Watch Out For Those Retroactive State Tax Gotchas!

Published on: 18:01PM Jan 17, 2013

We just read an article in the Xconomy website on a drastic retroactive law change specific to the state of California that will possibly impact many taxpayers.  Federal law has a rule under Section 1202 that allows you to deduct a certain percentage of your gain from investing in Qualified Small Businesses (QSB).  We won't go into all of the details, but in general, this deduction is 50% (in some years 100%).  The state of California decided many years ago to enact a law essentially similar to the federal law.

In the article the author explained how the state lost a Court case that challenged part of the law requiring QSB's to maintain a certain amount of the business in California.  The Courts finally ruled that this part of the law was unconstitutional.  When parts of income tax law are rule unconstitutional, etc. the state or federal government normally changes the laws to make it correct.

HOWEVER, the Franchise Tax Board in FTB Notice 2012-03 decided not to correct the issue, but rather, retroactively demand payment for any income tax refunds granted since January 1, 2008.  This means that if someone deducted $1,000,000 of gain on their 2008 tax return and saved about $45,000 in tax, they will be required to pay this back to the state.

Here is their very convoluted reasoning for disallowing the deduction:

Federal income tax law provides for the exclusion or deferral of gain from the sale or exchange of qualified small business stock (QSBS). Beginning in 1993, California adopted its own standalone QSBS provisions dealing with exclusions, which generally mirrored existing federal law. However, California law required that at least 80 percent of the company's payroll at the time the stock was purchased must be within California and 80 percent of assets and payroll must be within California during the taxpayer's holding period for the stock in order to qualify for a QSBS gain exclusion or deferral. In 1998, California adopted its own standalone QSBS provision dealing with deferrals.

The provisions in California law regarding the 80 percent asset and payroll requirements were found to be unconstitutional in August 2012 by the California Court of Appeal in Cutler v. Franchise Tax Board (FTB). The court's decision made California's entire QSBS statute invalid and unenforceable. As a result, all QSBS gain exclusions and deferrals previously allowed under California law became invalid. It is important to note that the court's decision in Cutler did not change the federal treatment of QSBS.

Because QSBS gain exclusions and deferrals are no longer valid for California purposes, taxpayers who previously took advantage of California's preferential treatment of QSBS in years still open for assessment under the four-year statute of limitations (generally 2008 and later) must now recompute their taxable income for each affected year without excluding or deferring gains from the disposition of QSBS. For 2007 (and prior) tax years still open under the statute of limitations, a QSBS gain exclusion or deferral will be allowed if the taxpayer meets all other requirements under California law, i.e., those other than the 80 percent asset and payroll requirements (See FTB Notice 2012-03).

This is probably one of the most egregious retroactive tax increases that we have seen in a long time.  None of the taxpayers did anything wrong, rather the State decided they would lose too much money and simply took away the benefit granted to taxpayers over a 4 year period.

We think as states need more and more revenue, you may see more cases like this (especially in California).