As of January 2014, the California Legislature has restored and increased opportunities for investors to defer or exclude gains from the sale of investments in California start-ups. Individual taxpayers should consider whether they qualify for the qualified small business stock (“QSBS”) incentives, now available once again to taxpayers and subject to reduced restrictions. Individual taxpayers also should consider positioning themselves to take advantage of further litigation possible in this area.

California’s Qualified Small Business Stock Investment Incentives

Prior to 2012, California provided tax incentives for investment in small businesses by allowing the exclusion or deferral of gains on sales of certain qualified small business stock. Individual taxpayers could defer gains from the sale of QSBS by using the proceeds to purchase QSBS from another issuer, or exclude 50% of gains from the sale of QSBS held for more than five years. Rev. & Tax. Code §§ 18038.5 & 18152.5. The provisions largely followed the language of analogous federal incentives, but added requirements that 80% of the issuer’s assets and payroll remain in California during the period the taxpayer held the stock.

Cutler v. Franchise Tax Board

The Court of Appeals decision in Cutler v. Franchise Tax Bd., 208 Cal. App. 4th 1247 (2012) arose from a challenge by a taxpayer who sold shares in an Internet startup company that did not maintain 80% of its assets and payroll in California. In his tax returns, Cutler claimed a deferral of gains on the sale of those shares. When the Franchise Tax Board (“FTB”) disallowed the deferral. Cutler claimed that the statute discriminated against investors in companies that conduct more than 20% of their business outside of California. The California Court of Appeal agreed, holding the statute’s discrimination violated the Commerce Clause of the U.S. Constitution.

FTB Seeks to Retroactively Deny Incentives

The Cutler decision generated a great deal of uncertainty among taxpayers who were planning to exclude or defer gains from the sale of QSBS, or who had already done so on returns for tax years still open under the statute of limitations. In December of 2012, the FTB – not missing the opportunity for a tax revenue windfall – issued FTB Notice 2012-03, which adopted the highly unpopular position that:  (1) the entire QSBS statute was invalid and unenforceable, (2) QSBS exclusions or deferrals of gains could no longer be claimed,and (3) taxpayers who had claimed QSBS exclusions or deferrals of gains in tax years still open for assessment had to file amended returns eliminating those exclusions or deferrals for each year affected.

The FTB began issuing notices of proposed assessment to taxpayers who had carried out long-term investment plans responding to the State’s active encouragement to invest in California start-ups. These taxpayers were faced with an unforeseeable tax hike that operated retroactively for periods of four years or greater. These features of FTB Notice 2012-03 left the FTB’s policies open to challenge on due process grounds.

Legislative Action

On October 4, 2013, the Governor signed AB 1412 (Stats. 2013, ch. 546, effective January 1, 2014), rejecting FTB Notice 2012-03 and providing relief for taxpayers affected byCutler. Under the new legislation, shareholders selling QSBS can once again claim exclusion or deferral of gains – now irrespective of what percentage of the issuer’s assets and payroll remained in California during the period the taxpayer held the stock. The new statute still requires 80% of the issuer’s payroll to have been in California at the time of the taxpayer’s acquisition of the stock. These amendments will be repealed by their own terms as of January 1, 2016.

As a result of the legislation individual taxpayers may want to consider the following:

  • Act now. AB 1412 extended the statute of limitations for 2008 through the first 180 days of 2014 (so, through June 30) to permit retroactive refund claims based on QSBS exclusions or deferrals for that tax year.
  • Re-examine your eligibility. As a result of the elimination of the requirements that 80% of the issuer’s assets and payroll have remained in California throughout the period during which the stock was held, individual investors should consider whether they might now be eligible for an exclusion or deferral that was previously unavailable – for example, if they invested in a California start-up whose business then expanded to other states.
  • Re-claim your deferrals or exclusions. Individuals who paid additional taxes based on the FTB’s policy under FTB Notice 2012-03 may want to file refund claims.
  • Take advantage of all open tax years. Individuals who did not previously claim the QSBS exclusion or deferral can do so now filing an amended return for all tax years for which the statute of limitations remains open.
  • Preserve your rights. Taxpayers who, like Cutler, would qualify for the QSBS incentives but for the requirement that 80% of the issuer’s payroll was in California at the time of the taxpayer’s acquisition of stock may want to claim refunds in anticipation of a possible future Commerce Clause challenge to that remaining requirement.