California Startups are Struggling because of California Taxation?

August 23, 2013

The California legislature may have just taken another step toward remedying a terrible mistake that the Franchise Tax Board made earlier this year, but in this case, it could be too little, too late, for the state’s reputation as a nurturing and caring space for new businesses.

Woman touching a screen with annotations "startup".

What Happened to California Startups?

Last year, a California court struck down a tax break that had been in place since 1993, which allowed certain small businesses to deduct 50% of their gains when paying income taxes on a sale of stock. The exclusion was intended to incentivize entrepreneurs to both start and keep their companies within the state, but the court ruled that such a policy was discriminatory.

The Franchise Tax Board analyzed the ruling and then decreed that the tax deduction would be rejected retroactively for up to 4 years, back to tax year 2008. Business owners who sold stock in their companies within the past 4 years were sent letters demanding retroactive taxes, as well as interest and penalties.

Entrepreneur Brian Overstreet wrote about this situation for CNBC in May, and explained that he had sold a company in 2012 and dutifully paid  tax on 50% of his capital gains. Then in early 2013, he was sent a notice, demanding an additional $250,000 plus interest and penalties, after the FTB cancelled the tax break and made the revocation retroactive.

What’s Happening Now with California Taxation

Entrepreneurs and legislators immediately took action, with the Senate putting forth Bill 209, which would reinstate the exclusion, although only 38% of gains would be excluded, as opposed to the 50% that the previous law allowed.

On Monday, August 12th, the Committee on Revenue and Taxation approved the bill, which goes next to the Appropriations Committee. The committee, however, has over 100 other bills under consideration, so it may be a while before SB 209 is addressed.

Young employees of a California startup at a meeting.

Texas As An Alternative fo California Startups

While California messes around with its entrepreneurs, however, Texas is not hiding its desire  to attract them.

Rick Perry, governor of Texas, made a trip to California earlier this year in an effort to lure start-ups to his state. In the radio advertising campaign that accompanied his trip he said, “Building a business is tough. But I hear building a business in California is next to impossible. See why our low taxes, sensible regulations, and fair legal system are just the thing to get your business moving to Texas.”

Austin is one of the fastest-growing tech hubs in the country, and it offers a stark contract to other tech business communities like New York or Boston: Less expensive real estate, lower taxes and less regulation.

Joe Trammell, Chairman of the Austin Technology Council,  said that his office phone is ringing off the hook with calls from businesses in California that are considering a relocation. “All the major companies have a presence in Austin, so it’s pretty easy for people to switch.”

Is It Too Late?

When John Kinzell started his third company, Xeris Pharmaceuticals, in 2010, he chose to launch the company in Austin instead of in California, where he had started his previous two businesses, and where he had lived for 25 years.  “It’s just become a very unfriendly state to run a company. Once that sort of bleed starts, it gets hard to reverse it.”

Other entrepreneurs agree. Ethan Anderson, co-founder and CEO of start-up MyTime, said, “You can’t really plan for the future when the rules of the game are changing retroactively. You feel insecure investing in the state, why would you take that additional risk when they’ve set a precedent now showing that anything could happen anytime?”

Anderson claims that entrepreneurs like him have helped drive much of the state’s economy, and is truly insulted by the FTB’s actions.  “Who else is creating the jobs? Why would they hurt us like this? The next time I start a business, it most probably won’t be in California.”