Around 2,000 taxpayers, who thought they had received a great small-business state tax break the past four years, are finding out the break was a mirage and the bill for back taxes is real.

The state Franchise Tax Board (FTB) wants $120 million from small-business owners and investors who took advantage of a 20-year-old law to claim a 50% break on the taxable gain on the sale of their stock. The Qualified Small Business (QSB) stock exclusion is acknowledged to be a pretty nice incentive for entrepreneurs in a state not known for aggressively courting business.

Among the law’s requirements for qualification is that 80% of a company’s employees and assets be in California. When Frank Cutler was denied the tax break by the FTB, he sued the state in Los Angeles County Superior Court, claiming that the provision was an unconstitutional violation of the federal interstate commerce clause.

The trial court sided with the state and Cutler appealed. The California Court of Appeal for the Second Appellate District reversed the judgment and asked the lower court to reassess application of the law without the offending provision.

The FTB interpreted the appeals court’s ruling to mean that the entire law was invalid, not just the provision, and announced in December it would be collecting back taxes from anyone who profited from the tax break during the past four years. The board would liked to have gone back further, but a four-year statute of limitations constrained them.   

Some legal scholars think the FTB overreached and should only have stricken the offending provision, rather than declare the law dead. They offer as evidence the directive by the appeals court that the trial judge consider if Cutler is entitled to a “refund under the qualified small business stock provisions that are not the subject of this appeal.”

The board says the only way it can allow the tax break is if the state Legislature revises the 1993 law. At least one legislator disagrees.

 “The FTB staff is wrong, wrong, wrong to say this issue requires action by the Legislature,” state Senator Ted Lieu told the Los Angeles Times. “The FTB staff is misleading the public.”

The senator complained in a letter to FTB Executive Officer Selvi Stanislaus that retroactively going after taxpayers in this situation was inherently unfair and yet another discouragement to the business community. He asked that the decision be reversed.

–Ken Broder

To Learn More:

California Seeks $120 Million in Back Taxes from Small Businesses (by John Tozzi, Bloomberg Businessweek)

State Seeks Back Taxes from Small-Business Shareholders (by Marc Lifsher, Los Angeles Times)

California To Hit Startup Founders with Big Retroactive Tax Bills (by Brian Overstreet, Xconomy)

Tax Alert: FTB Disallows California Qualified Small Business Stock Benefits (JD Supra Law News)

What Happened to California's Qualified Small Business Stock? (California Franchise Tax Board)