is there any case -- is there any precedent 7 here where the alternative minimum tax exclusion of all 8 deductions has been modified? 9 Appeals? FTB? 10 MR. MC KEE: Well, simply the new 2004 law, I 11 mean it's ironic that Miss Watanabe filed her action in 12 2003. Had she waited within the statute of limitations 13 and filed it in 2004, we wouldn't be here, because she 14 would have been able to clearly exclude -- 15 MR. LEONARD: So, that portion of the law was 16 changed in 4? 17 MR. MC KEE; Yes. 18 MR. MC EVILLY: It was effective '05. 19 MR. LEONARD: Effective '05. 20 MR. MC EVILLY: I understand objections to the 21 A. M. T. 22 As your Board staff hearing summary indicated, 23 the resolution of that -- that item, the A. M. T., is 24 something has to be taken up through the legislature 25 because we're -- we're bound by it through legislative 26 action that imposed the A M. T. originally. 27 So, all Respondent is doing is following the 28 law as it is now. 25 1 MR. MC KEE: Unfortunately, the effect of it -- 2 MS. YEE: Hold on. 3 MR. MC KEE: -- is the fact that in the normal 4 A. M. T. situation where someone has a large amount of 5 medical or a large amount of property tax and then gets 6 hit by the A. M. T., there is no one else to shift that 7 income tax burden to. In this case, there was. The 8 150,000 excluded from her income went right on the 9 attorney. 10 MR. LEONARD: It's a good argument to modify 11 the A. M. T. permanently in this case. 12 Is the federal -- is the federal return closed 13 now? 14 MR. MC KEE: Yes. 15 MR. LEONARD: It's not subject to audit or 16 reopening or -- 17 MR. MC KEE: We have not heard anything since 18 the closing letter, which would have been in 2005, I 19 believe. 20 And, Members, I certainly understand the 21 argument on the federal side. Our major distinction 22 here is the difference between Sinyard's interpretation 23 of the A. D. E. A. statute, which said we don't care if 24 it's a fee shifting statute, we're still going to have 25 the attorney's fees be part of the litigant's income and 26 Prentice v Flannery where the long legislative history 27 in that case, if you can read that, it clearly 28 differentiates the two statutes and treats California 26 1 where attorneys fees -- 2 MS. YEE: I want to follow up on that. 3 MR. LEONARD: My question is to Appeals, is 4 there anything in your reading of the California 5 A. M. T. that would allow this Board to make that 6 distinction? 7 MS. KELLY: No, I'm not aware of anything that 8 would allow the Board to do that. 9 MR. LEONARD: Thank you. 10 MS. YEE: Thank you. 11 Ms. Mandel? 12 MS. MANDEL: I have a question because I'm 13 getting a little confused and I know we don't 14 necessarily have to follows what IRS did, but FTB is 15 saying they looked at the IMF, the individual master 16 file, and they don't see anything that indicates that 17 this year was examined. 18 But the Petitioner's counsel keeps talking 19 about a closing letter from the IRS. He thinks it was 20 examined. So, I'm confused. 21 MR. MC EVILLY: I called at 5 o'clock yesterday 22 afternoon to check with the staff as to the IMF that was 23 in front of me. 24 There was no examination code on it. That was 25 a question I had. There was no examination code on it. 26 MR. MC KEE: I have A big, thick file sitting 27 on the chair back there (indicating). 28 MS. YEE: Do you have a copy of the closing 27 1 letter? 2 MR. MC KEE: I believe I will. 3 MS. YEE: Okay. 4 MR. MC KEE: Would you like to have me see? 5 MS. MANDEL: I guess -- I mean, again, you 6 know, it sort of all depends we're not necessarily bound 7 by IRS, but it's curious to me if IRS actually examined 8 this question that's involved. 9 I guess I'd just be interested. 10 MS. KELLY: Exactly. And it seems that there 11 is some question as to whether or not the attorney fee 12 was excluded or whether it have deducted. 13 MS. YEE: Right. 14 MR. MC KEE: It was excluded. The tax returns 15 were treated the same. There was no deduction on the 16 State tax return. 17 MS. MANDEL: Yeah. 18 MS. KELLY: And, so, there wouldn't have 19 been -- 20 MR. MC KEE: Counsel found out about -- 21 MS. YEE: Hold on just a minute. Let me get 22 clarification. 23 MS. MANDEL: And -- well, I guess I'd be 24 interested in what the IRS looked at and what the IRS 25 report was. It may be that it was prior to Banks and 26 Benitez -- I mean Banks and Benitez out of the Supreme 27 Supreme's -- it's just -- it's not usual where we have 28 FTB saying it wasn't examined and taxpayer saying they 28 1 have a huge file showing it was examined. 