BILL ANALYSIS Ó
SB 209
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Date of Hearing: August 12, 2013
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Raul Bocanegra, Chair
SB 209 (Lieu) - As Amended: May 24, 2013
2/3 vote. Fiscal committee.
SENATE VOTE : 34-3
SUBJECT : Income taxes: exclusion: deferral: qualified small
business stock.
SUMMARY : Partially reinstates the income exclusion and deferral
provisions for gain from the sale or exchange of qualified small
business stock (QSBS), as defined, for taxable years beginning
on or after January 1, 2008, and before January 1, 2013.
Specifically, this bill :
1)Provides that, for taxable years beginning on or after January
1, 2008, and before January 1, 2013, a taxpayer may exclude
from gross income, under the Personal Income Tax (PIT) Law,
thirty-eight percent (38%) of any gain attributable to the
sale or exchange of QSBS held by the taxpayer for more than
five years.
2)Limits the aggregate amount of eligible gain for the taxable
year, in the case of one or more dispositions of QSBS by a
taxpayer, to the greater of the following:
a) Ten million dollars ($10,000,000), reduced by the
aggregate amount of eligible gain taken into account by the
taxpayer for prior taxable years and attributable to
dispositions of QSBS, as provided.
b) Ten times the aggregate adjusted basis of QSBS issued by
the corporation and disposed of by the taxpayer during the
taxable year.
3)Defines a QSBS as a stock in a "C" corporation that is
originally issued after August 10, 1993, if both of the
following requirements are met:
a) As of the date of issuance, the corporation is a
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qualified small business.
b) The stock is acquired in exchange for money or property,
or as compensation for services provided to the
corporation, as specified.
4)Defines a "qualified small business" as a domestic "C"
corporation, provided all of the following apply:
a) The aggregate gross assets of the corporation at all
times on or after July 1, 1993, and before the issuance did
not exceed $50 million;
b) The aggregate gross assets of the corporation
immediately after the issuance do not exceed $50 million;
c) At least 80% of the corporation's payroll, as measured
by total dollar value, is attributable to employment
located within California; and,
d) The corporation agrees to submit reports to the
Franchise Tax Board (FTB) and to shareholders as the FTB
may require to carry out the purposes of the QSBS statutes.
5)Specifies that a stock in a corporation shall not be treated
as a QSBS unless, among other requirements, during
substantially all of the taxpayer's holding period for the
stock, the corporation meets a new non-discriminatory active
business requirement, as provided.
6)Authorizes a taxpayer to elect to defer gain from the sale of
QSBS made after August 5, 1997, and before January 1, 2013,
provided that the taxpayer held the QSBS for more than six
months, the gain is not treated as ordinary income for
purposes of the PIT law, and the taxpayer acquires a
replacement QSBS within 60 days of the date of the sale.
7)Requires the FTB to waive all penalties and interest for taxes
assessed as a result of the court decision in Cutler v. FTB
(2012) 208 Cal.App.4th 1247, as specified, and allows
taxpayers to enter into a written installment payment
agreement with the FTB for the payment of those taxes due in
installments for a period of up to five years.
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8)States that, if for any reason the exclusion provisions of
this bill are held invalid, ineffective or unconstitutional by
a court of competent jurisdiction, the FTB will be required to
waive all penalties and interest imposed as a result of those
provisions for each taxable year beginning on or after January
1, 2008, and before January 1, 2013, and the affected
taxpayers may enter into written installment payments
agreements with the FTB for the payment of any tax due.
9)Makes legislative findings and declarations regarding the
public purpose served by the bill.
10)States that the bill's provisions are severable and, if any
provisions of this bill or its application are held invalid,
the invalidity will not affect other provisions or
applications that can be given effect without the invalid
provision or application.
11)Provides for a continuous appropriation from the General Fund
(GF) to the FTB in the amounts necessary to make payments
required by this bill.
EXISTING FEDERAL LAW :
1)Allows a taxpayer to exclude 50% (60% in the case of
empowerment zone businesses) of the gain from the sale of QSBS
acquired at original issue and held for at least five years.
