BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 5901 Green Valley Circle, Room 207 Culver City, California REPORTER'S TRANSCRIPT JUNE 21, 2011 ITEM B4 FRANCHISE AND PERSONAL INCOME TAX HEARING APPEAL OF THOMAS NAJARIAN and TAMAR NAJARIAN (No. 522166) AGAINST PROPOSED ASSESSMENT OF ADDITIONAL TAX Reported by: Beverly D. Toms CSR No. 1662 1 1 2 P R E S E N T 3 For the Board Jerome E. Horton of Equalization: Chairman 4 Michelle Steel 5 Vice-Chairwoman 6 Betty T. Yee Member 7 George Runner 8 Member 9 Marcy Jo Mandel 10 Appearing for John Chiang State Controller 11 (per Government Code Section 7.9) 12 13 Diane Olson, Chief Board Proceedings Division 14 15 For Board of Grant Thompson Equalization Staff: Appeals Division 16 17 For Franchise Tax Sonia Deshmukh Board: Tax Counsel 18 Bill Hilson 19 Tax Counsel 20 For Appellant: Meher Der Ohanessian 21 Representative 22 ---oOo--- 23 24 25 26 27 28 2 1 Culver City, California 2 June 21, 2011 3 ---oOo--- 4 MR. HORTON: Ms. Olson, what is our next 5 scheduled matter? 6 MS. OLSON: Our next item is B4, Thomas 7 Najarian and Tamar Najarian. Please come forward. 8 MR. HORTON: Mr. Thompson, would you please 9 introduce the issues in this case. 10 MR. THOMPSON: Good afternoon. The issues in 11 this case -- or actually the sole issue in this case is 12 whether Franchise Tax Board correctly disallowed claimed 13 loss deductions for years 2003 through 2006 on the basis 14 that appellant Thomas Najarian lacked sufficient basis 15 in the stock in debt of Thomas International Home 16 Furnishings, which was an S-Corporation. 17 MR. HORTON: Thank you very much. Would the 18 taxpayer please introduce yourself for the records. 19 You'll have ten minutes to make your presentation and 20 upon which time we will go to the Department and then 21 return to you for rebuttal. 22 MR. OHANESSIAN: Thank you. Ladies and 23 Gentlemen of the Board, my name is Meher Der Ohanessian 24 and I represent Mr. and Mrs. Thomas and Tamar Najarian. 25 The issues here are, as the Franchise Tax Board 26 has presented, whether the taxpayer had basis for their 27 2003, '4, '5 losses, to deduct their losses on their tax 28 return based on the loans that they had acquired. 3 1 The -- the taxpayer operates a furniture retail 2 store he opened up in 2002, I believe, and then 2003, '4 3 and '5 they sustained huge losses. For them to be able 4 to carry on their operation they had to borrow from 5 lenders. They had -- they have l.7 million borrowed on 6 a promissory note dated September the 19th of 2000. And 7 they had another line of credit agreement from the same 8 lender for the same time that was signed by Mr. Thomas 9 Najarian and the lender, personally. 10 The promissory note line of credit of 1.7 was 11 signed by the corporation and the -- the President, 12 Thomas Najarian. 13 Now, the reason for the loans obviously was to 14 continue the operation of -- of -- of the business. 15 Now, the Franchise Tax Board had disallowed the -- the 16 deductions for the year 2002, '3, '4 and '5 based on the 17 fact that the loans were not directly from the 18 shareholder. 19 The reason that the -- probably the shares -- 20 the -- the loans were not directly from the -- from the 21 shareholder is if you consider the environment in 2003 22 and '4 and '5 I don't think anybody would have lent him 23 any credit based on his personal credit only. So, the 24 lender had chose to have the corporation as a co-signer 25 on his personal, but then we do have a line of credit 26 agreement between the lender and him, personally, for 27 the same line of credit back in December -- September of 28 2000. 4 1 Therefore, the taxpayer contention is that the 2 loans advanced to the corporations were made by him 3 based on the line of credit that he has signed with -- 4 with the -- with the lender. 