BILL ANALYSIS                                                                                                                                                                                                    




                     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.