California Franchise Tax Withholding

What happens to California Franchise Tax Withholding when the Exchanger files a tax return, and pays tax, on a failed exchange while the Qualified Intermediary is still holding the exchange funds?

Example:

• Exchange begins in November of Year 1 but the exchange fails in Year 2.
• Taxpayer files Year 1 tax return, reporting the transfer of the relinquished property as a taxable sale during Year 1.
• Taxpayer pays all of the taxes due with the filing of the Year 1 tax return, on or before April 15, Year 2.
• Taxpayer notifies Qualified Intermediary on April 16, Year 2 that the exchange terminated on April 15 and requests return of exchange funds.

Unfortunately, the California Franchise Tax Board (“FTB”) takes the position that the Qualified Intermediary must still withhold, notwithstanding that the taxpayer has already filed a tax return reporting the relinquished property as a taxable sale and has already paid the taxes.

The FTB has informed us that Investment Property Exchange Services, Inc. (IPX1031®), as Qualified Intermediary, must withhold as if no tax had been paid, because the FTB’s position is that there is no statutory exemption from the withholding requirement under these circumstances. The only allowable exemptions are those listed on the California FTB Form 593-C. If we do not withhold, we will be subject to severe penalties and fines from the FTB.

The FTB has informed us that the proper procedure under these circumstances is

• The Qualified Intermediary must submit withholding for Year 1
• The taxpayer must file an amended Year 1 California tax return, claiming the withholding amount we submitted, and seek a refund from the FTB.

This procedure was outlined to us by the CA FTB. If you or your advisor has any questions, please direct them to CA FTB Withholding Services & Compliance Section (888) 792-4900. If you have a continuing problem that cannot be resolved through the Withholding Services & Compliance Section, please contact the CA FTB Executive & Advocate Services unit at (800) 883-5910.