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

1/24/13Follow @wroush

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paid estimated taxes based on the provision, which—as an alternative to the rollover that Cutler had executed—allowed investors in QSBs to exclude 50 percent of the taxable gain on the sale of their stock. Now Overstreet learned he would owe much more.

“I didn’t make so much money on this transaction that I can go live on the beach—I rolled out of bed the next day and went back to my job,” he says. “But at the same time, it was enough that the tax bill I am going to be faced with is a lot of money. And when you start multiplying this across all the potential people who this affects, it’s going to be a boatload.”

Overstreet says that as the holidays wrapped up and the news spread about the FTB notice, he was sure “there would be outrage, but there was nothing. I was checking Google News every three hours, and there was just no information coming out.” Knowing that he wasn’t the only person who’d be affected, Overstreet wrote his commentary and sent it to “several media outlets,” including Xconomy. Only Xconomy responded.

Overstreet is accustomed to being a lightning rod. His startup is focused on cleaning up flaws in the FDA’s database of patients who suffer adverse drug reactions, and as you might imagine, pharmaceutical companies aren’t excited over the prospect of more transparency in this area. But while Overstreet says he’s willing to keep making noise about the FTB policy, he’d rather see someone else take up the mantle.

“As much as I feel like I have a lot of money at stake, there are people who are going to have a lot more at stake, and have a lot deeper pockets,” he says. “For them, fighting this in any arena is going to be worthwhile.”

It’s hard to determine how many people will be affected by the retroactive disallowance of QSB exclusions and deferrals. Azimi, at the FTB, told me that the board estimates that only 500 tax returns per tax year will be subject to additional assessments, with the average assessment being around $60,000.

According to a 2011 estimate from the FTB’s Economic and Statistical Research Bureau, exclusions on the sale of small business stock represented a tax expenditure of $6.6 million in 2008—meaning, the state would have collected $6.6 million more that year if the exclusion hadn’t existed. But the bureau said there’s no way to know how many people actually took the exclusion, since taxpayers have never been required to identify themselves when they do so.

But the psychological impact of the FTB notice may be large, even if the financial one isn’t. I talked with several investors and legal experts who warned that it’s a bad time to be hitting investors—who are already spooked by the increased state income tax rates imposed by Proposition 30—with more tax bills.

“Some of my angel friends are in the process of moving because they don’t want to pay that 13 percent tax,” says Anne DeGheest, founder and managing director of HealthTech Capital, a venture fund focused on health IT companies. “These are high-net-worth individuals who may put 5 to 10 percent of their income into these investments. And what’s interesting is that these are the people who take the earliest risks, starting companies like Facebook. If you take away their disposable income it may kill job creation in California.”

Ackerman, at Allegis Capital, agrees. “The two most mobile resources in the world are capital and talent,” he says. “Both go where they are most welcomed and most rewarded. And increasingly, we are seeing an environment in California that is less hospitable for both investors and innovators.”

The most surprising and disturbing part of the FTB’s action, to many, is the five-year clawback. (The FTB says people who claimed exclusions or deferrals since 2008 can either file amended returns, or wait to receive a bill—but the sooner a taxpayer pays up, the less interest they may owe.) “There is something, dare I say, un-American about a retroactive tax bill with a five-year look-back,” says Overstreet. “Starting and running a company is hard enough. But when you get to the finish line and then you get punched in the gut again, it makes you rethink wanting to do it all over again.”

Overstreet’s commentary has provoked widespread discussion. The article attracted hundreds of comments on Xconomy and Y Combinator’s Hacker News site, as well as more than 600 tweets and 2,000 Facebook Likes. New York-based BusinessInsider jumped on the story with an article entitled “California Screws Silicon Valley: Entrepreneurs and Angels Socked with Absurd Retroactive Tax.” Even Canadians took notice, in a TechVibes story observing that “While this is bad news for Silicon Valley, it may prove good news for Canada: local startups may find fleeing south to be a decidedly less desirable option.”

But despite that firestorm, so far, Overstreet says he doesn’t know of any organized efforts to challenge the policy. State legislators contacted by Xconomy either weren’t familiar with the changes, or didn’t respond. Rodriquez says that only one California legislator has contacted her association about the change, “asking whether what the FTB was doing was legal.” (She says it’s not illegal, just wrong-headed.)

Valerie Dickerson, a partner at Deloitte Tax, LLP, who warned clients about the FTB notice in a Jan. 3 alert, says that in the past, courts and state legislatures have stepped in to repair popular tax breaks that had been rendered unconstitutional. “The court could read the statute in a way that omits the offending language and maintains the rest of the statute,” Dickerson says. “In other situations the legislature has re-enacted a statute without the language. But in at least one case other remedies were litigated and the FTB’s position was ultimately upheld.”

Ironically, one of the loudest protests I heard came from the people who started this whole thing—Cutler’s legal team at ReedSmith.

“To me this is a black eye for California,” Dakessian says. “The entrepreneurial spirit is synonymous with California. The Gold Rush, the Golden Gate Bridge, the Pacific Ocean, that is what we think of when we think of California. This is taking an axe to the incentives that symbolize that very hope.”

Dakessian dropped a hint that his firm might be open to mounting a legal challenge aimed at resurrecting the QSB incentive in some form (as long as it doesn’t discriminate against investors in out-of-state businesses, presumably).

“It’s always difficult to get people spurred into action, but I can tell you that separate from the Cutler case, we are looking very carefully at the FTB’s position, and we are deeply concerned about the legality of its actions,” Dakessian says. “Frankly, the FTB should be too.”

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.