5 Now, just a brief history. As we speak today, 6 the -- the taxpayers is in -- liquidation. He is 7 closing down his business. And to walk away from his 8 promissory notes he's going to have to file a bankruptcy 9 personally so that he walk away from the line of credit 10 that he had signed in 2000. 11 Therefore, my contention is that the loan that 12 he had received in 2000 is his personal loan and it 13 should have increased her basis, thus allowing him to 14 deduct his losses on his tax returns. 15 Now, obviously we have filed the -- the Federal 16 and State taxes. We have absolutely no objections from 17 the Federal government. The Federal government has 18 accepted the tax returns as filed. 19 That's all I have to say. 20 MR. HORTON: Thank you very much for your 21 presentation. 22 MR. OHANESSIAN: Thank you. 23 MR. HORTON: Would the Department please 24 introduce yourself for the records. You have ten 25 minutes to make your presentation, as well. 26 MS. DESHMUKH: Okay. Good afternoon. My name 27 is Sonia Deshmukh. And sitting next to me is Bill 28 Hilson, and we represent the Franchise Tax Board on this 5 1 matter. 2 The question in this case is whether appellant 3 made a personal loan to his S-Corporation that would 4 increase his basis and indebtedness and allow him to 5 take losses passed through from the corporation in tax 6 years 2003 through 2006. 7 The FTB disallowed the loss deductions because 8 we found that the taxpayer didn't have sufficient basis 9 in stock in debt in his corporation. 10 Subchapter S allows S-Corporation losses to 11 pass through to the shareholder to the extent of his 12 basis in stock and his basis in any debts loaned to the 13 corporation. As the losses pass through from the 14 corporation they first deplete the shareholder's stock 15 basis. After the shareholder has depleted his stock 16 basis he can continue to take losses to the extent that 17 he has basis in any debts loaned to the corporation, and 18 after completing both stock and debt basis any losses 19 are suspended until a year when the shareholder has 20 actual basis. 21 In this case appellant claims that he borrowed 22 funds from a third party and then loaned the proceeds to 23 his corporation in 2000. Appellant's documents suggest 24 that he negotiated a line of credit, however it's 25 unclear -- there's no indication that funds were 26 actually advanced from the line of -- of credit 27 reflected in the promissory note. 28 He's also failed to -- to prove that he 6 1 contributed any borrowed funds to the S-Corporation. 2 So the loan documents provided by appellant are 3 contradictory and they tend to suggest that the 4 transaction was actually between a third party lender 5 and the corporation rather than the lender and -- sorry, 6 rather than a loan from the shareholder to the 7 corporation. 8 Appellant has not demonstrated that this third 9 party loan cost him anything or left him poorer in a 10 material sense that would allow him to increase his 11 basis. 12 It's important for an S-corporation shareholder 13 to track his basis accurately because of the rules 14 regarding the pass through of losses. Unfortunately in 15 this case appellants' basis records have been 16 inconsistent with his claim that he made a loan to the 17 corporation. 18 For example, his basis schedules reflect 19 $100,000 of stock basis at the beginning of every year 20 despite the pass through of losses that should have 21 depleted that basis. 22 The basis schedules did not reflect the 23 shareholder loans that he claims to have made and the 24 corporation's tax returns similarly failed to reflect 25 any shareholder loans. 26 Really the only evidence that appellant has 27 submitted to show that a loan occurred are two 28 conflicting promissory notes. 7 1 The first note was produced during the audit 2 and that note reflects that an -- a loan between a third 3 party lender and the corporation. 4 Appellant produced a second note after the 5 audit and the protest proceeding only after the protest 6 hearing officer advised appellants that he would have to 7 show that he made a loan personally to the corporation. 