1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 NOVEMBER 17, 2010 10 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 11 APPEAL OF 12 CHARLES P. FRANKLIN 13 (ITEM B2) 14 AGAINST PROPOSED ASSESSMENT OF 15 ADDITIONAL INCOME TAX 16 17 18 19 20 21 22 23 24 25 26 27 Reported by: Kathleen Skidgel 28 CSR No. 9039 1 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 P R E S E N T 2 For the Board Betty T. Yee of Equalization: Chair 3 Jerome E. Horton 4 Vice-Chair 5 Barbara Alby Acting 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 12 Board Proceedings Division 13 For Board of 14 Equalization Staff: Anthony Epolite, Staff Counsel Amy Kelly, Staff Counsel 15 16 For Franchise Tax Board: Daniel Biedler, Tax Counsel 17 Ann Hodges, Tax Counsel 18 For Appellant: Eric M. Anderson, Representative 19 Amanda Horst, Representative 20 Also Present: Charles P. Franklin, Taxpayer Greg George, Witness 21 22 ---oOo--- 23 24 25 26 27 28 2 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 NOVEMBER 17, 2010 4 ---oOo--- 5 MS. YEE: Good morning. Let us call today's Board 6 of Equalization meeting to order. 7 Ms. Olson, our first item, please. 8 MS. OLSON: Our first item this morning is B2, 9 Charles P. Franklin. Please come forward. 10 Board Proceedings has received contribution 11 disclosure forms from this morning's hearing from the 12 parties, agents or participants. All forms were properly 13 completed and signed. All parties, agents and participants 14 are on the alpha listing provided to your office. 15 Each person sitting at the table will be asked to 16 introduce themselves and, if necessary, their affiliation 17 with the taxpayer of the record. Ten minutes is allocated 18 for the taxpayer's opening presentation, followed by ten 19 minutes for the Franchise Tax Board presentation, and five 20 minutes is allocated for the taxpayer for rebuttal. 21 Ms. Yee. 22 MS. YEE: Thank you very much, Ms. Olson. 23 Okay, Members, good morning. Our first item is 24 Item B2, Charles P. Franklin. Let me have Mr. Epolite with 25 the Appeals Division introduce the matter. Good morning. 26 MR. EPOLITE: Good morning, Members. Anthony 27 Epolite with the Appeals Division. 28 The issues before the Board in this matter are 3 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 whether Appellant has shown that the $1 million Promissory 2 Note he owed to Prefix Venture Partners is includable in 3 his basis in Prefix, whether Appellant is entitled to 4 exclude 50 percent of the gain in the sale of stock he held 5 in Endeavor Information Systems as qualified small business 6 stock, and whether the Board has jurisdiction to review the 7 post amnesty penalty. 8 MS. YEE: Thank you very much, Mr. Epolite. 9 Good morning. 10 MR. ANDERSON: Good morning. My name is Eric 11 Anderson with the firm of WTAS. I represent Mr. Franklin. 12 And to my right is Miss Amanda Horst, also a representative 13 from WTAS. And to my the left is the taxpayer, Mr. Charles 14 Franklin. 15 MS. YEE: Great. Thank you. Good morning. Please 16 proceed, Mr. Anderson. You have ten minutes for your 17 presentation. 18 MR. ANDERSON: Okay. Thank you to the Board for 19 hearing this matter of Mr. Franklin. 20 All of the matters in controversy have been briefed 21 before you, and all of the points and authorities are there 22 for you to find for Mr. Franklin in all matters. 23 Now the history of this case involves an audit that 24 was very brief, followed by a period of controversy with 25 the FTB that is anything about brief. At all levels 26 there's been very little consideration to the quality and 27 nature of Mr. Franklin's business and an utter disregard of 28 facts provided by Mr. Greg George who was involved in these 4 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 business dealings. 2 Mr. Franklin is a serial entrepreneur and investor. 3 Over the years Mr. Franklin has started, invested in, and 4 managed several business ventures in technology and related 5 fields that have employed hundreds of Californians. He has 6 worked with Mr. George for decades in several business 7 ventures, including the ones before you today. 8 Because of issues raised in the hearing summary, we 9 have provided you with a declaration of Mr. George, a new 10 declaration in Exhibit 9, clarifying the relationship with 11 Mr. Franklin and the circumstances surrounding the 12 formation and operation of Prefix Venture Partners. Mr. 13 George is also in the audience, in the gallery today and is 14 available for any questions later on. 15 Let's turn to the Prefix partnership issue. 16 Leading up to the year 2000, Mr. Franklin was working with 17 Mr. George and others in managing and turning around 18 technology companies. In 2000, Prefix was formed by other 19 venture capital funds as well as new investors, including 20 Mr. George and Mr. Franklin. Prefix was and still is in 21 the business of taking equity positions and emerging 22 technology companies and loaning funds to entrepreneurs to 23 start up companies. 24 One of these loans is the Note for $1 million that 25 is before you today, the Note that is in Exhibit 1 and 2 26 that we have provided, the secured Promissory Note, and the 27 Loan and Security Agreement. This Note was executed for 28 the purpose of providing Mr. Franklin capital to start up a 5 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 company. That company later became Metara, Inc. And in 2 the normal course of Prefix's business operations of 3 loaning money to entrepreneurs, Prefix took an interest in 4 the Metara company once it was formed. The Note was not 5 created or executed for tax purposes. 6 Now let's talk about some undisputed facts that are 7 related to the Note. The Note was a recourse obligation 8 for which Mr. Franklin was fully and unconditionally 9 liable, the Note for a market rate of interest of seven 10 percent. It was secured by Mr. Franklin's interest in 11 Prefix Venture Partners in the year 2000. It was, by its 12 terms, a negotiable instrument under the uniform commercial 13 code. It could have been sold to a third party. It was 14 recollatoralized in subsequent years, as intended, with the 15 stock of Metara, and the Note was fully repaid in the year 16 2004 with all accrued interest. 17 So given these facts, it is clear that there was a 18 bona fide obligation that Mr. Franklin owed to Prefix 19 Venture Partners. 20 So let's talk about what is and is not in 21 controversy in this case. It is not in dispute that when a 22 partner puts cash or other property into a partnership, 23 that they get basis to the extent of that cash or other 24 property. It is not in dispute that a partner may take a 25 tax deduction for losses in a partnership to the extent of 26 that basis. It is also not in dispute that Mr. Franklin 27 was a member of Prefix Venture Partners at the time and 28 that Prefix Venture Partners suffered a loss in the year 6 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 2000 that Mr. Franklin was properly allocated. The only 2 issue before this Board is whether or not Mr. Franklin had 3 basis in the Prefix Note so that he could take a loss for 4 tax purposes for the year 2000. 5 So stated a different way, the issue here is 6 whether Mr. Franklin contributed valuable property to 7 Prefix. It is clear had Mr. Franklin borrowed the money 8 from a third party and contributed cash to the venture, 9 that he would have had that basis. The reason the 10 transaction didn't happen that way is because Prefix 11 Venture Partners wanted to have an interest in the company 12 that Mr. Franklin was starting, as an entrepreneur, in 13 starting up Metara, Inc. So that is why Prefix lent 14 Mr. Franklin the $1 million Note -- or the $1 million. 15 So we are asking this Board to find that 16 Mr. Franklin had basis in his contribution to Prefix and 17 that the Note from Prefix to Mr. Franklin does not strip 18 that basis away. 19 So let's turn our attention to whether Mr. Franklin 20 does indeed have basis in that obligation. The respondent 21 here is proposing that there is no basis in a Note until it 22 is paid, until cash actually goes in. But this is an 23 over-broad reading of the relevant law that is unduly 24 restrictive and commercially unreasonable and unfair to 25 Mr. Franklin under the facts of this particular case. 26 In support of this position, the respondent is 27 citing tax shelter cases from the 1980s. In a typical tax 28 shelter transaction I put $10 into a venture, take an 7 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 interest in nonrecourse debt that I have no interest in 2 repaying, take depreciation deductions and a lot of -- and 3 maybe $25 of tax deductions or tax reduction, walk away 4 from my Note, walk away from my $10, and the promoter is 5 happy because he got my cash. I'm happy because I got my 6 tax deductions, having never had a reason to repay the 7 Note. 8 That is not what is happening in this case. But 9 that is what happened in the case of Wybenga that was 10 before this Board 24 years ago that the respondent is 11 relying on. In Wybenga, the taxpayers attempted to take 12 depreciation deductions allegedly related to a farm. The 13 Wybenga taxpayers could not even establish that the 14 noninterest bearing Note was created. It was, quote, 15 "allegedly executed". They failed to demonstrate to the 16 IRS that it was a bona fide debt and even conceded that it 17 was a Nonrecourse Note that didn't have basis without 18 something more. 19 The Wybenga decision hinges on Brannen and Oden 20 which are two cases, also from the 1980s, that went before 21 the IRS. In Brannen cash in a Nonrecourse Note was 22 contributed to fund the distribution of a film that the 23 partners had not even seen. The activity was found to be a 24 tax shelter not engaged in for profit and the taxpayers 25 tried to take 100 percent -- 110 percent return on the 26 money they contributed through fictitious tax deductions. 