California Franchise Tax Board Strikes Again

One of the few benefits that entrepreneurs and investors were able to take advantage of in California was the partial state income tax exclusion on the sale of stock for a Qualified Small Business (QSB). Due to a recent court decision ruling its unconstitutionality, the Franchise Tax Board (FTB) is retroactively disallowing this exclusion.

This exclusion allowed entrepreneurs and investors in QSBs to exclude 50% of the taxable gain on the sale of their stock. Instead of paying the regular California tax rate on the gain of 9%, entrepreneurs and investors paid about 4.5%, an incentive for those looking to invest in or start a business in California.

In the Cutler Decision on August 28, 2012, the California Court of Appeal upheld that certain sections of the California Revenue and Tax Code were unconstitutional as they related to Qualified Small Business Stock (QSBS). The QSBS exclusion required that at least 80% of the corporation’s assets be used in California and at least 80% of its payroll must be for employment located in California. Subsequently, the FTB ruled that the applicable Sections are now unenforceable and invalid.

Although California’s rules attempted to mirror the Federal provisions on the issue, California had certain requirements that favored heavy California activity and gave California companies preferential treatment not required at the Federal level, thus causing the findings to be deemed unconstitutional.

The FTB’s response has been a retroactive disallowance of the QSBS exclusion, resulting in hefty tax bills for many. From January 1, 2008 through December 31, 2011, the FTB will retroactively disallow the exclusion. Generally, taxpayers who took the exclusion on their individual returns are expected to amend their returns and pay the tax. Those who took the exclusion on or after January 1, 2008 can expect a tax bill related to the exclusion. Currently, interest will be applied to the amended outstanding balance, but no penalty will be assessed. For tax years beginning in 2012, the exclusion will no longer be permitted.

It is important to note that this ruling does not affect federal QSBS exclusions. Additionally, the American Taxpayer Relief Act of 2012 extended the federal QSB benefit, allowing 100% exclusion for gains on the sale of qualifying small business stock at the federal level.

For tax years beginning on or after January 1, 2008, the FTB will individually notify taxpayers who took the QSBS exclusion and expect them to remedy their returns. Alternatively, taxpayers can voluntarily amend their returns in anticipation of receiving their Notice of Proposed Assessment. For tax years beginning before January 1, 2008, no action is required due to expired statutes of limitations.

While it seems California has fixed another wrinkle in their taxing system, one has to wonder what message they are sending to start-up businesses in California.

Please feel free to contact me at rdarling@bpw.com or (805) 963-7811 with any questions you may have regarding this change.