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 JUNE 26, 2012 10 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 11 APPEAL OF 12 HENRY F. LENARTZ AND NONA M. LENARTZ 13 NO. 524571 14 AGAINST PROPOSED ASSESSMENT OF 15 ADDITIONAL INCOME TAX 16 17 18 19 20 21 22 23 24 Reported by: Juli Price Jackson 25 CSR No. 5214 26 27 28 1 1 P R E S E N T 2 For the Board Jerome E. Horton of Equalization: Chair 3 Michelle Steel 4 Vice-Chairwoman 5 Betty T. Yee Member 6 George Runner 7 Member 8 Marcy Jo Mandel Appearing for John 9 Chiang, State Controller (per Government Code 10 Section 7.9) 11 Joann Richmond Chief 12 Board Proceedings Division 13 14 For Board of William J. Stafford Equalization Staff: Tax Counsel 15 Anthony Epolite 16 Tax Counsel IV 17 For Franchise Tax Ann Hodges 18 Board: Tax Counsel 19 Ting Lee Auditor, Technical 20 Resources Section 21 22 For Appellants: Michael Lenartz Representative 23 24 ---oOo--- 25 26 27 28 2 1 5901 GREEN VALLEY CIRCLE 2 CULVER CITY, CALIFORNIA 3 JUNE 26, 2012 4 ---oOo--- 5 MR. HORTON: Ms. Richmond. 6 MS. RICHMOND: Our next item is B, Corporate 7 Franchise and Personal Income Tax Hearings. There is 8 only one oral hearing on today's agenda. 9 Our first and only oral hearing is B1, Henry F. 10 Lenartz and Nona M. Lenartz. Please come forward. 11 Board Proceedings has received contribution 12 disclosure forms for this morning's hearings from the 13 parties, agents and participants. All forms were 14 properly completed and signed. All parties, agents and 15 participants are on the alpha listing provided to your 16 office. 17 Each person sitting at the table will be asked 18 to introduce themselves and, if necessary, their 19 affiliation with the taxpayer for the record. Fifteen 20 minutes is allocated for the taxpayer's opening 21 presentation, followed by fifteen minutes for the 22 Franchise Tax Board's presentation and five minutes is 23 allocated to the taxpayer for rebuttal. 24 Mr. Horton. 25 MR. HORTON: Thank you very much. 26 Mr. Johnson, will you please introduce the 27 issues in this case? 28 MR. STAFFORD: Okay. The first issue is 3 1 whether Appellants meet the active business requirements 2 for exclusion of gain under California Small Business 3 Stock law. 4 The second issue is whether Appellants meet the 5 active business requirements for deferral of gain under 6 California Small Business Stock law. 7 And the third issue is whether California Small 8 Business Stock law is constitutional and whether the 9 Board has jurisdiction to consider a constitutional 10 question. 11 MR. HORTON: Sir, what's the basis of your 12 description? 13 MR. STAFFORD: The hearing summary. 14 MR. HORTON: Yes. 15 MR. STAFFORD: Yes. 16 MR. HORTON: Any research to support that 17 position? 18 MR. STAFFORD: Excuse me, I'm -- I didn't 19 understand the question. 20 MR. HORTON: Did you conduct any research to 21 support your presentation here today? 22 MR. STAFFORD: In preparing the hearing 23 summary, I did, yes. 24 I'm not the Appellant. 25 MR. HORTON: I know you're not. 26 MR. STAFFORD: Okay, sorry. 27 MR. HORTON: But this is your first time before 28 the Board, right? 4 1 MR. STAFFORD: No, it's not. 2 MR. HORTON: Oh, it's now? Oh, okay, I thought 3 it was. 4 All right, then we'll -- 5 MR. STAFFORD: I'm not here that often. 6 MR. HORTON: -- we'll dispense with the hazing. 7 Members, we have -- as a courtesy to the 8 taxpayer, we've allowed them additional time in order to 9 make his presentation. We will do the same with the 10 Department. 11 And, so, would you please introduce yourself 12 for the record? You have 15 minutes to make your 13 presentation, upon which time we will go to the 14 Department. They too will have 15 minutes. We will 15 return to you on rebuttal. 16 At your convenience, sir. 17 MR. LENARTZ: I'm trying to see a clock so I 18 can see what time it is. 19 MR. HORTON: Oh, we will help you with that. 20 MR. LENARTZ: I need it. I tend to be a little 21 longwinded -- as you noticed, probably, by the 22 documentation. 23 MR. HORTON: No, no, you did an excellent job. 24 MR. LENARTZ: My name is Michael Lenartz and 25 I'm representing my mom and dad, Doctor and Mrs. Henry 26 Lenartz. 27 Should I just start in? 28 MR. HORTON: Yes, sir, please. 5 1 MR. LENARTZ: Okay. As -- by way of 2 introduction, my mom and dad invested in this company 3 when they were about 60 years old, back in 1995. So, 4 this issue from investing to now has taken a long time 5 to get us to the point where we are now. 6 In 2008 the Franchise Tax Board audited the 7 return and decided to disallow all of the tax incentives 8 my parents claimed. And we disagreed. And we went 9 through the whole process of saying, but, but, but. And 10 now we're here to say the same thing, that we think that 11 they qualify. 12 There are a couple of different ways that they 13 qualify just -- just so you can get an idea of where 14 we're coming from. 100 percent of the payroll of 15 Novacept was located within California for each of the 16 three stock certificates they owned for the first -- 17 over -- more than the first five years that they owned 18 stock for gain exclusion and more than the first six 19 months they owned the stock for gain and rollover. In 20 fact, it was owned for considerably longer than those 21 periods of time as qualified small business stock, as 22 we'll show. 23 Second -- and we think they'll prevail if you 24 decide that. Because if you decide five years is all 25 that's needed if they had 100 percent of their payroll 26 in California, we think that that should be a reason to 27 -- for them to prevail. 28 Second is the stock options are included. We 6 1 discovered in the S-1 filing that we uncovered back in 2 late May or whatever of 2008 and discussed with the 3 business auditor briefly, we -- we thought that it 4 wasn't relevant back then because of what we heard or 5 understood. But we later looked at it and found out 6 that stock options are part of payroll expense and that 7 that was brought up in -- by Mark Muntean in his case of 8 Garnett Morgan that he prepared a summary for that gave 9 us that extra research we needed to know that that was 10 something else to look at. So, if stock options are 11 included, they should prevail on all things because 12 there is a lot of stock options that were given to the 13 top management that was located within California. 14 The third is the Respondent relies upon 15 Treasury Regulation 1.1394-0 or -1, that has as 16 paragraph L that defines "substantially all" to mean at 17 85 percent. That regulation became effective after my 18 parents bought the first two stock certificates. And, 19 so, in applying that as a standard, you're going 20 backwards in time where you're retroactively applying 21 that regulation as the definition for substantially all. 22 But within the regulation -- and it says -- 23 it -- the regulation says to be applied in whole and not 24 in part -- but within that regulation they allowed -- 25 considering -- this is for when it's required that 26 the -- that the entity meet the requirement every year 27 on a yearly basis, they allow a percentage of period 28 averaging. 7 1 And, so, that kind of allowing -- figuring -- 2 well, logistically, if you really meet that or not 3 instead of just being arbitrarily cut off -- let's say 4 you had 78 percent for one year, and 81, for the other, 5 they'll say, "Well, do you meet it in general?" 6 They allow a percentage of -- average 7 percentage basis. So, you could just take the 8 percentages for each of the years that you see that the 9 FTB calculated and do an average of it and you'll get 10 between 82 and 84 percent for payroll for the whole 11 period of time. 12 So, based on the Treasury regulation, the 13 Appellants -- my parents -- would -- should prevail on 14 all -- all their stock on that one. 15 The third point -- or fourth point, I guess, is 16 in the law the active business requirement is allowed to 17 be met by the issuing corporation of the stock meeting 18 the active business requirements of Subdivision (e) for 19 any period of time as long as that period of time adds 20 up, if you will, to more than substantially all of the 21 taxpayer's holding period, whether you define it as five 22 years or eight, nine or more years as -- as the 23 Respondent defines it. 24 In either of those cases, at the very least, 25 stock certificates 1 and 2 would two qualify because 26 they're well over 90 percent within California during 27 that particular period of time. And the third stock 28 certificate is right next to it, it's about 79 percent. 8 1 So, we would need a lower definition of "substantially 2 all" under that basis. But the first two should 3 qualify. 4 And then we get to the last one would be the 5 Respondent's way of testing where they -- they want to 6 use disqualifying years and make the requirement to be 7 met, basically, for substantially all of all of the 8 years the stock was held during. 9 When they make that test, they're cumulatively 10 adding the years instead of stock that's been held for 11 8.67 years, you're saying the stock needs to meet the 12 requirements for a ten-year period, instead of 7.68, 13 they need to meet the requirement for a nine-year period 14 and instead of meeting the requirements for a 4.69 15 year -- which is the entire time the stock was held -- 16 they need to meet it for six years. 