27 And by the way, the film that they invested in was called 28 "Beyond the Law". 8 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 Finally, in a similar oil partnership scheme, the 2 Oden promoter was indicted for fraud. These are the 3 decisions that the respondent is trying to apply to my 4 taxpayer Mr. Franklin. 5 We are not asking this Board to disregard Wybenga 6 or these other cases. What we are simply asking is that 7 this Board take a reasonable approach based on the facts of 8 this case. And to that end the Peracchi decision is 9 instructive. The Ninth Circuit ruled in Peracchi that a 10 taxpayer has basis in its own bona fide Note that was 11 contributed to a closely held corporation. The court found 12 that basis should exist where there is any realistic 13 possibility that the Note would be enforced by creditors in 14 the event of bankruptcy. 15 The Peracchi decision focuses on the Note-maker's 16 economic exposure as the ultimate measuring rod. Now they 17 give you some criteria for what is a bona fide Note: The 18 credit worthiness of the issuer; whether the Note has a 19 market rate of interest; whether the Note has a fixed term; 20 if the transferee can sell the Note; and whether the Note 21 is enforceable by third parties. 22 This Board should find that the Peracchi rule 23 extends here. This is in line with the economic reality 24 that Mr. Franklin was on the hook personally and 25 unconditionally for $1 million to Prefix Venture Partners. 26 Now we do acknowledge that the Peracchi court 27 implies there should be more scrutiny over partnership 28 transactions. But the Peracchi court was directly 9 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 addressing the type of tax shelter transactions that were 2 at issue in Wybenga, Oden and Brannen. We submit that this 3 Board should use the Peracchi factors in this case because 4 there was a lack of tax motivation and more than a mere 5 possibility that the Note would be repaid. It was, in 6 fact, repaid in full with interest. 7 Let's turn to the matter of the qualified small 8 business stock briefly. A brief review of the facts. In 9 1994 Mr. Franklin fortunately became a founder of Endeavor 10 Information Systems, Inc. In March '95 the Board of 11 Endeavor authorized and communicated to Mr. Franklin an 12 issuance of 7,000 shares of stock that were immediately 13 vested. 14 The company became a wild success, and in May of 15 2000, six years after its founding and more than five years 16 after the award of stock to Mr. Franklin, Mr. Franklin sold 17 his stock along with everybody else. Mr. Franklin 18 appropriately reported the stock sale on his tax returns, 19 taking the appropriate exclusion for qualified small 20 business stock. 21 There is no question, given the authorities in 22 front of you, that the date that Mr. Franklin had a 23 beneficial interest in the stock was that March Board of 24 Directors meeting when the issuance was set and when 25 Mr. Franklin had that communicated to him. No question. 26 Had Mr. Franklin been hit by a bus in April of 1995, those 27 shares would have been in his estate. 28 The only real issue before this Board is the 10 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 constitutionality of the apportionment provision. Now, 2 that issue is exactly the issue that is going up before the 3 Los Angeles Superior Court in the case of Cutler that is 4 set for the docket in March of 2011. So we are asking this 5 Board to hold this case in abeyance pending the outcome of 6 that decision. Not to do so would waste this taxpayer's 7 money and the rest of California's taxpayers' money by 8 forcing this taxpayer to litigate the same matter and force 9 the State of California to defend the same matter that is 10 already going before the Court in Cutler. 11 In summary, this is not a case about tax shelters 12 and careful tax planning. This is merely a matter 13 involving an entrepreneur who started up a company, 14 suffered a loss and took appropriate tax deductions. We 15 ask that Mr. Franklin's transactions be viewed in their 16 appropriate light. 17 Thank you. 18 MS. YEE: Thank you, Mr. Anderson. 19 Mr. Franklin, do you have anything to add at this 20 point? 21 MR. FRANKLIN: No, ma'am. 22 MS. YEE: Okay. Well, we'll give you time on 23 rebuttal. Thank you. 24 Franchise Tax Board, good morning. 25 MR. BIEDLER: Good morning, Madam Chairwoman, 26 Members of the Board. My name is Daniel Biedler. I'm with 27 respondent Franchise Tax Board. To my right is Ann Hodges, 28 also with respondent Franchise Tax Board. 11 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 With regard to the Prefix matter, the law's very 2 clear. In a partnership context, a partner cannot get 3 basis, cannot increase their basis with a promise to pay. 4 A Promissory Note, simple, I'll promise to pay money in the 5 future. You do not get money -- basis from that until 6 money is actually paid on that Note. That law is clear. 7 In the year at issue appellant did not pay anything. 8 A new exhibit, Exhibit 9, was introduced as we 9 walked in this morning, a declaration from Mr. Gregory 10 George that appears to indicate, and as appellant's 11 representative has reiterated in his presentation, that the 12 $1 million loan was a loan from Prefix to Mr. Franklin to 13 invest in Metara. But in appellant's own Exhibit 2, the 14 hearing exhibits, the Loan and Security Agreement indicates 15 that under the terms of the Purchase Agreement, debtor, 16 Mr. Franklin, acquired preferred shares of lender, Prefix. 17 So there's a contradiction between what Mr. George's 18 statement says and what the documents provided by appellant 19 say as well. 20 Further, the notion that this loan Note was some 21 sort of non -- or excuse me, Recourse Note is not within 22 the bounds of the document. Section three of that same 23 Loan and Security Agreement lists the secured obligations 24 of the debtor. And it says specifically the collateral, 25 which was the Notes -- excuse me, the shares in the lender 26 Prefix, secures and shall hereafter secure, and there's no 27 mention in the balance of this document of any personal 28 liability of Mr. Franklin beyond that. 12 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 So clearly this is just a promise to pay in the 2 future, secured by the very same property for which the 3 loan was given, and that's the shares of Prefix, not the 4 shares of Metara. Metara's shares were added into the mix 5 of this transaction in 2001 when, in Exhibit 3 to 6 appellant's appeal exhibits, there was an amendment number 7 one to the Loan and Security Agreement where shares of 8 Metara were added as additional collateral. They weren't 9 converted to payment on the Note until 2004, in the second 10 amendment to the Loan and Security Agreement. 11 So even if there were payment, if Metara's shares 12 actually were valuable enough to pay off the Note, that 13 wouldn't have happened until later, until after the year at 14 issue. So being as there was no payment and this was just 15 a promise to pay, for the year at issue, 2000, appellant 16 didn't pay anything and has no basis and cannot get this 17 allocation of loss in that year. 18 As far as the Endeavor stock, there are several 19 requirements before a taxpayer can benefit from the 20 qualified small business stock provision. Two of which are 21 at issue here, only one of which was addressed by 22 appellant's initial presentation. 23 The first is the active business requirement. This 24 is a benefit for investors who invest in California 25 businesses. Reflecting that, the active business 26 requirement requires that for the five-year holding period 27 there must be at least 80 percent of the property of the 28 business in California and 80 percent of the payroll. 13 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 In no year was there property in California, and in 2 only one year did the amount of payroll exceed 20 percent. 