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Tax Law

California Taxpayers Whipsawed!

QSBS Exclusion, Deferral Statutes Unconstitutional

In August 2012, California's Second District Court of Appeal determined that the "qualified small business stock" (QSBS) exclusion and deferral statutes were unconstitutional.  See Cal. Rev. & Tax. Code Sections 18038.5 and 18152.5; Cutler v. Franchise Tax Board, 208 Cal. App. 4th 1247 (2012).  Because the statutes required companies to maintain a certain percentage of their workforce in California, the Court of Appeal held the tax exclusion/deferral favored domestic corporations and was thus facially discriminatory under a federal Commerce Clause analysis.  While there are federal rules governing QSBS, California does not conform to the federal system, and has its own gain exclusion and deferral rules.

FTB's Retroactive Treatment

At the end of 2012, the California Franchise Tax Board (FTB) issued guidance as to how they could apply the Cutler holding.  See Notice 2012-03. The FTB determined the appropriate remedy was to not allow the exclusion/deferral.  In addition, because the exclusion/deferral had been permitted for many years, the FTB decided that an appropriate remedy required retroactive application.  Using the four-year statute of limitations as a guide, the exclusion/deferral was permitted only for those tax years ended prior to January 1, 2008.

 The Whipsaw Effect: Comply, Then Pay Extra!!

The effect of the Cutler decision and the subsequent FTB guidance on how to apply the decision has been rigid opposition to the disallowance of the exclusion/deferral and particular dismay with respect to the retroactive application of the guidance.  Flummoxed corporate taxpayers that had previously complied with requirements for qualifying for the exclusion/deferral (including a requirement that a company maintain at least 80 percent of its workforce in California) now see that no good deed goes unpunished. However, they have secured a stay on Notices of Proposed Assessments (NPAs) so that no actual bills have yet been issued. 

Legislative action on this matter is still a possibility, and some lawmakers have promised a more taxpayer-favorable remedy in response to Cutler.  In the interim, the FTB is holding off on issuing NPAs and taxpayers should consult their tax practitioners before filing amended returns or paying any potential tax owed.

RELATED LINKS: For additional information about California's QSBS exclusion, see:

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