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California: Remember the Taxes You Didn’t Owe? Surprise!

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California cannot chase business away fast enough, it seems: high taxes, cap-and-trade, voracious unions, bankrupt cities, and now retroactive taxation.

Shortly before the Christmas holidays and oh so quietly, the California Franchise Tax Board (FTB) rescinded a tax break that dated back to 1993. The Qualified Small Business Stock (QSBS) exclusion allowed small businesses and investors who met certain conditions to exclude or to defer 50 percent of the profits of sold stock from their personal income taxes. The incentive was intended to lure startup companies of under $50 million into the state.

Now those who were ensnared have not only lost that tax break for the future; many are also being taxed retroactively back to 2008. Plus interest. Plus possible penalties.

U-T San Diego (Jan. 25) reported on just one businessman affected,

Bruce Hansen, who cofounded ID Analytics in San Diego and led the company as chairman and chief executive until its sale to LifeLock for $195 million in 2012, said the biggest heartache was discovering that the state was changing the rules dating back several years. It’s a decision that he says will cost him several hundred thousand dollars.

The tax board estimates the retroactive tax will impact up to 2,500 people, who collectively owe up to $150 million. By contrast, the Los Angeles law firm Manatt, Phelps & Phillips believes “countless taxpayers” could be impacted; clearly, the law firm believes many more than 2,500 have filed QSBS exclusions since 2008. Businessman Brian Overstreet, who broke the story in the publication Xconomy, believes the tax-bill estimate is also considerably understated. (Dollar estimates also vary depending on interest and possible penalties.)

But the numbers are less important than the precedent being set. Apparently, those who complied with tax law can still be hounded by a tax agency that reaches back several years to change its own rules and then demands payment or else. The precedent is particularly dangerous, because it came from tax-board staff rather than from elected officials. A massive and arbitrary power rests in the hands of unaccountable bureaucrats.

The proximate cause of the tax grab

The Franchise Tax Board (FTB) bureaucrats blame one court case: Frank Cutler v. the Franchise Tax Board. Orange County businessman Cutler accused the tax break of discriminating against California-based companies with a significant presence in other states. The QSBS provision applied only to small businesses with 80 percent of their property and payroll within California.

When Cutler was denied a QSBS filing in 1998, he went to court. In August 2012, after 14 years, he won. The San Francisco Chronicle (Aug. 29, 2012) stated, “The Second District Court of Appeal in Los Angeles said the law interferes with the free flow of interstate commerce by favoring California businesses over their competitors.” In short, the tax was unconstitutional.

The court did not prescribe a remedy, and the FTB had several options under previous case law. The most obvious one was to change or eliminate the one provision found to be unconstitutional: the 80 percent requirement. Or the board could have dropped the QSB exclusion as of the date of the court decision, awaiting legal or legislative guidance.

But tax agencies do not like losing, and so the FTB turned a court loss into a tax-collection spree. Cutler’s attorney explains,

We thought the appellate court decision would be a big win for taxpayers. By ending the discriminatory nature of the incentive, it should have expanded the pool of startups and small businesses that qualified for the benefits. But we were taken aback by the FTB’s approach.

They shouldn’t have been. Ex post facto or retroactive law is prohibited by the U.S. Constitution’s article 1, section 9, clause 3, which states that “No Bill of Attainder or ex post facto Law shall be passed.” But this provision does not apply to laws that were passed and subsequently invalidated. Moreover, retroactive liability for estate taxes was upheld by the United States Supreme Court in the 1994 case United States v. Carlton.

Conclusion

The California tax bills should be arriving shortly, if they have not already. The statute of limitations on taxes from 2008 will expire in April 2013. Those will be the first bills received.

For businessmen with startup plans, other states will beckon. Overstreet explains,

Here’s the real kicker. Just at the moment when California is retroactively taxing entrepreneurs, the federal government is extending the federal QSB benefit.

Per amendments in the new “fiscal cliff” law, if you started or invested in a QSB between September 28, 2010 and January 1, 2013 and ultimately sell stock under the federal QSB provisions, you’ll pay no federal capital gains tax, and in some states, no state taxes. But not California — we’ll pay up to 13 percent!

Overstreet has cofounded the California Business Defense (CBD) group to fight back by taking the matter to the media and to the legislature in Sacramento. The CBD has a decent chance of reversing the retroactive tax. The media and public have expressed outrage.

There are strong voices of support in Sacramento. On January 18, Senator Ted Lieu circulated a letter he had written to the Executive Director of the FTB, demanding a reverse of its decision. Declaring that “California is not a banana republic,” he excoriated the FTB for punishing “innocent, law-abiding taxpayers retroactively just because it may have the power to do so.”

Assemblyman Bob Wieckowski has vowed to legislatively fix the FTB policy.

(Both Lieu and Wieckowski are Democrats.)

The bottom line is that California politicians do not want to quash the startups, especially tech ones. Their investment has been a rare ray of optimism in the state’s economy. California does not want to lose more employers and affluent taxpayers to Texas.

It may be too late. News coverage frequently includes statements from entrepreneurs who now see the Californian government as arbitrary and openly hostile. Ethan Anderson is an example. The cofounder of one business and a well-known mentor to other startups, Anderson explains the impact of the FTB policy, which may be irreversible even if the retroactive tax is abandoned.

You can’t really plan for the future when the rules of the game are changing retroactively. You feel insecure investing in the state, why would you take that additional risk when they’ve set a precedent now showing that anything could happen anytime?”

 

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    Wendy McElroy is an author for The Future of Freedom Foundation, a fellow of the Independent Institute, and the author of The Reasonable Woman: A Guide to Intellectual Survival (Prometheus Books, 1998).