BILL ANALYSIS                                                                                                                                                                                                    

                                                                  SB 209
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          Date of Hearing:   August 21, 2013

                                  Mike Gatto, Chair

                      SB 209 (Lieu) - As Amended:  May 24, 2013 

          Policy Committee:                             Revenue and  
          Taxation     Vote:                            9-0

          Urgency:     No                   State Mandated Local Program:  
          No     Reimbursable:              


          This bill 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,  
            38% of any gain attributable to the sale or exchange of QSBS  
            held by the taxpayer for more than five years, a reduction  
            from 50% in existing law.

          2)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. 

          3)States, 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. 

           FISCAL EFFECT


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           Following is a table of estimated fiscal impacts for SB 209  
          developed by FTB.  This fiscal effect estimate is based on the  
          FTB's interpretation of existing law, which is the QSBS has been  
          eliminated by court decision.  

          FTB's interpretation is not accepted by some supporters of the  
          bill, who argue the FTB decision improperly voided a statute,  
          and that FTB could have continued implementing existing law.   
          This view has a significant impact on the fiscal effect of this  
          bill (see comment #9).


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                      SB 209 Estimated Loss of Revenues by Tax Year ($  

          |Provisions of SB 209  | 2012-13  | 2013-14  | 2014-15  | 2015-16  |
          |Loss from allowing    |$21.0     |$18.0     |$2.0      |$0.3      |
          |38% exclusion to      |          |          |          |          |
          |taxpayers who have    |          |          |          |          |
          |not already claimed   |          |          |          |          |
          |the QSBS exclusion    |          |          |          |          |
          |between 2009 and 2012 |          |          |          |          |
          |Loss from issue       |$16       |$12       |$12       |$12       |
          |limited assessments   |          |          |          |          |
          |for tax years         |          |          |          |          |
          |2008-2011             |          |          |          |          |
          |Loss due to waiving   |$2.2      |$1.5      |$1.6      |$1.5      |
          |interest on           |          |          |          |          |
          |assessments for tax   |          |          |          |          |
          |years 2008-2011       |          |          |          |          |
          |Total                 |$39.2     |$31.5     |$15.6     |$13.8     |

          Potential additional costs in the tens of millions if there is  
          subsequent litigation.  The severability clause would allow FTB  
          to attempt to determine if a program could be continued in the  
          event of an adverse court ruling.  This provision opens the door  
          to a potentially more expensive program.  This more costly  
          result is what would have happened if FTB had agreed with the  
          legal argument of some supporters of SB 209.
           1)Purpose.   The author states that retroactive changes in tax  
            law which trigger retroactive tax assessments are inherently  
            unfair.  The author explains that 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 FTB.  According to the author, they also risked their  
            capital and poured their efforts into creating start-up  


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            businesses that are the heart of the California economy.  

            The author argues the taxpayers 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 would result in the state  
            receiving an unfair windfall of close to $200 million.  

            The author argues that issuing retroactive tax assessments  
            when a legal defect is found with a tax credit provision will  
            undermine confidence in California tax incentives.  According  
            to the author, 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.   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, including  
            the California Chamber of Commerce and BIOCOMM, state that SB  
            209 would protect small business investors who made a good  
            faith reliance on California's tax law.  They argue  
            retroactive changes in tax law, which trigger retroactive tax  
            assessments, are inherently unfair.  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 that SB 209 is a reasonable solution to a unique  
            situation.  The proponents assert that, unless SB 209 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, the California School  
            Employees Association, argue the state should not restore a  
            tax break that was shown to be discriminatory and  
            unconstitutional.  The opponents assert the problem with many  
            state tax breaks is they either violate interstate commerce  
            laws, or provide tax benefits irrespective of any economic  
            activity to benefit California.  The opponents conclude the  
            retroactive tax relief proposed by SB 209 amounts to a tax  
            refund, with no incentive to invest in California.

           4)QSBS Background.   In 1993, the California Legislature enacted  
            SB 671 (Alquist, Statutes of 1993), which among things,  
            conformed California tax law to the federal tax provisions  


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            relating to a partial capital gains exclusion for small  
            business stock.  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.  
             State law provided all of the following requirements had to be  
            met 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 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.

             c)   During the taxpayer's holding period of the QSBS, no  
               more than 20% of the corporation's payroll expense could be  
               attributable to employment located outside of California.
          5)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.  This is known as the  
            "dormant" or "negative" Commerce Clause.  The courts have  
            struck down taxes and tax benefits that legislatures have  
            enacted to help in-state businesses as discriminatory against  
            interstate commerce.

           6)Cutler vs. FTB.   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.  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, spawned a host of decisions, articles and  


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            communications attempting to address what is without question  
            a complex and awkward situation.