3 So clearly this requirement -- which is one of several 4 mandatory requirements, all of them inclusive, not 5 separately, it's not like an "or" situation -- it's failed. 6 With regard to the holding period, beneficial 7 ownership hasn't been established for Mr. Franklin until 8 the June 23rd, 2000 date which the stock ledger indicates 9 that there was actually a transfer of stock. There may 10 well have been discussion in March, and Mr. George's first 11 statement discusses that. But there have been no minutes 12 presented from the meeting indicating that the Board had 13 voted and that this had occurred. 14 So until there was actual possession, a 15 distribution to Mr. Franklin of the stock, he had no right 16 to enforce anything. There was no promise, that we have 17 evidence of, that as a founder he was going to get stock. 18 In fact, that idea is contradicted by the fact that how 19 much he would get was determined in March of 2000. 20 So absent some concrete evidence, including an 21 original contract for Mr. Franklin's services which may 22 have set out what he was going to get for what he 23 contributed as a founder and early employee, we cannot be 24 certain what his actual enforceable rights were from the 25 context of contract law. 26 So that's two of the five. You know, even if we 27 somehow produce a document that indicates that there was a 28 beneficial interest in the stock as early as March of 2000, 14 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 because the active business requirement has failed, the 2 qualified small business stock benefit is not available. 3 If I may have a moment. 4 (Pause.) 5 MR. BIEDLER: I would like to take any questions 6 you may have. Thank you. 7 MS. YEE: Thank you very much, Mr. Biedler. 8 You have five minutes on rebuttal. 9 MR. ANDERSON: Okay. You know, I think it's -- 10 just to go back and talk about the flavor of what's going 11 on here. 12 These are gentlemen that are entrepreneurs that are 13 involved in startup investments in Silicon Valley. I feel 14 like the Franchise Tax Board, from the auditors to the 15 legal division, assumes that these have the same 16 formalities of some microsystems in oracle, which they 17 don't. We have never seen startup companies that have the 18 same formalities as very mature companies. 19 But let's leave that aside. And let's look back at 20 the respondent's statement that the law is clear about a 21 promise to pay on a Promissory Note. I agree, the law is 22 clear that when there is a tax shelter and you have 23 individuals that have absolutely no reason and no impetus 24 to repay on a Note, that you should never find that that 25 Note is actually real property. 26 Now, if you look at the actual partnership law, 27 section 752 gives you the treatment of liability. Section 28 752 tells you that a partner in a partnership has basis to 15 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 the extent of those liabilities. And then when you look at 2 section 722 -- actually section 752 tells you that the 3 assumption of a Note is treated as money. And section 722 4 tells you that a contribution of money is treated as basis 5 in the partnership. 6 All we are asking for you to do here is look at the 7 facts of this case and not look at the tax shelter cases 8 where the law is, quote, "clear". 9 The loan from Prefix to Mr. Franklin was a loan for 10 the purpose of Prefix Venture Partners to later on be 11 recollateralized with the stock of Metara, Inc. That is 12 what was going on in this transaction. That is something 13 that the auditor never considered, that this was a business 14 dealing that Adventure Fund had in the normal course of its 15 business, and Mr. Franklin was one of the entrepreneurs 16 that this venture lent money to. 17 Finally, they contest whether or not there was any 18 repayment of the Note. The matter -- everything in front 19 of you shows you that the Note was repaid in 2004, I 20 believe. And the Note is clear on its face that it has all 21 of the indicia of being a real obligation for which 22 Mr. Franklin was personally and unconditionally liable. 23 You can't apply Wybenga and Oden and Brannen to 24 this particular set of facts. And we're not asking this 25 Board to break any new ground here. All we're asking is 26 that this Board look at this taxpayer and see that he 27 actually contributed valuable property to this venture. 28 By the way, Prefix Venture Partners ultimately had 16 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 about 20,000 investors. These investors were not in the 2 business of giving Mr. Franklin a million dollars. And 3 that's what the respondent is asking you to find, that the 4 Note was somehow fictitious and all these other people that 5 were invested in these ventures were allowing Mr. Franklin 6 to walk away with some beneficial interest that he 7 ultimately didn't have. He really had the interest. He 8 repaid on that Note, evidencing that interest. 9 On the qualified small business stock, we agree 10 with the active business requirement. That is a 11 constitutional matter. We would like you to hold that in 12 abeyance pending the outcome of the court cases that are 13 going through. Not to do so puts us all in the 14 disadvantage of having to defend that matter multiple 15 times. 16 On the holding period, the respondent talks about a 17 stock ledger on June 23rd. On June 23rd there was a 18 communication to the employees saying, hey, we decided as a 19 Board to give everybody some founder stock. How great is 20 this? Everybody gets their stock. We're all happy because 21 we have a startup company, hope it goes somewhere and does 22 really well. And five years later it actually did very 23 well and everybody sold their stock at a gain. 24 This was not, again, the formality of some 25 microsystems or an oracle or a very mature company. This 26 was a company that was trying to make a go of it, trying to 27 get into some new technologies and make a buck. And to say 28 that a one-page memoranda that came out to the employees 17 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 somehow was the date that conferred the beneficial interest 2 is an aberration. The Board set that date when it 3 adjourned on March 17th, having decided to award the stock 4 and communicating that award to Mr. Franklin. 5 So again, the only issue here on the qualified 6 small business stock is the active business requirement. 7 That is what is in front of the Los Angeles Superior Court 8 and we should let that case run its course and hold this 9 case in abeyance. 10 MS. YEE: Thank you, Mr. Anderson. 11 Mr. Franklin, anything further? 12 MR. FRANKLIN: I only want to say that I'm 13 surprised at this process. The original audit took less 14 than ten minutes. And -- and I've been pushing back 15 against forces that are pretty substantial because this is 16 what I do. I am a serial entrepreneur. I invest in 17 companies. And -- and if I had intended for this to be 18 some sort of tax sham, I wouldn't have -- I would have made 19 sure that when I filed my tax return, that I had a million 20 dollars on the line that said "Prefix Venture Partners". 21 It wasn't until well after, when I discovered other 22 errors in my return, that I filed an amendment that 23 included that issue. This is not a tax scam. This is what 24 I do. 25 MS. YEE: Thank you, Mr. Franklin. 26 Questions, Members? Ms. Steel. 27 MS. STEEL: To the taxpayer, that you invested and 28 Promissory Note was given to that company on 2000, and then 18 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 you paid the payment of million dollars on 2004. 2 Didn't you deduct that as investment at that point 3 or -- you know, I kind of like confused at this point for 4 2000 that you just gave them the Promissory Note. Money 5 was not really going back and forth. Maybe I just 6 misunderstanding the new setup companies. But can you 7 explain that a little more about that part? 8 MR. FRANKLIN: Go ahead. 9 MR. ANDERSON: Okay. Yeah, at the time the Prefix 10 Venture Partners was formed, there were several different 11 investors. And you can see that in the exhibits. There's 12 a schedule of investors. Some of them you can't ultimately 13 see the individuals that are above some of the other funds. 14 But these -- but Prefix was in the business of seeding 15 startup companies and giving loans to entrepreneurs like 16 Mr. Franklin. 17 Now Mr. George, who is seated right back there in 18 the gallery, knew that Mr. Franklin, in the year 2000, had 19 come into quite a bit of money because of the stock that 20 was sold and the qualified small business stock matter. So 21 Mr. Franklin had significant funds that he was going to 22 pour into a new venture. 