All of the action at
the public portion of the State Board of Equalization's October 19-21 meetings
in Culver City involved tax appeals, and in most, taxpayers did not prevail.
Some of the more interesting appeals are described below.
Phantom Federal Audit
an Issue in Income Tax Appeal; FTB Says Taxpayers Must Use Federal AGI in
Determining Limit on Charitable Contributions. Two major issues surfaced in
an income tax appeal by Haik and Alice Arakelian: the actions of Franchise Tax
Board staff about a phantom IRS audit, and the use of federal adjusted gross
income (AGI) instead of state AGI in the determination of the limits on
charitable contributions.
The taxpayers filed their 2003 return with the normal
charitable contribution deduction. According to Ara Hovanesian, an attorney who
represented the couple before the board, on April 17, 2006, they received a
notice of proposed assessment from the FTB based on an IRS audit. The FTB also
requested from the taxpayer a copy of the IRS audit.
The taxpayer responded to the notice by saying there was no
IRS audit, but nothing happened. The taxpayer went to a discussion conference
with the FTB and insisted there was no IRS audit. In protest, the FTB said the
taxpayer had not proved that there was no IRS audit. When the case came to the
Board of Equalization for the first time, the FTB brief and the BOE hearing
summary both referenced the alleged IRS audit. Finally, on July 28, 2010, the
FTB sent the taxpayer a letter admitting there was no IRS audit.
Still, the FTB contended at the hearing that the taxpayers'
charitable contribution should be disallowed, and that they owed $1,636 in
additional taxes for 2003.
The reason for the disallowance, according to FTB attorney
Maria Brosterhouse, is that the taxpayer had to use federal AGI to compute the
limit on state charitable contributions. In 2003, California suspended its net
operating loss carryover provisions, but the federal government did not. As a
result, according to the FTB, taxpayers were required to use the lower federal
AGI to compute the contribution limit, rather than the higher state AGI,
because the carryover losses were not allowed on the state return. Mr.
Hovanesian said he could not find anywhere in the FTB instructions a mention
that state charitable contributions are limited by federal AGI.
The board voted 4-1 to sustain the FTB. Voting
"aye" were BOE Chair Betty Yee, Vice Chair Jerome Horton, Board
Member Michelle Steel and Deputy State Controller Marcy Jo Mandel, representing
Controller John Chiang. Acting Board Member Barbara Alby voted "no."
(CalTax: This
decision means that the new NOL suspension in the budget trailer bill will harm
certain taxpayers with carryforward losses who will not be able to deduct their
state charitable contributions. There also may be some taxpayers who might
benefit from this interpretation, and an educational campaign should be
launched to ensure they are maximizing their charitable contribution
deductions. For example, seniors itemizing charitable contributions may be able
to increase their deductions, as their federal AGI may be higher because Social
Security benefits are not taxed by California.)
Surrogate Parent
Denied Head-of-Household Filing Status. A woman who acted as a surrogate
mother to a teenage girl was denied head-of-household filing status by a 5-0
vote (Appeal of Cecilia Raza).
The woman was the domestic partner of a man, but they were
not married. When the man was ill, she moved to separate quarters, but agreed
to parent his teenage girl. According to testimony at the hearing, she was
considered in every respect as the child's mother. She also claimed she was
saving the state thousands of dollars because the state did not have to pay for
the child's care as a "foster child." She also said the IRS did not
contest her head-of-household filing.
The Franchise Tax Board argued that for a taxpayer to be
eligible for head-of-household filing, the child must be a stepchild, adopted
child or foster child. (CalTax: The
FTB's online description of the qualification requirements can be found here.) As a
result, the woman has to pay $1,500 in additional state income tax for her
efforts.
Palm Springs Area
Indian Income Tax Status Referred to Court. In three cases that would set a
precedent for exempting all Indian tribe members living in the Palm Springs
area from paying state income tax, even if they don't live on reservation land
and are provided with state services, the board decided that the issue was a
constitutional issue that should be decided by a court. On a 4-1 vote, with Ms.
Steel in opposition, the board denied the appeals on abstention grounds (Appeals of Edmund Siva, Harold Riggs, and
Wayne and Kelly Hause).
The conflict between the tribal members and the tax agencies
arises from the fact that the reservation in question is not one contiguous
piece of land. A bit of background:
The Pacific Railway Act of 1862 was enacted to assist in the
construction of a continuous railway across America. The act, and subsequent
amendments in 1864, 1866 and 1869, granted alternating sections of land on
alternating sides of the railroad track to the railroad companies. Congress
authorized the president to set aside four tracts of public land in California
for Indian reservations in an 1864 act. One of the reservation tracts set aside
was for the Mission Indians, and subsequently its parts were set aside for the
individual bands of Mission Indians.
President Grant, in an executive order in 1876, set aside
Section 14 and parts of Section 22 of township 4 south, range 5 east, San
Bernardino for the Agua Caliente Reservation. President Hayes, in an executive
order in 1877, added all the even-numbered and unsurveyed portions of the
general area around Section 19, except Sections 16 and 36, and any tracts for
which title already had passed out of the U.S. government's control. The
executive branch retained the power to add to or diminish the four reservations
as deemed necessary.
