BOARD OF EQUALIZATION STATE OF CALIFORNIA ) ) ) ) ) ) ) )

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1 STATE BOARD OF EQUALIZATION In the Matter of the Appeal of: PEDRO V. DATING AND SIMONA V. DATING Representing the Parties: For Appellants: For Franchise Tax Board: Counsel for the Board of Equalization: BOARD OF EQUALIZATION STATE OF CALIFORNIA SUMMARY DECISION Case No. Adopted: October, Glen P. Hubahib, Esq. Andrew Loveland, Tax Counsel III Sergio Avila, Tax Counsel This appeal is made pursuant to section 0 of the Revenue and Taxation Code (R&TC from the action of respondent Franchise Tax Board (FTB or respondent on appellants protest against a proposed assessment of tax in the amount of $,.00 and an accuracy-related penalty of $,. for 0. The issue presented in this appeal is whether appellants have shown error in the FTB s proposed assessment, which is based on federal changes provided by the Internal Revenue Service (IRS. FINDINGS AND DISCUSSION Background Appellants filed a timely joint California tax return for 0. On this return, appellants reported a California adjusted gross income (AGI of $,, less itemized deductions of $,, resulting in a taxable income of $, and a tax liability, after the application of exemption credits, of $. After applying withholding credits of $, appellants reported a refund due of $, which - -

2 the FTB refunded. Subsequently, the FTB received audit information showing that, for 0, the IRS adjusted appellants return. These adjustments included the disallowance of various Schedule A and Schedule C deductions and the inclusion of various income amounts. As a result, the IRS assessed an additional tax of $, and an accuracy-related penalty of $,. Based on this information, the FTB issued a Notice of Proposed Assessment (NPA on October 0,. To the extent applicable under state law, the FTB conformed to the federal adjustments and increased appellants taxable income by $,, from $, to $0,. Accordingly, the NPA proposed an additional tax in the amount of $,.00, plus interest, and an accuracy-related penalty of $,.. Appellants protested the NPA, asserting that the assessment was erroneous because they were charged with theoretical income by virtue of the loan forgiveness they received from the short sale of their house. In addition, appellants asserted that the IRS stopped and closed the collection of the assessed tax on the loan forgiveness because of their financial hardship. In response, the FTB sent appellants a reply letter explaining that the NPA amount due was based upon information received from the IRS. Moreover, the FTB stated that it was not clear from appellants letter which adjustments they were disputing on the NPA. As a result, the FTB requested that appellants explain which adjustments they believed were incorrect and why they believed the adjustments were incorrect. Appellants replied to the FTB s letter and reiterated that the said assessment [was] erroneous since the IRS [had] also stopped and closed the collection of the assessed tax on the loan forgiveness theoretical income because of [their] financial hardship. Thereafter, the FTB sent appellants a second letter, whereupon the FTB acknowledged The $, in adjustments included the following: ( a $ increase in the one-half self-employment tax deduction; ( a $, increase in Schedule C adjustments; ( a $, increase in Schedule D long-term capital gains; ( a $, increase in pensions and annuities; ( a $, increase in other income; ( a $,0 disallowance of Schedule A real estate taxes; ( a $,0 disallowance of Schedule A other expenses; and ( a $ itemized deductions limitation. It appears that appellants are referring to a letter from the IRS (dated August, entitled Case Closed Currently not Collectible. A copy of this letter is attached to appellants appeal letter. - -

