Wednesday, September 18, 2013

State Tax Absurdities: California's Time Travel Laugh-In

I do enjoy following tax developments out of California, as they are so … so…. How to be diplomatic? Think Rowan & Martin Laugh-In reruns – entertaining, but in a time-travel sense. Hearing “groovy” seems a bit imbecilic after all these years, and surely, McGovern is not still running for President, is he? Why then does California continue to give the same answer to every problem - “tax them more?”

Here are a couple of tax grenades that California has thrown out there recently:

1. There is an Iowa corporation (Swart) that owns farms in Kansas and Nebraska. It also has a few investments, one of which is a 0.02% interest in a California LLC (“Cypress”) that bought and sold capital equipment across several states.  Mind you, Swart did not exercise any management or control over its investment. This would be the equivalent of you investing in a California REIT (a REIT is an investment that owns real estate, such as apartment buildings). The California Franchise Tax Board nonetheless contacted Swart and told them that their investment in Cypress was “enough” to require them to file a California LLC tax return.
So what, you are thinking. Here is what: California imposes a minimum $800 annual fee on an LLC tax return.
Think about the numbers for a moment. Let’s say that Cypress made a tidy profit. We need a number. How about $4 million? Swart’s 0.02% share would be $800, which coincidentally is the same as California’s minimum fee. Not to mention the fee for an accountant to wade through this.
Swart filed suit on July 9, 2013, so we do not yet know the outcome.
California’s interest is obvious, duplicitous and mercenary: it wants money. Your money, if you stand on that street corner long enough. Cypress alone has 384 other members who are California nonresidents. 
It is also self-defeating. Tax Analysts summarized it well:
While states are always on the lookout for each and every dollar of tax revenue, taxing investments in California serves as a big disincentive for out-of-state companies to invest in the state.”
2. Do you know what a Section 1031 exchange is? This is where you exchange one property for another, and the government gets no taxes. More accurately, the tax effect is “deferred.” An easy example would be swapping one office building for another.
Don’t get me wrong here: a 1031 has all kinds of rules and sub-rules which, if you get them wrong, will transmute your tax-deferred exchange into a fully taxable event. I wanted only to introduce the concept.
Let’s say that you own an office building in Burbank. You swap it for another in San Antonio, Texas. The IRS doesn’t care that you moved states. California does care, though. The Laugh-In time travelers in Sacramento have passed a new tax law. Beginning in 2014, you will have to file an annual report if you exchange California property for non-California property in a Section 1031 exchange. The forms do not exist yet, but they will … and soon. You will have to acknowledge that you still own the replacement property. If you do not, California will assess you a tax.
Think about that for a moment. Let’s say that Steve Hamilton, a tax CPA in the Napa Valley swaps California for Florida real estate. Years go by, and as part of his estate planning, and preparatory to retiring to Ireland, he places the Florida real estate in a family limited partnership.  Is California REALLY going to send him a tax bill? And why would he pay it? What are they going to do: stop him at the airport?
In graduate school (many years ago), we discussed an efficient tax system as having the least drag on economic decision-making and the fewest reductio ad absurdum conclusions.  Sacramento needs to get back to the future with its tax policy, as they are stuck in a time warp.


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