8 The second note reflects a loan between the 9 same third party lender and appellant individually but 10 appellant has failed to explain the discrepancy between 11 these notes and regardless neither document proves that 12 appellant made a loan to his S-Corporation. 13 With -- with regard to a loan between a third 14 party lender and the corporation the case law is 15 essentially unanimous. Loans from a third party to an 16 S-Corporation will not increase a shareholder's basis 17 even if the shareholder personally guarantees the note. 18 And the reason for this is that the rules are 19 really intended to limit the amount of loss deductions 20 to the shareholder's actual economic outlay in his 21 corporation. 22 So, accordingly, the first promissory note will 23 not increase appellant's basis. 24 The second promissory note reflects a loan been 25 the lender and appellant individually and if he contends 26 that he reloaned these funds to the corporation he's 27 failed to provide any evidence of that loan. 28 The case law also tells us that only those 8 1 amounts directly traceable to loans by the shareholder 2 will constitute indebtedness for purposes of computing 3 the pass-through of losses. 4 So if appellant wishes to prove that he made a 5 personal loan to the corporation that would increase his 6 basis he must provide proof of that loan, such as bank 7 statements reflecting the deposits, cancelled checks or 8 proof of repayment of the loans, or accurate accounting 9 records that reflect the basis has been properly tracked 10 and applied. 11 Any of these items would help to prove that 12 appellant took out a personal loan from a third party 13 lender and then reloaned those funds to his 14 S-Corporation in the year 2000. But without any of this 15 evidence and with the inconsistencies in his 16 documentation it's impossible to establish that he made 17 loans to his corporation that could increase his basis. 18 And for these reasons appellants' claimed 19 pass-through loss deduction should be disallowed. 20 Thank you. 21 MR. HORTON: Thank you very much. On rebuttal, 22 please. 23 MR. OHANESSIAN: The -- the line of credit, I 24 mean when -- when the Franchise Tax Board say that they 25 have two contradictory notes I really seriously doubt 26 that because one of them -- the promissory note is 27 directly from the lender to the corporation, which we 28 don't dispute that. 9 1 But the other loan -- line of credit is 2 directly from the third party to the shareholder. Now 3 the reason that it has -- we have a line of credit from 4 the third party to the shareholder is to substantiate 5 the source of the -- the funds. I mean, the source of 6 the funds are from the third party. Obviously he had 7 deposited in -- in his bank account because he couldn't 8 have operated without those funds. 9 And that's the reason that he has a line of 10 credit from a third party to his personal, just to 11 substantiate the source of documents. Just in case if 12 the Franchise Tax Board had asked where did the fund 13 come. That's the reason that he had a direct credit 14 line from the -- the third party to the shareholder, 15 just to prove that the source are coming from a loan. 16 It's -- it's a loan from a third party 17 deposited in his -- in his business with -- he can go on 18 with his operation. 19 MR. HORTON: Thank you very much. 20 Discussion, Members? 21 MS. STEEL: Question. 22 MR. HORTON: Member Steel. 23 MS. STEEL: So, you -- I mean, this taxpayer 24 provided two different promissory note here that you 25 said that money came from one -- that one to individual 26 and then it came. 27 MR. OHANESSIAN: Correct. 28 MS. STEEL: So there is two loans that we're 10 1 talking about then? 2 MR. OHANESSIAN: Yes, there is two promissory 3 note; one from the third party to the corp -- to the -- 4 to the corporation and one from the third party to his 5 personal. 