3 that it had received appellants IRS documentation which stated that the IRS would stop collection action for the 0 tax year. However, the FTB explained that the IRS letter stated that appellants still owed the money to the IRS even though they temporarily closed their collection case. Moreover, the FTB stated that recently-obtained IRS information indicated that the IRS had not reduced or cancelled the adjustments to appellants return, nor did it indicate that the IRS was in the process of reconsidering the adjustments. Finally, the FTB concluded that, unless appellants produced additional information for review, the NPA would be affirmed. Because appellants did not respond, the FTB issued a Notice of Action on August,, affirming the NPA. Appellants filed this timely appeal. Contentions Appellants Contentions On appeal, appellants contend that the proposed assessment is erroneous and unfair because there is no actual income on the loan forgiveness amount. Appellants argue that this is an anomalous situation where a taxpayer who was already burnt on his investment is made liable for any tax on a theoretical or phantom income. In addition, appellants contend that taxation should be fair and levied on actual income. Appellants assert that income can only be called income if [the taxpayer is] physically in possession of the dollar amount. Next, appellants appear to suggest that the FTB should relieve appellants of their tax liability, stating that the IRS has already made a determination that appellants are in financial hardship. Specifically, appellants contend that appellant-wife has lost her job, that their house is under water, and that their income is not enough to make ends meet. The FTB s Contentions Deficiency Assessment The FTB asserts that appellants have not established that the proposed assessment for the 0 tax year, which is based on the federal audit, is incorrect, and that appellants have the burden of proving error. The FTB contends that a taxpayer must concede the accuracy of a federal determination or prove that the changes are erroneous, citing R&TC section, subdivision (a. In addition, the FTB contends that deductions and credits are a matter of legislative grace, and that the - -

4 burden is on the taxpayer to show that he or she is entitled to the claimed deductions. Specifically, the FTB asserts that appellants do not argue or provide evidence that the federal adjustments are erroneous or that the FTB erred in its actions. Moreover, the FTB contends that it is not required to follow an IRS decision that is erroneous, and that it is willing to review and consider any evidence that appellants can provide to establish error. However, the FTB asserts that appellants have not provided any evidence showing that the federal adjustments or that the NPA are erroneous, and thus they have failed to meet their burden of proof. Moreover, the FTB notes that a review of appellants 0 IRS Account Transcript indicates that the IRS has not changed its adjustments or abated the penalties imposed. Cancellation of Debt Income Upon Foreclosure or Short Sale of Real Property The FTB asserts that appellants 0 FEDSTAR IRS Data Sheet contains a federal adjustment of $, in other income. In addition, the FTB contends that appellants 0 IRS Wage and Income Transcript indicates that the lender Aurora Loan Services issued a Form -A Acquisition of Abandonment of Secured Property showing that this lender acquired property in Mountain House, California. The FTB argues that appellants Form -A shows an outstanding loan balance at the time of the transfer of $,0, and a fair market value of the property of $,. Moreover, the FTB asserts that the difference between the outstanding loan balance and the fair market value of the property (i.e., $, is the exact amount represented as other income on appellants 0 IRS Data Sheet, and that this amount presumably represents the phantom income and loan forgiveness amount referred to by appellants on appeal. Although appellants assert that this income is unfair, the FTB argues that this result is entirely consistent with well-settled law. Specifically, the FTB contends that Internal Revenue Code (IRC section (a(, which California conforms to through R&TC section 0, declares that income from the discharge of indebtedness is gross income. In addition, the FTB argues that such income is ordinary income, citing Callahan v. Comm r, T.C. Memo. -, -. The FTB asserts that the measure of ordinary income realized is the difference between the amount of the debt discharged and the fair market value of the property received by the lender, citing id.; Treasury Regulation section.0-(c, Exhibit. Here, the FTB contends that appellants owed the lender $,0, the lender accepted the property securing the debt (valued at $, in cancellation of the - -