17 We think that they're actually extending and 18 making it harder to meet standards by doing that. And 19 if you more closely match the period rather than 20 arbitrarily beginning on January 1, that they instead 21 match it when the stock was acquired -- and all three of 22 the stocks were acquired in July, why not say July 1, 23 or, better yet, use the actual acquisition date and go 24 from there for one year periods going forward? 25 If you do that, the stock certificate No. 1 26 goes over 80 percent of the period, as long as you cut 27 it off on the date it was sold. If you don't, it's 28 still in the 78 percent range on a percentage of periods 9 1 basis. 2 Stock certificate No. 2 is about 78 percent if 3 you cut it off -- I mean, if you make sure it has to be 4 -- each period is counted completely, then it would be 5 75 percent. 6 And stock certificate No. 3 kind of trails in 7 the 60 percent -- 65 or what -- it's lower, it wouldn't 8 meet any definition of the substantially all that I've 9 heard here on that basis. 10 So, that's basically a summary to go into the 11 law in this. I just thought I would bring it and I 12 don't know how we are on time, so, I thought -- how many 13 more minutes do I have on my first 15? 14 MS. RICHMOND: You still have eight minutes. 15 MR. LENARTZ: Okay. All right, in regards to 16 this case, the Respondent has taken a few positions that 17 are not substantially justified. And they haven't 18 supported these positions with any legislative intent, 19 authority or any persuasive evidence. They simply said 20 it and because of their public trust, we're supposed to 21 believe that that makes it so and so, that's where we 22 want to go to what the law actually says. And I'm 23 hoping that maybe -- whatever the legal term is -- pro 24 novo (verbatim) or whatever, you know, looking again or 25 fresh and see what's the law really say as far as how -- 26 how a taxpayer will qualify under these -- under these 27 statutes. 28 So, in looking at the legislative intent and 10 1 just another summary form, legislative intent that -- I 2 have also -- I'll just say it here and we can look at it 3 later -- but in the Governor's chapter bill file for 4 enrolled bills SB 671 by Alquist, it measures -- it 5 says, 6 "The small business stock capital gains 7 provision of this measure is structured to 8 reward toward patient capital." 9 We believe that the Franchise Tax Board's 10 interpretation of extending the period of time and then 11 subjecting the taxpayers to a percentage of periods 12 testing goes right against that intent because the 13 taxpayers are being, if you want to call it, 14 disincentivized for -- they're being penalized for 15 holding the stock longer that what is required. 16 Second is that SB 671 generally permits a 17 qualified taxpayer who holds qualified small business 18 stock for more than five years to exclude 50 percent of 19 any gain on the sale or exchange of the stock. It 20 doesn't specify that stock has to be qualified small 21 business stock on the date it's sold. It needs to be 22 held as qualified small business stock for that 23 five-year period. 24 And then third -- in the same legislative 25 intent thing, in a related area of that, assets, it 26 says, 27 "Stock that otherwise constitutes qualified 28 small business stock would not lose that 11 1 characterization solely as a result of a 2 subsequent event." 3 And, so, we're thinking that if you go beyond 4 the five years, running into a subsequent event to what 5 they need to qualify. 6 That's the introduction. I've already used up 7 most of my time. So, I'll go into the law briefly, if 8 you -- I don't know if you have the table of exhibits 9 that I got you? 10 MR. HORTON: Yes, we do. 11 MR. LENARTZ: On page 1 it cites the most 12 applicable law to our case. Most of the dollar value of 13 the tax incentives at issue were granted under the gain 14 exclusions provisions of Section 18152.5. 15 But in that same section there's a Section 16 18151 that basically says that unless otherwise provided 17 in 181 -- in the Qualified Small Business Stock law, 18 Internal Revenue Code relating to capital gains and 19 losses, those are rules or whatever, the way that it's 20 done, shall apply. 21 So, unless it's provided within it, like for 22 measuring how long a taxpayer's holding period is, it's 23 supposed to follow those rules for capital gains. And 24 the taxpayer's holding period for capital gains 25 purposes, they use the term "for more than," like for 26 more than one year, for more than five years or for more 27 than six months. And that is -- has a cut-off time. As 28 soon as the tax is -- the stock is held for more than 12 1 one year. 2 And when they -- they give it in -- they 3 examine it and they say if it's -- let's say you have a 4 stock. You bought it on February 6th of 2010 and sold 5 it on February 6th of 2011, they would say that's not 6 held for more than one year, even though it goes into 7 two different years, it's only held for one year. And 8 to be more than one year, you have to sell it one day 9 later, on February 8th or whatever, of the following 10 year. That's how it's measured. It's a -- it's a 11 timeline measurement. 12 The way the Franchise Tax Board measures time 13 is if that, say, as an example you bought stock at noon 14 on December 30th of 2010 and sold it at noon on January 15 1st, if you use the same way -- this ten-year method it 16 would be -- the Franchise Tax Board, as far as we 17 understand, would say this holding period was two years, 18 not two days and it had to meet the requirements during 19 substantially all of those two years. 20 So, we believe that that's an arbitrary measure 21 that the Respondent is applying to how they're measuring 22 time and how they're applying numbers in this. And, so, 23 the -- what we would say is we're using what's called -- 24 what we would call a cumulative yearly testing basis 25 where they're adding 16 months in to the testing period, 26 if that testing period was supposed be the entire 27 taxpayer's holding period. 28 However, we disagree because the clear wording 13 1 is "substantially all of the taxpayer's holding period 2 is supposed to be the testing period." The relevant 3 period is whether or not the active business 4 requirements are met during "substantially all of." The 5 key word is "of," it's not just "substantially", it's -- 6 I mean, it's -- the language comes into the part because 7 it's a part of all. And, so, I tried to explain that. 8 So, if you can, I have an exhibit that 9 immediately follows that I'm going to skip for the time 10 being, Exhibit 3, where we address Respondent 11 unsupported assertions, and point to various law where 12 it's not really good. 13 And just as a visual thing, you know, basically 14 just shows, you know, it's part of it and it shows six 15 months before is not part of it, nine months after is 16 not part of it. And, so, I think we've -- we're trying 17 to demonstrate there there is error in how the Franchise 18 Tax Board is calculating a holding period. And I'm only 19 bringing it up because it's our duty. It's our burden 20 to demonstrate error if we want to prevail. 21 And in going back into the -- what is 22 substantially all the taxpayers' holding period, we 23 break it down and try to -- and in Exhibit 10, try to 24 just show what that means and with pictures. So, 25 it's -- it doesn't waste your time and you can kind of 26 see what we're trying to communicate. And it eventually 27 breaks down to how we held it for a percentage of that 28 time and how we calculated that. 14 1 On Exhibit 11 is where we show how we would 2 need it -- things on a comparative basis of percentage 3 of one period versus percentage of periods that the 4 Franchise Tax Board tests. And we show that for stock 5 certificate No. 1 we would need it for 80.8 percent of 6 the time if it's cut off at March 31st. And it would be 7 77.8 percent if it's cut off -- in the -- in the ten 8 individual requirement periods. And that's Exhibit 11. 9 Contrasted with above, the percentage of the 10 length of the taxpayers' holding period, the payroll 11 percentage met is over 80 percent. It's met over 91.6 12 percent, a period that's at least 91.6 percent of the 13 entire period the taxpayers hold the stock for stock 14 certificate No. 1. We think that's clearly over any 15 definition of "substantially all" that's being presented 16 here. 17 Stock certificate No. 2, we give as an example, 18 where the stock options are included and we try to show 19 that once stock options are included, that the 85 20 percent threshold that the Respondent issued -- raises 21 is met for stock certificate No. 2. And because stock 22 certificate No. 1 has even better things than stock 23 certificate No. 2 that stock certificate 1 would also 24 qualify, if stock options are included. 25 In Exhibit -- let's see -- let's see here, how 26 much time, do I have? About two minutes left or so? 27 MS. RICHMOND: You have 47 seconds 28 MR. LENARTZ: Okay. Well, then, I'll reserve 15 1 my final 43 seconds or whatever. 