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

1/24/13Follow @wroush

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treating investments in multi-state or out-of-state companies the same way as investments in in-state companies. In other words, the FTB could have extended the option to defer or exclude gains on the sale of stock to anyone who invested in a small business, no matter how much of its operations were outside the state.

Or it could have disallowed deferrals on rolled-over gains—the specific section of the statute at issue in Cutler—while still allowing taxpayers to take advantage of the other option provided in the tax break law, a 50 percent exclusion on gains from the sale of stock in QSBs.

It had gone a similar route before. In another Commerce Clause case, Hunt-Wesson v. Franchise Tax Board (2000), the U.S. Supreme Court struck down an FTB rule that allowed corporations to deduct interest expenses from in-state income, but not from out-of-state income. The board responded by extending the deduction so that it also applied to out-of-state income as well.

But Rodriquez says early hints caused her to fear that FTB would look to a different precedent. In yet another Commerce Clause case, Farmer Bros. v. Franchise Tax Board (2003), the state Court of Appeals affirmed a trial court judgment that a section of the state tax code dealing with dividend deductions was unconstitutional. Under that section—which, like the QSB statute, had been intended to encourage investment in California companies—allowable deductions were computed on a sliding scale. The higher the amount of corporate taxes a dividend-issuing company paid in California, the larger the deduction taxpayers who received the dividends were allowed to claim.

The plaintiff, a coffee company called Farmer Bros., successfully argued that the scheme was unconstitutional and that it should be allowed to claim the top deduction on dividends, no matter how much of the dividend-paying company’s business was outside California. The FTB could have responded to the ruling simply by allowing the deduction and granting a refund to Farmer Bros. But instead—saying that the entire statute was now “invalid and unenforceable”—it decided to disallow the dividend deduction for all taxpayers.

To Rodriquez, the clue that the FTB might be contemplating taking the Farmer Bros. approach to the Cutler decision, rather than the Hunt-Wesson approach, came in the form of a draft version of the filing instructions FTB was preparing to accompany 2012 tax forms. The same language it had used after the Farmer Bros. case showed up there. “An unconstitutional statute is invalid and unenforceable,” the FTB said. “Therefore, the California deferral and exclusion [on gains from QSB stock sales] are not available.”

“I saw their draft 2012 forms, and they were clear they were going to disallow everything,” Rodriquez says now. “That was the way they were headed, and it was bothersome because there was no policy discussion. They didn’t ask anybody. They just said, ‘Here’s how we are implementing it.”

The California Taxpayers Association warned members that the decision might break this way in its December 21 newsletter. Ironically, the FTB issued its official notice to taxpayers—explaining that it would respond to the Cutler decision by disallowing the QSB exclusion for all tax returns going back to 2008—on the same day.

Dakessian says the legal team at ReedSmith was thunderstruck by the FTB’s notice. “They now have to level the playing field, and the courts have given tax agencies some discretion in how they want to accomplish that,” says Dakessian. “They ought to have gone to the legislature to ask for direction. But they didn’t do that. They picked the most extreme option—the one that would result in the most revenue for the state.” (At least in the short term. In the long term, the decision could actually reduce revenues, if the elimination of the QSB incentive were to prompt investors to take their money elsewhere.)

I contacted the Franchise Tax Board to ask why it went down this path. “We believe this was the only remedy available to us” after the Cutler decision, FTB spokeswoman Denise Azimi told me.

As an administrative body, the FTB “must adhere to decisions handed down by the court,” Azimi continued. “In this instance the Cutler decision ruled that the QSB exclusions were discriminatory and unconstitutional. To implement this ruling and remedy the discrimination found by the court, we determined that we must issue tax assessments to reverse the unconstitutional benefits, and we have to treat all taxpayers the same.”

Azimi says the FTB has already begun sending out notices of back taxes owed, starting with people who claimed the QSB exclusion or deferral on their 2008 returns.

Rodriquez says she still thinks the board had the legal wiggle room to go either way. “The sensible response to Cutler would have been to adopt a Hunt-Wesson approach and preserve the benefits of the QSB statute by eliminating the discriminatory requirements,” says Rodriquez. “It would have preserved the intent of the legislation, which is that we all want more investment in California companies.”

Totally Surreal

Coming, as it did, on the Friday before a four-day Christmas weekend, the FTB notice attracted almost no attention from the business community. Brian Overstreet, who founded Healdsburg, CA-based AdverseEvents.com in 2011, says he wouldn’t have learned about it himself if he hadn’t clicked on a “fairly innocuous e-mail newsletter” the he gets from his legal counsel every two weeks.

“I don’t think I’ve ever opened one of those, but this one had something in the subject line about the QSB tax exclusion, and that let me to the actual FTB announcement, which came across as totally surreal. I said, ‘What is this you’re talking about, rolling this back for five years? How is that even possible?’”

Overstreet had good reason to care about the QSB rules. As he explained in his Jan. 15 commentary, he had sold his previous company, San Diego-based enterprise data startup Sagient Research Systems, in mid-2012. By September, he’d already … 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.