BILL ANALYSIS Ó
SENATE GOVERNANCE & FINANCE COMMITTEE
Senator Lois Wolk, Chair
BILL NO: SB 209 HEARING: 5/1/13
AUTHOR: Lieu FISCAL: Yes
VERSION: 4/3/13 TAX LEVY: No
CONSULTANT: Grinnell
INCOME TAX EXCLUSIONS: QUALIFIED SMALL BUSINESS STOCK
Reenacts a recently struck down income exclusion for gains
when selling qualified small business stock.
Background and Existing Law
I. The United States Constitution and Discriminatory
Taxes. The United States Constitution grants the power to
Congress to "regulate Commerce with foreign nations, and
among the several states" a provision widely known as the
Commerce Clause (Article I, Section 8). If Congress fails
to regulate interstate commerce wholly or in part, the
United States Supreme Court has asserted consistently that
the Constitution still precludes states from doing so,
known as the "dormant" or "negative" Commerce Clause.
Many states seek to shift burdens of tax from firms with
most business operations inside their states to ones that
don't, and the United States Supreme Court has decided
several cases applying the dormant commerce clause to
affirm the power of states to tax interstate business;
however, the taxpayer must have nexus, the tax must be
fairly apportioned and non-discriminatory, and a fair
relationship between the tax and the services provided must
exist. Complete Auto Transit v. Brady , 430 U.S. 274, 97
S.Ct. 1076 (1977). The Supreme Court and others have
struck down taxes and tax benefits that legislatures have
enacted to help in-state businesses as discriminatory
against interstate commerce when it "tax[es] a transaction
or incident more heavily when it crosses state lines than
when it occurs entirely within the State." Complete Auto
Transit . The commerce clause protects taxpayers from
"regulatory measures designed to benefit instate economic
interests by burdening out-of-state competitors." Fulton
Corp v. Faulkner , 516 U.S. 325 (1996).
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II. The Qualified Small Business Stock Exclusion. As
originally enacted, the Internal Revenue Code allowed
taxpayers to defer the entire gain or exclude from income
50% of the gain from the sale of qualified small business
stock in specified circumstances, known as the "QSB
exclusion." In 1993, California enacted its own QSB
exclusion, seeking to draw more investment into
California-based firms (SB 671, Alquist, 1991). Taxpayers
could have claimed a deferral or income exclusion on the
gain on the sale of the stock, subject to a cap, if:
At issuance, the Corporation is a "C" Corporation
with less than 50 million in aggregate gross assets,
The taxpayer acquires stock at original issue,
either in exchange for money, other property, or as
compensation for services provided to the Corporation,
The taxpayer holds the stock for five years,
At the date of issuance, the Corporation is a
qualified small business, and during the holding
period, meets the active business requirements,
Among other requirements, to be a qualified small business,
a corporation must have 80% of its payroll located in
California at the time of issuance. To meet the active
business requirement during the holding period, a firm must
continue to have at least 80% of its payroll in California
and 80% (by value) of the assets of the corporation used in
the active conduct of a qualified trade or business in
California for substantially all of the holding period.
III. Cutler v. Franchise Tax Board (FTB) . Frank Cutler
sued the Franchise Tax Board when it disallowed a 1998 gain
deferral for one stock that it determined did not meet the
requirement to be treated as qualified small business
stock. Cutler argued that the FTB was wrong and the stock
did meet the requirements, but even if it didn't, the
requirement discriminated against interstate commerce in
violation of the dormant commerce clause of the United
States Constitution. The Board of Equalization decided
against Cutler, but he paid the tax and filed suit against
FTB in Superior Court in 2009, represented by noted tax
attorney Marty Dakessian (See Comment #5).
The trial court sided with FTB because Cutler still could
not document that the corporation that issued the stock in
question met the active business requirement, and that
Cutler didn't prove the law was discriminatory. However,
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the Second District Court of Appeal reversed, ruling the
QSB law was discriminatory on its face, citing Fulton :
"A regime that taxes stock only to the degree that its
issuing corporation participates in interstate
commerce favors domestic corporations over their
foreign competitors in raising capital among North
Carolina residents and tends, at least, to discourage
corporations from plying their trades in interstate
commerce."
The Appeals Court added that a discriminatory tax benefit
is no different than a discriminatory tax. Cutler v. FTB .