2 MR. HORTON: Sir, if you like, it's your 3 decision, but you can go ahead and use those. We will 4 return to you on rebuttal and there may very well be 5 questions that will allow you to elaborate further. 6 It's your decision. 7 MR. LENARTZ: I'll stop now. 8 MR. HORTON: Thank you very much. 9 We'll now go to the Department. The Department 10 will have 15 minutes as well, if necessary, to make 11 their presentation. 12 MS. HODGES: Good morning, Chairman Horton and 13 Members of the Board. My name is Ann Hodges and I'm 14 representing the Franchise Tax Board. 15 To my right is Ting Lee, a member of our Audit 16 Division's Technical Resource Section, also representing 17 the Franchise Tax Board. 18 As you have previously heard, the issue in this 19 case involves the qualified small business stock 20 statutes, which I'll refer to as QSBS. The California 21 QSBS statutes were enacted to encourage investments in 22 California businesses. In exchange, the taxpayer may be 23 entitled to two separate tax incentives. The first 24 incentive is a 50 percent exclusion from gain from the 25 sale of qualified small business stock. The second 26 incentive is a deferral of gain from the sale of 27 qualified small business stock in amount that is roughly 28 equivalent to investment in replacement qualified small 16 1 business stock The requirement that's the central issue 2 of this appeal is as follows: 80 percent of the 3 corporation's payroll expense has to be attributable to 4 California for substantially all of the taxpayer's 5 holding period. Respondent determined that 6 "substantially all" meant 85 percent. 7 So, stated another way, the central issue is 8 whether for 85 percent of the taxpayer's holding period 9 Novacept met the requirement that 80 percent of its 10 payroll expense was attributable to California. 11 Respondent's auditor disallowed both the 12 exclusion and the deferral of gain from Appellants' sale 13 of the Novacept stock. Respondent determined that 14 Novacept met the 80 percent expense requirement for a 15 maximum of 74 percent of Appellants' holding period. 16 Furthermore, Respondent determined that 74 17 percent was not substantially all and, therefore, 18 Appellants were not entitled to the exclusion or 19 deferral. 20 Appellants have made various arguments as to 21 why the Novacept stock should be considered QSBS stock, 22 such that they are entitled to exclude and defer the 23 gain. 24 For ease of reference, I will follow the order 25 of presentation in the SBE hearing summary, skipping a 26 few that weren't mentioned. 27 Appellants have made various arguments that the 28 stock has to be tested for the payroll requirements for 17 1 something less than the taxpayer's entire holding 2 period. These arguments appear to be based on the 3 statute's minimum holding period requirements. 4 For example, for purposes of the exclusion, the 5 statute states that taxpayers must hold the stock for a 6 minimum of five years. However, separate and apart from 7 the minimum holding period requirement, the statute also 8 requires that the payroll expense been tested for the 9 taxpayers' entire holding period. Specifically, the 10 statute states that, quote, 11 "Stock in a corporation shall not be 12 treated as qualified small business stock 13 unless during substantially all of the 14 taxpayer's holding period for the stock," 15 unquote, the corporation meets the payroll 16 expense. 17 Secondly, the QSBS provisions do not define 18 substantially all. Respondent based its determination 19 that substantially all means 85 percent on the 20 following: Respondent reviewed the Internal Revenue 21 Code and the Revenue and Taxation Code sections which 22 used the term "substantially all." For approximately 23 two-thirds of the sections which actually define the 24 term, substantially all was defined as 85 percent or 25 more. 26 In addition, if substantially all is defined as 27 80 percent or less, it is theoretically possible that 28 over a five-year holding period for stock that a 18 1 corporation could have zero payroll in California for 2 one of those years and still meet the 80 percent test. 3 Third, with regard to stock options, in general 4 a company is required to recognize a payroll expense and 5 an employee is required to recognize compensation income 6 when an employee exercises a stock option to purchase 7 company stock. In March of 2004 Novacept was acquired 8 by another corporation. 9 Appellants argue that at the time of the merger 10 there were millions of dollars of stock options awarded 11 to California employees, which had yet to have been 12 exercised. Appellants argue that the merger resulted in 13 these options being exercised and, as a result, there 14 were millions of dollars of payroll expense, which were 15 not included in Novacept's last tax return. 16 However, I'd like to first point out that the 17 corporation that had all the information made the 18 determination that, apparently, these millions of 19 dollars of stock options should not be included on its 20 return. And, secondly, the merger agreement 21 specifically stated that these options were converted to 22 a right to receive payment from the entity acquiring 23 Novacept. Therefore, because it was the acquirer, and 24 not Novacept, who actually paid the expense, it can not 25 be considered a payroll expense of Novacept, which is 26 consistent with the way the return was filed. 27 Fourth, Appellants have proposed a number of 28 different methods for calculating the payroll 19 1 requirement. Respondent notes that the statute provides 2 that the interval for testing payroll is, quote, "any 3 period," unquote. As a result, Respondent has tested 4 the requirement on an annual, quarterly and monthly 5 basis. I would like to note that by testing on the 6 quarterly and monthly basis, Respondent has achieved the 7 precision that Mr. Lenartz was hoping for in that we can 8 get close to when the holding period started by using 9 months and quarters. In addition -- when it starts and 10 ends. 11 In addition, Respondent tested Appellants 12 entire holding period as one period. The Novacept stock 13 did not meet the payroll requirements for any of these 14 periods. Two consistent themes in Appellants' proposals 15 are that something less than the entire holding period 16 needs to be tested in averaging. However, as I pointed 17 out previously, the statute requires that you test the 18 entire holding period. And, in fact, Respondent did do 19 an averaging when it tested payroll over the entire 20 holding period. And the stock did not meet the 21 requirements. 22 Seventh -- or, excuse me, I think I'm up to six 23 -- five? Anyway, there's been an argument that the 24 statute is unconstitutional. And I just want to note 25 that in addition to your longstanding policy of not 26 deciding constitutional issues, Respondent notes that 27 the constitutional issue, as well as substantially all, 28 are currently issues in the Cutler case which is before 20 1 the Court of Appeal. That case has been fully briefed 2 for a couple of months now. And we're anticipating an 3 oral hearing by the end of the year. Also the Franchise 4 Tax Board did prevail at the Superior Court level. 5 Finally, Appellant has made various arguments 6 about the deficiencies of the administrative process, 7 including the audit and NPAs. However, as set forth in 8 detail in my briefs, it is apparent that the auditor 9 communicated with Appellants on a consistent basis. 10 They were allowed an ample opportunity to present their 11 arguments and that Respondent's reasons for disallowing 12 the incentives were detailed and well documented. 13 MR. HORTON: Thank you very much. 14 Sir, on rebuttal. 15 MR. LENARTZ: Okay. One of the things I've 16 noticed throughout, beginning in around September of 17 2008, is the Respondent has replaced the word "during" 18 with "for" as the reason why they're applying the law 19 the way they are. 20 The key is that -- as far as we understand it, 21 says that the active business requirement stating that 22 during substantially all of -- emphasis on "of." 23 It's -- I'm using grammar. I'm not very good 24 with grammar. So, if you know grammar better, please 25 let me know. But it means there is a -- it's a part of 26 the taxpayer's holding period requires that -- means 27 requirements met during. It's kind of like in school 28 when you're -- you're allowed to have your grade 21 1 calculated based on, say, four tests instead of five, 2 you're able to drop one exam. I think it's a similar 3 principle in the terms of lengths of time. You can drop 4 off a little bit of the length of time and as long as 5 it's over 80 percent payroll for, say, 75, 80 or as high 6 as 85 percent as the Respondent reasons for a period 7 that long then -- then -- then the taxpayer should be 8 able to qualify for the tax incentive. 9 As -- and I'd like to also just point out 10 there's -- Respondent hasn't supported why they're 11 changing the word from "during" to "for," you know, why 12 they're dividing the periods into these arbitrary years 13 or quarters or months when the Tax Code says something 14 to the contrary. 15 So, Exhibit 19 I'll start with. And in Exhibit 16 19 the requirements of this subdivision are met by a 17 corporation for any period if during that period such 18 and such takes place. 