The Surreal, Ironic Story Behind California’s Retroactive Tax on Small Business Investors

1/24/13Follow @wroush

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defer gains on the sale of stock in a qualified small business as long as they reinvested the proceeds in another qualified small business within 60 days.

The real trouble started brewing five years later, in May 2004, and it had to do with the definition of “qualified.” The Franchise Tax Board had reviewed Cutler’s 1998 return—which was still open to additional assessment under the statute of limitations—and in its view, US Web couldn’t be classified as a qualified small business. So it disallowed Cutler’s 1998 deferral and sent him a bill for $200,000 in unpaid taxes and $47,600 in penalties.

The FTB’s main argument was that because US Web had extensive operations outside California, it didn’t meet the “property and payroll” requirement in the state tax code. Under this requirement, an investment didn’t qualify for the tax break unless the company had at least 80 percent of its property and 80 percent of its payroll expenses in California. (At the same time, the FTB said Cutler had failed to demonstrate that the three new companies in which he invested in 1998 also met those requirements—more on that in a moment.)

Cutler filed a formal protest against the tax assessment, saying that US Web did meet the 80 percent requirement. And even if it didn’t, Cutler argued, the requirement was unconstitutional under the Commerce Clause of the U.S. Constitution.

This clause has been interpreted by federal courts over the years to mean that states can’t impose regulations or taxes that impede interstate commerce or that favor local businesses by burdening out-of-state competitors. Cutler’s position was that the 80 percent requirement was discriminatory. For fairness’ sake, his legal team argued, the QSB incentive should also be available to taxpayers who invest in companies that do a large portion of their business outside California.

In February 2007 the FTB denied Cutler’s protest. He appealed to the State Board of Equalization, the body that handles income tax appeals in California. The board sustained the denial, and in July 2009 Cutler finally paid the overdue taxes, penalties, and interest, which amounted by then to $442,000.

But the story wasn’t over. In September 2009 Cutler sued the FTB in the Los Angeles Superior Court, demanding a full refund, on the same constitutional grounds. He lost, and appealed the decision to the state Court of Appeals. And that’s where it began to look like Cutler might score his first win.

To decide the case, the appeals court had to review the constitutionality of the property and payroll requirement, which the lower court had found unobjectionable. Citing earlier case law—specifically, a 1996 ruling, Fulton Corp. v. Faulkner, in which the U.S. Supreme Court found that a North Carolina state income tax law favoring in-state investment violated the Commerce Clause—Justice Grimes eventually concluded that Cutler and his attorneys had been right all along.

Because taxpayers weren’t eligible to defer income from the sale of stock in corporations that have property and payroll outside California, the incentive was discriminatory on its face, Grimes wrote in her decision. She reversed the trial court’s judgment.

That doesn’t mean Cutler is going to get his refund—not yet, anyway. The aspect of the case dealing with whether the rolled-over gains actually went into qualified small businesses wasn’t decided in the appeal, and was sent back to the lower court for resolution. (Cutler claimed a deferral on the gains, rather than an exclusion, so he isn’t eligible for a refund on that basis either.) So the litigation continues.

Still, Cutler’s lawyers were happy with Grimes’ ruling, which definitively invalidated the property and payroll requirement.

“The way the FTB had been implementing it for all these years, it was essentially penalizing businesses for expanding outside California,” says Dakessian. “When you take on the State of California, it’s always fraught with risk, but I have a team of lawyers with me at ReedSmith that believe in Frank and believe that what the FTB was doing was just wrong. So we were very pleased that the Court of Appeals recognized that there was a discriminatory component to this incentive.”

“Invalid and Unenforceable”

But as convoluted as the story of Cutler v. Franchise Tax Board may seem, this is the part where it gets truly twisty. The appellate court had deemed the disputed section of the tax code to be invalid as written—a decision that would obviously apply not just to Cutler, but to everyone who wanted to claim a QSB deferral on their state tax returns. But exactly how it would apply was up to the FTB.

Gina Rodriquez, of the California Taxpayers Association, says the board had several options open to it under previous case law. One path would have been to leave the spirit of the statute intact and fix the unconstitutional bit by … Next Page »

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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  • http://xaminmo.livejournal.com Josh Davis

    That seems a whole lot like both an bill of attainder (the back charges without a trial) and an ex post facto law (we changed the law because the old law wasn’t
    legal, and you’re now retroactively affected), both of which are prohibited by the US constitution, both at the State and Federal level.

  • foramerica

    Californians never cease to amaze me. I swear common sense is dead here.