Taxable Talk

Medical marijuana is a complex subject. California voters passed an initiative legalizing it; the federal government says its still illegal under federal law. I'll let the attorneys battle that one out.

However, whether medical marijuana is legal or illegal doesn't impact the tax situation for a grower. Illegal income is just as taxable in the United States and California as legal income. And that's where our story begins.

Edwin Hoey pleaded no contest last year to possessing and selling "hundreds of pounds of pot." He has now been arrested on five charges of filing a false state income tax return.

Mr. Hoey's attorney, Ben Rice, is quoted by the Central Coast Sentinel, as stating, "This gray area is very gray, very dark and it's hard for people who want to do this exactly the way they're supposed to...It's hard for people to know how to do it... Hoey has paid his taxes and he's prepared to rectify his tax statements but it's really difficult to know how to do that."

I hate to tell Mr. Rice, but I think he's very wrong here. Mr. Hoey was conducting a business. It's pretty simple: add up all your income, subtract your expenses, and you've got your net income. Perhaps it was hard for Mr. Hoey to include his illegal income on his tax return but it's the law.

Mr. Rice also complained that the government is getting a second bite at the apple. But tax charges are different from drug charges—it's not double jeopardy.

And I have even more bad news for Mr. Rice and Mr. Hoey. It's quite possible that the IRS will take a look at this case, too. The IRS and the Franchise Tax Board (California's state income tax agency) share information.

So if you decide to get in a business that's in a gray area (or even one that's over the line) do make sure to file and pay your taxes.

Back in October 1991 Gilbert Hyatt moved from California to Nevada. California's Franchise Tax Board didn't think he did, so they commenced a residency audit. California determined that Mr. Hyatt didn't establish residency in Nevada until April 1992. Normally, six months wouldn't be a big deal; however, Mr. Hyatt had invented a microprocessor and received a substantial amount of income during that time period. California assessed $49 million in taxes.

Mr. Hyatt fought the judgment through administrative appeals. He also wasn't happy about the methods the FTB used to investigate him. Mr. Hyatt filed a lawsuit against the FTB in Nevada, alleging

...that [FTB] directed “numerous and continuous contacts … at Nevada” and committed several torts during the course of the audit, including invasion of privacy, outrageous conduct, abuse of process, fraud, and negligent misrepresentation.

The FTB fought the case, arguing that they were immune from being sued. (As an aside, had the actions that Mr. Hyatt alleged took place in California, the FTB would be immune.) The case went all the way to the US Supreme Court; the Court ruled unanimously that the FTB could be sued in Nevada. The case was remanded back to the Nevada District Court for trial.

The first phase of the trial ended last week, and the FTB suffered a ringing rebuke. According to Bill Leonard's Leonard Letter, Mr. Hyatt prevailed on every claim and was awarded $137 million in damages plus $1.08 million in legal fees. The jury is now looking at potential punitive damages which could easily be another $400 million or so.

What did the FTB do? From the Leonard Letter:

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 stormtroopers are alive and well at the FTB.

I have little to add to what Mr. Leonard stated. And he should know; Bill Leonard is an elected member of California's Board of Equalization. The BOE hears administrative appeals on FTB cases after an individual (or organization) exhausts appeals at the FTB.

What's the cost to California? To date, the FTB has spent $8.8 million fighting Mr. Hyatt. Add the $138.88 million that is now owed to Mr. Hyatt and the total is $146.08 million. If we add another $250 million for punitive damages the total is nearly $400 million. And while Mr. Leonard is hopeful that the FTB won't appeal the case, I am almost 100% certain that the FTB will appeal. Thus, unless the FTB gets lucky in Nevada this case could easily cost California taxpayers over half a billion dollars.

Welcome to the Bronze Golden State....

No surprise, really, that California still has no budget and frankly there's been no progress. Democrats want to increase taxes, Republicans don't, and neither side is talking to the other.

Yes, things are normal in Sacramento....