California Continues to Challenge Economic Substance and Business Purpose

In Matter of Gatewood Corp, OTA Case No. 19105425 (July 3, 2024), the California Office of Tax Appeals (“OTA”) concluded that Gatewood Corporation’s (“Gatewood”) transfer of stock did not entitle it to a $10 million deduction because the transaction lacked economic substance and was for the purpose of tax avoidance, resulting in $831,398 additional tax.  The California Franchise Tax Board (“FTB”) conceded a $332,559 non-economic substance transaction (“NEST”) penalty that it had originally imposed.

In 2001, James Previti (“Mr. Previti”) wrote a $10 million promissory note to Forecast Construction Inc. (“Forecast Construction”), whose stock he wholly owned, and subsequently transferred his Forecast Construction shares to Gatewood (which Mr. Preveti indirectly owned through a family trust).  Forecast Construction subsequently contributed the $10 million promissory note to Forecast Group LP (“Forecast Group”) in exchange for an interest in the partnership.  Finally, Gatewood assigned the stock in Forecast Construction to a qualified settlement fund (“QSF”) that was previously established by Mr. Preveti to deal with present and future liability claims related to his construction businesses.  Gatewood then claimed a $10 million deduction as a qualified payment to a QSF under IRC section 468B on its California corporate income tax return.  The FTB rejected the deduction, asserting that the transaction had no economic substance other than tax avoidance, and imposing $831,398 in additional tax plus a NEST penalty of $332,559, plus applicable interest.

The OTA provided that for a deduction to be allowed pursuant to a stock transfer, the transaction must have (1) a subjective nontax business purpose that is sufficient to justify the form of the transaction, and (2) objective economic substance beyond tax avoidance.  Gatewood argued that the stock transfer’s business purpose was to help pay for expected settlements in current and future litigation.  Gatewood claimed that without the transfer in stock (or by making an equivalent transfer in cash), the purchase value of Forecast Group (which was to be sold) would have been reduced.  Gatewood also noted that if the transfer had been in cash, the same tax result would have been achieved.  The OTA rejected Gatewood’s business purpose explanation, noting that: (1) there was no evidence of any claims or potential claims at the time the transfer was made, and (2) there were insufficient facts presented (e.g., planning documents, correspondence, etc.) that supported the purported objectives of the transaction.  Next, the OTA determined that the transaction lacked economic substance because the transaction objectively did not produce any economic benefits aside from a tax benefit.  Specifically, the OTA noted that the stock transfer provided no practical benefits that were not already present when Gatewood held the stock itself.  The OTA summed up the ruling by saying: “[t]here is no indication that the obligations or rights of any independent third parties were materially affected by the reported transfer, and potential claimants were not bound by or even aware of the transfer.  In short, the reported transfer reflected nothing more than ‘drawing up papers’ to obtain a tax benefit, rather than any business reality.”

The case reflects the close scrutiny with which the FTB looks at intercompany transactions and highlights the importance of maintaining internal documentation that evidences the purpose of a given transaction.

Contact the Authors: Trevor Mauck, Kent Strader and David Simon-Fajardo