California Tax Board Imposes Retroactive Taxes on Capital Gains

California Tax Board Imposes Retroactive Taxes on Capital Gains
March 5, 2013

Steve Stanek

Steve Stanek (sstanek@heartland.org) is a research fellow at The Heartland Institute and managing... (read full bio)

When people follow rules, they don’t expect to be penalized years later for having done so.

But that’s what’s happening in California, where state tax officials have decided to retroactively apply taxes that small business owners and investors were told they would not have to pay.

The Franchise Tax Board’s move “has the potential to have a chilling effect on business creation and entrepreneurship,” said Brian Overstreet, a California entrepreneur who started rallying opposition to the retroactive tax and created the California Business Defense Web site to keep up the heat (cabusinessdefense.org). “We can’t plan if we can’t rely on rules. The reality is it’s much easier than even 10 years ago to pick up and move and have people work remotely. That’s what the solution is going to be” if retroactive taxation happens.

“It’s an egregious move by California’s tax board,” said Jeffrey McKinley, a certified public accountant and president and cofounder of Senex Solutions, LLC, which provides accounting services to proprietary trading firms, hedge funds and commodity trading advisors.

“Given the explosion of state debt and obligations, businesses must adapt and thoroughly assess the political environment of the state they choose to locate, expand or even remain in. The California tax move appears to be out of the blue, but at some point businesses that naively set up in states that are fiscal disasters run by politicians who routinely treat residents like an ATM shoulder at least some of the blame,” McKinley said.

$120 Million from 2,500

With its many “Silicon Valley” and other startup companies ripe for the picking, California officials predict they can bring in another $120 million of taxes from small business owners and investors who sold a business as much as five years ago. Tax officials estimate 2,500 taxpayers could be affected.

The state government 20 years ago provided a tax incentive to lure entrepreneurs and early-stage investors to California. The incentive allowed their sales of stock of a "qualified" small business to be taxed at half of the regular state rate on capital gains or rolled over into a new qualified small business if reinvested within 60 days of the sale.

But the Franchise Tax Board has declared these people will be billed retroactively -- with interest -- to 2008 for the 50 percent of the taxes they had legally excluded. The state's tax rate on capital gains several years ago was 9 percent and is now 13.3 percent.

Incentive Unconstitutional

The FTB’s move comes in response to a court decision issued last year in Cutler v. Franchise Tax Board. The Second District Court of Appeal declared one part of the qualified small business stock exclusion unconstitutional because it required businesses to have 80 percent of their payroll and assets in California. The court ruled this provision violated the Constitution’s Commerce Clause.

However, the court did not direct California to seek back taxes. The tax board staff made that decision.

“As an elected official and taxpayer advocate, I cannot remain silent while state tax officials punish California taxpayers who in good faith followed our laws,” said Board of Equalization member and former California State Senator George Runner, who has been working to persuade the tax board to reverse its decision. The BOE is the final arbiter of tax board appeals.

‘Understandably Outraged’

In a February 5 letter to the tax board, Runner wrote, “Understandably, affected taxpayers are outraged by this action. They made business decisions in good faith based on existing California tax law. It is not possible for them to undo these decisions in response to FTB’s retroactive actions.”

He added, “FTB’s action sends entirely the wrong message to investors, entrepreneurs and job creators doing business in our state.”

Outrage appears to be bipartisan. On February 19, 38 members of the California Legislature from both major political parties signed a letter to Selvi Stanislaus, executive director of the FTB, in which they wrote the decision to send retroactive tax assessments “is not acceptable, inconsistent with the law as we understand it and contradicts prior FTB action . . . Under no circumstances is FTB staff required [their emphasis] to issue retroactive QSBS assessments going to back to 2008. That is simply not true and there is nothing in the Cutler case – or any other that we are aware of that says so. FTB staff chose [their emphasis] to do so for whatever reason.”

In a separate letter, Sen. Ted Lieu (D-Torrance) wrote, “I recently spoke with a taxpayer who all of a sudden is faced with a new retroactive tax bill of over $200,000 plus interest even though he complied with the law. I am informed there are thousands of other taxpayers who will be faced with potentially even higher retroactive bills and penalties. I am requesting that your staff reverse the retroactive portion of the decision.”

‘Tipping Point’

“One wonders at what point will capricious taxation policy, including retroactive taxation, produce a tipping point whereby creative individuals reassemble outside of Silicon Valley and to say, Austin, Texas” said Hilary Till, co-founder of Premia Capital Management, LLC, a proprietary trading and research firm.

In the wake of the anger and opposition from lawmakers from both sides of the political aisle, the tax board recently announced it would delay sending payment notices to affected taxpayers, to give the legislature time to address the issue.

SIDEBAR

The Man Who Sounded the Alarm Against California’s Retroactive Taxation

But for a letter from his firm’s lawyers that Brian Overstreet could hardly believe, more than 2,000 California small business owners and investors already might have received notices that they collectively owe $120 million on capital gains they thought were not to be taxed.

On January 15 Overstreet published an article on the California Franchise Tax Board declaring it would retroactively pursue payment for capital gains that were, at the time, legally excluded from taxation. That article, on the Xconomy.com Web site, detailed what he had learned from his lawyers several weeks earlier. Before long major newspapers in the state were writing about it, and businesspeople and lawmakers were rising in opposition.

‘Almost Got Away With It’

“They almost got away with it,” Overstreet said of the FTB. “I waited three or four weeks [after receiving the letter from his lawyers] before I wrote the article because I expected someone would start screaming about it, but no one did. I’m not sure what would have happened if I had not been affected by this and spoken out. It’s very possible this would have gone through. It’s kind of mindboggling.”

In 1999 Overstreet cofounded Sagient Research Systems, an enterprise-focused data company in San Diego that had about 40 employees, all of them in California. In 2012 he sold the company, which resulted in a capital gain. He now runs AdverseEvents in Healdsburg, Calif., which compiles and provides safety and outcome information on all FDA-approved drugs. Some of that capital gain money has gone into AdverseEvents.

Near the end of 2012, Overstreet’s lawyers notified him the FTB staff had reached a decision that would make the capital gain on his sale of Sagient Research Systems fully taxable, even though, at the time, he qualified for a 50 percent reduction in the tax.

‘Money Spent or Reinvested’

“I’ve spoken to a number of people who had transactions, sold companies, and took a tax exclusion, and what they took out was spent or reinvested. To come up with hundreds of thousands of dollars after the fact, they don’t have that cash sitting around,” Overstreet said.

“Since I’ve raised the noise level on this issue, while the FTB has not backed off, it has said publicly a fix must come from the Legislature, and they are happy to do what they need to do to support it.”

Bipartisan Fix in Works

The FTB has said it will wait until the end of the year to send out notices for back taxes. In the meantime, a bipartisan bill was introduced to cancel the retroactive application of the capital gains tax.

“This doesn’t guarantee it gets signed by the governor, but at least we’ll have something in writing to rally people round,” Overstreet said.

Steve Stanek

Steve Stanek (sstanek@heartland.org) is a research fellow at The Heartland Institute and managing... (read full bio)