For QSBS acquired after February 17, 2009, and before
September 28, 2010, the exclusion percentage is increased to
75%. For QSBS acquired after September 27, 2010, and before
January 1, 2014, the exclusion percentage is increased to 100%
and the minimum tax preference no longer applies. (Internal
Revenue Code (IRC) Section 1202).
2)Provides for the deferral of gain recognized by a
non-corporate taxpayer from the sale or exchange of QSBS held
more than six months where the replacement QSBS is purchased
during the 60-day period beginning on the date of the sale.
3)Defines "QSBS" or a "qualified small business stock" as any
stock in a qualified small business acquired by the taxpayer
at the original issue date after August 10, 1993, in exchange
for money or other property (not including stock), or as
compensation for services provided to the corporation.
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4)Defines a "qualified small business" as a domestic "C"
corporation in which the aggregate gross assets of the
corporation at all times since August 10, 1993, up to the time
of issuance, do not exceed $50 million. The stock must also
meet certain active business requirements during substantially
all of the taxpayer's holding period to be considered QSBS.
5)Authorizes a taxpayer to elect to report the disposition of
QSBS using the installment method, with the exception of
trades occurring on an established securities market. (IRC
Section 453(k)(2)).
EXISTING STATE LAW :
1)Does not allow the exclusion or deferral of gain on QSBS.
2)Conforms, by reference, to the federal installment sales
statutes and specifies that the installment method applies
unless the taxpayer affirmatively elects out of the
installment method. (Revenue and Taxation Code (R&TC) Sections
17551 and 17560).
PRIOR STATE LAW :
1)Did not specifically conform to the federal QSBS exclusion and
deferral provisions, but allowed individual taxpayers to
either exclude from income 50% of the gain recognized on the
sale of QSBS or elect to rollover that gain into another QSBS.
2)Provided that all of the following requirements had to be met
in order to qualify for the deferral or exclusion of gain:
a) At the time of issuance of QSBS, at least 80% of the
corporation's payroll had to be attributable to employment
located within California (a so-called "payroll at
issuance" requirement);
b) During substantially all of the taxpayer's holding
period of the QSBS, at least 80% of the corporation's
assets had to be used in the active conduct of one or more
qualified trades or businesses in California; and,
c) During substantially all of the taxpayer's holding
period of the QSBS, no more than 20% of the corporation's
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payroll expense could be attributable to employment located
outside of California.
3)Specified that, in order to qualify for the election to roll
over gain from the sale of QSBS, the taxpayer had to have held
the stock for more than six months and the replacement stock
must have been purchased during the 60-day period beginning on
the date of the sale.
FISCAL EFFECT : The FTB estimates that this bill would result
in an annual GF revenue loss of $39.2 million in fiscal year
(FY) 2012-13, $31.5 million in FY 2013-14, $15.6 million in FY
2014-15, and $13.8 million in FY 2015-16.
COMMENTS :
1)Author's Statement . The author states that, "Retroactive
changes in tax law which trigger retroactive tax assessments
are inherently offensive and unfair. The taxpayers the FTB
would assess under their proposed remedy followed the QSBS law
exactly as it was written by the Legislature and implemented
by the 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 break. To allow the state to
retroactively "move the goalposts" is contrary to California's
ideals of fundamental fairness and would result in the state
receiving 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 retroactive taxes, preserve the rule of
law and implement a Cutler remedy, legislative action is
necessary."
2)Arguments in Support . The proponents of this bill state that
SB 209 would "protect small business investors - who made a
good faith reliance on California's tax law - from receiving
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large, retroactive tax bills." They argue that "retroactive
changes in tax law, which trigger retroactive tax assessments,
are inherently offensive and unfair" and to allow "the state
retroactively 'move the goalposts' is contrary to California's
ideals of fundamental fairness," resulting in "an unfair
windfall [to California] of close to $200 million." The
proponents point out that, according to the most recent
studies, "virtually all of California's net job growth is
attributable to start-up ventures," and thus, SB 209 is a
"reasonable solution to a unique situation." The proponents
assert that, unless it passes, "the loss of the QSBS
exclusion/rollover would cause fundamental damage to
California's efforts to emerge from recession and put
Californians back to work."