The Agua Caliente reservation was created in a checkerboard
fashion, with the odd-numbered sections already having been granted to the
railroad by the time the reservation was established, and with the reservation
consisting of only even-numbered sections.
The appellants in the three cases did not live on the
reservation land, but lived in former railroad sections. Mr. Siva lived in
section 19 in Palm Springs, Mr. Riggs lived in Section 9 of Cathedral City, Mr.
and Mrs. Hause lived in Section 15 of Cathedral City.
Keith Shibou, representing the appellants, said the income
tax exemption for Indians applied to "Indian land," which he argued
was broader than reservation land. He argued that a court decision (Seymour v. Superintendent of Washington
State Penitentiary) discouraged checkerboard jurisdiction and asserted that
lands within the exterior boundary of an area are Indian lands.
The Franchise Tax Board argued that the appellants'
reservation-sourced income is taxable in California because they were
California residents and did not live in Indian country. The department also
contended that the appellants' interpretation of Indian country under section
1151(a) would convert non-reservation lands into reservation land, and said
that only Congress and the president have the power to create or enlarge
reservation land. The FTB also noted that Section 19 was never set aside as
Indian reservation land, and contended that the U.S. Supreme Court has stated
that an Indian reservation does not have to be contiguous, and, therefore, it
is an untenable notion that the law forces all reservations into contiguous
reservations.
The FTB contends that to follow appellants' approach would
be to assert that all of the land and residents of the odd-numbered sections
would be within the limits of power or jurisdiction of the tribe, and subject
to its control merely by virtue of the fact they are surrounded by reservation
land.
Board Holds That Spa
Purchased for Neck Injury Wasn't a "Medical Necessity" for Income Tax
Deduction. Debra J. Lee was severely injured in an auto accident in late
2002, when her vehicle was rear-ended by a truck. A physician prescribed a
therapeutic spa as an indispensable and effective treatment for her neck
injury.
In 2004, she underwent surgery (a disectomy and fusion in
her cervical spine) that involved removing a central portion of intervertebrate
disc and fusing the portion back together to increase mobility and alleviate
pain. After the surgery, she suffered chronic neck pain and debilitating
migraine headaches.
Ms. Lee built a home spa in 2005, based on a physician's
prescription, to alleviate the pain, and deducted 40 percent of the cost of the
spa as a medical expense.
Raul Escatel, representing the Franchise Tax Board, said the
board denied the deduction because the spa was not a "medical
necessity." He said the deduction must be narrowly construed. On a 5-0
vote, the board upheld the action denying the deduction of a portion of the
spa's cost, agreeing with the FTB – and disagreeing with the licensed medical
doctor who had treated Ms. Lee – that the spa was not a "medical
necessity." (Appeal of Donald R. and
Debra J. Lee.)
Sales Tax on Tips
Issue Surfaces Again. Joseph Barbara, owner of the small chain of Finbars
Italian Kitchen restaurants in Orange County, protested a board audit
concluding that he owes $5,742 in unpaid sales tax and interest on tips he said
were not mandatory. "All tips are voluntary," he said, adding that a
person hosting a large party often will ask in advance to place a tip on the
bill so that it can be claimed as an expense reimbursement.
Board staff said the restaurant menu said "an 18
percent gratuity will be added to parties of eight of more," which made
the gratuity mandatory and thus subject to tax. Mr. Barbara said he never
enforced this statement. (CalTax: A menu currently
posted on the chain's website does not mention a gratuity policy, but does
warn: "We reserve the right to refuse service to anyone not having
fun!")
Board staff also said that Mr. Barbara had no documentary
evidence that guests asked in advance for a tip to be added to the bill. The
board voted 4-1, with Ms. Steel opposed, to deny the appeal (Appeal of Finbars Italian Kitchen, SB,
Inc.).
Mark-Up Audit Blasted
by Taxpayer; Re-Audit Ordered. A "mark-up" audit conducted by
board staff showing that the Los Angeles Country Club owed an additional
$102,000-plus, including interest, was blasted by a club representative as
being totally erroneous. After hearing comments from Gail Egan, representing
the club, and from the BOE staff, the board decided to send the case back for a
re-audit.
Ms. Egan said board staff, pursuant to the BOE's audit
manual, should have used the direct audit approach rather than the
"mark-up" method. She said the club has a very sophisticated system
for recording every sale and billing members, and said the amount of sales tax
remitted to the state was correct. She also showed that the club's books
reconciled to their IRS filing. "We can prove every single sale," she
said.
Board staffers did not say why they decided to use a mark-up
method in the first place. They based their case on the fact that the mark-up
between purchase invoices and prices on the Bar Fact Sheet was 271.89 percent,
while the taxpayer's mark-up was 114.67 percent.
Ms. Egan said the board marked up alcohol, but not other
items sold at the bar. She also said her establishment's wine mark-up is low
because the club is not a business. Another factor could be the size of the
drink pour, which the mark-up method may not capture.
Cal-TaxReports, October 22, 2010
© 2010 California Taxpayers' Association. All Rights
Reserved.