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). SB 209 - 4/3/13 -- Page 2 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 As originally enacted, the Internal Revenue Code allowed taxpayers to defer the entire gain or exclude from income 50% of the gain from the sale of qualified small business stock in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, SB 209 - 4/3/13 -- Page 3 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 SB 209 - 4/3/13 -- Page 4 (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 SB 209 - 4/3/13 -- Page 5 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 SB 209 - 4/3/13 -- Page 6 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 SB 209 - 4/3/13 -- Page 7 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 SB 209 - 4/3/13 -- Page 8 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.