California Seeks $120 Million in Back Taxes from Small Businesses

Taxpayers see purple: downtown Los Angeles at dusk, viewed from the Griffith Observatory Photograph by Eddie Brady

About 2,000 small business owners and investors in the Golden State who lawfully took a tax break that was later struck down have the taxman knocking at their doors. Following a state appeals court decision invalidating a 20-year-old state tax, the Los Angeles Times reports, California tax collectors are trying to get $120 million from people who profited by selling stakes in small businesses. The paper’s Marc Lifsher writes:

The Franchise Tax Board is going after four years’ worth of these tax breaks. It recalculated the back taxes of people who benefited and mailed out a holiday surprise.

“It’s a surreal situation,” said Brian Overstreet of Healdsburg in the Sonoma County wine country. He said investors learned they owed taxes only in late December when the board sent out letters telling them the so-called qualified small-business capital gains tax incentive had been deemed unconstitutional.

“California is not a banana republic,” said one critic, state Sen. Ted Lieu (D-Torrance). “California government should not punish innocent, law-abiding taxpayers retroactively just because it may have the power to do so.”

Business owners got the tax benefit by keeping 80 percent of their operations in-state. For some of them, the tax incentive may have made the difference between staying in California and moving to a lower-cost state—or offshore. A new business group, California Business Defense, has formed to push back. Overstreet, a software entrepreneur quoted above, is one of the founders. He wrote about the surprise tax bill in Xconomy:

I’m not ungrateful or unrealistic. I fully understand the scope of the economic problems at both the state and federal level and the need for everyone to pay their fair share. And as a product of California’s public university system, I fully appreciate the opportunities afforded to me by living and working in the great state of California.

But 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.

California’s Franchise Tax Board frames the change as though it has no choice but to collect the tax money that falls within the law’s four-year statute of limitations:

The provisions in California law regarding the 80 percent asset and payroll requirements were found to be unconstitutional in August 2012 by the California Court of Appeal in Cutler v. Franchise Tax Board (FTB). The court’s decision made California’s entire [qualified small business stock] statute invalid and unenforceable. As a result, all QSBS gain exclusions and deferrals previously allowed under California law became invalid.

This is an unusual situation. The state didn’t go looking to kill this tax break. In fact, it defended the law in court. Now that the statute has been struck down, however, the tax board says people who benefited from the break within the past four years need to pay up. Perhaps that’s the case by the letter of the law, but it defies common sense and good governance.

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