5 debt, and that the difference ($, is ordinary income. Next, the FTB argues that appellants claim that income may only be called income, if a taxpayer is in physical possession of the dollar amount, has been thoroughly rejected. Specifically, the FTB asserts that a taxpayer who transfers mortgaged property and is discharged from the liability on the mortgage debt in consideration for the transfer not only realizes a benefit in the amount of discharged liability, but the taxpayer is treated as if the money was first paid to the taxpayer and then paid over by the taxpayer to the creditor, citing Emmons v. Comm r, T.C. Memo. -, ; Crane v. Comm r ( U.S.,. Possible Exclusion from Income for Qualified Principal Residence Indebtedness The FTB contends that appellants cancellation of debt income may be eligible for exclusion from income under the Mortgage Forgiveness Debt Relief Act of 0. Specifically, the FTB asserts that R&TC sections and. incorporate IRC section, which pertains to income from the discharge of indebtedness, with certain modifications. The FTB notes that, for 0, former R&TC section., subdivision (c (applicable to the 0 and 0 tax years, declared that, for purposes of IRC section (a((e, the amount excluded from gross income shall not exceed $0,000. The FTB asserts that IRC section (a((e provides that gross income does not include any amount which (but for that subsection would be includable in gross income by reason of the discharge of indebtedness of the taxpayer if the indebtedness is qualified principal residence Indebtedness which is discharged before January,. The FTB explains that, pursuant to IRC The FTB notes that, where property that is subject to recourse debt is disposed of in satisfaction of the debt and the amount of the debt exceeds the property s fair market value, not only is cancellation of the debt income realized, but gain from the sale arises to the extent that the fair market value of the property exceeds basis. (Citing Treas. Reg.,.0-(c, Ex.. The FTB notes that the gain realized upon such a transfer may explain the $, capital gain adjustment on appellants 0 Fedstar IRS Data Sheet. The FTB notes that the current R&TC section., subdivision (a, applicable to the 0 through tax years, provides that the excludable amount shall not exceed $00,000 ($0,000 for married individuals filing separately. The FTB notes that appellants debt was discharged on May, 0. In addition, this Board notes that IRC section (a((e has been amended and currently provides that gross income does not include any amount which (but for that subsection would be includable in gross income by reason of the discharge of indebtedness of the taxpayer if the indebtedness is qualified principal residence indebtedness which is discharged before January,. - -

6 section (h(, qualified principal residence indebtedness means acquisition indebtedness within the meaning of IRC section (h((b. Moreover, the FTB explains that, under IRC section (h((b, acquisition indebtedness means any indebtedness which ( is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and ( is secured by such residence. Finally, the FTB contends that the refinancing of such acquisition indebtedness also qualifies, but only to the extent that the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness. Thus, the FTB contends that the key to obtaining an exclusion from gross income for discharged indebtedness under R&TC section. is that the discharged indebtedness must qualify as acquisition indebtedness under IRC section (h((b and that, to do so, the taxpayer must establish that the loan proceeds were used to acquire, construct, or substantially improve the taxpayer s principal residence. The FTB asserts that such loan proceeds used for other, non-qualifying, purposes are not excludable from gross income. In this case, the FTB contends that the IRS adjustments included $, in other income and, thus, appellants appear to not have been eligible for the IRC section (a((e exclusion from gross income for such cancellation of debt income. Moreover, the FTB contends that it is not required to follow an erroneous IRS decision, and that it is willing to review and consider any evidence that appellants can provide to establish error. However, the FTB asserts that appellants have not provided any evidence showing that the federal adjustments or that the NPA is erroneous, and thus they have failed to meet their burden of proof. Accuracy-Related Penalty The FTB contends that appellants have not made any specific arguments concerning the accuracy-related penalty, and that they have not established that the accuracy-related penalty should be abated. The FTB contends that R&TC section provides for an accuracy-related penalty determined in accordance with IRC section. In addition, the FTB asserts that R&TC section provides for an accuracy-related penalty of percent of the applicable under payment. The FTB states that, for example, to the extent that the use of acquisition indebtedness is to pay for credit card bills or other personal expenses other than the acquisition, construction, or improvement of the taxpayer s principal residence, then upon the cancellation or forgiveness of such debt by the creditor, such loan proceeds are not excludable from gross income. (Citing I.R.S. Pub.. It appears that the FTB is referring to IRS Publication for the tax year. - -