6 MS. STEEL: I got that but -- so there's two 7 loans existing? 8 MR. OHANESSIAN: Yes. 9 MS. STEEL: Oh, okay. Then -- 10 MR. OHANESSIAN: And I -- I'm sorry, I -- I 11 don't know why the Franchise Tax Board claims that the 12 second promissory note was later on presented. I don't 13 think it was later on presented. 14 MR. HORTON: Pardon, sir. 15 MR. OHANESSIAN: I'm sorry. 16 MS. STEEL: No, actually -- yeah, it was on the 17 same date that I saw for both promissory notes on 18 September 19, 2000. 19 So both of them -- so, two loans on the same 20 day; one directly to the company and one directly to the 21 investor -- investor? Yeah, the taxpayer -- 22 MR. OHANESSIAN: The shareholder. 23 MS. STEEL: Shareholder to the company. That's 24 what you are saying, right? So, there's two loans? 25 MR. OHANESSIAN: On April the 23rd of 2010 I 26 have received a letter from the Franchise Tax Board, 27 appeals analysis -- and it was asking us for -- if we 28 can provide more information. Number one, you loaned -- 11 1 you loaned funds to the corporation and by loaning funds 2 to the corporation you increase your basis. 3 You personally guarantee it, there is -- number 4 three, if you obtained a personal loan and contributed 5 money from the loan to the corporation which created 6 basis in the corporation. That is when we have 7 submitted the line of credit from the third party to the 8 shareholder directly. 9 MS. STEEL: So there's two loans -- 10 MR. OHANESSIAN: Yes. 11 MS. STEEL: -- but yours -- so do you have any 12 proof that the money came from that personal loan to the 13 company? 14 MR. OHANESSIAN: Oh, surely -- 15 MS. STEEL: That's what Franchise Tax Board 16 said that you don't have any documents regarding that 17 that money came from not directly to the corporation 18 loan but this is to the shareholder to the company that 19 loan money. 20 MR. OHANESSIAN: Well, the loan money 21 obviously -- again, when you -- when you operate an 22 operation at a loss you need to fund the operation. 23 That's when you deposit money more than your sales. 24 Let's say your sales are $100,000 but -- 25 MS. STEEL: I totally got that. I just -- 26 MR. OHANESSIAN: Okay. 27 MS. STEEL: I'm -- I'm just asking you that 28 there's a proof of cancelled checks or any documents 12 1 that money came from that second loan from the 2 shareholder's money came to the corporation. That's 3 what I'm asking. I'm -- 4 MR. OHANESSIAN: I'm sure if we go over the 5 bank statement I -- I'm sure we can trace the deposit. 6 MS. STEEL: So we never asked for that during 7 the process that came all the way up here? 8 MS. DESHMUKH: We did, we asked for any 9 documents that proved that the funds went directly from 10 the shareholder to the corporation during the audit and 11 the protest. 12 MS. STEEL: But we never got it? 13 MS. DESHMUKH: We never received -- 14 MS. STEEL: Okay. 15 MS. DESHMUKH: -- any such documents. 16 MR. OHANESSIAN: Can I -- 17 MS. STEEL: Yeah. 18 MR. OHANESSIAN: I -- I would disagree on that. 19 I'll tell you why I would disagree. 20 MS. STEEL: So if you have time do you think 21 you can provide more documents? 22 MR. OHANESSIAN: I think we can. 23 MS. STEEL: That's what I'm asking. 24 MR. OHANESSIAN: The reason that I disagree is 25 the following. The original issue was whether a 26 personal loan was deposited in a bank account or it was 27 in indirect loans from -- from a third party to the 28 corporation directly. That's where the issues are. 13 1 MS. STEEL: Right. There's -- there's the 2 issues because if money was lent directly to the 3 corporation this taxpayer is in big trouble. But if it 4 was going to the personal loan and then went to the 5 company -- 6 MR. OHANESSIAN: Correct, I -- 7 MS. STEEL: That's why I'm asking you that if 8 you can provide that documents then off the hook. 9 That's what I'm asking. 