19 And it basically says, if -- if the 20 requirements found in paragraph 1 -- subparagraph A and 21 B, if those are met and they still apply after 22 consideration of the payroll requirement and other 23 things that are stipulated in the language of 24 Subdivision (e), then the active business requirements 25 are met for that period. 26 So, it's -- what we're simply doing is applying 27 the line and saying, "Well, for this three-year period 28 or five-year period or seven-year period, for the 22 1 entirety of that period," the -- we're actually doing it 2 as a whole period, just like it says here, "for any 3 period." We're not breaking it into parts or whatever, 4 we're simply saying that for that whole period the 5 requirements are met during that period. And the law 6 says, really clearly, that the requirements of 7 Subdivision (e), which is this subdivision, are met by a 8 corporation for any period if during that period. 9 Then I wanted to point to Subdivision (e), 10 paragraph 9. They use the word "treated." Treated's 11 not the same thing as saying they're not met. And it's 12 just a distinction, but throughout all of this the 13 Franchise Tax Board is treating the word, if you will, 14 "treated" as if it means shall not be or as -- it means 15 the same thing as the requirement's not met or it means 16 that the requirement's not -- if the stock is not 17 qualified small business stock. I know it's a subtle 18 point, but it's very important to our case. So, I 19 thought I would just raise it. 20 Now if you turn to Exhibit 20 -- and I think 21 I'll use the bulk of my five minutes on this -- while 22 testing can be done for any period, testing need only be 23 done until the active business requirements are found to 24 be met for a qualifying period that was at least 25 substantially all of the taxpayer's holding period for 26 the stock. This is because once stock meets the 27 requirements to be acquired as qualified small business 28 stock under Section 18152.5, the stock is qualified 23 1 small business stock, plain and simple. 2 So, you're starting with it is qualified small 3 business stock and then the question is does it remain 4 so? 5 So, we would say for any period that it's not 6 specifically disqualified from being qualified small 7 business stock, it still isn't. We think that paragraph 8 2 would disqualify specific periods, but not the whole 9 thing. You wouldn't drop the baby with the bath water, 10 you'd still allow it to qualify for some periods. 11 The second part is that the stock meets the 12 active business requirement for any period the taxpayer 13 holds the stock if during substantially all of that 14 period the active business requirements of Subdivision 15 (e) are met by the issue. 16 During substantially all of the taxpayer's 17 holding period of the stock, which we -- we believe is 18 80 percent, but during that period -- once again, it's a 19 length of time entire period, we've shown that we can 20 find periods where that's met over 80 percent of the 21 time. 22 Now, the second part. Now the Respondent, in a 23 memo we just got over the weekend, Respondent tax 24 counsel misrepresents that the California personal 25 income tax law supports her assertion that there is a 26 requirement that in order to be entitled to the benefit 27 of the statutes, the stock must be tested for the 28 Appellants' entire holding period, determined -- 24 1 determined if it is qualified small business stock, not 2 if it's treated as, but if it is. 3 We believe Respondent's misrepresentation 4 contradicts, directly contradicts, both paragraph 1 and 5 2 of Subdivision (c). We don't think that supports her 6 position that it should be tested for the entire period 7 or for individual blocks of the period. It should 8 already be met for -- for one period that is at least 9 substantially all of the period. 10 Also in arguing for how a statute could be -- 11 should be construed, Respondent asserts there is a 12 well-established proposition that a statute which offers 13 an exclusion from a tax must be construed liberally in 14 favor of the taxing authority. 15 MS. RICHMOND: Time's expired. 16 MR. LENARTZ: Okay. 17 MR. HORTON: Thank you very much. 18 Discussion, Members? 19 Member Runner. 20 MR. RUNNER: Let me just kind of see if I can 21 get through some of this issue. 22 I think -- I think you're making two -- two 23 specific arguments. One is the issue as to whether or 24 not this is a test that takes place in five years plus 25 one day, that's one argument, correct? 26 MR. LENARTZ: Yes. 27 MR. RUNNER: And, therefore, you would submit 28 that if that be the test, that it's clear that, 25 1 therefore, this meets that -- that -- that -- that 2 requirement in regards to California State employment, 3 right? 4 MR. LENARTZ: Yes. 5 MR. RUNNER: The second argument you're saying 6 is if that's not the test and you go for the whole 7 holding period, you believe that there are substantially 8 issues within those at later years, such as the stock 9 options and those issues, that would still meet the 10 test? 11 MR. LENARTZ: Yes. 12 MR. RUNNER: Okay. So, you're basically going 13 down two different paths at the same time? 14 MR. LENARTZ: Maybe three or four. 15 MR. RUNNER: Well, okay. But I mean in terms 16 of the holding and whatnot -- 17 MR. LENARTZ: Yeah. 18 MR. RUNNER: -- those are the two substantially 19 different issues, right? 20 MR. LENARTZ: Well -- well, actually I would -- 21 it's like when I introduced, it would also be that even 22 if you adjust the Respondent's testing periods, instead 23 of beginning on -- 24 MR. RUNNER: Okay. The testing period was 25 in -- was part of that discussion too. Gotcha, okay. 26 let me go -- let me go to -- to Mr. Stafford 27 real quick here in regards to some of this discussion. 28 And that is, do we believe -- do we believe the statute 26 1 is clear in regards to the five year -- whether -- again 2 if it's five year plus one day or if it's the whole 3 holding period, is the statute clear? 4 MR. EPOLITE: Senator Runner, I'm going to 5 speak on Mr. Stafford's behalf, Anthony Epolite of the 6 Appeals Division. 7 In our review of the statute, the legislature 8 uses the term "five years" several times in the statute. 9 And in Subdivision (c)(2)(A) the legislature chose not 10 to use five years, but the term "taxpayer's holding 11 period." 12 And based on the rules of statutory 13 construction, we have interpreted that term to mean from 14 the day the stock is purchased until the day the stock 15 is sold is the taxpayer's holding period. 16 MR. RUNNER: Okay. So, we -- we would believe 17 that the statute is clear? 18 MR. EPOLITE: Yes. 19 MR. RUNNER: Okay. How about in regards to the 20 issue of the -- of the -- the issue of "substantially," 21 the 80 versus the 85 percent? 22 MR. EPOLITE: The statute does not provide a 23 specific term as to what that term means. 24 MR. RUNNER: So, the statute does not create 25 clarity in regards to what "substantial" is? 26 MR. EPOLITE: Correct, "substantially all." 27 MR. RUNNER: Substantially all. 28 So, that -- so, we believe at that point that 27 1 there's clarity in regards to more than five, but that 2 that it is -- or it is the whole holding period, I 3 should say? 4 MR. EPOLITE: Correct. 5 MR. RUNNER: And that -- but it is not clear in 6 regards to what "substantially all" is? 7 MR. EPOLITE: Correct. 8 MR. RUNNER: Okay. So, there's -- do you -- at 9 that point is there room for confusion on the part of 10 the taxpayer on these these kinds of issues? 11 MR. EPOLITE: Yes, absolutely. 12 MR. RUNNER: Okay. Let me ask -- back to 13 the -- to the -- to the Franchise Tax Board. 14 On the -- on the date issues, at least what I 15 just heard from -- from our Appeals folks -- again, see 16 if get this right -- that it's the day -- the time that 17 the stock is held, purchased and sold, as the period. 18 Now, do I understand that FTB interprets that 19 differently? 20 MS. HODGES: No, that is also our 21 interpretation. 22 MR. RUNNER: Okay. Let me go to the taxpayer 23 then. 24 How -- at least, if they're saying it is that 25 -- I thought I heard you say differently? 26 MR. LENARTZ: Yeah, I think that maybe 27 something is being overlooked, just based on the thing 28 that it says -- the law says, "Taxpayer's holding 28 1 period," there is a real -- there is a real reason for 2 that in the Code that it doesn't say, "five years." And 3 that's because, as we've seen in the later thing amended 4 to the the Code, they wanted to apply the six months, 5 but, most importantly, if you look under Subdivisions 6 (f) and (h), there are other periods of time the 7 taxpayer needs to hold stock that are indeterminate. In 8 other words, let's say you convert stock into other 9 stock in the same company, which is what Subdivision (f) 10 is, which I -- actually happens whenever the stock -- 11 MR. RUNNER: Again, I'm not -- are you going -- 12 are you answering my question? 13 MR. LENARTZ: Yeah, I'm trying to. 14 MR. RUNNER: Okay. Try to get there a little 15 quicker. 