7 Moreover, the FTB argues that the penalty generally applies to the portion of the underpayment that is attributable to negligence or to the disregard of the rules and regulations, or to any substantial understatement of tax. (Citing Int.Rev. Code, (b. Specifically, the FTB contends that a review of appellants 0 Federal Account Transcript indicates that the IRS imposed a percent accuracyrelated penalty in the amount of $, ( percent of the federal tax deficiency of $,. Moreover, the FTB argues that appellants Account Transcript shows that there has been no subsequent abatement of the accuracy-related penalty by the IRS. Thus, the FTB contends that, in accordance with the accuracy-related penalty imposed by the IRS, the FTB imposed a percent accuracy-related penalty in the amount of $, ( percent of the tax deficiency of $,. Finally, the FTB asserts that, when based on a federal action, its assessment of an accuracy-related penalty is presumed correct and that a taxpayer bears the burden of proving error. (Citing Appeal of Bernard J. and Elia C. Smith, -SBE-0, Jan., ; Appeal of Robert and Bonnie Abney, -SBE-, June,. Moreover, the FTB contends that tax deductions are a matter of legislative grace, and the burden is on the taxpayer to prove that he or she is entitled to the deduction. (Citing Appeal of James C. and Monablanche A. Walshe, -SBE-0, Oct., ; New Colonial Ice Co. v. Helvering ( U.S.,. Yet, the FTB contends that, although the accuracy-related penalty is presumed correct, the accuracy-related penalty shall not be imposed as to any portion of an underpayment to which a taxpayer can show that he or she acted with reasonable cause and in good faith. (Citing Rev. & Tax. Code,, subd. (d; Int.Rev. Code, (c(; Cal. Code Regs., tit., section, subd. (a. To establish reasonable cause, the FTB contends that a taxpayer must demonstrate that he or she exercised ordinary business care and prudence. (Citing Appeal of Stephen C. Bieneman, -SBE-, July,. However, as mentioned above, the FTB asserts that appellants have failed to address the FTB s imposition of the accuracy-related penalty, and have not offered any evidence to support a claim of reasonable cause. Moreover, the FTB asserts that appellants have failed to substantiate the deductions or items of omitted income claimed on their return. Financial Hardship The FTB notes that appellants suggest that the FTB should relieve them of their tax liability because of their financial hardship, and that appellants state that the IRS has already made a - -

8 hardship determination with respect to their ability to pay their 0 tax liability. However, the FTB contends that the IRS letter, which appellants included with their appeal, does not relieve them of their tax liability, but instead merely indicates that the IRS will suspend collection activities with respect to their 0 tax year account. The FTB asserts that the IRS letter clearly states that you still owe the money to the IRS. Moreover, the FTB contends that the hardship determination by the IRS bears on the issue of collectability, and does not bear on the correctness of the federal adjustments or the NPA. In addition, the FTB argues that, as of December,, appellants have an installment agreement pending with the IRS. Next, the IRS contends that, under California law, there are no provisions for the withdrawal of a proposed assessment or an abatement of tax due to hardship. However, the FTB notes that, pursuant to R&TC section, the FTB has the discretion to abate interest in matters of extreme financial hardship caused by a significant disability or other catastrophic circumstance. The FTB asserts that it is willing to review any evidence of hardship caused by a significant disability or catastrophic circumstance that appellants wish to submit at the conclusion of this appeal. Yet, the FTB asserts that there are no provisions in the Revenue and Taxation Code which allow this Board to review the FTB s interest determinations based on a claim of financial hardship. Finally, the FTB contends that, in addition to the relief under R&TC section, the FTB has three collection programs that may address appellants financial hardship concerns. As a result, the FTB provided appellants information regarding its collection programs, which the FTB asserts appellants can explore following the conclusion of this appeal. Discussion Federal Assessment R&TC section, subdivision (a, provides that a taxpayer shall either concede the accuracy of a federal determination or state wherein it is erroneous. It is well-settled that a deficiency assessment based on a federal audit report is presumptively correct and that a taxpayer bears the burden of proving that the determination is erroneous. (Appeal of Sheldon I. and Helen E. Brockett, -SBE-, June, ; Todd v. McColgan ( Cal.App.d 0,. Unsupported assertions are not sufficient to satisfy a taxpayer s burden of proof with respect to an assessment based - -

