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California Loses Big in Litigation Involving Its Tax Jurisdiction and Related Residency Audits

Expert Witness: Fulcrum Inquiry
A former California resident received a jury award of more than $388 million after suing California's Franchise Tax Board (FTB) for its conduct in auditing him.

A former California resident received a jury award of more than $388 million after suing California's Franchise Tax Board (FTB) for its conduct in auditing him. After a 15-week trial, a Nevada jury returned a unanimous liability and compensatory damage verdict, including $85 million for emotional distress, $52 million for invasion of privacy, $1.1 million in attorney fees, plus prejudgment interest required by Nevada law. The jury then found that the FTB acted with oppression, fraud, or malice, and assessed $250 million of punitive damages.

Mr. Hyatt is an inventor with more than 70 patents. His patents cover
a computer microprocessor chip and a computer data storage system. One of his creations, made while living in California, resulted in a patent for which he was due $40 million in royalties. In October 1991, he moved from California to Nevada, where there is no state income tax. California claimed that Mr. Hyatt did not establish residency in Nevada until April 1992. Normally, six months wouldn't be a big deal, but shortly after Mr. Gilbert’s move, he received a $40 million licensing payment.

California is well known for disputing taxpayer claims that they have moved from California’s jurisdiction. Mr. Hyatt contended that the FTB audited him in bad faith, assessed fraud penalties without evidence of fraud, and attempted to force him to settle by assessing taxes and penalties at a rate of $8,000 per day. The FTB says Hyatt owes California $49 million, comprised of (i) $1.8 million in taxes, a $1.4 million fraud penalty, and $7.2 million in interest for the 1991 tax year (ii) $5.6 million in taxes, a $4.2 million fraud penalty, and $19 million in interest for 1992, and (iii) a $10 million penalty for not taking advantage of California’s tax amnesty program.

The case continued for over ten years. California fought every step of the way, and has lost every step. After the case was filed in Nevada, California’s FTB took the case to the Nevada Supreme Court. California jurisdiction was important to the FTB because California's Government Code section 818 provides:

"Notwithstanding any other provision of law, a public entity is not liable for damages awarded under Section 3294 of the Civil Code or other damages imposed primarily for the sake of example and by way of punishing the defendant."

In addressing the need for Nevada to protect its citizens, the Nevada Supreme Court noted that:

"Nevada does not allow its agencies to claim immunity of discretionary acts taken in bad faith, or for intentional torts committed in the course and scope of employment … We believe that greater weight is to be accorded Nevada's interest in protecting its citizens from injurious intentional torts and bad faith acts committed by sister state’s government employees, than California's policy favoring complete immunity for its taxation agency."

Not liking this result, the FTB appealed to the U.S. Supreme Court. The FTB argued that Nevada courts could not adjudicate Hyatt's claims against the California FTB, and that the Nevada Supreme Court was impermissibly interfering with California's capacity to fulfill its sovereign responsibilities. The U.S. Supreme Court unanimously upheld the Nevada Supreme Court's ruling, holding for Hyatt that the Constitution's Full Faith and Credit Clause didn't require Nevada to abide by California's statutes providing its tax collection agency with immunity from suit. Accordingly, Hyatt's complaint could proceed to trial in Nevada.

Bill Leonard is a member of the California State Board of Equalization (California’s other tax collection agency) and a 24-year member of the California Legislature. Mr. Leonard critiqued California’s conduct as it came to light in the Hyatt trial as follows:

“…the FTB investigators crossed many ethical lines and demonstrated how tax agents are not held to the same legal standards we demand of law enforcement officers. Tax agents rummaged through his trash without warrants, visited business partners and doctors, and shared his Social Security Number and other personal information with the media. This is outrageous behavior and I call on the FTB to rein in their agents. What really galled me is the FTB testified in open court that this level of harassment was only a typical audit. If true, then the storm troopers are alive and well at the FTB.”

The case has ongoing relevance to California’s debt collection tactics involving those who move from California because of California’s high state income tax rates. In response to California’s ongoing budget crisis, increasing state income taxes is an often-proposed solution. If California continues to increase income tax rates for the “rich”, the motivation for business owners, retirees, and others to move to lower-tax states will escalate. The Hyatt case will make it more difficult for California to chase its former residents.

Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials, CPA, MBA, CMA and ASA.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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