16 MR. LENARTZ: Okay. The thing is that it's -- 17 there is -- it refers to other periods of time than five 18 years. The Code is not specifically -- 19 MR. RUNNER: But the question was specifically 20 in regards to the holding -- 21 MR. LENARTZ: Yeah, I am -- 22 MR. RUNNER: -- period. Okay. 23 MR. LENARTZ: -- I'm referring to that. 24 You see, the taxpayer's holding period is not 25 just five years under that statute, it refers to other 26 periods of time. 27 MR. RUNNER: So, you would agree, though, that 28 they are dealing with the issue in regards to 29 1 identifying the holding period as when the stock was 2 bought? 3 MR. LENARTZ: Yeah. 4 MR. RUNNER: Regardless of how it's five years 5 or longer -- 6 MR. LENARTZ: Yes. 7 MR. RUNNER: -- when it's bought and when it's 8 sold? -- 9 MR. LENARTZ: No, I wouldn't agree with when 10 it's sold. 11 MR. RUNNER: Now tell me why -- 12 MR. LENARTZ: Because -- 13 MR. RUNNER: -- if they think they do? 14 MR. LENARTZ: -- okay, because, No. 1, that 15 their rationale is flawed. 16 You're -- you're -- you can't just say because 17 you're not using five years in that case it 18 automatically means it's the entire period. 19 The Code is -- that part of the Code is written 20 specifically for the purposes of other parts of the 21 statute. 22 The other parts of the statute are not written 23 for purposes of that particular definitional 24 requirement. And, so, let's say if you have a stock 25 that you had a rollover in in the same company that was 26 two years, the period you held it was two years. 27 MR. RUNNER: Again, maybe I'm missing something 28 here. 30 1 I -- my question is pretty specific. And, that 2 is, are they using the date that you sold -- your 3 parents sold the stock as the end of the test period or 4 are they using a different date? 5 MR. LENARTZ: The Code has different dates. 6 MR. RUNNER: What did they use in your test? 7 MR. LENARTZ: Oh, in our our test they used 8 nine months and one week beyond the date my parents sold 9 the stock. 10 MR. RUNNER: Nine months beyond when they sold 11 the stock? 12 MR. LENARTZ: Yes. 13 MR. RUNNER: Let me ask FTB, is that how -- 14 how -- why does the taxpayer believe the date that FTB 15 used was nine months and one day beyond when they sold 16 the stock? 17 MS. HODGES: Because one of the tests we used 18 was a yearly period from the Schedule R, which reports 19 payroll attributable to California for the entire year. 20 But we also tested on a quarterly period and a 21 monthly period. So, we did get the precision for the 22 first quarter or for the first three months of that last 23 year. 24 They sold it pretty much at the end of March. 25 I believe that's why he's saying when you add nine more 26 months onto the end of the year, if you use the annual 27 test, yes, you are including -- 28 MR. RUNNER: Did you use the annual test? 31 1 MS. HODGES: -- we used four different tests. 2 MR. RUNNER: And under every one of those 3 tests -- 4 MS. HODGES: Correct. 5 MR. RUNNER: -- it did not meet the 6 substantial -- your defi -- the substantial is 7 substantial, correct? 8 MS. HODGES: The highest it got was 74 9 percent. 10 MR. RUNNER: The highest they got was 74 11 percent? 12 MS. HODGES: Correct. 13 MR. RUNNER: Okay. Let me go back to the issue 14 of the -- of the phrase "substantially all." 15 MS. HODGES: Uh-huh. 16 MR. RUNNER: When did -- when did that phrase 17 "substantially all" come into play so the taxpayers had 18 guidance? 19 MS. HODGES: Well, the statute was enacted in 20 1993. 21 MR. RUNNER: Right. 22 MS. HODGES: There -- it's been referenced in 23 the Internal Revenue Code and Revenue and Taxation Code 24 more than 100 times and defined about twenty. 25 So, there was that type of guidance. 26 MR. RUNNER: When -- well, guidance to this 27 particular -- to -- so, you believe "substantially all" 28 was given clear guidance and applicable to this use of 32 1 it beyond -- before 1993? 2 MS. HODGES: No, no, I was -- after 1993 -- 3 MR. RUNNER: So -- so, "substantially all" was 4 applied after 1993? When? 5 MS. HODGES: The statute was enacted in 1993. 6 MR. RUNNER: Right. 7 MS. HODGES: So, I'm just saying that after 8 1993, at that time, in other Code sections 9 "substantially all" had been defined. 10 MR. RUNNER: Prior to 1993? 11 MS. HODGES: I'm am not certain of that, 12 but after 1993. 13 MR. RUNNER: So, here's what I'm trying to get 14 to, I'm trying to get to whether or not a -- a taxpayer 15 bought a piece of stock underneath -- under what they 16 considered then substantially all, loose definition in 17 regards to that, and then made some investment decision, 18 but at that point did not have the guidance of what 19 substantially all meant. 20 So, my question is, when they bought that stock 21 was there clear guidance in regards to what 22 "substantially all" would be interpreted as? 23 MS. HODGES: There were Code sections that 24 defined it. Whether or not it was clear for this 25 purpose -- 26 MR. RUNNER: Again, were those Code sections in 27 place in -- applicable in 1993, when they bought the 28 stock? 33 1 MS. HODGES: Yes, there were some Code sections 2 that existed at that time 3 MR. RUNNER: And where -- can you give me one 4 real quick? 5 MS. HODGES: Sure. 6 MR. RUNNER: 'Cause again what I heard the 7 taxpayer say is it wasn't, right? 8 MS. HODGES: He's referring to one that I -- 9 he's right -- that I cited to, but that was just one. 10 There are -- 11 MR. RUNNER: So, the one cited was after 1993? 12 MS. HODGES: -- it's one of 20 that I cited, 13 yes. 14 MR. RUNNER: But you believe there are some 15 that you didn't cite that are before 1993? 16 MS. HODGES: I have cited all Code sections 17 that define "substantially all" in my brief. There 18 may -- I am not certain of the date of when all of them 19 existed, although I believe that there were some at 1993 20 that define "substantially all." 21 MR. RUNNER: Okay. Can you -- well, I won't 22 ask you. I was going to ask you -- it's pretty clear 23 and appreciative, it seems to be, in my eyes, that 24 there's a lot of room for confusion in regards to a 25 taxpayer making an investment in this particular case, 26 especially if all of a sudden and somebody's got to go 27 elsewhere in other tax codes to find out the definition 28 of "substantially all." 34 1 Let me just ask you this then in -- in just the 2 last -- the last couple of questions. The -- the intent 3 language of the -- and let me -- I'll ask of the -- of 4 our -- of our Appeals folks, the intent language that 5 was cited talked about the fact that -- that the goal 6 here was to create -- to be -- what was the phrase, cap 7 -- patient? 8 MR. LENARTZ: Patient capital -- reward patient 9 capital. 10 MR. RUNNER: Patient capital reward -- I guess 11 in the -- in the issue of holding of stock, is -- is -- 12 I have never thought of, I guess, five years, you know, 13 as kind of the end of patiently holding stock. 14 So, I'm just wondering if -- I may go back to 15 Appeals. You don't believe at that point then that the 16 issue of patiently holding the stock, the issue of a 17 longterm investment, is what that would -- would refer 18 to, it seems to me, is relevant to the issue of that 19 five years? 20 MR. EPOLITE: I wouldn't believe so, no. 21 MR. RUNNER: Okay. 22 MR. EPOLITE: I mean, it's possible that a 23 stockholder could be rewarded for holding the stock for 24 15 years and still gain the benefit of the exclusion. 25 MR. RUNNER: Let me ask -- okay, let me just 26 ask and follow up on this. 27 Do you think the intent of the legislation was 28 to hold stock for the five years and then have to sell 35 1 it? Because, all of a sudden, the company that you 2 invested in started doing some things outside the area 3 and, so, the intents of the law -- you know, beyond 4 California? 5 I mean, they may still have the same number of 6 employees, may have a growing number of employees in 7 California, but now they're investing in other states 8 and other places. 9 The intent of the legislation was then you 10 better sell your stock, otherwise you're going to lose 11 this benefit? 12 MR. EPOLITE: Well, I'm not sure, Senator, I 13 want to speak on the intent, but I can say that -- 14 MR. RUNNER: The consequence, do you believe 15 that that would -- do you believe that was the intended 16 consequence? 17 MR. EPOLITE: Probably not in that the longer a 18 taxpayer holds stock, the larger his capital gain could 19 be far outweighing the tax benefit of selling it at five 20 years as well. Because if you hold it for ten years, it 21 could be twice the capital gain -- 22 MR. RUNNER: Right. 23 MR. EPOLITE: -- which would far outweigh any 24 tax savings from selling it at five years. 25 MR. RUNNER: But there is -- yeah, okay. I 26 guess it's hard to get in the heads of legislators, I 27 get that. Who wants to go there anyhow? 28 MR. EPOLITE: I don't have a comment on that. 36 1 MR. RUNNER: Who wants to go there? 2 But the idea, I guess, I'm trying to figure out 3 is why that would be the intent at that point to where 4 you'd actually have to sell the stock because now you're 5 concerned because you're going to start losing the test. 6 And, therefore, you're going to lose all the capital 7 gains that you got, when the intent is to try to get you 8 to invest in a small business in the State of 9 California. 10 Okay, that's it for now, thanks. 11 MR. HORTON: Thank you. 12 MS. STEEL: Can I get a follow-up question? 13 MR. HORTON: Member Steel. 