BILL ANALYSIS                                                                                                                                                                                                    Ó

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          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  


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             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.


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          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. 


          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  


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            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  :


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          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  


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            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  

           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  


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            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  


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            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  

          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. 


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            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  


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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  


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            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). 


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            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  

          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. 


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            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)  

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