United States: California Court Of Appeal Holds Statute Allowing Deferral Of Gain From Qualified Small Business Stock Sales Is Unconstitutional

The California Court of Appeal has held that a personal income tax statute that allows a taxpayer to defer capital gains on the sale of qualified small business (QSB) stock if the taxpayer uses the gain to purchase stock in another QSB violates the Commerce Clause.¹ The Court found the statute to be unconstitutional because the deferral is limited to situations where the stock sold and purchased was issued by corporations that use at least 80 percent of their assets to conduct business in California and maintain at least 80 percent of their payroll in California.

Background

The taxpayer sold stock that he had acquired in an Internet start-up company (US WEB) and used some of the proceeds to purchase stock in several other small businesses. The US WEB stock did not meet the statutory active business requirements because the company did not maintain 80 percent of its assets and payroll in California. On his California personal income tax return, the taxpayer deferred that part of the gain from the sale of the stock that he invested in three other small businesses. The California Franchise Tax Board (FTB) disallowed the gain deferral and stated in its notice of proposed assessment that the US WEB stock was not QSB stock.² The taxpayer filed a protest and asserted that the US WEB stock met all of the statutory requirements for deferring gain. Also, the taxpayer argued that the statute violated the Commerce Clause because it discriminated against investors in companies that conduct some of their business outside California.

The FTB denied the taxpayer's protest and affirmed the proposed assessment. The California State Board of Equalization subsequently denied the taxpayer's appeal and sustained the FTB's action. The taxpayer appealed this decision to the California Court of Appeal.

Deferral of Gains in California

Under federal law, a taxpayer does not recognize gain on the sale of small business stock if the taxpayer purchases stock in other qualified businesses within 60 days.³ This rollover provision does not apply to California personal income tax.⁴ Instead, California has its own statutes deferring gains on QSB stock that are similar to the federal provisions,⁵ but California limits the incentive to gains on investments to small businesses that are based in California.⁶ The California statute requires that "[a]t least 80 percent (by value) of the assets of the corporation [must be] used by the corporation in the active conduct of one or more qualified trades or businesses in California."⁷ A corporation does not meet this requirement "for any period during which more than 20 percent of the corporation's total payroll expense is attributable to employment located outside of California."⁸

California Statute Violates Commerce Clause

In determining that the California statute violates the Commerce Clause, the Court of Appeal reviewed federal and state case law on this subject. The U.S. Supreme Court explained in Fulton Corp. v. Faulkner⁹ that the Commerce Clause "has long been seen as a limitation on state regulatory powers, as well as an affirmative grant of congressional authority." This limitation on state powers, commonly referenced as the dormant Commerce Clause, prohibits "regulatory measures designed to benefit instate economic interests by burdening out-of-state competitors."¹⁰ When a dormant Commerce Clause challenge is made, courts must determine whether a statute discriminates against interstate commerce. State laws that discriminate against interstate commerce on their face generally are invalid, but there are some limited exceptions.¹¹

The Court of Appeal explained that the U.S. Supreme Court has considered numerous challenges of state statutes under the dormant Commerce Clause. Although the Court of Appeal summarized many U.S. Supreme Court decisions, the Court of Appeal emphasized the Fulton case that held a North Carolina statute violated the dormant Commerce Clause.¹² In Fulton, the U.S. Supreme Court invalidated North Carolina's intangibles tax that was imposed on a fraction of the value of corporate stock owned by residents of the state. The tax was structured so that stock in a corporation not doing business in North Carolina was taxed at 100 percent of its value, but stock in a corporation only doing business in the state was not taxed.¹³

After reviewing the federal decisions, the Court considered two seminal California tax cases holding that statutes violated the dormant Commerce Clause. In Ceridian v. Franchise Tax Board,¹⁴ the Court held that a corporate tax deduction for dividends paid to a corporation by its insurance company subsidiaries violated the Commerce Clause because the deduction was limited to dividends paid from income from California sources. In Farmer Brothers Co. v. Franchise Tax Board,¹⁵ the Court invalidated a statute that provided corporate taxpayers a deduction for dividends received from corporations subject to California tax, but not if the dividends were from corporations not subject to California tax.