9 on a federal action. (Appeal of Aaron and Eloise Magidow, -SBE-, Nov.,. A taxpayer s failure to produce evidence that it is within his or her control gives rise to a presumption that such evidence is unfavorable to his or her case. (Appeal of Don A. Cookston, -SBE-0, Jan.,. Moreover, deductions are a matter of legislative grace and the taxpayer has the burden to show that he or she is entitled to any claimed deduction. (Appeal of James C. and Monablanche A. Walshe, -SBE-0, Oct., ; New Colonial Ice Co. v. Helvering ( U.S.,. Here, appellants have not met their burden of proving error in the FTB s proposed assessment for 0, or in the IRS s determination upon which the FTB s based its proposed assessment. Specifically, appellants make no claim that the federal determination or the FTB s proposed assessment is erroneous. Moreover, appellants have not provided any documentation to establish error by the IRS or the FTB. Thus, appellants have not shown error in either the federal determination or in the FTB s assessment. Cancellation of Debt R&TC section 0, subdivision (a, provides in pertinent part, that tax shall be imposed upon the entire taxable income of every resident of California. R&TC section 0 incorporates IRC section, which declares that gross income means all income from whatever source derived, including income from discharge of indebtedness. (Int.Rev. Code, (a(. Income realized on the discharge of debt is ordinary income. (Callahan v. Comm r, supra. The measure of the amount realized is the difference between the amount of the debt discharged and the fair market value of the property received by the creditor. (Id.; see also Treas. Reg.,.0-(c, Ex.. Moreover, in this situation, the taxpayer is treated as if the money were first paid to the taxpayer and then paid over by him or her to the creditor. (Emmons v. Comm r, supra. Here, appellants argue that the inclusion of the loan forgiveness amount is erroneous and unfair, that it is phantom income, and that income can only be called income if the taxpayer is in the physical possession of the dollar amount. However, based on the federal information, it is evident that appellants realized ordinary income from the discharge of indebtedness in the amount of $,. Specifically, appellants 0 FEDSTAR IRS Data Sheet indicates that the IRS made an adjustment of $, in other income. Moreover, appellants 0 IRS Wage and Income Transcript indicates - -

10 that Aurora Loan Services issued a Form -A and acquired property in Mountain House, California. In addition, the Form -A shows that appellants had an outstanding loan balance at the time of the transfer of $,0, and that the fair market value of the property was $,, a difference of $,. As the FTB notes, this is the exact amount represented as other income on appellants FEDSTAR IRS Data Sheet. Thus, based on the federal information, it appears that appellants owed the lender a total of $,0 on the date of the short sale of their property, and that the lender accepted the property, valued at $,, in settlement of the debt. Thus, appellants realized ordinary income from the discharge of indebtedness in the amount of $,. Moreover, appellants need not be in physical possession of the dollar amount to realize income. (See Emmons v. Comm r, supra. Exclusion from Income for Qualified Principal Residence Indebtedness R&TC sections and. incorporate IRC section, which pertains to income from the discharge of indebtedness, with certain modifications. Former R&TC section., subdivision (c (applicable to the 0 and 0 tax years, declared that, for purposes of IRC section (a((e, the amount excluded from gross income shall not exceed $0,000. IRC section (a((e provides that gross income does not include any amount which (but for that subsection would be includable in gross income by reason of the discharge of indebtedness of the taxpayer if the indebtedness is qualified principal residence indebtedness which is discharged before January,. Pursuant to IRC section (h(, qualified principal residence indebtedness means acquisition indebtedness within the meaning of IRC section (h((b. Under IRC section (h((b, acquisition indebtedness means any indebtedness which ( is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and ( is secured by such residence. Refinancing of such acquisition indebtedness also qualifies, but only to the extent that the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness. (Id. As noted by the FTB, to obtain an exclusion from gross income for discharged As stated above, IRC section (a((e has been amended and currently provides that gross income does not include any amount which (but for that subsection would be includable in gross income by reason of the discharge of indebtedness of the taxpayer if the indebtedness is qualified principal residence indebtedness which is discharged before January,. - -