14 MS. STEEL: Okay. Substantially all, that 80 15 -- 85 percent, that means 85 percent that you are using, 16 there is 18 times, almost 20 times, as you said, only 13 17 times they used over 85 percent of the time, but that 18 was all federal regulations that you were following. 19 So, that -- actually, the issue here in 20 California law, how many cases we have since 1993 and 21 then we are following federal regulations here? 22 MS. HODGES: First, I would like to point out 23 that I also listed -- there is three is instances in the 24 Rev. and Tax Code -- 25 MS. STEEL: Uh-huh. 26 MS. HODGES: -- where they cite to 27 substantially all, one of which is defined as 85 percent 28 or more. 37 1 MS. STEEL: They never really in the law -- 2 they never said 85 percent? 3 MS. HODGES: In the QSBS provisions, no. The 4 term is not defined, you're correct. 5 MS. STEEL: So, just the "substantially all", 6 that's all you have there? 7 MR. RUNNER: Just for -- 8 MS. STEEL: So, when -- 9 MR. RUNNER: -- what were the dates of those? 10 Could I find out what the dates of those were? 11 MR. HORTON: Member Steel? 12 MS. STEEL: Since 1993. 13 MR. RUNNER: It's after 1993. 14 MS. STEEL: Right. 15 MR. RUNNER: Okay, thank you. 16 MS. STEEL: So, the key terms here 17 "substantially all" is undefined and it's completely 18 mysterious because, you know, sometimes the number comes 19 -- it can be 85 percent, but even federal government 20 that where they had cases, they were using under 85 21 percent too? 22 MS. HODGES: You are correct. 23 MS. STEEL: So, when we are not clear in this 24 kind of uncertain environment, don't we suppose to give 25 taxpayers the benefit of the doubt? 26 So, even it's 70 percent, for us "substantially 27 all" means when you have over two-thirds, 67 percent, at 28 this point we're talking about 74 percent. So, we are 38 1 fighting for the numbers that it's not even cited on the 2 law? 3 MS. HODGES: I believe my research revealed to 4 me that "substantially all" was -- in over the majority 5 of the times -- defined as 85 percent. 6 MS. STEEL: Why not 90 percent then? It's 7 depends on, you know, we just the State bar, you know, 8 how we going to put the bar there? 9 MS. HODGES: Because the sections I looked at 10 said 85 percent or more and why we kept it at that level 11 also was the policy reason that a company could have 12 zero payroll in California over a five-year period if it 13 was 80 percent. 14 MS. STEEL: But 80 percent and 85 percent was 15 not cited on the law? 16 MS. HODGES: You're right, it wasn't. 17 MS. STEEL: And even those out of 18 cases, 18 five were not really at -- actually using for 85 19 percent? 20 MS. HODGES: You're right, two-thirds, you're 21 right. 22 MS. STEEL: Thank you. 23 MR. HORTON: Further discussion, Members? 24 Member Yee. 25 MS. YEE: I'm going to exhaust the 26 substantially all subject matter, I think. 27 But let me ask you, to the extent that the 85 28 percent citations were in either Treasury regs or 39 1 related federal small business statutes, we -- we 2 conform to the federal statutes, yes? 3 MS. HODGES: We do not specifically conform. 4 In fact, we say we're not conforming to them, but as a 5 practical matter, the language is virtually identical -- 6 MS. YEE: The same, yeah. 7 MS. HODGES: -- but for the fact that we have 8 added the California active business requirements, the 9 one that's at issue today. 10 MS. YEE: Okay. So, there is some relevance to 11 the federal? 12 MS. HODGES: Yes. In addition, the Code 13 section says -- specifically says we'll follow federal 14 regs -- 15 MS. YEE: Right. 16 MS. HODGES: -- unless there's a contrary. 17 MS. YEE: Okay. And then subsequent to 18 California's enactment of those provisions, any -- any 19 guidance at all with respect to any reference to the 85 20 percent or was that just assumed that it was picked up 21 in the federal -- federal guides? 22 MS. HODGES: Any specific guidance for QSBS 23 purposes? 24 MS. YEE: Uh-huh. 25 MS. HODGES: No. 26 MS. YEE: Okay. All right, I wanted to turn to 27 the issue of inclusion of the stock options and fringe 28 benefits in the payroll factor. 40 1 MS. HODGES: Sure. 2 MS. YEE: The Appellant, I think, had provided 3 some additional information that suggested that some 4 corrections could maybe help their case. 5 Have you had a chance to look at those? 6 MS. HODGES: I did, yes. 7 MS. YEE: Could you comment on them? 8 MS. HODGES: Sure. First, I want to reiterate 9 again that no Novacept's final return -- and Novacept 10 would have had access, of course, to all the relevant 11 information about stock options for their employees and 12 they made a determination, apparently, it should not 13 have been included in the final return. 14 Secondly, the form that was used as the basis 15 for the calculations was the form that Novacept filed 16 with the SEC in anticipation of an initial public 17 offering. 18 But that initial public offering never 19 happened. And they ultimately withdrew that form and 20 the form did indicate that the information might change. 21 So, it's not clear that that information can be relied 22 on. 23 MS. YEE: Okay. Mr. Lenartz, can you comment? 24 MR. LENARTZ: I welcome the opportunity because 25 this is a -- something -- we just got this information, 26 it's like a new matter in this case that the stock 27 options wouldn't count because of the wording on the -- 28 on the S-1 or the -- basically the front cover of the 41 1 prospectus. 2 That wording is required by the SEC when you 3 omit pricing information on the cover. And I just -- we 4 didn't have a chance to do it. 5 Turn to Exhibit 17, page 3, you'll see the very 6 cover we're referring to. You see the highlighted areas 7 in yellow? The point is is that the SEC requires that 8 very language. I put it in the text here that -- the 9 person who does it -- the legend may be in the following 10 or other clear, plain language, 11 "The information in this prospectus is not 12 complete and may be changed." 13 That's boilerplate language when you don't have 14 the pricing information. And, so, we don't think it has 15 any relevancy to whether or not the information 16 contained is accurate or not. 17 MS. YEE: So, Mr. Lenartz, I -- what was the 18 basis of these adjustments? 19 I was trying to understand this. 20 MR. LENARTZ: Which adjustments? 21 MS. YEE: So, you had -- you first had an 22 adjustment in the unreported payroll expenses, right? 23 And then -- you know, what was the source of them? 24 MR. LENARTZ: Okay. Most of it was related to 25 the stock options as a payroll expense. 26 And in Exhibit 16 we covered that a little bit. 27 You know, our non-cash stock option wage is an expense 28 of Novacept. And just to quote Warren Buffett, he 42 1 explains, 2 "Non-cash stock option wages are an expense 3 as follows: if stock options aren't a form of 4 compensation, what are they? If compensation 5 isn't an expense, what is it? And if expenses 6 shouldn't go into the calculation of earnings, 7 where in the world should they go?" 8 This is a real expense to the shareholders 9 because it was very dilutive. Instead of getting, say, 10 14 or $15 a share, they got 10 or 11 because of a large 11 volume of stock options that were executed and converted 12 by top company management. And we're talking about $40 13 million worth of stock options here. It's equal to the 14 amount of cash wages the employees received for pretty 15 much all of Novacept's existence. 16 MS. MANDEL: I think the question -- excuse me, 17 Ms. Yee, I think question was now that she's -- now that 18 we've seen the front page where you said there was no 19 pricing information -- 20 MR. LENARTZ: I'm sorry. 21 MS. MANDEL: -- you had numbers that you used 22 for, here's how much stock options there were by all 23 these different people and how much should be in the 24 payroll factor. 25 And I think Ms. Yee was trying to ask you where 26 did you get the numbers? Because we're looking at a 27 page now that has no pricing information, that's one. 28 So, where did you get the numbers from? 43 1 MR. LENARTZ: Pricing's when they were going to 2 issue their stock, you know, going public, they were 3 looking at two options. 4 MS. MANDEL: But where did you get the numbers 5 from for the numbers you gave about here's how much 6 should be in payroll for stock options? 7 MR. LENARTZ: Okay. I got them from two 8 places. One was from the 1099B my mom and dad received. 9 They -- they got a certain dollar amount. I took that 10 number they got, divided by the total number of shares 11 they had and got $10.63 per share. 12 In the S-1 they show the average execution 13 price, the price that stock subject to execution can be 14 exercised at was, you know, around 50, 60 cents. 15 You take the difference, it's about $10 per 16 share. That would be the difference between the fair 17 market value of the stock and the stock. 18 The actual options I got from the text of the 19 S-1, predominantly from company management. They had 20 full disclosure. It said that a certain executive was 21 granted a certain option on a certain date during a 22 certain year. And, so, I was able to add up all those 23 numbers. 24 And then they also had schedules like F-23 and 25 the S-1, where it actually shows the beginning at 26 December 31st, 1999, there was almost 3 million stock 27 options at that time that were outstanding. And by the 28 time of the merger, there were about 5 million 44 1 outstanding. 