Opponents of California's Retroactive Tax on Investors Win A Reprieve

[Updated 3/6/13, see below] In a bitter contest over tax changes that could hit California investors with bills for up to $120 million in unpaid taxes dating back to 2008, one side has stopped the clock.

Under pressure from the office of California Gov. Jerry Brown, the state’s Franchise Tax Board indicated today that it will refrain, for now, from trying to collect income taxes that it believes thousands of taxpayers now owe under a 2012 court ruling that invalidated an important tax incentive for small-business investors.

Taxpayers and lobbyists opposed to the retroactive assessments are greeting the change with relief.

“This is certainly not a victory at all for our position, but it takes the time pressure off, and it takes the immediate financial hit that a lot of people were looking at off the table,” says Brian Overstreet, the Healdsburg entrepreneur who first sounded the alarm about the FTB’s retroactive tax in an Xconomy column in mid-January.

Overstreet and several other California businessmen are behind a group called California Business Defense that has spent the last three weeks petitioning Brown’s office to stop the FTB from sending the bills.

“I feel very grateful to the governor’s office, which, I think, has been instrumental in making this happen,” says Overstreet (pictured above right). “They certainly could have told us they had other things to deal with. It feels great, after spending way too much of my time on this for the last few weeks, to actually have something to show for it.”

What Overstreet’s group has won is a temporary reprieve, rather than a concrete change in the FTB’s position. Now Overstreet’s group and legislators opposed to the FTB’s plan say they’ll seek an administrative or legislative fix that restores the original tax incentive in some form or, at a minimum, prevents the FTB from issuing the retroactive assessments.

As we detailed in a January 24 analysis, the tax dispute has a long and twisted history. In the early 1990s, California legislators created a tax incentive designed to encourage investors to put their money into California-based small businesses. The so-called qualified small business stock (QSBS) incentive allowed investors to exclude 50 percent of their gains on the sale of small-business stock from their taxable income. If they rolled the money into another small business within 60 days, they could exclude 100 percent of the gains.

One key requirement was that the qualifying small businesses maintain 80 percent of their assets and payroll in California. In other words, the incentive wasn’t available to people who invested in multi-state companies—and in a case decided last August, a state court of appeals ruled that this part of the tax statute violated the Commerce Clause of the U.S. Constitution.

In a notice issued on the final business day of December, 2012, the FTB declared that under its interpretation of the case, known as Cutler v. California Franchise Tax Board, the entire incentive statute was void. The FTB said everyone who had taken advantage of the QSBS incentive since 2008—the oldest tax year still open to new assessments—would have to pay taxes on the income they’d previously excluded.

To get in under the statute of limitations, the FTB said it would be forced to issue the first retroactive assessments by April 15, 2013. And in fact, it has already sent letters to some 2,000 taxpayers, warning them that a tax bill is on the way.

But today the FTB posted a set of changes to an online FAQ about QSBS gains, indicating that it won’t send a tax assessment to affected 2008 taxpayers for now, as long as they sign an agreement waiving the statute of limitations.

The FTB didn’t make clear how long the postponement would last. But it said taxpayers protesting their bills would have the “option to request that the protest be held pending legislative action.”

In effect, that stops the countdown on the 2008 assessments—and creates a lot more breathing room for taxpayers who were facing big retroactive increases in their 2009, 2010, 2011, or 2012 tax bills.

The approaching April 15 deadline was “a major issue” for opponents of the FTB’s policy, according to Overstreet, because “once those bills go out the state starts thinking about how it is going to spend the money, and then we are in a fight against much bigger organizations about whether or not they would get that money.” The FTB has estimated that about $120 million in unpaid back taxes is at stake overall.

Business groups have been working feverishly to mobilize opposition to the FTB’s plan in Sacramento. Some 39 state legislators signed a February 19 letter to Selvi Stanislaus, the FTB’s executive officer, calling the December notice a “sucker punch” to taxpayers and asking Stanislaus to reverse the policy.

Now Gov. Brown’s office has joined the fray. Overstreet says members of California Business Defense, as well as tax law experts hired by the group, have been in consultation with Brown’s senior staff throughout February. “The problem was that the governor’s office, as well as the legislators, have only been hearing from the FTB about what they could and couldn’t do” in reaction to the Cutler ruling, Overstreet says. “So we showed up and said, ‘Listen, there are alternatives, and here is an opinion about what those could be, and the minimum you should ask for is a standstill until there is additional time taken to get input from the governor, the legislature, and other interested parties.”

Overstreet, who is CEO of a Healdsburg, CA-based drug safety startup called AdverseEvents.com, says members California Business Defense heard “rumblings” early this week “that we had convinced the right people [in the governor’s office] and that a change from the FTB was imminent.”

Those changes showed up today in the form of the alterations to the FAQ. Now Overstreet says his group is waiting for a more formal indication from the FTB or the governor’s office about the most likely path toward a resolution.

Under continued pressure from the Brown Administration, the board could ultimately conclude that the Cutler ruling doesn’t actually require it to claw back payments from past tax years. But such a thorough reversal might be unlikely—in which case Overstreet says California Business Defense would turn to sympathetic legislators, who are already drafting bills that would aim to restore the small business investment incentives without violating the Commerce Clause.

“It was an administrative decision and we’d like to find an administrative fix,” Overstreet says. “That may or may not be possible. If it does end up going the legislative route, obviously we would like to see a provision that wipes out the retroactive tax, and if it’s possible, preserves the option of a QSB tax incentive going forward.”

Says Overstreet, “This isn’t just about protecting our own personal pocketbooks—it’s about maintaining the incentive for people to start, grow, and keep their businesses in California.”

Update, March 6, 2013: California state Senator Ted Lieu, a Democrat from Torrance, CA, announced March 5 that he is working with members of the California State Assembly to write legislation that would override the retroactive tax assessments. Lieu said that bills moving through the Senate and the Assembly will be amended to “bring relief” to taxpayers who received notices of assessment from the FTB, and to prohibit the agency from seeking penalties and interest when it asks for retroactive tax payments as the result of court rulings like the Cutler ruling. Lieu told U-T San Diego that “The language will very clearly fix the problem that the FTB said they could not fix administratively.”

Wade Roush is the producer and host of the podcast Soonish and a contributing editor at Xconomy. Follow @soonishpodcast

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  • Davidws

    The real issue here is the State’s Taxing Authority being overly aggressive, with a four (4) year reach back for correcting a law that our legislatures founded and intended to help spur small business growth in California. Now, as the courts have found, a clause in the Tax Code was unconstitutional. Going back four (4) years was not a stipulation of the courts findings…this was decided by the Franchise Tax Administrative body…NOT the “GOVERNOR” and NOT our “LEGISLATORS” and NOT the Franchise Tax “BOARD OF DIRECTORS”.

    If this retroactive tax affected the general tax paying population of California citizens,..it never would have happened!. And since it affects 2,000 job creating entrepreneurs and investors…it isn’t getting the press it would have. Our government servants well know the general population will have little sympathy for an additional tax burden on the rich….we can thank our current President for setting this tone. On the other hand, every citizen knows deep in their hearts that reaching back four (4) years is …. SIMPLY WRONG!