California Pursuing Small Business Owners for Retroactive Tax

July 1, 2013

The California Franchise Tax Board infuriated thousands of small business owners earlier this year when it sent out letters informing them that they owed four years’ worth of taxes due to a recent decision of the state’s Supreme Court.

The court struck down a 20-year-old tax break as unconstitutional, and the FTB then felt obliged to go after business owners who took the break during the last four tax years, which are still open for reexamination under the government’s statute of limitations.

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What’s at Stake

The tax break allowed certain small business owners to pay only half of the ordinary capital gains rate of 9% on their sale of company stock, provided that the business kept 80% of its payroll costs and assets within the state after the sale. The break was designed to keep businesses from moving offshore or to other states.

After the statute was struck down last August, the FTB then recalculated taxes for those business owners that had qualified for the exclusion, including interest and penalties, and says that about 2,000 residents are affected for tax years 2008 to 2011, to the tune of $120 million owed.

Officials from the Franchise Tax Board argue that the statute’s invalidation requires them to demand the retroactive taxes, but business owners and legislators don’t agree.

“An Incredibly Dangerous Precedent”

One extremely vocal critic, state Sen. Ted Lieu (D-Torrance, said, “California government should not punish innocent, law-abiding taxpayers retroactively just because it may have the power to do so.” He says that the move serves as

“an incredibly dangerous precedent” that could potentially discourage businesses from locating in California.

Lieu is demanding that the board reverse its decision, and cites a number of U.S. Supreme Court decisions as a legal basis for a reversal.

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Business Owner Reaction

Brian Overstreet, a software engineer, said this about the decision: “… in this instance California changed the rules after the fact, and that’s just not right. More importantly, the [Franchise Tax Board’s] radical action is going to send a terrifying message that will have the unintended consequence of driving young, growing businesses to friendlier environments. That’s the last thing that the state of California needs right now.”

Overstreet has founded an organization, California Business Defense, and is allying with the Bay Area Council, an alliance of large, high-tech companies, to put together a plan to counter the FTB.

The group is working together with legislators to craft a new version of the original 1993 law, which will extend the tax break to all investors, regardless of whether or not the business retains its employees and assets in California.

No New Law Necessary

Senator Lieu claims that the Franchise Tax Board can resolve the problem without any new legislation being needed.  “The FTB staff is wrong, wrong, wrong to say this issue requires action by the Legislature,” he said. “The FTB staff is misleading the public.”

He says that the board has the power to grant the break to all investors, and that it can also choose not to apply the retroactive taxes. “It’s wrong to sock it to these taxpayers,” he said, “after they relied on the law the way it was written.”

Current Situation

As of May 30th, the California Senate has appoved Bill S.B. 209 that addresses the issue. The bill offers some relief, but not a total reversal of the Franchise Tax Board’s decision.

Under S.B. 209, owners who have already received notification will be obligated to pay 25% of the proposed assessment. Taxpayers who were denied the exclusion are entitled to a 38% refund of taxes paid. And the Franchise Tax Board also will waive all interest and penalties on any retroactive taxes.

The bill passed 4 to 3, and moved on to the California Assembly.