2 So -- 3 MR. MC EVILLY: Well, I think something you 4 said is -- it revolves around something you said, which 5 is you said you'd be interested in the question of 6 whether this item was examined by the IRS. 7 And think if you have a closing letter, it's 8 not going to indicate that this item -- 9 MS. MANDEL: No, but he says he has a big file. 10 MR. MC EVILLY: Right. 11 MS. MANDEL: So, it may not be -- the closing 12 letter must just say -- can often say, "Well, you know, 13 we looked at your thing and you're cool," IRS words, 14 not -- 15 MR. MC KEE: Basically that's what -- 16 MS. MANDEL: -- Ms. Mandel words. 17 MR. MC KEE: Yeah. 18 MS. MANDEL: But if he has a file that shows 19 what -- you know, maybe what they were looking at. 20 I mean I don't know, I don't know what's in the 21 file. It's just a curious happenstance. 22 MR. MC EVILLY: Well, certainly relevant if the 23 audit examination took place in this case. And at 24 protest would have been a fact that the IRS was 25 examining the same issue and coming to different 26 conclusions. 27 That has never been thrown out to Respondent, 28 it's never been presented that the IRS was examining 29 1 this issue. 2 MS. MANDEL: Well, perhaps, maybe, if he has 3 the big file, someone should look at it? 4 MS. YEE: Let's take a look and see what those 5 documents, at least, suggest what the IRS was looking 6 at. 7 MR. MC KEE: That's my thought. 8 And again I just go back to my -- our major 9 distinction between federal and state law. 10 MS. YEE: Well, and I guess my question on that 11 is explain to me why you don't believe the Green case 12 applies here? 13 Because that's definitely a -- 14 MR. MC KEE: It's a federal court that were the 15 -- from Sinyard, basically any appeals from Green, the 16 Tax Court are going to go in the federal appellate 17 system, which means going right back to the 9th Circuit, 18 which means Sinyard, which means they've already made 19 their decision. They think the A. D. E. A. controls the 20 F. E. H. A. statute in California. 21 And our major distinction is if we read 22 Flannery very carefully, the California Supreme Court 23 distinguishes F. E. H. A. from A. D. E. A. completely. 24 MS. YEE: Okay, and -- 25 MR. MC KEE: And it's directly opposite each of 26 them. 27 MS. YEE: Okay, and I guess that's where I'm 28 losing your argument, in terms of the application of 30 1 Flannery, which is not a tax case. 2 And there are several distinctions about the 3 facts in this matter that really are counter to some of 4 the facts in Flannery, including the fact that there was 5 an agreement in this particular matter, which Flannery 6 spoke to with respect to what happens in the absence of. 7 MR. MC KEE: But I believe Flannery was 8 speaking in terms of an enforceable agreement that the 9 attorney's fees belonged to the -- to the client. 10 I mean, attorneys have agreements all the time 11 and in Flannery they just didn't happen to have one or 12 they had a -- they a verbal agreement that nobody could 13 prove. 14 MS. YEE: But Flannery didn't deal with the 15 issue of taxability. 16 MR. MC KEE: Only by inference. I mean, it 17 talks about attorneys who labored for -- for their 18 efforts. And to me, laboring, working, that means 19 taxation. We all know that. 20 MS. YEE: Well, little bit of a stretch for me. 21 MR. MC KEE: Well, it's an inference, but I 22 mean -- yeah, I agree. 23 But it must mean something. 24 MS. YEE: Okay. Other questions, Members? 25 Okay, I'd like to have you have an opportunity 26 to, at least with the documents you have with you today, 27 to have an opportunity for the Franchise Tax Board take 28 a look at those, see if it can shed some further light 31 1 with respect to what's in the federal -- 2 MR. MC KEE: Would the Members like copies 3 also? 4 MS. YEE: Let me just ask that the two parties 5 get together. 6 And, in the meantime, why don't we -- pleasure 7 of the Members? 8 Take this under submission for discussion 9 later? 10 MS. STEEL: Sure. 11 MS. MANDEL: Yeah. Are you guys on the next 12 case or are you able to -- 13 MS. SMITH: He's not. 14 MS. MANDEL: Are you able to look at the 15 material that he has? 16 And can we get -- you have to sit there. 17 MS. KELLY: We may want to simply continue the 18 hearing until after lunch or -- 19 MS. YEE: Sure. 20 MS. KELLY: -- after the next case so that both 21 side have a chance to look at it. 22 But also the concern is that I think one of the 23 FTB attorneys will need to -- will be absent for the 24 next hearing. 