The Court of Appeal acknowledged that there were differences in the discriminatory taxes in Fulton, Ceridian and Farmer and the tax involved in this case. The tax benefit provided on the exchange of QSB stock is a tax deferral rather than an outright exemption or deduction. Also, the deferral occurs in connection with a sale and subsequent purchase of QSB and not in connection with dividends on the stock. Further, the deferral of gain is provided for individual taxpayers rather than corporations. However, the Court determined that these distinctions did not warrant a departure from Fulton and the other Commerce Clause cases. Similar to the statute in Fulton, the statute at issue served to "favor investment in corporations doing business within the State" and operated as a "disincentive . . . to buying stock in corporations doing business out of state."

In rejecting the FTB's argument that the California property and payroll requirement does not discriminate against interstate commerce, the Court determined that the FTB did not offer a sufficient analysis to support its claim. The FTB argued that Department of Revenue v. Davis¹⁶ supported its argument that the California statute was valid. In Davis, the U.S. Supreme Court upheld a Kentucky statute that exempted interest on its own bonds from state income taxes that are imposed on bond interest from other states.¹⁷ The Court applied the "market participation" doctrine in determining that Kentucky could exempt interest on its own bonds. However, the "market participation" exception did not apply to California's statute limiting the deferral of gain from QSB stock. The California statute was discriminatory on its face under Fulton because it favored domestic corporations over foreign corporations in raising capital among California residents.

The taxpayer argued that a full refund was the only proper remedy in this case. However, because the trial court granted the FTB's motion on the ground that the statute was constitutional, the trial court did not consider the FTB's argument that the stock purchased by the taxpayer did not meet the other statutory requirements for QSB stock. Because there were material disputed facts, the Court could not determine whether the taxpayer was entitled to a refund under the QSB provisions that were not the subject of the appeal. Therefore, the case was remanded to the trial court.

Commentary

This is the first time that the California Court of Appeal has considered the constitutionality of the QSB stock gain deferral statute. The Court of Appeal provided a detailed analysis to support its decision that the California statute violated the dormant Commerce Clause because it limited the deferral of gain to taxpayers that sell and purchase QSB stock in corporations that maintain assets and payroll in California. The statute operates to favor investment in small corporations operating in California over small corporations operating outside the state. As explained by the Court, this statute differs from the statutes invalidated in previous cases, but apparently not enough to override constitutional concerns. Given the constitutional issue, it is very likely that the FTB will appeal the decision to the California Supreme Court.

It is interesting to see tax provisions designed to provide incentives for investors to purchase stock with significant in-state property and payroll be attacked on the basis that the location of the investment's property and payroll should not impact the tax-favorable treatment of the investment. Presumably, these tax provisions were never thought of as unconstitutional when first adopted, and were developed to stimulate businesses within California's economy. The Court's decision may have a chilling effect on states considering incentives designed to stimulate their own economies, for fear that such incentive may be considered discriminatory.

While the Court of Appeal rendered the statute unconstitutional, the taxpayer at issue (and by extension, other similarly situated individuals) did not receive the benefit of the QSB deferral, at least at this time. Ultimately, a full resolution of the appropriate remedy could take several years. Even so, California individuals that were unable to defer gain on sales of QSB stock because the small corporations did not meet the statutory asset and payroll requirements should consider filing protective refund claims for open tax years.

Footnotes

1 Cutler v. Franchise Tax Board, California Court of Appeal, Second District, No. B233773, Aug. 28, 2012.

2 The FTB also alleged that the taxpayer did not substantiate other requirements such as purchasing the replacement stock within 60 days of the sale.

3 IRC § 1045.

4 CAL. REV. & TAX. CODE § 18038.4.

5 CAL. REV. & TAX. CODE §§ 18038.5, 18152.5.

6 CAL. REV. & TAX. CODE § 18152.5(c)(2)(A), (e)(1)(A), (e)(9).

7 CAL. REV. & TAX. CODE § 18152.5(e)(1)(A).

8 CAL. REV. & TAX. CODE § 18152.5(e)(9).

9 516 U.S. 325 (1996).

10 Id.

11 A facially discriminatory tax is not invalid if it is a compensatory tax that is designed to make interstate commerce pay for a burden that already is realized by intrastate businesses. Id. Also, there is a "market participation" exception when a state goes beyond regulation and participates in the market so that its citizens are favored over others. Department of Revenue v. Davis, 553 U.S. 328 (2008).

12 516 U.S. 325 (1996).

13 Id.

14 85 Cal. App. 4th 875 (2000).

15 108 Cal. App. 4th 976 (2003).

16 553 U.S. 328 (2008).

17 Id.

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