3)Arguments in Opposition . The opponents of this bill argue that
"the state should not restore a tax break which was shown to
be discriminatory and unconstitutional." The opponents assert
that "the problem with state tax breaks" is that they either
"violate interstate commerce laws" or "provide tax benefits
irrespective of any economic activity to benefit California."
The opponents conclude that the retroactive tax relief
proposed by SB 209 to those who "may have invested
out-of-state" amounts to a tax refund, arguably, with no
incentive to invest in California.
4)Background: QSBS and Life Before Cutler . In 1993, the
California Legislature enacted SB 671 (Alquist; Chapter 81,
Stats. 1993), which among things, conformed California tax law
to the federal tax provisions relating to a partial capital
gains exclusion for small business stock (the QSBS statute).
The original California QSBS statute created a tax incentive
for investments made in certain "C" corporations on or after
August 10, 1993, and before December 31, 1998. Specifically,
it allowed a non-corporate taxpayer to exclude from gross
income 50% of the capital gain (up to a lifetime limit of $10
million) recognized by the taxpayer from the sale or exchange
of a stock that met the requirements of QSBS, provided the
stock was held for five or more years. The statute defined
QSBS as a stock in a "C" corporation issued in exchange for
money, property (other than stock) or compensation for
services, provided that the corporation, as of the date of
issuance was a "qualified small business." In order to be
treated as a "qualified small business," a corporation had to
be organized as a domestic "C" corporation, its aggregate
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gross assets before, and immediately after, the issuance of
the stock could not have exceeded $50 million, and it had to
agree to submit reports to the FTB and the shareholders.
These criteria were consistent with the federal provisions,
but the QSBS statute also contained additional requirements.
Specifically, it required that at least 80% of the
corporation's payroll - at the time of its stock issuance - be
attributable to employment located within California. It also
required the corporation to meet the "active business test."
The later test was satisfied for any period in which at least
80% of the assets were used by the corporation in the active
conduct of one or more qualified trades or businesses in
California and at least 80% of the corporation's total payroll
expenses were attributable to employment located in California
(collectively referred to as the "active business
requirements").
Furthermore, in 1998, the Legislature enacted SB 519 (Lockyer;
Chapter 7, Stats. 1998) to allow taxpayers, in conformity with
the federal law, to defer recognition of gain from the sale of
QSBS, provided that it was used to purchase another QSBS. The
holding period for the QSBS for purposes of deferral was set
at six months (as opposed to five years for purposes of the
gain exclusion). Thus, as an alternative to claiming the 50%
capital gains exclusion, the taxpayer could have elected to
defer 100% of the gain recognition by reinvesting the sales
proceeds in another QSBS within 60 days of the initial
disposition.
As part of the original statute, the Legislature required the
Legislative Analyst's Office (LAO), in conjunction with the
FTB, to conduct a study of the effectiveness of the QSBS tax
incentive. (SB 671, Section 29). In particular, the
Legislature asked the LAO to look at the amount of additional
investment and the number of additional jobs, if any, created
in California as the result of the enactment of the QSBS
statute. The LAO found that the program was designed
primarily to promote startup operations in manufacturing and
related activities in California, but noted that "the extent
to which the program actually expands the amount of financial
capital available to the small business community, and how its
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benefits are shared, is unknown."<1> The LAO report also
stated that it was unclear "why owners of small corporate
(emphasis added) enterprises should receive more favorable tax
treatment than other types of small businesses." Nonetheless,
in 1999, the Legislature extended the program indefinitely by
removing the January 1, 1999 sunset date. (AB 1120 (Havice;
Chapter 69, Statutes of 1999)). The Assembly analysis of that
bill highlighted the fact that the QSBS statute was intended
"to spur venture capital investment in small companies with
substantial amounts of their employees and assets (emphasis
added) in California." (Assembly Floor Analysis 6/16/1999).