25 So -- 26 MS. MANDEL: But he's -- I think Mark's -- 27 Mr. McEvilly's not assigned on the next hearing, that's 28 what she's saying. 32 1 MS. YEE: Okay. 2 Well, why don't we continue it to the afternoon 3 so that we have all parties able to review the documents 4 and then we'll bring it back up at that point? 5 MR. MC KEE: What time is that? 6 MS. MANDEL: Well, if you're going to sit down 7 with them now so they can look at the stuff or you'll 8 figure that out, you might want to see -- 9 MS. YEE: And then we'll -- 10 MS. MANDEL: -- the normal afternoon session 11 would start at -- 12 MS. YEE: 1:30. 13 Okay, without objection, let's proceed in that 14 manner. 15 Thank you very much. 16 (Whereupon unrelated matters were heard.) 17 MS. OLSON: That concludes our morning, unless 18 you would like -- would you like Franchise to come back 19 up? 20 MS. YEE: Why don't we recess until -- 21 actually, do we have further information? 22 MR. MC EVILLY: Yes, the Appellant counsel are 23 ready to, they asked if they could? 24 MS. YEE: Yes, please come forward. 25 MR. MC KEE: Yes, Madam Chairman, Steve McKee 26 again for the Appellant. And I have found two documents 27 in my file and shared them with counsel, who has had a 28 chance to look at them. 33 1 One is a CP 2000 notice from the Department of 2 Treasury, Internal Revenue Service to Takashi and Marcia 3 Watanabe for the year 2003 on their 1040, which 4 essentially is, "You must return the response form by a 5 certain date and answer the questions." And that was 6 dated June 6th of 2005. 7 And then I also have a copy of a closing notice 8 directed to them, CP 2005 notice. Again this one's 9 dated August 29th, 2005, which again is for the 2003 10 year. The closing notice says, 11 "Thank you for providing us with additional 12 information about the issue we recently wrote 13 to you about. And we are pleased to tell you 14 that with your help we were able to clear up 15 the differences between your records and your 16 payor's records." 17 It does appear in looking at the detail of the 18 CP 2000 notice that the issue the IRS was addressing was 19 the deduction on the 1040 tax return of some $48,100, 20 which we believe to be the emotional distress award. 21 And I don't have any other response that the 22 taxpayer made. She doesn't remember anything that was 23 sent to the IRS back then, but whatever was sent 24 appeared to be satisfactory. And they dropped that 25 issue. 26 So, it does not appear that they addressed the 27 other $150,000 of attorney's fees. 28 MS. MANDEL: Okay, thank you. 34 1 MR. MC KEE: There's nothing on the return that 2 indicated a deduction. 3 MS. MANDEL: Right. 4 MR. MC KEE: That it was just simply not put on 5 the return as -- 6 MS. MANDEL: And 48,100 was on the 10 -- part 7 of the 1099 to her? 8 MR. MC KEE: Correct. 9 MS. MANDEL: And that's the same thing that the 10 FTB then started its investigation with? 11 MR. MC KEE: Yes. 12 MS. MANDEL: Okay. Thanks for clearing that 13 up. 14 MS. YEE: Thank you very much for going through 15 those records. 16 Any other further comment from the Franchise 17 Tax Board? 18 MR. MC EVILLY: No. I think Mr. McKee's 19 covered it. 20 MS. YEE: Okay, very well. 21 Pleasure of the Members? 22 MS. MANDEL: I don't have further questions, so 23 I'd take it under submission. 24 MS. YEE: Okay, motion by Ms. Mandel on the 25 matter of B2, Takashi Watanabe and Marcia Watanabe to 26 take the matter under submission. 27 Is there a second? 28 MS. STEEL: Second. 35 1 MS. YEE: Second by Ms. Steel. 2 Without objection, that motion carries. 3 Thank you very much, we will discuss your 4 matter later today. 5 MS. WATANABE: Thank you very much. 6 MS. YEE: We will send a written notice. 7 MR. MC KEE: Thank you. 8 MS. YEE: Thank you. . 9 Okay, then we will recess until 1:30. 10 MS. OLSON: Thank you. 11 MS. YEE: Thank you. 12 ---o0o--- 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 36 1 . 2 REPORTER'S CERTIFICATE 3 4 State of California ) 5 ) ss 6 County of Sacramento ) 7 8 I, JULI PRICE JACKSON Hearing Reporter for the 9 California State Board of Equalization certify that on 10 SEPTEMBER 22, 2009 I recorded verbatim, in shorthand, to 11 the best of my ability, the proceedings in the 12 above-entitled hearing; that I transcribed the shorthand 13 writing into typewriting; and that the preceding pages 1 14 through 36 constitute a complete and accurate 15 transcription of the shorthand writing. 16 17 Dated: October 6, 2009 18 19 20 21 22 23 ____________________________ 24 JULI PRICE JACKSON 25 Hearing Reporter 26 27 28 37