208 Cal.App.4th 1247 (2012). The Court cited two cases
where the California Supreme Court invalidated California
tax statutes as discriminatory: Ceridian Corp. v. FTB 85
Cal.App.4th 875 (2000), that invalidated section 24410 of
the Revenue and Taxation Code, which provided for a
dividend received deduction for dividends paid by an 80% or
more owned insurance corporation to the extent that the
insurance corporation was subject to the California gross
premiums tax, and Farmer Brothers v. FTB 108 Cal.App.4th
976 (2003), that allowed for a dividend received deduction
to the extent that the dividend payor was subject to
California corporate income or franchise tax. Similar to
those cases, the Court in Cutler found the statutory scheme
discriminatory on its face, and remanded the case to the
trial court to calculate the refund, declining a refund
request. The Court also did not attempt to sever
unconstitutional aspects of the statute from the
non-discriminatory ones. FTB did not appeal.
On December 21, 2012, FTB issued notice 2012-03 stating
that because the Appeals Court held the statutory scheme of
the QSB exclusion discriminatory, the only possible remedy
that FTB as an administrative agency bound by California
Constitution's Article Three, Section 3.5 could issue that
would treat all taxpayers the same was to invalidate all
QSB deferrals and exclusions taxpayers claimed in each
taxable year within the statute of limitations, which is
2008, while allowing refund claims for prior years. FTB
updated its website to include new FAQs in regards to the
issue on February 28, 2013, directing affected taxpayers to
file amended returns without QSB deferrals or exclusions
back to 2008, and pay any tax due as a result. FTB states
that it started sending notices of proposed assessment
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(NPAs), which are essentially tax bills, on April 11th to
ensure collection before the statute of limitations expires
for the 2008 taxable year for taxpayers who did not
voluntarily waive the statute of limitations.
Proposed Law
Senate Bill 209 reenacts California's qualified small
business stock deferral and 50% exclusion statutes with the
requirement that the firm have 80% of its payroll in the
state at issuance. SB 209 reenactment applies to the 2008
through 2012 taxable years, thereby absolving taxpayers who
claimed the deferral or exclusion and expect to soon
receive NPAs from FTB. The measure then enacts the QSB
deferral and exclusion again in the 2016 taxable year.
State Revenue Impact
The FTB revenue impact analysis is pending.
Comments
1. Purpose of the bill . According to the author,
"Retroactive changes in tax law which trigger retroactive
tax assessments are inherently offensive and unfair. The
taxpayers the FTB seeks to assess followed the QSBS law
exactly as it was written by the Legislature and
implemented by the Franchise Tax Board. They also risked
their capital and poured their efforts into creating
start-up businesses which are the heart of the California
economy. They are entitled to rely on the state's
representations that in exchange for doing so, they would
receive a tax benefit. To allow the state to retroactively
"move the goalposts" is contrary to California's ideals of
fundamental fairness and would result in the state getting
an unfair windfall of close to $200 million. Additionally,
issuing retroactive tax assessments when a legal defect is
found with a tax credit provision will undermine confidence
in ALL of California tax incentives. If taxpayers know
that the state may send multiple years of retroactive tax
assessments anytime a tax incentive provision is
challenged, confidence in California's economic development
program is seriously undermined. In order to stop the
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retroactive taxes, preserve the rule of law and implement
Cutler v. Franchise Tax Board , legislative action is
necessary. Specifically, Senate Bill 209 would eliminate
the retroactive collection taxes from 2,500 small business
entrepreneurs, hold the General Fund harmless and
prospectively preserve the incentive to invest in
California start-up ventures to the maximum degree
possible."
2. Issues . SB 209 responds to the Court's decision in
Cutler and FTB Notice 2012-03 by reenacting a recently
invalidated tax benefit for persons that sold stock in a
California-based business held for five years. There are
three distinct issues for the Committee to consider:
First, should the Legislature absolve taxpayers
affected by the pending FTB notice? These taxpayers
reasonably relied on the tax law in place at the time
they filed returns, but are now facing considerable
tax bills as a result of the decision. However,
operating a business requires some risk of
uncertainty, including the chance that a Court could
strike down a tax break.
Second, should the Legislature do something about
enterprising attorneys that file lawsuits against the
state on a contingency basis or in pursuit of rich
attorney's fees on behalf of affluent taxpayers taking
highly creative and aggressive tax return positions?
Neither Cutler nor SB 209 would exist but for a lack
of restriction in the area, but some point out that
these attorneys need incentives to ensure the state
does not assess unconstitutional taxes.
Lastly, what's the value to employment of the QSB
exclusion? Some state that the exclusion aids capital
formation and investment in the state, while others
consider it duplicative of federal law and an
inefficient subsidy to investors who would invest in
California-based firms anyway. Should the state
reenact the exclusions as a tool to increase
employment?
