California’s Elimination of Qualified Small Business Stock Exclusion for All Individual Taxpayers for 2008 State Returns and Beyond May Not be the Final ResultMarch 2013
Under Federal law, an individual taxpayer’s gain on the sale of qualified small business stock (QSBS) is not recognized if the taxpayer uses the gain to purchase stock in another qualified small business within 60 days. 26 U.S.C. § 1045. While this Federal “rollover” provision did not apply to California’s personal income tax,i see Cal. Rev. & Tax Code. § 18038.4, from 1993 until 2012, California had its own provisions for the exclusion and deferral of gains on QSBS, which were contained in Cal. Rev. & Tax Code §§ 18038.5(a),ii 18152.5(c)(1)iii and 18152.5(c)(2)(A).iv
On August 28, 2012, the California Court of Appeals for the Second District issued an opinion in the case of Cutler v. Franchise Tax Board, 208 Cal.App.4th 1247 (2012), that determined that the California provisions for the exclusion or deferral of gain on QSBS were a violation of the U.S. Constitution’s commerce clause, as they improperly favored investment in California companies (defined as corporations using 80% of their assets in the conduct of business in California and maintaining 80% of their payrolls in California) over investments in non-California companies.v In response to this opinion, on December 21, 2012, the California Franchise Tax Board (FTB) issuedNotice 2012-03 to advise the public as to how it intended to implement the Cutler decision.
In Notice 2012-03, the FTB stated that because the exclusion and deferral provisions of Cal. Rev. & Tax Code §§ 18038.5(a), 18152.5(c) (1) and 18152.5(c)(2)(A) were determined unconstitutional, “these sections are now invalid and unenforceable” and, according to other precedent, “an appropriate remedy is to deny the exclusion/deferral to taxpayers who benefited from either the exclusion/deferral.” But, because the determination of the appropriate remedy for an unconstitutional provision also requires that similarly situated taxpayers be treated similarly, the Notice went on to state that this remedy cannot be applied to taxpayers for taxable years beyond the four-year statute of limitations. In other words, the FTB determined to allow the exclusion/deferral for taxpayers on returns for taxable years prior to 2008, as those years’ four-year statutes of limitation had already expired, but to deny the exclusion/deferral for taxpayers on returns for taxable years beginning January 31, 2008.
Because QSBS exclusions/deferrals are, at present, no longer valid for California purposes, taxpayers who previously took advantage of California’s treatment of QSBS in years still open for assessment (generally 2008 and beyond) must now recompute their taxable income for each affected year without excluding or deferring gains from the disposition of QSBS, and submit amended returns to the FTB to correct this item. Those affected taxpayers who do not undertake these efforts will eventually be contacted by the FTB, which may assess interest and penalties as appropriate.vi As early as April, 2013, the FTB intends to start issuing Notices of Proposed Assessments (“NPAs”) to some 500 individual California taxpayers who claimed QSBS exclusions or deferrals on their 2008 returns. Taxpayers receiving NPAs can protest the FTB’s proposed disallowance of the QSBS exclusions or deferrals under procedures established by the FTB.
While this may appear to be the end of a favorable tax treatment for QSBS investors, the jury is still out on whether the FTB’s actions, particularly the retroactive application of the elimination, will ultimately be determined to be appropriate. Affected taxpayers will likely work collectively to challenge the FTB’s action in court. Further, the California legislature is expected to take on the issue, and may provide relief from the effects of the FTB’s actions, or possible alternative remedies. In light of these very likely scenarios, the FTB’s protest procedures allow affected taxpayers who wish protest the proposed disallowance in an NPA to request that their protest be held in abeyance pending anticipated court or legislative action.
For taxable years beginning before January 1, 2008, that are still open under the statute of limitations, a QSBS exclusion or deferral will be allowed if the taxpayer meets all other requirements under California law. Taxpayers with pre-2008 taxable years that are still open should consider filing a protective claim for refund and may wish to seek appropriate legal counsel to assist them in this process.
If you have questions regarding the FTB’s Notice and its possible effects on you or your clients, or you need assistance with California franchise or income tax matters, please contact any of the following Sideman & Bancroft tax professionals at (415) 392-1960: Emily J. Kingston, Steven M. Katz, and Jay R. Weill.
i The deferral of gains on QSBS is only applicable to individual taxpayers, not to corporations. Cal. Rev. & Tax Code § 18038.5(a).
ii Cal. Rev. & Tax Code § 18038.5(a) states in pertinent part that: “In the case of any sale of qualified small business stock held by a taxpayer other than a corporation for more than six months …, gain from that sale shall be recognized only to the extent that the amount realized on that sale exceeds: (1) the cost of any qualified small business stock purchased by the taxpayer during the 60-day period beginning on the date of that sale.
iii Cal. Rev. & Tax Code §18152.5(c)(1) defines “qualified small business stock” as “any stock in a C corporation which is originally issued after August 10, 1993,” if “[a]s of the date of issuance, the corporation is a qualified small business,” and “the stock is acquired by the taxpayer at its original issue,” either in exchange for money or other property or as compensation for services provided to the corporation.
iv Cal. Rev. & Tax Code § 18152.5(c)(2)(A) specifies that stock in a corporation is not to be treated as qualified small business stock “unless, during substantially all of the taxpayer’s holding period for the stock, the corporation meets the active business requirements of subdivision (e)(defined as corporations maintaining 80% of their assets and payroll in California), and the corporation is a C corporation.
v The Cutler decision has no effect on the IRS’s treatment of QSBS.
vi The FAQs to the FTB’s notice provides that while interest will accrue on a balance due, “[g]enerally there will not be penalties assessed due to the correction of a reported gain exclusion or deferral relating to QSBS.”