2 I subtracted out directors, which I didn't 3 think should be counted as employees, and focused on any 4 differences between the award of stock options -- the 5 amount of granting to the particular years that they 6 were granted. And I -- I had to make an estimate for 7 about 600,000 worth of stock options out of 4 million. 8 And in that estimate I used the actual percentages that 9 were reported on, say, the Schedule R, I took the EDD 10 divided by the IRS information, but I made that 11 percentage lower for within California than without to 12 err on the side of being conservative by subtracting the 13 executive, or other known stock option numbers out of 14 the equations. So, we would only focus on an apples to 15 apples comparison. 16 Could I make a correction? I heard an error in 17 this proceeding and I just wanted to correct it? 18 Okay. 19 MS. MANDEL: I just wanted to make sure your 20 question was -- 21 MS. YEE: No, that's exactly right. 22 And I guess now to the Franchise Tax Board, 23 what would you need to see with respect to what was 24 either included or not included? 25 MS. HODGES: Well, I guess, ideally, the final 26 year return for this corporation. It appears that this 27 was not included, so, any type of work papers or 28 anything that went into making that determination on how 45 1 that return was ultimately completed. 2 MS. YEE: Okay. 3 MR. LENARTZ: Can I make a small correction? 4 MS. YEE: Actually, could you respond to 5 Miss Hodges? Do you have any of that source 6 information? 7 MR. LENARTZ: Remember, my parents were non 8 significant shareholders, we've been lucky to get what 9 we've gotten. I mean, we didn't have access to any of 10 this information at day 1. 11 But there -- there is, I think, a correction 12 thing. I think Novacept filed their own returns after 13 Cytek (verbatim) bought them and they ceased to exist. 14 They couldn't perform any actions after March 24th as a 15 corporation because they didn't exist. 16 We believe the return was filed by Cytek and 17 then consequently Hologic bought Cytek and we asked for 18 information from legal from Hologic. They seemed like 19 they were going to agree and once they came upon this 20 thing, probably because maybe the return was cited under 21 perjury or they had liability, they were disinclined to 22 acquiesce to our requests for additional information. 23 MS. YEE: Okay. Thank you, Mr. Chairman. 24 MR. HORTON: Thank you. Member Mandel. 25 MS. MANDEL: Sure. This is Franchise Tax 26 Board, I've been through this a couple times and maybe 27 if you go over it with me again, I will retain it in my 28 head -- not on substantially all, but let's switch gears 46 1 a little bit. 2 And this goes to how to measure -- I can either 3 look at you or look at my papers, I'm going to choose to 4 look at my papers -- how to measure the time when the 5 test -- the 80 percent is passed. 6 MS. HODGES: Okay. 7 MS. MANDEL: And (e)(1), which is the 8 substantially all the holding period you've got to meet 9 the test, and if we've got the holding period from day 1 10 of ownership to date of sale; (e)(9), which is kind of 11 the inverse of the test, but I don't know, you might 12 just say, "Oh, it's a reminder that you have to meet 80 13 percent," which says you're going to flunk -- you're 14 going to flunk if for any period during which more than 15 20 percent is outside California. And there's a 16 question about how to do the counting. 17 You've done it by the standard temporal periods 18 that we all live our lives by of days and months and 19 years. I think you've also used, sort of, taxable years 20 in the sense of short periods because the first year 21 here is really kind of slightly over half a year and the 22 last year is really a quarter of a year. But even if 23 you put those in at a half and a quarter on a year to 24 year basis, you're still not much more than 74 percent. 25 MS. HODGES: Correct. 26 MS. MANDEL: But his -- his -- his major 27 argument on this point, as I understand it, is that if 28 you have an entire holding period, today I buy, today I 47 1 sell, as -- I wish I had a white board as a, you know, 2 the big circle and making a, you know, one of those 3 fabulous venn diagrams or whatever -- and then I have 4 another period with, you know, within that outer shell I 5 have some -- I keep calling it a blob, but a blob that 6 represents that it is 85 percent. 7 And for simplicity in this case, also because 8 in this case he's got many days and months and years 9 where everything's in California before they start not 10 having it in California, so, he has a single blob within 11 the larger blob that starts from the day they get the 12 stock and goes for a length of time -- oh, I did figure 13 out how to say it without saying "period" -- a length of 14 time that is 85 percent of the entire time. 15 And his argument is that that length of time is 16 a period that should be considered for purposes of this 17 (e)(9). And if they are over 80 percent for that length 18 of time that they have met the substantially all because 19 that length of time is itself 85 percent of the entire 20 length of time. 21 And I think that you have argued that that 22 interior length of time that I've defined can't be a 23 period for purposes of counting. And I need to 24 understand your response on that, if you could, please? 25 MS. HODGES: Sure. 26 MS. MANDEL: Now I will look at you again. 27 MS. HODGES: I guess the first place I'd like 28 to go back to is the C language where it specifically 48 1 says that you have to meet the requirements for 2 substantially all of the taxpayer's holding period. 3 I read that to mean you have to test the entire 4 holding period. And the substantially all language 5 giving -- providing taxpayer assistance that they don't 6 have to meet the 80 percent of the 100 percent of the 7 time, but 85 percent of the time. 8 And I'm not sure if -- if I'm understanding 9 what the characterization of Mr. Lenartz's argument is, 10 once you get to 85 percent of this holding period and 11 they've met the test, that's how you would conduct it. 12 But where does it say in here what day? Do you 13 start at the beginning of the holding period? Would you 14 start one month after? I would -- I don't think 15 there's -- if you chose that method, there's no guidance 16 on how that actually would apply. 17 MS. MANDEL: In every case? 18 MS. HODGES: Yes. And I -- but, first and 19 foremost, I believe that the (c)(1) language clearly 20 provides that you look at the entire holding period. 21 Ting, do you have anything you want to add? 22 MR. LEE: We did do the calculation always 23 starting with the annual period because that's the 24 information readily available to the auditor based on 25 the schedule out on the corporation's return. 26 However, we do -- because the Code section says 27 "any period." So, we understand the taxpayer can raise 28 quarterly, monthly or yes, we have even taxpayer asking 49 1 us to do daily. So, we do try to accommodate them to 2 get those information from EDD or IRS on the payroll 3 information. 4 So, again, I want to emphasize the Code 5 sections say "payroll." So, that's why we go -- go by 6 the payroll. We look at the payroll expenses 7 corporation claim on the return. And we look at the 8 payroll information EDD and IRS. 9 So -- and we even consider -- in this case we 10 treated the whole holding period as one period. We 11 added the payroll from day 1, the purchase of stock to 12 the last return the corporation filed, which is ended in 13 March. So, we did using that one as one payroll, one 14 period. 15 So, if we -- even if we use one period, so 16 there is no -- like we ending nine months later or 17 starting six months earlier, something like that -- even 18 we used that method, it end up with like 74 percent. 19 If we using one payroll, I want to remind you 20 is there is no substantially all because we are only 21 talking about one number. We're not talking about, 22 like, year after year, month (unintelligible). If we 23 only use -- if we only use one number, then we should 24 use 80 percent, that's it. Whether the taxpayer meet 25 the 80 percent rule or not meet the 80 percent rule. 26 MS. MANDEL: Okay. So, I guess -- I think what 27 I'm hearing is that in the (e)(9) when it says "any 28 period," that that's -- that you wouldn't -- that that 50 1 substantially all of the entire period is not -- is not 2 a single period by which to pass the measurement test 3 because you're defining it away somehow? Is that -- 4 MS. HODGES: I think you've summarized it 5 accurately. 6 MS. MANDEL: Do you understand what I'm -- 7 MR. EPOLITE: I believe so. I believe 8 Subdivision (e) is asking for you to count how many 9 periods meet the active business requirements. 10 And then you go back to (c)(2)(A) and look to 11 substantially all and is that substantially all? Those 12 periods you just counted, was that substantially all of 13 the taxpayer's holding period? 14 MS. MANDEL: Okay. Thank you, Mr. Horton. 15 MR. HORTON: Thank you. Member Runner. 16 MR. RUNNER: Just a quick question in regards 17 to going back to stock options. The stock options that 18 were identified, were they ever exercised? 