11 indebtedness under R&TC section., the discharged indebtedness must qualify as acquisition indebtedness under IRC section (h((b. To do so, appellants must establish that the loan proceeds were used to acquire, construct, or substantially improve the principal residence. However, as noted by the FTB, the IRS audit included $, in other income and, thus, appellants cancellation of debt income appears to not have been eligible for exclusion. Moreover, appellants have not provided any evidence showing that the federal determination or the NPA is erroneous, and thus they have failed to meet their burden of proof. Accuracy-Related Penalty R&TC section, which incorporates the provisions of IRC section, provides for an accuracy-related penalty of percent of the applicable underpayment. As relevant to this appeal, the penalty applies to the portion of the underpayment attributable to ( negligence or to the disregard of rules and regulations or ( any substantial understatement of income tax. (Int.Rev. Code, (b. The Internal Revenue Code defines negligence to include any failure to make a reasonable attempt to comply with the provisions of the code. (Int.Rev. Code, (c. The term disregard is defined to include any careless, reckless, or intentional disregard. (Id. IRC section provides that a substantial understatement of tax exists if the amount of the understatement exceeds the greater of percent of the tax required to be shown on the return or $,000. (Int.Rev. Code, (d(. An understatement means the excess of the amount required to be shown on the return for the taxable year over the amount of the tax imposed which is shown on the return, reduced by any rebate. (Int.Rev. Code, (d(. An accuracy-related penalty shall not be imposed as to any portion of an underpayment as to which the taxpayer shows that there is reasonable cause and the taxpayer acted in good faith with respect to such portion of the underpayment. (Rev. & Tax. Code,, subd. (d; Int.Rev. Code, (c(; Cal. Code Regs., tit.,, subd. (a. A determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis and depends on the pertinent facts and circumstances, including the taxpayer s efforts to assess the proper tax liability, the taxpayer s knowledge and experience, and the extent to which the taxpayer relied on the advice of a tax professional. Generally, the most important factor is the extent of the taxpayer s effort to assess his or - -

12 her proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer. (Treas. Reg.,.-(b(. When based on a federal action, the FTB s assessment of an accuracy-related penalty is presumed correct. (Appeal of Robert and Bonnie Abney, -SBE-, June,. Appellant bears the burden of proving error in the FTB s determination that a penalty applies. (Id. To overcome the presumption of correctness of a penalty, an appellant must provide credible and competent evidence to support the claim; otherwise, the penalty should not be abated. (Appeal of Wintson R. Schwyhart, -SBE-0, Apr.,. Here, appellants have failed to meet their burden of proving error in the FTB s imposition of the accuracy-related penalty. Specifically, appellants make no claim that the FTB s imposition of the accuracy-related penalty is erroneous and they make no claim of reasonable cause. Moreover, a review of appellants 0 IRS Account Transcript indicates that the IRS imposed a percent accuracy-related penalty in the amount of $, (i.e., percent of the federal tax deficiency of $,. In addition, appellants IRS Account Transcript indicates that the IRS has not abated the accuracy-related penalty. Thus, in accordance with the IRS information, the FTB correctly imposed a percent accuracy-related penalty in the amount of $, (i.e., percent of the state tax deficiency of $,. Financial Hardship On appeal, appellants suggest that the FTB should forgive their tax liability and forgo any collection activity because they are experiencing financial hardship. Specifically, appellants contend that the IRS has already made a determination that they are in financial hardship. In addition, appellants assert that their home is under water, that appellant-wife has lost her job, and that their income is not enough to make ends meet. However, as noted by the FTB, the IRS letter dated August,, to which appellants cite, indicates only that the IRS temporarily closed the collection of appellants 0 account. Moreover, the IRS letter explicitly states that, although the IRS temporarily closed the collection case, appellants still owe the money to the IRS. Thus, the letter does not relieve appellants of their tax liability. This is evidenced by the fact that, as the FTB indicates, - -

13 appellants have an installment agreement pending with the IRS. In addition, there are no provisions under California law for a withdrawal of a proposed assessment or an abatement of tax due to financial hardship. R&TC section provides the FTB with discretion to abate interest in matters of extreme financial hardship caused by a significant disability or other catastrophic circumstance. However, appellants make no request for an abatement of interest and this Board does not have the authority to review the FTB s interest determination based on financial hardship. Once this appeal is final, appellants may contact the FTB and consider any of the three programs for collection matters that the FTB offers and explained in its briefing. The options include the following: ( a request for an abatement of interest due to extreme financial hardship with the FTB Collection Advisory Team; ( an OIC; and ( enter into an installment agreement. CONCLUSION For the foregoing reasons, the FTB s action is sustained. /// /// /// Dating_sa - -