23 At the time they wanted to set up Prefix Venture 24 Partners with all of these other investors, to conduct a 25 similar type of business. So there were really two 26 transactions that were going on. Mr. Franklin was 27 investing in Prefix Venture Partners, and concurrently 28 Prefix Venture Partners was investing in Mr. Franklin to 19 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 start up a new company, and that company later on became 2 Metara. 3 What I think is important here is, whether you say 4 that money changed hands or not or Mr. Franklin put cash 5 into Prefix Venture Partners or a Note into Prefix Venture 6 Partners, I think the appropriate question is, is that Note 7 real property? I mean, does that Note actually have some 8 substance? 9 I don't think that the law is if there is a promise 10 to pay, you don't get basis. I think the law is you get 11 basis for property that you put into a partnership. And if 12 we view that as what was put into the partnership, it was 13 relied on by all of these other people that were also 14 similarly in the partnership. It bore a market rate of 15 interest. It was a true obligation secured by Mr. 16 Franklin's interest in Prefix. It could have been sold to 17 a creditor. So it is tantamount to him having put in 18 money, and that's what we're asking you to find. 19 MR. FRANKLIN: I would -- 20 MS. STEEL: Okay. Go ahead. 21 MR. FRANKLIN: I would add one other point. If it 22 hadn't been for Prefix Venture Partners and their 23 investment in Metara, the $48 million that ultimately went 24 into Metara would never have happened. It was a real 25 transaction. 26 MS. STEEL: So you're saying the Promissory Note 27 helped to get investment. 28 MR. FRANKLIN: Absolutely critical. 20 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 MS. STEEL: Okay. Let me ask Franchise Tax Board, 2 I just heard from the taxpayer side that startup companies 3 are different than already, you know, those big companies 4 already set up. How can treat them different -- I mean, 5 why you are not treating them different? Because, you 6 know, when they said that that Promissory Note triggered 7 the business and to get investment and then, you know -- so 8 startup companies totally different than what we have those 9 big companies out there. So how can you explain that? 10 MR. BIEDLER: Thank you for the question, Ms. 11 Steel. 12 Appellant's representative has indicated that 13 there's a difference. What they spoke to was the 14 formalities of the corporate conduct of business and the 15 records that may or may not be available. The law does not 16 differentiate between startups and bigger businesses for 17 tax purposes. And when a taxpayer chooses the form of its 18 transactions, the taxpayer's bound by that form. 19 There's no evidence that Mr. Franklin made an 20 investment in Prefix and then was lent a million dollars. 21 There is evidence from Mr. Franklin that there was a loan 22 to him for his purchase of Prefix shares. Metara didn't 23 get involved until Mr. Franklin's stock in Metara was made 24 collateral for the loan for the Prefix shares. 25 So under the law applicable to all corporations and 26 businesses, big and small, they have to have had paid in -- 27 and I would like to address the representative's comment 28 about property and not a promise to pay. Well, in order 21 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 for 752 -- IRS 752 to allow a taxpayer to take a basis in a 2 partnership, there has to be property. But a Note that 3 merely is a promise to pay, that is not a Recourse Note, 4 isn't property for purposes of 752. 5 So as of 2000 -- and just to remind you, this Note 6 was -- these documents were all executed in December of 7 2000, so right before the end of the year. This enabled, 8 by the way that it was reported, Mr. Franklin to make no 9 actual cash or other valuable property contribution and get 10 a million dollar loss from the -- from a -- excuse me, a 11 disposition of Prefix property, something that he had to 12 know was coming. 13 And so while this is not a tax shelter perhaps, the 14 law doesn't -- wasn't written just for tax shelters. The 15 law was written for all business transactions, and some tax 16 shelters happen to fall within this purview. 17 Peracchi is limited, by its own discussion, to 18 corporations, and there's a very good reason for that. 19 Because of this ability to distribute losses immediately to 20 an owner versus a corporation's losses going into the basis 21 of the stock not realized until the stock shares are sold, 22 there's an immediate tax impact. And so the rationale used 23 by the Peracchi court fits the corporation situation, but 24 it does not fit, for a variety of policy reasons, the 25 partnership in this context and should not be allowed to be 26 applied here. 27 And on the Endeavor holding period question, while 28 that may be before the -- in the Cutler case, it's not 22 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 dispositive here. Because of the failure to meet the 2 requirement for the active business test, we don't even 3 need to reach the holding period. The Board can make a 4 decision upholding respondent's action simply on the basis 5 of the failure to meet the active business requirement. 6 MS. STEEL: But isn't Peracchi that court found the 7 contribution of Promissory Note by the corporate 8 shareholders of the stock increased the base in the stock. 9 So you can -- 10 MR. BIEDLER: In the corporate stock. 11 MS. STEEL: Right. 12 MR. BIEDLER: That was a corporation, not a 13 partnership, which is what this entity is taxed as. 14 MS. STEEL: Don't you think you're stretching a 15 little bit? It has to be corporate showing it's not 16 partnership. I mean, this is the startup company that 17 because of the Promissory Note that increased the value of 18 the company. 19 MR. BIEDLER: The Ninth Circuit says it doesn't 20 apply to partnerships. 21 MS. STEEL: Can you explain that. You know, it 22 seems like we are just one law here that, you know, we are 23 translating totally different way, interpreting different 24 way here for both sides. 25 Can you give us a little more about that? 26 MR. ANDERSON: Yeah, absolutely. So, first of all, 27 the respondent continues to say that there is just a 28 promise to pay. But there is no law decided that says just 23 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 a promise to pay does not confer basis, unless you look at 2 tax shelter cases. 3 And let me read you exactly what the respondent is 4 talking about from Peracchi. The Peracchi decision 5 cites -- and I think this is on page 6 of the Peracchi 6 decision, and we gave this to you in one of our exhibits. 7 Let me see which exhibit that was. I think it was Exhibit 8 6. But in any case, it is in one of the exhibits. 9 But let me read you what they actually say about 10 the partnership context. 11 "The tax treatment of nonrecourse that 12 primarily creates problems in the partnership 13 contexts where the entities lost deductions 14 resulting from depreciation based on basis 15 inflated above and beyond the taxpayer's true 16 economic investment can be passed through to the 17 taxpayer." 18 They go on to cite Oden, Brannen, talk about tax 19 shelter cases. They also cite the cases that the 20 respondent is relying on for the proposition that there 21 should be no basis here. 22 So what we're talking about is Peracchi says you 23 shouldn't apply this to a tax shelter situation. But you 24 can apply it when a partner or when a corporate shareholder 25 has tendered a Note that is a true economic obligation. 26 Let's take that one step further. In Peracchi, the 27 taxpayer contributed the Note so he wouldn't have to have a 28 tax gain. So the Peracchi taxpayer was actually tax 24 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 motivated, and they said that that was okay. 2 Here we have a taxpayer that didn't even take the 3 loss on his originally filed tax return. He just happened 4 to have an obligation that later on he realized this is a 5 true obligation that gives me basis and he wanted to take 6 his appropriate share of his loss on his startup company. 7 MS. YEE: Thank you, Ms. Steel. 8 Let me pose this question to Appeals if I may. I 9 just want to be clear about the limitations of the Peracchi 10 holding. I thought in the decision itself that there was 11 specific caution about extending the holding to a 12 corporate -- or a partnership context. 13 MR. EPOLITE: The Court does make that statement in 14 Peracchi. The Court states that "our holding, therefore, 15 does not extend to the partnership or S Corp context". 16 MS. YEE: Okay. 17 MR. ANDERSON: May I address that? That statement 18 is directly after what I just read to you, relating to 19 depreciation and fictitious tax deductions and cites the 20 tax shelter cases that we went through. 21 MS. YEE: Okay. Mr. Epolite, how should we kind of 22 view that caution, I guess? 