10 Let me ask just one more question that did IRS 11 examine this? 12 MS. DESHMUKH: There's no indication that the 13 IRS examined his -- 14 MS. STEEL: So IRS never did. 15 MS. DESHMUKH: -- tax return. 16 MR. OHANESSIAN: No, we do not have any audits 17 from the IRS -- 18 MS. STEEL: Okay. 19 MR. OHANESSIAN: -- nor any reference to any -- 20 MS. STEEL: Okay. 21 MR. OHANESSIAN: -- discussions on -- 22 MS. STEEL: Thank you. 23 MR. OHANESSIAN: -- this. Absolutely. 24 MS. STEEL: So if you have more time that you 25 can bring more documents that it came from the personal 26 loan? 27 MR. OHANESSIAN: I -- I would definitely if the 28 Franchise Tax Board give us the -- the opportunity to do 14 1 that. 2 MR. HORTON: Can -- Ms. Steel. 3 MS. STEEL: Yeah. 4 MR. HORTON: May I? Can -- can you describe 5 the additional documents that you would be able to 6 provide? 7 MR. OHANESSIAN: I'm sure the taxpayer is going 8 to have to go over the bank statements and then anything 9 that is not sales would be -- would be described as a 10 loan from the third party. 11 MS. YEE: Not necessarily. 12 MR. HORTON: Question of the Department without 13 drawing a conclusion, would those documents change your 14 position and if -- one way or the other; can you 15 describe what additional documents might be helpful. 16 MR. HILSON: If I may, Mr. Horton. The -- the 17 second loan that the taxpayer and his representative are 18 talking about is couched in the terms of a line of 19 credit. 20 So, in the first place we'd need confirmation 21 that there were actually draws on that line of credit to 22 establish an indebtedness from the lender to the 23 taxpayer in the first place. 24 And then in the second place we'd need 25 documents showing a transfer of some or all of those 26 funds that the case may be from the taxpayer to the 27 S-Corporation. 28 And yes, if that type of -- if that type of 15 1 stuff were presented we would consider it very 2 seriously. 3 MR. HORTON: Continue along the lines of Member 4 Steel's inquiry. Are you able to provide that type of 5 information? 6 MR. OHANESSIAN: I am sure we can. The only 7 problem is going back to the 2003 bank statement and 8 I -- and I'm -- I'm positive that we do have records. 9 The taxpayer is -- is a person that he does not -- does 10 not destroy any documents even gas receipts. So, I am 11 sure that he would have documentation to substantiate 12 his -- his claim. 13 MR. HORTON: All right. Thank you very much. 14 Further discussion, Members? 15 Hearing none, is there -- 16 MS. STEEL: Move a 30-30. 17 MR. HORTON: -- a motion? 18 It's been moved by Ms. Steel to grant a 19 30-30-30. 20 Is there a second? 21 MR. RUNNER: Second. 22 MR. HORTON: Second by Mr. Runner. 23 Objection, Members? 24 MS. YEE: No objection, but can we just request 25 that perhaps there be some conference with respect to 26 the documents? 27 MR. HORTON: Sure. The motion is to grant 28 30-30-30 with clarification from the Department on the 16 1 specific documents that they would like to see. 2 Without objection, Members, such will be the 3 order. 4 MS. STEEL: Thank you. 5 MR. OHANESSIAN: Thank you. 6 MR. HORTON: Thank you very much, sir, for 7 appearing. We look forward to seeing those documents. 8 MR. OHANESSIAN: Thank you. Thank you. I 9 appreciate the opportunity. 10 ---oOo--- 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 17 1 REPORTER'S CERTIFICATE. 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, BEVERLY D. TOMS, Hearing Reporter for the 8 California State Board of Equalization certify that on 9 June 21, 2011 I recorded verbatim, in shorthand, to the 10 best of my ability, the proceedings in the 11 above-entitled hearing; that I transcribed the shorthand 12 writing into typewriting; and that the preceding 17 13 pages constitute a complete and accurate transcription 14 of the shorthand writing. 15 16 Dated: July 6, 2011. 17 18 19 ____________________________ 20 BEVERLY D. TOMS 21 Hearing Reporter 22 23 24 25 26 27 28 18