“If Proposition 41 or 42 on this same ballot receive more “yes” votes than Proposition 40, then Proposition 40 could be stopped from becoming law even if it gets yes votes from a majority of voters. That is because the courts could find that Proposition 41 or 42 conflict with Proposition 40”— Proposition 40 ballot statement by the California Legislative Analyst.
My previous article on the “Billionaire Tax” addressed the facts that i) the California legislature can amend the tax without going back to the voters for approval, ii) a legislative amendment can change the “billionaire” tax threshold to a far lower number, and iii) that amendment can also make the supposed “one time” wealth tax apply more than one time. The article also pointed out the lack of consistency and logic in many of Proposition 40’s provisions.
Even ignoring conflicting ballot propositions, Proposition 40 itself will be a litigation magnet. Commentators have suggested many constitutional challenges to Proposition 40, including arguments based on the Due Process Clause, the Dormant Commerce Clause, nexus, and apportionment challenges. Although Proposition 40 includes provisions for expedited judicial review, expedited review would not apply to federal court challenges.
Now we can add some more internal inconsistency to the mix. To illustrate, let’s assume the example of a billionaire and his wife who own interests in investment real estate through a number of privately held partnerships and LLCs. How would those interests be valued for purposes of the Billionaire Tax?
Proposed new Revenue and Taxation Code Section 50303(a) (“RTC”, meaning proposed additions which would become law if Proposition 40 passes) seems helpful. It says: “Unless otherwise specified by the Board, and except as otherwise specified in this Section, the fair market value of each asset owned by a taxpayer is the price at which the asset would change hands between a willing buyer and a willing seller, neither being under compulsion to buy or to sell, and both having reasonable knowledge of relevant facts”. This is the standard value definition incorporated in federal estate and gift tax law and industry standard for appraisals
RTC Section 50303 (b) then goes on to prohibit valuation discounts (such as discounts for lack of marketability or minority interests) that are allowed in federal estate and gift tax valuations. In my example, this seems less of an issue—our billionaires own 100% of the business entities and the real estate they own. So let’s ignore the unfairness of disallowing discounts to someone who owns only 1% of an entity and has no ability to control their right to receive distributions from what they own.
RTC Section 50303 (c) (3) (E) then throws our billionaires another zinger by presuming the value of their business entities “to be the sum of the book value of the business entity according to generally accepted accounting principles” (GAAP) “as of the end of the tax year plus a present value multiplier of 7.5 times the annual book profits of the business entity—as averaged over the current tax year and the preceding two tax years, if available”…all according to GAAP.
Clearly the lawyers and economists who drafted Proposition 40 don’t understand that GAAP is not a precise definition of either value or income. For one thing, GAAP incorporates all kinds of estimates and assumptions. Give 5 different auditing firms the same set of facts, and they can come up with 5 different sets of GAAP figures.
Even worse, these Proposition 40 rules incorporate one of the many anti-taxpayer biases in Proposition 40. In the marketplace, a “willing buyer” who knows a business lost significant sums of money in previous years will pay less money for that business even if the last year was profitable. But RTC Section 50303 (c) (3) (E) ignores losses: “if the average book profits over the relevant period are less than zero, they shall be treated as zero”.
Which raises another question—what if our billionaires don’t have audited financial statements? RTC Section 50303 (c) (3) (E) says the FTB “may permit a taxpayer to compute book value and book profits using an accounting method other than generally accepted accounting principles if the business to be valued consistently maintains its books and records and reports income and expenses using such other method”. Unfortunately, the word “may” injects unwelcome certainty into the valuation. And sometimes even substantial privately held businesses don’t use GAAP accounting.
The typical method for valuing a business entity owning real estate is to take the appraised current market value of each parcel and subtract the debt. Very simple. But RTC Section 50303 (c) (3) (E) instead presumes that GAAP is more accurate, a very shaky premise for investment real estate. And even more uncertainty—RTC Section 50303 (c) (3) (F) allows either the taxpayer OR the Board to demonstrate, with clear and convincing evidence, that the GAAP valuations incorporated in RTC Section 50303 (c) (3) (E) understate or overstate the business entity’s value. Only then will a certified appraisal be allowed.
Real estate is an essential industry in California, and many high net worth taxpayers hold extensive interests in real estate through business entities to protect themselves from liability. The logic behind using GAAP concepts to value such interests creates unnecessary complexity and opportunities for disputes, especially for a supposed “one time” tax.
The final article on the Billionaire’s tax will discuss even more of the anti-taxpayer valuation rules incorporated in Proposition 40.