23 MR. EPOLITE: Well, when I reviewed the case just 24 now, the only case that I saw referenced to was not 25 cases -- was a levy case, was the only case mentioned after 26 the quote made by Appellant. None of the cases mentioned, 27 I believe, in the Wybenga case. 28 MS. YEE: Okay. Thank you. 25 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 Other questions, Members? Ms. Mandel, please. 2 MS. MANDEL: Franchise Tax Board, you talk about 3 this Note as a Nonrecourse Note. Is there a dispute about 4 whether it's recourse or nonrecourse? Is there a dispute 5 about it being a Nonrecourse Note? 6 MR. ANDERSON: I didn't think so. Because I 7 thought in respondent's brief they said "Recourse" in their 8 brief. 9 MS. MANDEL: But I'm hearing "Nonrecourse" from 10 Franchise Tax Board. Are my ears plugged today? 11 MR. BIEDLER: You're hearing correct. Based on the 12 documents provided for this hearing, there is no mention 13 that this is recourse. It's secured only by the stock, the 14 Prefix stock. 15 MS. MANDEL: So Franchise Tax Board's position is 16 that it is a Nonrecourse Note. 17 MR. BIEDLER: Correct. 18 MS. MANDEL: Not recourse to Mr. Franklin. And 19 that's when I saw Mr. Franklin's body language indicate 20 that there was not agreement. So can you address whether 21 it's -- 22 MR. FRANKLIN: If it was nonrecourse, I wouldn't 23 have paid it. Let's start with that. 24 MS. MANDEL: Because the Franchise Tax Board, you 25 seem to stress nonrecourse as though that's -- I mean, that 26 would be a significant factor. Can you -- does it make a 27 difference if it is recourse? And then maybe we've got to 28 figure out if it's recourse or nonrecourse. 26 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 MR. BIEDLER: If the Note were recourse, that would 2 be a much stronger case for saying that the investment was 3 an economic risk at the time the Note was made for 4 Mr. Franklin. 5 MS. MANDEL: Right. And does having an economic 6 risk in the partnership context impact then whether he 7 would be entitled to get the deduction when he took the 8 deduction? If deduction's the right word. The loss. 9 MR. BIEDLER: Absolutely. As the Wybenga and other 10 cases discuss, it would be considered essentially as having 11 put money in. 12 MS. MANDEL: Money in, which is what I'm hearing 13 them say. And that's why he's talking about tax shelter. 14 Tax shelters, it's often, you know, the traditional, I 15 think, was probably often nonrecourse. And I didn't walk 16 in here with a real sense that there was a dispute about it 17 being nonrecourse. And now I'm hearing there's a dispute 18 about it being nonrecourse, which impacts whether he's at 19 risk under the basic partnership rules. 20 MR. BIEDLER: There is no evidence that there was 21 cash or other valuable property contribution to get those 22 Prefix shares. What we have is a Note. 23 MS. MANDEL: Well we have the Note. 24 MR. BIEDLER: Which does not say it's recourse. 25 MS. MANDEL: You're saying it does not say it's 26 recourse. So you're saying it's nonrecourse, secured only 27 by the stock that he acquired with that Note, and that 28 that's fundamental -- that sounds like it's really 27 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 fundamental to your case. 2 MR. BIEDLER: It is. 3 MS. MANDEL: It is. The taxpayer's position is 4 that he was at risk, which is why they're going down the 5 regular partnership rules. I'm at risk, therefore, look at 6 it this way. 7 So I guess, can you explain -- I understand he 8 personally feels like he was at risk because why wouldn't I 9 walk away from the million dollars, why would I have paid 10 it? But as sort of a legal -- can you address that issue? 11 Because it's -- 12 MR. ANDERSON: Sure. And I can address it in a 13 couple of ways, and then if you want to provide some 14 commentary. 15 First of all, the other members of Prefix Venture 16 Partners would not have just given Pat Franklin a million 17 dollars. I mean, that's essentially what the respondent 18 wants you to believe, that all of these other venture funds 19 and other individuals that invested in Prefix Venture 20 Partners would allow Mr. Franklin to have an interest in 21 that venture without being on the hook at all for his 22 contribution. So that just distorts the economic reality 23 of what is happening in the case. 24 Mr. Franklin's interest was secured by the interest 25 in Prefix which also included the value of all of the 26 underlying entities that were contributed to Prefix and all 27 of the rest of the business activity that was contributed 28 to Prefix. 28 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 So there is some security because this was a real 2 live venture that was operating a business. This is not a 3 partnership that tried to claim that a film that was bought 4 for $85,000 was worth a million two. That's what happened 5 in Brannen. This is not Wybenga where the individuals 6 contributed a Nonrecourse Note with no intention to repay 7 it and then tried to claim depreciation deductions. 8 Mr. Franklin was actually on the hook for this 9 obligation and that was the intent upfront. The Loan and 10 Security Agreement shows that there is security for the 11 Note. 12 Now, let's address whether or not that all even 13 actually matters, because I think it does. But let's say 14 you conclude that, gee, this is actually maybe a 15 Nonrecourse Note. It was sellable to a third party, 16 callable, which makes me think that he was at risk. But 17 even if you say it, for some reason, was nonrecourse, it 18 was sellable. It was callable. It was relied upon by 19 creditors. It was treated as property in the partnership. 20 It was ultimately repaid, which we talked about later on. 21 And there was a market rate of interest. There was -- the 22 interest was fully repaid. 23 If you look at all of the criteria that the 24 Peracchi court gives you, this obligation should be 25 respected as a true obligation. Whether you come down on 26 the side of it's recourse or not, it's a true obligation of 27 Mr. Franklin that he ultimately repaid. But our position 28 is that it is a recourse obligation. And even the briefing 29 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 says that this was a recourse obligation. This is kind of 2 the first time that the respondent is telling us that it's 3 nonrecourse. 4 Now, on the Peracchi decision, the Peracchi court 5 gives you factors to look at. We're not telling you that 6 you need to apply Peracchi directly to this situation, but 7 apply the principles that are in Peracchi. And Peracchi 8 only cautions you that when there's a tax shelter 9 transaction, there shouldn't be a basis. 10 Do you want to add anything? 11 MR. FRANKLIN: There is a suggestion that this is a 12 tax shelter. If this was a tax shelter, I would have taken 13 the deduction on my tax return. I didn't. 14 There's a suggestion that this promise to pay is 15 nonrecourse. Well, if it was nonrecourse, I wouldn't have 16 paid it. I like Mr. George and I know his family. I know 17 his kids. I don't like him that much. Plain and simple. 18 My bank account, my net worth, does not reflect 19 economic gain as a consequence of a tax shelter. There's 20 real loss involved. 21 As to the issue of, gee, it just suddenly happened, 22 well, you know, you run out of money. Things do suddenly 23 happen. We had great expectations for a couple of the 24 companies that actually went south, from my perspective 25 prematurely. But those were not predicted, not 26 predictable. 27 It's what I do. I start companies. I employ 28 people. I take a lot of risk, and I invest in others who 30 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 do. That's what this business is all about. 2 I'm open to any questions you have. 3 MS. YEE: Thank you, Mr. Franklin. 4 Other questions, Members? Mr. Horton, please. 5 MR. HORTON: Thank you, Madam Chair. 6 I'd just like the Department to respond to the part 7 about whether or not -- well, respond to whether or not 8 acknowledging the taxpayer's contention that this is not a 9 tax shelter, the question and the debate comes whether or 10 not it resulted in sheltering the tax. 11 And so I'd like the Department to respond as to 12 whether or not that did occur, because clearly it would 13 have been able to -- the Promissory Note would have had 14 value at a point in which there was some obligation or some 15 actual payment. And so we're dealing somewhat with a 16 timing factor and when this was executed. 17 And so I'd like the Department to speak to the 18 ultimate results of the transaction. And then answer the 19 question, I guess in 2004 when the payment was rendered, 20 how would the transaction have been treated? 21 MR. BIEDLER: Thank you, Mr. Horton. I'll be happy 22 to address your question. 23 The timing is important here because the law states 24 that payment on a personal Note is necessary before basis 25 can accrue -- by the way, this is coming from secondary 26 authority such as McKee, Nelson & Whitmore, Federal 27 Taxation of Partnerships. 