            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, Mr. Cutler  
            argued the active business requirements violated the Commerce  
            Clause of the United States Constitution.  The trial court  
            sided with the FTB, 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  
            7)FTB response.  As the result of the Court of Appeal's decision  
            in Cutler, FTB 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.  However, the court did not 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, leaving open a  
            question of could the remainder of the statute be legally  
            administered.  To put it simply, FTB had to make a decision  
            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 the  
            remainder comprises a complete expression of legislative  

            FTB determined the QSBS statutes were invalid and 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 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.  By refusing to sever the offending requirements from  
            the remaining provisions of the QSBS statute, the FTB took a  
            position that the whole statute is unconstitutional and is  
            invalid under Cutler.   


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           8)Legislative response  .  SB 209 was introduced to address the  
            confusion and settle the claims and counterclaims.   
            Essentially, SB 209 helps 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  
            the result of the Cutler decision and the FTB notice.   
            However, SB 209 would provide only partial relief to those  
            taxpayers as they would be allowed an exclusion of only 38%,  
            not the full 50%, of the gain recognized on the sale of QSBS.   

             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.

           9)Alternative view  .  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 by the  
            remainder of the statute, namely the payroll at issuance  
            requirement, which was not at issue in Cutler.  They argue  
            that the payroll at issuance requirement encourages taxpayers  
            to seek out California-based businesses for investment and in  
            so doing clearly advances the legislative intent of spurring  
            investment in California.

            If FTB's interpretation is incorrect, the fiscal impact of SB  
            209 is much different, with a much smaller revenue impact.   
            Revenue losses would still result from allowing taxpayers, who  
            did not do so previously, to claim the QSBS exclusion from  
            2008 to 2012.  These are taxpayers who did not meet the  
            requirements of the now unconstitutional provisions of the  
            law, but with SB 209 could file and take advantage of the  
            exclusion.  However, savings result from two provisions, the  
            reduced exclusion, 38% as compared to 50%, and the ending of  
            the program.  With these provisions, SB 209 may not have an  
            aggregate net impact on General Fund revenues, again provided  
            the FTB interpretation is incorrect or reversed.

           10)  More QSBS litigation could follow.   SB 209 eliminates the  


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            80% California payroll and assets requirements, but retains  
            the requirement that at issuance at least 80% of the payroll  
            had to be attributable to employment based in California.   
            This requirement can be seen as discriminatory, much like the  
            other two requirements invalidated by the court in Cutler.   
            Some argue it is not discriminatory because it is not coercive  
            and does not compel the qualified small business to avoid  
            interstate commerce, but is rather a constitutionally  
            permissible means of encouraging investment in small business  
            in California without encouraging or discouraging investment  
            in other states.  However, the issues are not clear, creating  
            risk for the implementation of SB 209.  

           11)  Taxation with Representation.   It is a truth universally  
            acknowledged that if one group of taxpayers is helped by  
            legislation, they likely will not be the last group to request  
            assistance.  Cutler may be the first time courts have  
            nullified a California personal income tax benefit as  
            discriminatory; it won't likely be the last.  Attorneys are  
            likely to use Cutler to file suit against the state claiming  
            that other incentives, such as the Research and Development  
            Credit, the Enterprise Zone Credit, and the Motion Picture  
            Production Credit, discriminate 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.  Enacting SB 209 sends the message the Legislature  
            may act to save those disadvantaged by litigation, including  
            perhaps the litigants as in Cutler.

            In Ventas Finance I, LLC v. Franchise Tax Board, 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 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 claims.

           12)  Proposed amendment  .  The committee should amend out the  
            severability clause if the bill passes.  The severability  
            clause creates two potential issues.  

              a)   In the event of an adverse court decision, it would  
               allow the FTB or the courts to determine if they could  


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               fashion a program with what law remains.  This provision  
               increases the fiscal risks of this bill.  The results of  
               Cutler bear this out.  If FTB had done what many supporters  
               argue for, the state would have a much more expensive QSBS  
               program designed without input from the Legislature.  The  
               severability clause could facilitate the same situation  
               occurring again.  Although there is room for disagreement  
               about the interpretation of the law, the result of the FTB  
               decision was to preserve the Legislature's perquisites to  
               shape tax policy and make spending decisions.  

              b)   FTB has been subject to a great deal of criticism and  
               threats of litigation from many of the supporters of SB  
               209.  If these arguments are correct, it seems  
               contradictory to place FTB in the role of shaping this  
               policy in the future if there are additional court  
               decisions that could lead to the need for changes in the  
               QSBS program.  
           Analysis Prepared by  :    Roger Dunstan / APPR. / (916) 319-2081