3. Timing is everything . SB 209 eliminates California's
old QSB rule, but reenacts it absent two tests that the
Court explicitly found violate the Constitution. Instead
of ensuring that the corporation maintains 80% of its
payroll in California for the period the taxpayer holds
stock, the measure would only require the corporation meet
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the test at the date of the stock's issuance. In so doing,
the measure erases any tax due that would necessitate FTB
issuing NPAs to collect. However, the bill could help a
second, distinct population by allowing refund
opportunities for taxpayers that held stock that satisfies
SB 209's test, but not the old rules nullified by the
Court. As such, SB 209 would create a windfall for
taxpayers, and any accountant or consultants that prepare
returns for them, and a deadweight loss to the state by
rewarding taxpayers retroactively for something they've
already done. Additionally, under SB 209, taxpayers that
acquire stock during the period where SB 209 suspends the
QSB exclusion and deferral, the 2013 through 2016 taxable
years, wouldn't be able to claim it in future years; only
taxpayers buying stock 2012 or before or after the bill's
reenactment date of January 1, 2016 could.
Additionally, SB 209's "at issue" requirement may not be
any more Constitutional than the two elements the Court
threw out in Cutler ; the Court stated that the QSB deferral
and exclusion statute is discriminatory on its face, and
that "a burden placed at any point will result in a
disadvantage to the out-of-state producer." The Committee
may wish to consider whether SB 209's goal to hold harmless
past beneficiaries of the QSB exclusion will not likely be
any less discriminatory than the old one.
4. Tread lightly . Cutler may be the first time courts
have nullified a Personal Income Tax benefit as
discriminatory; however, it won't likely be the last.
Attorneys are likely to use Cutler to file suits against
the state claiming that its other incentives, such as the
Research and Development Credit, the Enterprise Zone
Credit, and the Motion Picture Production Credit,
discriminates against interstate commerce by not allowing
costs incurred by taxpayers outside the state to qualify
for credits when the same costs incurred inside the state
do. Just as Cutler asked the Court to order the state to
nullify the active business requirement for the QSB
exclusion and deferral, and allow the tax benefit
regardless of the location of the corporation's payroll
expenses, future litigants will ask the Court to award R&D
credits, and therefore refunds for past years, for costs
incurred in research and development costs California
taxpayers incur in other states. Enacting SB 209 gives
these future litigants the message that the Legislature
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will ride to the rescue and change the law for their
benefit. The Committee may wish to consider whether it
wants to create the precedent set in SB 209.
5. Get some . In Ventas Finance I, LLC v. Franchise Tax
Board (2008) 165 Cal.App.4th 1207, courts first allowed
attorneys' fees to be awarded prevailing parties in tax
cases under the richer Code of California Procedure instead
of the less generous Revenue and Taxation Code. Since
then, the state has seen an increase in questionable
lawsuits challenging the Constitutionality of its taxes, as
attorneys see richer fees as incentive to file suit, and
the state lacks an erroneous claims for refund penalty
which would provide some disincentive for filing
unsubstantiated claims. Marty Dakessian of Reed Smith, who
represented Cutler, has filed such suits on behalf of firms
seeking to invalidate the Department of Housing and
Community Development's 2007 enterprise zone regulations,
Cyntron v. HCD et al ., and again seeking to invalidate
FTB's authority to audit enterprise zone vouchers in Dicon
Fiberoptics v. Franchise Tax Board (Case B202997, 2009).
Despite losing those cases, he won Cutler , but Reed Smith
then set up a coalition offering to represent taxpayers
affected by the decision for a $50,000 fee for lobbying and
legal fees, and a 25% contingency for representing them in
Court. Dakessian then asked the Court that decided Cutler
that because he was a successful party in an action that
enforced an important right affecting the public interest,
with a significant benefit on a large class of persons, as
required under the private attorney general provisions.
Courts can award attorneys' fees using a multiplier to
private prevailing parties if they enforce a significant
public issue. However, the court rejected the motion,
stating that the taxpayer was wealthy enough to bring the
challenge without the incentive of a fee award, and the
case has not benefited a large class of people. Dakessian
has appealed this decision. Shouldn't the Legislature
restrict attorneys' fees as part of any effort to limit the
damage they created? The Committee may wish to consider
whether other measures are necessary to prevent future
bills like SB 209 from being necessary.
6. Another way . Should the Committee be unwilling to
absolve taxpayers from pending NPAs collecting taxes, it
could amend SB 209 to ensure that affected taxpayers are
absolved of penalties and interest that accrue on that tax
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due amount. That way, it could provide some help without
going the whole way.
Support and Opposition (04/25/13)
Support : Bay Area Council; California Business Defense;
California Healthcare Institute; TechAmerica; Silicon
Valley Leadership Group.
Opposition : None received.