28 "Because a partner's Note evidencing its 31 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 obligation to make a future contribution to the 2 partnership has no basis, the transfer of the 3 Note to the partnership does not increase the 4 basis of the partner's interest." 5 So by law there was no basis in 2000. So that 6 million dollar loss wouldn't be able to be taken until 7 there was basis in that interest in Prefix, which we can 8 see by the transfer of the property in 2004. So that would 9 be the proper year. 10 MR. HORTON: If I may interrupt you, I don't know 11 that it's by law. It's a condition of the facts. And so 12 if the facts establish that a Promissory Note -- that there 13 was some obligation, there was some value there and some 14 risk associated with it, then that changes the 15 consideration. So it's a fact pattern that we're looking 16 at. So maybe you can speak to that. 17 MR. BIEDLER: Thank you. Yes. 18 In the absence -- Ms. Mandel? 19 MS. MANDEL: Well, what you read from McKee sounds 20 different. Because what you read from McKee sounds like if 21 you -- just using Mr. Franklin's -- well, I won't use 22 Mr. Franklin's name. Using my name, that we decide to do a 23 partnership and, you know, you put some stuff in the 24 partnership. And what I put in the partnership is, I 25 promise that, you know, next month when I get paid, I'll 26 put three grand in the partnership. That's a promise to 27 pay next month when I get paid, I'll put the three grand 28 in. 32 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 What they're saying happened here is, if I've got 2 it straight, is yeah, there's a Note. Mr. Franklin -- and 3 recourse/nonrecourse, we got to get into that -- but that 4 there was a Note that he signed saying okay, Prefix, I'll 5 pay you a million dollars. But what they're saying is it 6 wasn't I'll pay you a million dollars, you know, some day 7 down the road, just that's what your client promised to 8 pay. 9 What I hear them saying is he got a million dollars 10 in his hand for that promise to pay. Which is different 11 than me saying, yeah, let's do a partnership and next month 12 when I get paid I'll give you three grand. Didn't he 13 get -- did he or did he not get a million dollars in his 14 hand to go do something? 15 MR. BIEDLER: The documents we have indicate he got 16 a million dollars worth of Prefix stock. 17 MS. MANDEL: Just a million dollars worth of 18 stock. 19 MR. BIEDLER: And he promised to pay the Note 20 within five years. It was not actually callable. It was 21 deferred for the five years, although there could be 22 prepayment. 23 MS. MANDEL: So then the issue becomes whether 24 there was a million dollars of value in fact in the Prefix 25 stock? 26 MR. BIEDLER: In the Note. 27 MS. MANDEL: No, because I'm saying what -- you're 28 saying he got nothing from Prefix. He got a million 33 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 dollars of Prefix stock, so-called a million dollars is 2 what you're saying. 3 MR. BIEDLER: We do not contend the value of the 4 Prefix stock. 5 MS. MANDEL: Well, whether he got -- I don't know, 6 I don't remember what he did with the Prefix stock. But 7 whether they hand him a million dollars of cash to go 8 monkey around with, sorry, or they hand him stock in Prefix 9 that you apparently agree is -- has a value of a million 10 dollars, to do whatever he's going to do with it, and he 11 says I'll pay a million dollars -- I'll repay this later. 12 Has he not gotten something of value from Prefix as opposed 13 to me just saying I'll pay the $3,000 into the partnership? 14 I mean, I guess I'm having a little trouble with 15 the difference between if he was handed a million dollars 16 cash out of the partnership or some other partnership 17 asset -- I'm sorry, yeah, partnership asset to go do 18 whatever he does, as opposed to he got this membership 19 interest, this partnership interest, LLC, this membership 20 interest worth a million dollars. Is there a difference 21 between those? Because it just sounded different than what 22 you said -- from what you read from McKee. 23 MR. BIEDLER: The tax consequence here was a 24 million dollar loss deduction, which would only be possible 25 if Mr. Franklin had a million dollars worth of basis in his 26 interest. So it doesn't matter whether he got cash or 27 Prefix stock -- he could get Prefix stock -- it's can he 28 take the loss? 34 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 MS. MANDEL: But does he have to be -- you know, 2 partnership was never -- does he have to be -- is the buzz 3 words that he has to be at risk? He has to be at risk. 4 MR. BIEDLER: Right, such as if it were a Recourse 5 Note. 6 MS. MANDEL: Which you don't -- and that's why your 7 hat is hung on the recourse/nonrecourse which they say they 8 didn't realize until they walked in here when you started 9 saying it. 10 MR. BIEDLER: Although I would like to point out 11 that in my brief I said that it was a secured Note. And 12 secured is not the same as recourse. Security is often 13 used in addition to or in the absence of a Recourse Note. 14 MS. MANDEL: Well -- I'm sorry to interrupt you, 15 Mr. Horton. 16 MR. HORTON: Oh, no, no. 17 I don't really see that it makes a difference. I 18 mean, I really think that this is still a timing issue. 19 And when in fact the liability was -- became real, and at 20 that point -- I mean, I respect your position that it 21 wasn't your intent to create a tax shelter, but pretty much 22 that's what happened. And the option could have been to 23 write a million dollar Note or a five million dollar Note. 24 And there has to be some obligation, some recourse, 25 associated with the Note. And I'm not saying it isn't. 26 I'm just asking that maybe you could tell us why and how to 27 establish that in order for there to be a basis. The 28 distinction between partnership and corporations is another 35 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 factor. 2 And the other -- so I think the issue of recourse, 3 nonrecourse, obligation of the Note, is important to 4 establishing your basis pursuant -- even to a partnership 5 law. So maybe you can help me with that. 6 The other area that I would like the taxpayer to 7 speak to is the notion that the LA case or the -- I didn't 8 really write down what the case was, but how that case 9 relates to this case and the fact that it's under 10 considerations by the court and why you believe we should 11 hold this in abeyance until that case is resolved. 12 MR. ANDERSON: One option to speak to the recourse 13 nature of the Note is our witness Greg George who was 14 involved in Prefix Venture who is back there. Would you 15 like to hear from Mr. George and his words? 16 MR. HORTON: That's up to the Chair. 17 MS. YEE: That's fine. Mr. George, come forward. 18 I'm going to ask that maybe you could give him a seat right 19 there. Thank you. 20 MR. GEORGE: Yes. Good morning. 21 MS. YEE: If you'll introduce yourself formally for 22 the record, and pull right up to the microphone, please. 23 MR. GEORGE: My name is Gregory George. I am the 24 managing director of Prefix Venture Partners. 25 MS. YEE: Okay. 26 MR. GEORGE: And is there a specific question that 27 you'd like me to address? 28 MR. ANDERSON: About the recourse nature of the 36 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 Note. 2 MR. HORTON: And if you could be time sensitive, 3 when you believe the -- I mean, at some point there was 4 some recourse. And at some point the taxpayer is entitled 5 to this particular -- to treat this payment the way that he 6 did initially. The question is, from my mind, is the 7 timing of this. And so maybe you can incorporate that in 8 your response. 9 MR. GEORGE: From the perspective of the Prefix 10 Venture Partners and all of our other investors, 11 Mr. Franklin bought a million dollars worth of Prefix 12 preferred A shares, which established his basis. 13 Then Prefix loaned Mr. Franklin a million dollars. 14 And it was our intent -- and I thought it was adequately 15 documented, but maybe I should go back and talk to some 16 other attorneys about that. It was our intent that 17 Mr. Franklin would use that money onto invest in a new 18 company which was not sufficiently mature for Prefix to 19 invest directly in that company yet. 20 That company was being minded in the venture 21 capital term of art and vernacular by another former 22 partner of mine from Technology Funding, and so we knew 23 that it would be used safely. Mr. Franklin was not 24 prepared to provide additional collateral at that time. 25 But as soon as additional collateral was available, we 26 increased the collateralization of the Note. And I think 27 that's been mentioned here, which, if I recall correctly, 28 was substantially before anybody raised the question as to 37 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 whether this was a Recourse or Nonrecourse Note. In our 2 mind it was, of course, a full Recourse Note, from the 3 beginning. 