California Grants Full Relief from Retroactive Capital Gains Taxes

California Grants Full Relief from Retroactive Capital Gains Taxes
October 7, 2013

Steve Stanek

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

Gov. Jerry Brown of California has signed a bill to give 100 percent relief to approximately 2,500 small business investors who had been threatened with retroactive collection of $120 million of capital gains taxes, interest, and penalties—taxes the state had promised they would never have to pay.

Brown’s signing of the bill ends almost a full year of worry for the investors, who had participated in a tax incentive program California established 20 years earlier.

“The sense of relief is indescribable,” said Brian M. Overstreet, one of the founders of California Business Defense, which led the fight against the retroactive taxation, and one of the small business investors who would have been hit by it. “We thank the governor for reassuring the state's innovators and risk-takers that California is still the place where the companies of tomorrow should be built. We are all eager to get back to work creating new jobs for California citizens and new opportunities for people to invest in California’s future.”

Governor Had Choice

It was a tense three weeks for Overstreet and the other affected investors. In mid-September the California Assembly sent Brown, a Democrat, two bills to deal with the issue. One provided full relief and the other only partial relief that would have required the investors to pay $30 million in retroactive taxes. Legislators and investors did not know which version of relief the governor would sign, or whether he might veto both bills.

The predicament in which the small business investors found themselves stirred strong bipartisan support for relief among a core group of legislators led by Sen. Ted Lieu (D-Torrance).

“Gov. Brown’s action reinforces the principle that California stands behind the rule of law,” said Lieu in a statement. “It’s simply unfair to punish people for following the law even if it was later overruled. Gov. Brown and the California Legislature today are sending a strong message that we will stand by our word and address situations that are unreasonable and bad for business. I applaud Gov. Brown for fully and completely ending this job-killing, retroactive tax.”

Overstreet and the other affected investors participated in California’s Qualified Small Business Stock incentive program, which allowed 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.

Program Ruled Unconstitutional

Last year, the Second District Court of Appeal struck down the incentive program, ruling it violated the Constitution’s Commerce Clause because it required a business to have 80 percent of its payroll and assets in California to qualify for the incentive.

The state’s Franchise Tax Board then announced it would demand payment of capital gains taxes going back to 2008, even though the court did not order the collection of taxes that had been forgiven under the program.

That decision went virtually unnoticed until Overstreet received a letter from his lawyers informing him he could be on the hook for capital gains taxes resulting from his sale of a company earlier in 2012. He had used the money he saved through the incentive program to help start AdverseEvents, a company that compiles and provides safety and outcome information on all FDA-approved drugs. Most of the other participants in the incentive program also had reinvested or spent the money they had saved. Some investors faced retroactive tax bills in the hundreds of thousands of dollars.

Quick Response

In January Overstreet wrote an article on what he had learned from his attorneys for the Xconomy.com Web site, and momentum to stop the retroactive taxation built from there.

In an article posted on Xconomy.com describing the effort to defeat the retroactive taxation after Brown signed the bill, Overstreet wrote, “Within hours of my original Xconomy post, three affected entrepreneurs contacted me. We four arranged a conference call and immediately decided to collaborate. On the spot, we formally organized a group to fight the retroactive tax. Within 48-hours we had a name—California Business Defense—as well as a brand, a website, and a mechanism to grow membership and collect funds. The coalition grew to 40 people, all founders of California start-ups that were penalized by the retroactive tax.”

Overstreet noted Sen. Lieu soon reached out to the group and they received early support from Assemblyman Jeff Gorrell (R-Venutra). The two legislators prepared SB209 to provide full relief as Overstreet and other businesspeople met with dozens of other legislators to lay out the issues and explain the need for relief.

Overcame Objections, Roadblocks

After much maneuvering, a new bill to address objections that had been raised and roadblocks that had been thrown up was introduced. That bill—AB1412—is the one Brown signed into law.

“A five-year retroactive tax on law-abiding start-up founders never should have happened,” Overstreet wrote. “Once enacted, it never should have required a dedicated team working full-time for nearly nine months to overturn it. Some will interpret these events as further evidence that our government is irrevocably broken. But I hope you will consider our outcome. We proved that success and progress can happen when we engage with our lawmakers.”

Steve Stanek

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