After a 2012 court ruling invalidated an old tax break for small-business investors, California entrepreneurs laid siege to Sacramento. They persuaded allies in the California Senate to whip up a bill that would rescue them from an estimated $120 million in back tax payments, only to see the bill watered down by amendments. Now, as the clock runs out on the current legislative session, they’re about to find out whether they’ll get full relief—or whether they’ll still owe millions on tax returns they filed as far back as 2008.
Members of California Business Defense, a group of entrepreneurs affected by the tax change, are back in Sacramento today to meet with Assembly Appropriations Committee chair Mike Gatto, a Democrat from Burbank, CA. They’re trying to get Gatto’s committee to undo the amendments before the bill, SB 209, is sent to the full Assembly for a vote, which could happen as soon as this Friday. If a final version of the bill isn’t on Governor Jerry Brown’s desk by the end of the legislative session on Oct. 15, a solution for the tax mess will be off the table until next year—and big lawsuits could grind into gear instead.
“What we’re really going in and saying is, it’s now do-or-die time,” says Brian Overstreet, CEO of Healdsburg, CA-based AdverseEvents and co-founder of California Business Defense. Overstreet sold his previous company, Sagient Systems, in 2012 and would be liable for big back tax payments under the court ruling. “It’s ridiculous to ask us to bear the burden of paying for this,” he says.
The story of the evaporating tax break is a long and strange one. Until last year, any entrepreneur who sold stock in a qualifying small business (QSB) based in California could exclude 50 percent of the gains from her taxable income on her California income tax returns. The tax break was meant to reward and encourage investment in California-based small businesses, and it was pretty attractive to people like Overstreet—that is, startup founders selling their companies. But a 2012 decision by a state appellate court, in a case called Cutler v. Franchise Tax Board, invalidated the exclusion as a violation of the Commerce Clause of the U.S. Constitution, which prohibits states from enacting laws that discriminate against out-of-state businesses.
In response to the decision, the Franchise Tax Board, the state’s revenue body, ruled that everyone in California who had claimed the exclusion since 2008 would now be liable for back taxes—plus interest and penalties—on the formerly excluded income. The FTB geared up to start sending out bills to some 2,500 taxpayers this spring.
But by that time, Overstreet and peers from the Bay Area business community had formed California Business Defense and begun lobbying Governor Brown’s office for a reprieve. The FTB granted one in February, saying it would postpone sending out the assessments until the state legislature had had a chance to weigh in on the issue.
And that’s exactly what happened next. In April, State Senator Ted Lieu, a Democrat from Torrance, CA, introduced a Senate bill, SB 209, that proposed to throw out the portion of the QSB stock provisions that the court had ruled unconstitutional, while restoring the 50 percent exclusion for past and future tax years in a different, somewhat broader form.
Lieu’s bill survived a review by the Senate Finance and Governance Committee, but in late May it ran into a hitch. The Franchise Tax Board told members of the Senate Appropriations Committee that under Lieu’s broader definition of the QSB exclusion, it might have to issue up to $30 million in tax refunds to taxpayers who could have qualified for the exclusion in past years and who might now file for it retroactively. To pay for those projected refunds and make Lieu’s bill revenue-neutral, the Appropriations Committee amended it, reducing the allowable exemption for past tax years from 50 percent to 38 percent, and eliminating the tax break entirely for future years.
The Senate Appropriations Committee sent the amended bill on to the full Senate, which approved it in a 34-3 vote in late May. It’s now before the Assembly Appropriations Committee, which must vote on whether to send it to the full Assembly by Friday.
Under the amended 38 percent exclusion, taxpayers would now owe taxes on 62 percent of their income from the sale of QSB stock between 2008 and 2012, rather than the
