California Taxpayers lose Past and Present Rights to Certain “QSBS”-Based Benefits
February 15, 2013Nilufar Haque, Director - Tax Services Anne Macdonald, Partner - Tax Services Some California taxpayers will once again face a retroactive increase in their California income tax liabilities. Last fall Proposition 30 retroactively increased 2012 tax rates. Now the California Franchise Tax Board (FTB) has announced that it will increase the tax liabilities of Californians who previously claimed tax benefits for certain qualified small business stocks or "QSBS." After a California Court of Appeal decision known as Cutler v. Franchise Tax Board found certain portions of California tax law to be unconstitutional, the FTB announced, in late December 2012, how it will apply this holding. Background on the California Appellate Court's Decision Since 1993, the federal Internal Revenue Code has allowed taxpayers to qualify for special tax benefits related to the exclusion or deferral of gain from the sale of stock held in a qualified small business. These QSBS provisions were meant to encourage investment in certain small business companies. The California legislature adopted a mirror version of the QSBS exclusion and deferral provisions in its own laws (Sections 18152.5 and 18038.5 of the California Revenue and Taxation Code or CR&TC) but it added two requirements: For taxpayers to qualify for the California benefits, the small business companies in which they invested must have had at least 80% of their assets and 80% of their payroll in California during substantially all of the time the taxpayers held the stock In Cutler v. Franchise Tax Board, a taxpayer challenged the constitutionality of California's QSBS provisions. The trial court rejected the challenge and upheld the constitutionality of these statutes. However, upon appeal, the Second District Court of Appeal reversed the trial court's determination. The Court of Appeal held that, because the purpose and effect of the California QSBS statutes is to favor California corporations over foreign corporations, the statutes are discriminatory and cannot stand under the commerce clause of the United States Constitution. In response to Cutler, the FTB issued a notice (FTB Notice 2012-03) on December 21, 2012, outlining the procedures that it will use in implementing the court's decision.