BILL ANALYSIS Ó SB 209 Page A SENATE THIRD READING SB 209 (Lieu) As Amended September 4, 2013 2/3 vote SENATE VOTE :34-3 REVENUE & TAXATION 9-0 APPROPRIATIONS 17-0 ----------------------------------------------------------------- |Ayes:|Bocanegra, Dahle, Gordon, |Ayes:|Gatto, Harkey, Bigelow, | | |Harkey, Mullin, Nestande, | |Bocanegra, Bradford, Ian | | |Pan, V. Manuel Pérez, | |Calderon, Campos, | | |Ting | |Donnelly, Eggman, Gomez, | | | | |Hall, Holden, Linder, | | | | |Pan, Quirk, Wagner, Weber | |-----+--------------------------+-----+--------------------------| | | | | | ----------------------------------------------------------------- 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, 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, 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. SB 209 Page B 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 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. SB 209 Page C 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)Waives the imposition of penalties and accrual of interest with respect to the additional taxes assessed as a result of the court decision in Cutler v. FTB (2012) 208 Cal.App.4th 1247, for each taxable year beginning on or after January 1, 2008, and before January 1, 2013, and allows the affected taxpayers to enter into a written installment payment agreement with the FTB for the payment of those taxes over a period not to exceed five years. 8)Allows taxpayers to file a claim for credit or refund, resulting from this bill, for taxable years beginning on or after January 1, 2008, and ending before January 1, 2009, within 180 days of the effective date of this bill. 9)Makes legislative findings and declarations regarding the public purpose served by the bill. 10)States that the bill's provisions are not severable and, if any provisions of this bill or its application are held invalid, the invalidity shall apply to other provisions or applications of this act, except for those provisions relating to the waiver of penalties and interest. 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 SB 209 Page D 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. 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 : SB 209 Page E 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 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 SB 209 Page F 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 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 SB 209 Page G 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 this bill 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, Statutes of 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 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 SB 209 Page H 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, Statutes of+ 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 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 -------------------------- <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. SB 209 Page I 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 Floor 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 June 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. SB 209 Page J 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 SB 209 Page K 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 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 --------------------------- <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). SB 209 Page L 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 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, this bill 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 --------------------------- <3> How Should California Policymakers Respond to Cutler? R. Waldow and R. Crawford, Tax Analyst, April 8, 2013. <4> Id., at p. 143. <5> The FTB Letter. SB 209 Page M 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, this bill 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, this bill 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 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, this bill 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. Thus, SB 209 would provide a windfall to those taxpayers for their past behavior. Analysis Prepared by : Oksana G. Jaffe / REV. & TAX. / (916) 319-2098 FN: 0002254