4 MR. ANDERSON: And the provisions of the Note 5 terms, if you look, there is security for the interest. It 6 is treated as a negotiable instrument. Had Prefix Venture 7 Partners, in the year 2000, needed additional liquidity, 8 they could have sold it, they could have called it. They 9 could have gone after Mr. Franklin for any of his personal 10 assets, assets that Mr. George knew that he had because 11 they had sold the Endeavor stock in that year. 12 So Mr. Franklin had some liquidity that was also 13 going into the Metara company. So the Note by its terms, 14 if you read through it, has security, it has the event of 15 default that they would be able to go after Mr. Franklin 16 personally and unconditionally. It does state that it is 17 an unconditional obligation in 5.3. Everything about the 18 Note reads as a recourse obligation in the year 2000. 19 So what our contention is, is that this is 20 property. And if you look at the factors that are out 21 there, that have been laid out in Peracchi, this is 22 property at the time the Note was executed because 23 Mr. Franklin was personally on the hook for the Note at 24 that time. 25 MR. GEORGE: This was our standard Note form, 26 pretty much, that I don't think anyone had ever suggested 27 was nonrecourse before or after, until today. 28 MS. YEE: Can I stop you there. Ms. Mandel, and 38 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 then I have a question as well. 2 MS. MANDEL: Okay. I just want to get it clear on 3 the table again. If it's a Recourse Note, FTB, is that the 4 end of the story and the taxpayer has -- 5 MR. BIEDLER: Essentially, yes. 6 MS. MANDEL: Essentially, yes. 7 MR. BIEDLER: Yes. 8 MS. MANDEL: Yes. We didn't have anything, at 9 least unless I was not reading it. I mean, I was so 10 focused on this -- on Peracchi and that it, you know, said 11 it doesn't apply to partnerships and are we going to extend 12 Peracchi to partnerships. This is a very basic -- sorry, 13 very fundamental question about whether he has basis, 14 which, you know, depends on whether he's at risk, depends 15 whether he's got a Recourse Note, which now is the dispute. 16 So maybe that's your question to them. 17 MS. YEE: Well, I was going to pose the question to 18 Appeals -- 19 MS. MANDEL: To Appeals. 20 MS. YEE: -- about this concept. 21 Excuse me, Mr. Horton. 22 MR. HORTON: No, no. 23 MS. YEE: We're kind of on this track. But the 24 threshold question about whether the Promissory Note and 25 the question of recourse versus nonrecourse. Franchise Tax 26 Board's position, I believe, is that it's nonrecourse 27 because of security provisions, that it was secured by -- 28 right? 39 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 MR. BIEDLER: And the lack of anything more about 2 his personal liability. 3 MS. YEE: Okay. Which you just heard is being 4 disputed by the appellant. 5 Mr. Epolite, how should we kind of be looking at 6 this given what the testimony we just heard with respect 7 to, you know, potential personal liability and otherwise? 8 MR. EPOLITE: Based on the documents presented by 9 appellant in this matter, the Loan and Security Agreement, 10 section two of that agreement provides the collateral 11 provision, and provides that the collateral, under this 12 loan agreement, is that personal property described in that 13 certain contribution agreement dated as of December 14th, 14 2000, specifically including one million Series A preferred 15 shares of Prefix. And the Note -- or, excuse me, the 16 agreement provides for the security interests of the Prefix 17 stock as well. 18 Appeals did not find in the record this particular 19 contribution agreement to find out what other personal 20 property there was of appellant's that may be a risk. 21 MS. MANDEL: But I think their position is it's not 22 just the little section of the agreement that says 23 security, but there's other provisions. I haven't read my 24 Mortgage Note in a long time, but it's a refinanced Note 25 and, you know, I'm on the hook even if they get the house 26 back, which hopefully never happens in either case. 27 But that's what I hear the taxpayer's 28 representative saying, is you have to look beyond what it 40 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 says under "security" to determine as a whole whether 2 it's -- whether there's recourse or not. And FTB, I think, 3 is just saying we didn't see the word "recourse". We 4 didn't see his name. 5 MR. BIEDLER: May we ask for additional time to 6 brief the matter and examine the documents, so we can -- 7 MS. MANDEL: Because FTB would -- I mean FTB said 8 yes, if they thought this was recourse, they would concede 9 this issue, right? 10 MR. BIEDLER: (Nodding head.) 11 MS. MANDEL: So that's -- and that's like a big 12 deal. 13 MS. YEE: That's a pretty threshold question. 14 MR. HORTON: Sounds like progress for FTB asking 15 for additional time to review documents and the arguments 16 that they had not considered. 17 MR. ANDERSON: Can we also address one quick point, 18 also, and that is that there was a concession that there 19 was security, recourse or not, security for the Note in the 20 underlying assets of Prefix, which nobody disputes were 21 valuable, and were valuable to the extent of Mr. Franklin's 22 contribution of his Note. 23 Again, I go back to that the other partners in 24 Prefix were not giving Mr. Franklin a million dollars. 25 They were relying on his $1 million Note as property as 26 part of the venture. 27 So whether or not the Note was recourse or not, I 28 still think a secured Nonrecourse Note that is backed up by 41 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 property that Mr. Franklin would have to walk away from in 2 the event of a default and that the other partners would 3 recoupe still means that this Note is a real, true 4 obligation in the year 2000 for which Mr. Franklin was 5 obligated. 6 So we still stand by that it is a secured Note. 7 But even if it's not a secured Note, you still -- or, I'm 8 sorry, even if it's not a Recourse Note, it is a secured 9 Note that is backed by property that had value. And that 10 is enough. 11 MS. YEE: Mr. Franklin. 12 MR. FRANKLIN: All of that is true. I come back to 13 the fact that if it was a tax shelter, I would have taken 14 the tax deduction. If it wasn't a liability of mine, I 15 wouldn't have paid it. 16 MR. ANDERSON: So, Mr. Horton, may I address your 17 other point on the Cutler case? 18 MR. HORTON: Sure. 19 MR. ANDERSON: Okay. So Cutler is before the Los 20 Angeles Superior Court on the active business requirement 21 for the qualified small business stock. This is exactly 22 the same issue that Mr. Franklin has with Endeavor, meeting 23 the active business requirement that several other 24 taxpayers are having that are similarly situated. And it 25 is only a matter of law about whether or not that provision 26 is constitutional. 27 So we think that in this matter, so that 28 Mr. Franklin doesn't have to go to court and spend his own 42 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 money and spend Franchise Tax Board money defending exactly 2 the same matter of law, that you should hold this qualified 3 small business stock matter in abeyance. 4 MR. HORTON: There are two factors, matter of law, 5 matter of fact, and evidence. The FTB is saying that 6 there's additional evidence that they haven't been able to 7 consider. And maybe we can -- I don't want to put words in 8 your mouth. Maybe you can articulate your thoughts based 9 on the most recent information. 10 MR. BIEDLER: With the exhibit -- with the 11 additional statement from Mr. George which we just received 12 today, I would love the opportunity to be able to consider 13 that in light of the documents and all that we've heard 14 today. 15 MR. HORTON: And what are your thoughts relative to 16 the case that's before the courts today? 17 MR. BIEDLER: We'd leave to that to discretion of 18 the Board. We'd concede the efficiency arguments. But we 19 do also maintain that you could make a decision on the 20 facts. 21 MR. HORTON: I didn't hear that concession. 22 MR. BIEDLER: I apologize. 23 MR. HORTON: I didn't hear the concession. 24 MS. MANDEL: You slowed. You got quiet at the 25 end. 26 MR. HORTON: Yeah. 27 MR. BIEDLER: I apologize. We understand the Board 28 could take -- we don't necessarily oppose the position to 43 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 wait on the Cutler decision, but only if your Board doesn't 2 decide that there wasn't a sufficient holding period 3 requirement that was met. That could dispose of the 4 case. 5 MR. HORTON: Okay. All right. I'm good. 6 MS. YEE: All right. Thank you, Mr. Horton. 7 Other questions, Members? Let me see if I can get 8 all the issues on the table. 