United States: California Temporarily Reinstates Qualified Small Business Stock Gain Deferral And Exclusion For Tax Years 2008 To 2012

On October 4, 2013, California Governor Jerry Brown signed legislation that retroactively allows the qualified small business stock (QSBS) gain deferral and 50 percent exclusion for tax years 2008 to 2012.1 On October 7, 2013, the California Franchise Tax Board (FTB) released guidance for taxpayers explaining the retroactive reinstatement.2 This legislation was enacted in response to a decision by the California Court of Appeal, Cutler v. Franchise Tax Board,3 holding that California's QSBS gain deferral and exclusion provisions violated the Commerce Clause of the U.S. Constitution because they favored California taxpayers, and an FTB policy following Cutler to deny the QSBS benefit for all open tax years.4

Background

Under prior law, California's QSBS personal income tax gain deferral and exclusion provisions required 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."5 A corporation did 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."6

In Cutler, the California Court of Appeal held that the statute allowing a taxpayer to defer capital gains on the sale of QSBS if the taxpayer used the gain to purchase stock in another qualified small business violated the Commerce Clause. The Court found the statute to be unconstitutional because the deferral was limited to situations where the stock sold and purchased was issued by corporations that used at least 80 percent of their assets to conduct business in California and maintained at least 80 percent of their payroll in California. In response to the Cutler decision, the FTB issued guidance, FTB Notice 2012-03,7 explaining that it would deny any previously allowed QSBS gain deferral or exclusion for open tax years. This action would have subjected taxpayers who benefited from either the deferral or exclusion to additional taxes.

New Legislation Reinstates QSBS Gain Deferral and Exclusion

The legislation eliminates the 80 percent California property and payroll requirement during the holding period for QSBS gain deferral for sales made after August 5, 1997 and before January 1, 2013.8 The elimination of the property and payroll requirements is also applicable for the QSBS gain exclusion for sales, including installment sales, occurring in each taxable year beginning on or after January 1, 2008 and before January 1, 2013.9 Also, the amendments apply to installment payments received in taxable years beginning on or after January 1, 2008 for QSBS sales made in taxable years beginning before January 1, 2013.10 The legislation sunsets the QSBS gain deferral and exclusion so that they remain in effect only until January 1, 2016.11 In addition, the legislation adds a new statute that waives the penalties and interest imposed with respect to the additional tax assessment from the implementation of the Cutler decision.12 The legislation authorizes a taxpayer's claim for credit or refund for taxable years beginning on or after January 1, 2008 and ending before January 1, 2009 within 180 days of the bill's January 1, 2014 effective date.13

FTB Guidance

Although the legislation is not effective until January 1, 2014, the FTB has already issued guidance providing information to taxpayers impacted by the amendments made by the legislation, the Cutler decision and/or Franchise Tax Board Notice 2012-03.14

The FTB explains that taxpayers who have not filed their 2012 tax return may claim the exclusion or deferral for QSBS by reporting the entire amount of the gain from the sale of QSBS on Form 540 Schedule D, and then write "QSBS exclusion" or QSBS deferral," as applicable, with a negative number immediately underneath the reported gain amount. For taxpayers who filed their 2008 – 2012 tax returns and were contacted by the FTB regarding their QSBS election, the FTB will notify them of the following:

  • Pending Notices of Proposed Assessments based on the Cutler decision or FTB Notice 2012-3 will be withdrawn;
  • Closing letters will be mailed to taxpayers who signed a limited QSBS waiver for 2008;
  • Unpaid tax, interest or penalty assessed as a result of the Cutler decision and/or FTB Notice 2012-3 will be abated; and
  • Refunds for payments received related to the Cutler decision and/or FTB Notice 2012-3 will be issued. No action is needed by taxpayers to request refunds, unless they do not hear from the FTB by November 30, 2013, in which case the FTB should be contacted.

Taxpayers who filed their 2008 – 2012 tax returns and did not claim the QSBS election may now do so. However, the FTB guidance states that the QSBS must meet the 80 percent California payroll requirement at the time of acquisition to claim the 50 percent gain exclusion or deferral in order to file an amended return (claim for refund) if the statute of limitations is open.15

Commentary

California taxpayers who were unable to defer or exclude gain on sales of QSBS because the small businesses did not meet the statutory property and payroll requirement should consider filing amended returns for refund claims. Even though the new legislation eliminates the requirement that at least 80 percent of the corporation's assets are used to conduct business in California, it does not remove the 80 percent California payroll requirement at the time of stock acquisition to claim the gain deferral or exclusion. It is hoped that the legislation finally puts to rest the controversy that has been engendered by the Cutler decision, and the FTB's initial interpretation of that decision to require a retroactive elimination of a benefit that served as an incentive to invest in small businesses.

Footnotes

1 Ch. 546 (A.B. 1412), Laws 2013.

2 Qualified Small Business Stock (QSBS) Gains – FAQs, California Franchise Tax Board, Oct. 7, 2013. This information is available on the FTB's Web site at https://www.ftb.ca.gov/law/Qualified_Small_Business_Stock_and_Cutler_Decision.shtm

3 208 Cal. App. 4th 1247 (2012).

4 For further discussion of Cutler, see GT SALT Alert: California Court of Appeal Holds Statute Allowing Deferral of Gain from Qualified Small Business Stock Sales Is Unconstitutional.

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

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

7 California Franchise Tax Board, Dec. 21, 2012. In this notice, the FTB explained that it would individually notify taxpayers who reported a QSBS exclusion or deferral for taxable years beginning on or after January 1, 2008 that because these provisions were invalid and unenforceable, Notices of Proposed Assessments would be issued denying the exclusion or deferral. Alternatively, taxpayers who received the benefit of either the deferral or exclusion and wanted to self-assess and pay additional tax before they were contacted by the FTB could file an amended return reporting an increase in tax liability due to the disallowance of the deferral or exclusion.

8 CAL. REV. & TAX. CODE § 18038.5(c).

9 CAL. REV. & TAX. CODE § 18152.5(m).

10 Id.

11 CAL. REV. & TAX. CODE §§ 18038.5(d); 18152.5(m).

12 CAL. REV. & TAX. CODE § 18153.

13 A.B. 1412, § 5. As explained by the FTB, taxpayers have until June 30, 2014 to file a QSBS claim for refund for the 2008 tax year. Qualified Small Business Stock (QSBS) Gains – FAQs, California Franchise Tax Board, Oct. 7, 2013.

14 Qualified Small Business Stock (QSBS) Gains – FAQs, California Franchise Tax Board, Oct. 7, 2013.

15 As explained by the FTB, the statute of limitations generally is four years from the date the return was filed (if filed within the extension period), or one year from the date of the overpayment, whichever is later.

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