5)Cutler vs. FTB: "Everything was in a state of confusion in the
Oblonsky's house" . On August 28, 2012, the Court of Appeal in
Cutler v. FTB determined that the active business requirements
of the QSBS statute were discriminatory on their face and,
thus, unconstitutional. [Cutler v. Franchise Tax Board (2012)
208 Cal.App.4th 1247, 1250]. This decision, along with the
FTB's position on how to implement it, has not only severely
impacted taxpayers, but also created confusion among tax
experts, attracted the attention of many state legislators,
and become a topic of cocktail conversations.
As discussed above, the QSBS statute allowed taxpayers a
deferral or a partial exclusion for income received from the
sale of stock in qualified corporations maintaining assets and
payroll in California, while providing no such benefit for
income from the sale of stock in corporations maintaining
assets and payroll elsewhere. In Cutler v. FTB, the taxpayer
- Frank Cutler - had sought to defer capital gains on the sale
of stock. He sued the FTB when it disallowed the deferral of
the gain, asserting that the stock was a QSBS, even if the
stock failed to meet the "active business requirements" of the
QSBS statute. Mr. Cutler argued that the '"active business
requirements" violated the Commerce Clause of the United
States Constitution. The trial court sided with the FTB
stating that Mr. Cutler had not proved the law was
discriminatory. However, the Court of Appeal reversed the
decision of the trial court, holding that the QSBS statute is
discriminatory on its face and cannot stand under the commerce
clause.
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<1> The Partial Capital Gains Exclusion for Qualifying Small
Business Stock, LAO report, March 1999. The LAO noted in its
report that the QSBS program was intended to reduce the cost of
financial capital for qualified small businesses.
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The U.S. Constitution authorizes Congress to regulate commerce
with foreign nations, and among the several states. (U.S.
Constitution, Article I, Section 8, Clause 3). While the
commerce clause is phrased as a positive grant of regulatory
power, it "has long been seen as a limitation on state
regulatory powers, as well as an affirmative grant of
congressional authority." [Fulton Corp. v. Faulkner (1996)
516 U.S. 325, 330.] This negative aspect, commonly referred
to as the dormant commerce clause, prohibits economic
protectionism in the form of state regulation that benefits
"instate economic interests by burdening out-of-state
competitors." (Ibid.) The Court of Appeal in Cutler held that
"the deferral provision discriminates on its face on the basis
of an interstate element in violation of the commerce clause."
Thus, the Court reversed the trial court's finding on the
constitutionality of the "active business requirements" and
remanded the case to the trial court for further proceedings.
Although the case was remanded, implementing the Court's
decision was left to the FTB, as the tax agency responsible
for administering the PIT Law.
6)FTB Notice 2012-03: the Implementation Issues. As the result
of the Court of Appeal's decision in Cutler, the FTB, the
agency in charge of administering the PIT Law, was faced with
the challenges of implementing that decision and fashioning
the appropriate remedy. The Court held that the 80% property
and payroll requirements, i.e., the "active business
requirements," discriminated against interstate commerce, but
it refused to opine on whether the unconstitutional provisions
could be "severed" from the remainder of the QSBS statute or
whether the reformation of the statute was appropriate. Under
the California Constitution, an administrative agency is
prohibited from declaring a statute unconstitutional or
unenforceable, unless an appellate court has made a
determination that such statute is unconstitutional. (Cal.
Const., Art. III, Section 3.5). Under the PIT law, when a
portion of a statute is found to be unconstitutional by the
court, the remaining part of that statute may be salvaged to
the extent that the unconstitutional portion can be
"reasonably separated" or "severed" from the remainder of the
statute. (R&TC Section 17033). However, the application of
the "severability law" depends on whether the unconstitutional
provision is grammatically, functionally, and volitionally
severable. (See, e.g., Abbott Laboratories v. FTB (2009) 175
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Cal.App.4th 1346; Farmer Brothers Co. v. FTB (2003) 108
Cal.App.4th 976). In determining whether the offending
provision of a statute is volitionally severable, it is
necessary to ascertain whether the remainder of the statute
"is complete in itself and would have been adopted by the
legislative body had it foreseen the statute's partial
invalidation, or whether it comprises a completely operative
expression of legislative intent." (Abbot Labs, at p. 1358).