9 Okay. It appears that Franchise Tax Board is 10 desirous of having more time to look at, I guess again 11 review in more detail, the provisions of the Loan and 12 Security Agreement just to make sure that we understand 13 what actually was proposed as security interest collateral 14 and like, so we have an understanding of the nature of that 15 agreement. 16 Members desire, additional time? 17 MS. MANDEL: Well, yeah, I think that that -- 18 because they would concede this issue -- 19 MS. YEE: Yeah. 20 MS. MANDEL: -- if they're satisfied, I'd do a 21 30/30/30 on it. They may -- you know, if they're not 22 ultimately satisfied, it's still up to this Board whether, 23 you know, then to make that decision. But because they 24 would concede that issue, and then as to what the Board 25 ultimately decides on -- you know, I don't know what our 26 practice is on holding things for litigation. Because then 27 that's like a separate thing. 28 MS. YEE: Right. 44 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 MS. MANDEL: And as FTB says, we'd have to -- you 2 know, we'd have to decide. 3 MS. YEE: Right. 4 MS. MANDEL: If we decided they met the holding 5 period, then that issue comes up on Endeavor stock -- 6 MS. YEE: No, exactly. 7 MS. MANDEL: -- then the issue doesn't come up at 8 all. 9 MS. YEE: Right. Let me get some clarification 10 from Ms. Kelly and Mr. Epolite with respect to the 11 appropriate action by the Board. 12 MS. KELLY: If the Board directs a 30/30/30, I'd 13 like to clarify whether you would like the matter to come 14 back on the consent calendar or for an oral hearing. 15 MS. YEE: Nonappearance. 16 MS. KELLY: Nonappearance. 17 MS. YEE: Yes. 18 MS. MANDEL: They were just asking nonappearance or 19 hearing. 20 MR. HORTON: Yeah. I mean, there -- it's sort of 21 conditioned on what FTB ultimately resolves as a result of 22 the debate. There are issues before that only this Board 23 can actually consider. So I think it should come back on 24 the appearance calendar. But how we accomplish that, I 25 would defer. 26 MS. YEE: And we still can consider those issues -- 27 MS. MANDEL: Yes. 28 MS. YEE: -- if it's on a nonappearance 45 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 adjudicatory calendar. 2 MR. HORTON: Okay. 3 MS. YEE: I'm not sure what -- I think we've had a 4 pretty thorough hearing of the matter. 5 MS. MANDEL: Yeah, the difference is whether they 6 come back and do a hearing or whether they're just on the 7 nonappearance H adjudicatory calendar -- 8 MS. YEE: Right. 9 MS. MANDEL: -- where we can discuss it on the H 10 calendar, and that's what the Chair's talking about. 11 MS. YEE: Right. We still have the ability to 12 deliberate on it. 13 MS. MANDEL: Right. 14 MR. HORTON: Okay. No, I'm good. 15 MS. YEE: Good. Okay. Mr. Franklin, did you have 16 a comment? 17 MR. FRANKLIN: Yeah. I wanted to comment about the 18 holding period. There was a Board meeting, decisions were 19 made, stock. There was an announcement later. Five years 20 past the decision, the stock was sold as -- not by 21 individuals, but the company sold it. There were 32 or 33 22 people involved. And there was thought given as to when 23 you triggered the date of the transaction. It was 24 thoughtfully done after five years had passed. It wasn't 25 oh, gee we can -- we can get a big fat check. Let's rush 26 to the bank. 27 MS. MANDEL: Okay. So in my 30/30/30, then as to 28 the holding period, any -- oh, so it's like a swappy 46 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 30/30/30. 2 MS. YEE: Yeah. 3 MS. MANDEL: Because -- 4 MR. HORTON: Is there such a term? 5 MS. MANDEL: Yeah, there is now. The technical tax 6 term, swappy 30/30. Because on the recourse/nonrecourse 7 it's really FTB's -- you know, unless there's anything 8 additional that you guys have. Okay, they say no. 9 So it's 30/30/30, FTB on the starting on the 10 recourse/nonrecourse. But on the holding period, FTB 11 talked about not having -- I don't know what else you might 12 have. If there are Board minutes or something from the 13 earlier date or anything else that you think would 14 assist -- we have Mr. Franklin's explanation and statement 15 the whole company sold, but anything else that you would 16 think would go to the point of establishing that earlier 17 date as the start date for the holding period. So that 18 that 30/30 would start with them. So a swappy 30/30/30. 19 How's that? That's my motion. 20 MR. HORTON: Second. 21 MS. YEE: Okay. I appreciate that, Ms. Mandel. 22 Thank you. 23 Motion by Ms. Mandel for a 30/30/30 on the 24 recourse/nonrecourse issue as well as the holding period 25 establishment date issue. Second by Mr. Horton. Without 26 objection, Members? Okay. Without objection -- 27 Ms. Kelly, clarification needed? 28 MS. KELLY: Could I just clarify that the 30/30/30 47 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 will be for appellants to -- starting the first 30 with 2 their arguments on the holding period to FTB? We won't be 3 producing a brief in the first 30 days. 4 MS. YEE: On the holding period matter, that is to 5 the appellant, in terms of triggering the 30/30/30. On the 6 recourse/nonrecourse matter, that's the Franchise Tax 7 Board. 8 MS. MANDEL: Yeah, and I did it that way -- 9 MS. KELLY: Appellant's to start? 10 MS. MANDEL: Well, "swappy" may be confusing. 11 Maybe they don't understand. 12 The 30/30/30 is basically the person who starts 13 gets 30 days to produce anything else that they have on the 14 issue. Then the other side, the Department, if you were 15 the starter, gets 30 days to review what you submit and 16 reply and make their comments. And the last 30 days is 17 actually for our appeals section to review everything. 18 Because -- and then make -- am I getting that right, Mr. 19 Epolite? 20 MR. EPOLITE: Yes. But, Madam Chairwoman, I would 21 request that we start with appellant. 22 MS. MANDEL: You want appellant to start on both? 23 MS. YEE: On both issues? 24 MR. EPOLITE: Yes, because there was the one 25 contribution agreement that Appeals was unable to find. 26 MS. YEE: Okay. 27 MR. EPOLITE: That may be helpful. 28 MS. MANDEL: Okay. Okay, I so revise my motion. 48 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 So, Mr. -- 2 MS. YEE: Anderson. 3 MS. MANDEL: Mr. Anderson, on the whole thing, it's 4 going to be 30/30/30, on you guys to start it. It just 5 makes it easier. 6 MR. ANDERSON: We may be able to simplify that a 7 little bit. There really is nothing else to provide on the 8 holding period matter. You have what is in the record, you 9 have the statement of Mr. George. You have the -- 10 MS. MANDEL: There's no minutes or anything of that 11 Board meeting? 12 MR. ANDERSON: No. I mean there were the 13 representations of Mr. George who was at the Board 14 meeting. 15 MS. YEE: Any other communications surrounding that 16 Board meeting that might be helpful? 17 MR. HORTON: The FTB had mentioned a contract 18 relative to the holding period. I sort of heard that in 19 your -- 20 MR. BIEDLER: If there were some agreement amongst 21 the founders that had been put in writing about what they 22 would be contributing, what they might get, that would be 23 helpful, yes. 24 MS. MANDEL: And you know what, you're sort of 25 thinking and remembering on the fly. You might want to 26 just take the 30 days. 27 MR. ANDERSON: Sure. 28 MS. MANDEL: And just go home and -- I don't want 49 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 you to be driving back from wherever you came from and go, 2 oh -- 3 MS. YEE: But Mr. Anderson's going to be -- 4 MS. MANDEL: I appreciate the effort. 5 MS. YEE: -- be expansive in terms of -- I mean, 6 it's not necessarily Board minutes. We're just suggesting 7 you know, some other documents that might be helpful. 8 MR. ANDERSON: Okay. 9 MS. YEE: But any communication that may have 10 happened around the time of that Board meeting, emails, 11 correspondence, other correspondence that suggest that this 12 was the intent. 13 MR. ANDERSON: Okay. 14 MS. YEE: And then -- yes, Mr. Epolite, thank you 15 for the clarification. 16 So the 30/30/30 process that we've just adopted 17 would be triggered by obviously the appellant on both 18 issues. Okay initiated by appellant in both issues. 19 MR. EPOLITE: Thank you. 20 MS. YEE: Okay. That motion carries. Thank you 21 very much. 22 (The matter concluded at 10:44 a.m.) 23 ---oOo-- 24 25 26 27 28 50 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, KATHLEEN SKIDGEL, Hearing Reporter for the 8 California State Board of Equalization certify that on 9 November 17, 2010, I recorded verbatim, in shorthand, to 10 the 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 50 constitute a complete and accurate transcription 14 of the shorthand writing. 15 16 Dated: December 17, 2010 17 18 19 ____________________________ 20 KATHLEEN SKIDGEL, CSR #9039 21 Hearing Reporter 22 23 24 25 26 27 28 51 TOWN & COUNTRY DEPOSITION SERVICE (530) 642-0333