19 MS. HODGES: We don't know. That we don't 20 know, that's one of the problems because the income and 21 expense are not included until they're exercised, but we 22 don't know exactly happened as a result of the merger 23 agreement other than it said -- 24 MR. RUNNER: I guess my material says that they 25 were honored during -- in the merger agreement. Is that 26 -- we don't know that? 27 MS. HODGES: All I know is what the merger 28 agreement said that it was converted to a right to 51 1 receive payment. What that -- 2 MR. RUNNER: It said the stock options were -- 3 MS. HODGES: Yes. 4 MR. RUNNER: -- converted? 5 MS. HODGES: To a right to receive payment from 6 the acquirer. 7 MR. RUNNER: Doesn't that sound like they were 8 paid? 9 MS. HODGES: It sounds like they were paid, I 10 don't -- 11 MR. RUNNER: Okay. 12 MS. HODGES: -- know if they were exercised as 13 a result of that, if you're following me. 14 MR. RUNNER: Okay, okay. So, they were 15 recognized? 16 MS. HODGES: Okay. 17 MR. RUNNER: How's that? 18 MS. HODGES: That works. 19 MR. RUNNER: So, the stock options that were 20 earned during that period were recognized? 21 MS. HODGES: Okay. 22 MR. RUNNER: The exact options may not have 23 been honored. Is that a fair -- 24 MS. HODGES: That's fair. 25 MR. RUNNER: Okay. Those -- that payroll that 26 was then honored during that merger, when were those 27 options given? Were they done during the -- during 28 the -- were they given during the holding period? 52 1 MS. HODGES: During the taxpayer's holding 2 period? 3 MR. RUNNER: Yes. 4 MS. HODGES: I think -- I don't know for sure, 5 I think Mr. Lenartz actually did a pretty good job of 6 looking at when they were granted and when they vested, 7 et cetera. 8 So, I think probably the vast majority were 9 granted. 10 MR. RUNNER: Okay. So, those were values that 11 were earned during the period to which the taxpayer held 12 the stock? 13 MS. HODGES: Some portion of it, yes. We don't 14 know the exact numbers. 15 MR. RUNNER: Okay. Did we honor any of the 16 numbers? 17 MS. HODGES: Well -- 18 MR. RUNNER: Did we give credit for any of 19 those? 'Cause again, this is all about people who earn 20 money in California, right? 21 So -- so, these were people who lived in 22 California, they earned -- they earned, you know, value 23 during that period of time while they lived in 24 California, which is what the test is. Did we -- did 25 we -- did we -- did we factor that in in regards to the 26 California employment percentages? 27 MS. HODGES: What we did do was honor what the 28 corporation's last return was filed. 53 1 MR. RUNNER: I'm just -- so, did -- it's either 2 yes or no. 3 So, did we -- did we -- did we honor those 4 options that were maybe not converted as options but at 5 least were honored during the -- during the merger? Did 6 we factor that in as income earned during the holding 7 period? 8 MS. HODGES: No. 9 MR. RUNNER: Did we -- 10 MS. HODGES: Unless -- 11 MR. RUNNER: -- do we know about how much that 12 is? 13 MS. HODGES: Mr. Lenartz has said it's about 44 14 million, but, again, we're not sure of the exact numbers 15 because the form that he based those numbers on was 16 withdrawn. 17 MR. RUNNER: Do we think it's more than -- I 18 mean, so, we think there's a number there? 19 MS. HODGES: There's a number, yes. 20 MR. RUNNER: We don't know what that number is? 21 MS. HODGES: That is correct. 22 MR. RUNNER: Okay. But we know that there's a 23 number there? 24 MS. HODGES: Yes. 25 MR. RUNNER: So, it -- again, let me go back, 26 let me ask our Appeals folks, doesn't that sound like -- 27 it seems to me that sounds like wages, value earned 28 while -- by Californians while this stockholder held the 54 1 stock? Is that reasonable? Is that -- 2 MR. STAFFORD: Well, what I would say is that 3 we're not sure what happened on the merger here. We 4 know that the -- they had options. 5 MR. RUNNER: Right. 6 MR. STAFFORD: Not sure whether those options 7 at merger were -- it appears they were canceled, no new 8 options were given. Or we're not sure if the old 9 options were actually exercised. It doesn't say. 10 MR. RUNNER: Okay. But weren't they valued? 11 MR. STAFFORD: I would say there was a value, 12 yes. 13 MR. RUNNER: So, they were valued? 14 MR. STAFFORD: Something was -- something 15 appears to have been -- 16 MR. RUNNER: So, there's some value given to, 17 again, money earned while that was being held and those 18 were wages earned California? 19 MR. STAFFORD: Well, there's value. If these 20 were non-qualified stock options, which I'm assuming 21 they were -- 22 MR. RUNNER: Uh-huh. 23 MR. STAFFORD: -- the compensation -- part 24 usually the general rule is it comes upon exercise of 25 the options. 26 So, looking at this right here from the 27 information we have, I don't know if these options were 28 exercised or not. I know that people had options. 55 1 MR. RUNNER: Right. 2 MR. STAFFORD: And I don't know on merger what 3 happened, actually, though. It appears that these 4 options were canceled and new options in the new 5 corporation may have been given. That's probably what 6 happened. 7 MR. RUNNER: Okay. But -- 8 MR. STAFFORD: And the old options were not 9 exercised. So, if they weren't exercised, I don't know 10 if I would include that. 11 MR. RUNNER: On what basis, though, would they 12 -- again, over -- so, they traded out new options for 13 old options? 14 MR. STAFFORD: Yeah. 15 MR. RUNNER: But those old options, that all of 16 a sudden now had value -- 17 MR. STAFFORD: Okay. 18 MR. RUNNER: -- were earned when? 19 MR. STAFFORD: When you're saying when they 20 were earned, I -- it's -- maybe you're talking about 21 when they were vested? There's vesting of options and 22 there's exercising. 23 If vesting -- if options are just vested, 24 usually that's not compensation for payroll. 25 MR. RUNNER: Okay, okay. 26 MR. STAFFORD: It's only upon exercise. 27 MR. RUNNER: Okay. 28 MR. STAFFORD: And we don't know when these -- 56 1 if these options were ever exercised because the -- the 2 S-1 doesn't say whether they were exercised or not. It 3 says they're probably cancelled, it looks like, and 4 maybe new options were given. But it doesn't say 5 anything about the options. 6 MR. RUNNER: Okay, okay. Let me ask the 7 taxpayer's perspective on that issue then real quick. 8 MR. LENARTZ: Thanks. What Novacept did to 9 pretty much avoid any ambiguity on this if you actually 10 look at the merger agreement, which Ann Hodges forwarded 11 to us over the weekend, or a little before, the wording 12 clear. 13 They were protecting their employees. And in 14 the event they did not exercise the options between 15 March 4th and March 20 -- March 5th and March 24th, and, 16 obviously, some did, some were incented (verbatim) to do 17 so -- then, on their behalf, there would be automatic 18 exercise and sale of the stock, if you will, as part of 19 the merger. 20 So, they would do it for them to make sure the 21 employees were not deprived of the $10 or so value per 22 share, subject to the options. I mean, the options -- I 23 mean, they didn't want any of their employees to miss 24 out. So, they made sure with the language, even if it 25 somehow didn't -- wasn't officially vested, if you look 26 at the actual plan, it said all options, practically, 27 would vest. 28 The executives have a thing on a merger that 57 1 they would all vest and be qualified to exercise. And 2 they -- they granted that for the employees. It's 3 pretty clear in reading the different things that they 4 -- if they made a decision. 5 Now, none of the options, the language is 6 really clear in the -- in the -- in the merger 7 agreement, none would go to the parent company at the 8 end of the option. They issued nothing. If -- if there 9 was anything left that would be canceled, as -- as has 10 been stated earlier, you know. 11 So, it's -- it's, you know -- I mean, this 12 company wasn't a monster, they weren't going to deprive 13 their employees. I mean, sure, it took a year -- 14 MR. RUNNER: You feel like they were trying to 15 recognize the wages earned by their employees during the 16 period of time that they worked for this company in 17 California? 18 MR. LENARTZ: They wanted to make sure that 19 those employees were rewarded for that effort they made. 20 MR. RUNNER: Okay, thank you. 21 MR. HORTON: Further discussion, Members? 22 Is there a motion? 23 MS. YEE: Move to take the matter under 24 submission. 25 MR. HORTON: Moved by Member Yee to take the 26 matter under submission. Second by Member Mandel. 27 Without objection, Members, such will be the 28 order. 58 1 Thank you very much for appearing before us 2 today. The Board will take your matter under 3 consideration later on this evening and send you a 4 written report of our decision. 5 Thank you very much. 6 MR. LENARTZ: Thank you. 7 ---o0o--- 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 59 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 JUNE 26, 2012 I recorded verbatim, in shorthand, to the 11 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 59 constitute a complete and accurate 15 transcription of the shorthand writing. 16 17 Dated: {Date} 18 19 20 ____________________________ 21 JULI PRICE JACKSON 22 Hearing Reporter 23 24 25 26 27 28 60