On December 21, 2012, the FTB issued Notice 2012-03 (the
Notice), outlining the procedures that the agency would use in
applying the court's holding in Cutler. The FTB determined
that the QSBS statutes (R&TC Sections 18152.5 and 18038.5)
were invalid and that the appropriate remedy was to deny the
exclusion/deferral to taxpayers who benefited from either
incentive. The FTB decided that there was no evidence
demonstrating that the Legislature would have enacted the
remaining provisions of the QSBS statute (without the "active
business requirements"), had it known the unconstitutional
provisions would later be struck down. <2> Thus, the FTB
refused to sever the offending requirements from the remaining
provisions of the QSBS statute and took a position that the
whole statute is unconstitutional and is invalid under Cutler.
Some disagree with the FTB's position that the California
payroll and property requirements could not be severed from
the QSBS statute. They contend that the legislative intent of
the QSBS statute, which was to spur investment in California
small businesses, is advanced "not by the offending language
in the statute's property and payroll requirements, but by the
payroll at issuance requirement, which was not at issue in
Cutler."<3> They argue that the payroll at issuance
requirement, i.e. a requirement that at least 80% of the
corporation's payroll - at the time of its stock issuance - be
attributable to employment located within California,
encourages taxpayers "to seek out California-based businesses
for investment, and in so doing clearly advances the
legislative intent of spurring investment in California."<4>
Nonetheless, the FTB believed that it had no authority to undo
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<2> See, e.g., the letter written to Assembly Member H.T. Perea
by Selvi Stanislaus, executive officer of the FTB on February
25, 2013 (the FTB Letter).
<3> How Should California Policymakers Respond to Cutler? R.
Waldow and R. Crawford, Tax Analyst, April 8, 2013.
<4> Id., at p. 143.
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the results of the court's decision and, in essence, invited
the Legislature to step in to resolve the problem.<5>
Meanwhile, the FTB allowed the exclusion/deferral for taxable
years before January 1, 2008, to taxpayers who met the
requirements of the QSBS statutes, other than the
unconstitutional California property and payroll requirements.
Specifically, it decided that, "because the determination of
the appropriate remedy for an unconstitutional provision also
requires treating similarly situated taxpayers the same, this
remedy may not be applied to taxpayers for taxable years
beyond the four-year statute of limitations." In contrast,
for taxable years beginning on or after January 1, 2008, the
FTB disallowed all exclusions and deferrals. The FTB started
sending notices of proposed assessments to taxpayers on April
11, 2013, to ensure collection of the tax before the statute
of limitations expired for the 2008 tax year for those
taxpayers who did not voluntarily waive the statute of
limitations.
7)Decisions, Decisions. In response to the FTB Notice and the
court's decision in Cutler, SB 209 proposes to partially
reenact the invalidated QSBS statute. Specifically, this bill
would reinstate the exclusion and deferral provisions for gain
recognized by a taxpayer from the sale or exchange of QSBS,
but only for five taxable years, starting with the 2008 tax
year and ending with the 2012 tax year. The amount of gain
eligible for the exclusion would be limited to 38% instead of
50% allowed under the now invalidated QSBS statute. Another
difference between the old statute and the proposed QSBS
statute is the absence of the "active business requirements"
invalidated by the court. Thus, SB 209 would eliminate the 80%
California-centric payroll and assets requirements, but would
retain the 80% at issuance payroll requirement. In other
words, it would require a corporation to meet the 80% payroll
test at the date of the stock's issuance. This bill would
also modify the 80% asset test requirement to provide that a
corporation must be engaged in active trade or business, but
not necessarily in California.
Essentially, SB 209 would help two groups of taxpayers. One
group is comprised of taxpayers who claimed the exclusion or
deferral in the past taxable years, but are now required to
pay the tax, interest and penalties for those years. SB 209
would waive all penalties and interest for taxes assessed as
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<5> The FTB Letter.
