Investors across California are upset about a surprise retroactive tax bill that could cost them millions in back taxes to the state of California. This California Retroactive Tax, in addition to the voter-approved income tax increase imposed by Proposition 30, has caused investors to be more thoughtful when deciding whether or not to fund a California-based company. Many are claiming that these decisions could cause long-term damage to California’s economy.

Federal income tax law currently allows for a certain deduction to be claimed from the sale or exchange of qualified small business stock, but California adopted its own provisions in 1993, which generally paralleled the federal scheme. However, the state of California offered a tax deduction to investors and founders of small businesses.  This deduction allowed a 50% exclusion of any gain on the sale of “Qualified Small Business” (“QSB”) stock. The capital gain tax in California was essentially reduced from 9% to 4.5%, which encouraged entrepreneurs and their investors to keep their companies in California.

As exemplified by the large number of start-up companies in California, especially in the Bay Area, many investors took advantage of this deduction. Unfortunately for them, the August 2012 decision by the California Court of Appeals in Cutler v. Franchise Tax Board rendered the statute that allowed the tax deduction invalid and unenforceable because it discriminated against investors in out-of-state companies. California was forced to eliminate this tax deduction, and, even worse, applied this elimination retroactively to 2008.  (It should be noted that the Court of Appeal’s decision only impacts the California QSB stock rules and not any federal tax benefits allowed by the Internal Revenue Code.)

Basically, if you sold a California company in the past five years and applied this tax deduction, you now have to pay back the tax…with interest.

If you took advantage of the QSB deduction, you must now file amended tax returns for the years in which you applied the deductions. If you fail to do so, the California Franchise Tax Board will contact you and may impose a penalty. The California interest suspension rule that suspends the accrual of interest if an assertion of tax is not made within 36 months after a tax return is timely filed may prove advantageous for certain tax payers. If 36 months have already elapsed since your tax return was timely filed, you may want to consider waiting for the Franchise Tax Board to make an adjustment by Notice of Proposed Assessment instead of filing an amended return. In any case, it is recommended that you consult with a tax expert to determine your appropriate course of action in light of this retroactive decision.

More information on the QSB retroactive tax can be found on the California Franchise Tax Board Website.

About the author

Matt Faustman

Matt Faustman

Matt is the co-founder and CEO at UpCounsel. Matt believes in the power of online platforms to change antiquated ways of life and founded UpCounsel to make legal services efficiently accessible. He is responsible for our overall vision and growth of the UpCounsel platform. Before founding UpCounsel, Matt practiced as a startup and business attorney.

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