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the result of the Cutler decision and Notice. However, those
taxpayers would be allowed an exclusion for only 38%, and not
the full 50%, of the gain recognized on the sale of QSBS. As
such, SB 209 would provide only partial relief to those
taxpayers. At the same time, SB 209 would reward taxpayers
who did not qualify for either tax exclusion or deferral under
the old statute because they could not meet the discriminatory
"active business" requirements. Essentially, SB 209 would
provide a windfall to those taxpayers for their past behavior.
Thus, the Committee is essentially being asked whether this
bill, in fashioning a non-discriminatory remedy, provides the
right balance between allowing retroactive taxation for those
who properly relied on California law, and rewarding those who
had no intention of doing so. The Committee may wish to
consider whether the partial solution proposed by this bill is
equitable to those who had invested in small businesses in
California relying on tax incentives allowed in the old QSBS
statute.
8)" At Issuance" Payroll Requirement . As discussed, SB 209 would
retain the 80% payroll "at issuance" requirement, raising a
question as to whether this requirement is discriminatory on
its face and is invalid, much like the other two invalidated
by the court in Cutler. Some argue that the 80% "at issuance"
requirement does not implicate the coercive power of the
state, does not compel the qualified small business to avoid
interstate commerce, and thus provides "a constitutionally
permissible means of encouraging investment in small business
in California without encouraging or discouraging investment
in other states."<6> However, the issue is clearly not without
doubt.
As pointed by the FTB staff in the analysis of this bill, while
there are differences between the proposed QSBS statute and
the statute invalidated by the Court of Appeal, it is
reasonable to assume that the 80% "at issuance" requirement
may be subject to a legal challenge as well. It appears that
the main distinction between the "at issuance" requirement and
the other two requirements found to be discriminatory by the
court is timing. The Committee may wish to consider whether
the inclusion of the 80% "at issuance" requirement in the bill
would undermine the bill's intended goal of providing relief
to certain taxpayers without discriminating against others.
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<6> How Should California Policymakers Respond to Cutler? R.
Waldow and R. Crawford, Tax Analyst, April 8, 2013, p. 144.
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The Committee may also wish to consider whether to clarify the
legislative intent in the case the 80% "at issuance"
requirement is challenged in court and found to be
unconstitutional.
9)FTB's Implementation Concerns . The FTB staff has identified
several implementation and technical concerns, as outlined in
their analysis of this bill. The FTB staff suggested
amendments, including an amendment to include a repeal date to
the deferral provision, as well as the provisions relating to
interest, penalties, installment agreements, and severability.
The FTB staff also recommended an amendment to clarify the
phrase "court of competent jurisdiction," and the terms "taxes
assessed" and "taxes due."
10)FTB's Legal Concerns . The FTB staff pointed out that, if
this bill is enacted after the statute of limitations for
filing a claim for refund for taxable year 2008 has closed,
the remedy for the unconstitutionality found to exist by the
Court of Appeal would be incomplete, and arguably defective,
as it would be unable to satisfy the requirement for treating
similarly situated taxpayers in the same manner. The FTB staff
has suggested an amendment to open up the statute of
limitations for filing a claim for refund until 180 days after
the effective date of this bill. The FTB staff also recommends
including language in the bill to clarify legislative intent
if the proposed QSBS statute is determined to be
unconstitutional by an appellate court.
11)Similar Legislation .
AB 901 (Wieckowski), introduced in the 2013 legislative session,
would, for taxable years beginning on or after January 1,
2008, modify the terms of the exclusion and deferral of
taxable gain applicable to the sale or exchange of QSBS. AB
901 is currently pending in this Committee.
AB 1203 (Gorell), introduced in the 2013 legislative session,
would waive interest and penalties assessed on additional tax
that is owed due to the Court of Appeal's decision in Cutler
v. FTB. AB 1203 is currently pending in this Committee.
REGISTERED SUPPORT / OPPOSITION :
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Support
California Chamber of Commerce
Santa Monica Chamber of Commerce
West Hollywood Chamber of Commerce
BIOCOM
Opposition
California School Employees Association
Analysis Prepared by : Oksana G. Jaffe / REV. & TAX. / (916)
319-2098