FTB Retroactively Denies “Qualified Small Business Stock” Personal Income Tax Benefits
Authors: David W. Herbst | Matthew A. Portnoff
On December 21, 2012, the Franchise Tax Board (FTB) released Notice 2012-03 (the “FTB Notice”), which notice outlines the procedures the FTB will apply in response to the Court of Appeal’s recent decision in Cutler v. Franchise Tax Board, 208 Cal. App. 4th 1247 (2012). In Cutler, the court held as unconstitutional under the Commerce Clause California’s personal income tax exclusion or deferral of gain from certain “qualified small business stock” (“QSBS”) dispositions as applied to California-based businesses only.
In what appears to be a very aggressive posture by the FTB, the FTB Notice provides that the FTB will deny any exclusion or deferral claimed on the sale of QSBS by taxpayers for California personal income tax purposes for tax years beginning on or after January 1, 2008. For tax years before January 1, 2008, the FTB will allow taxpayers to file a claim for refund of tax attributable to an exclusion or deferral of gain on the sale of QSBS, even for businesses that are not California-based; however, few taxpayers are likely to benefit from this because the applicable statute of limitations for filing such claim for refund is close to expiring or has expired. The FTB Notice also indicates that taxpayers who claimed any exclusion or deferral after January 1, 2008 should expect to receive notices of deficiency if an exclusion or deferral was claimed.
In Cutler, the taxpayer challenged the constitutionality of California’s QSBS statutory provisions for qualified small businesses. The taxpayer sold stock acquired in a start-up company and used some of the proceeds to purchase stock in several other small businesses. The taxpayer deferred a portion of the gain from the sale on his 1998 California tax return under Revenue and Taxation Code (“RTC”) Sections 18038.5 and 18152.5, which together, provide for elective gain-recognition deferral for individuals on the sale or exchange of QSBS held for more than six months, to the extent the amount realized was used to purchase QSBS within a 60-day period beginning on the date of the sale to the extent QSBS sold and purchased was issued by “domestic corporations” (i.e., corporations that use 80% of their assets in the conduct of business in California and maintain 80% of their payrolls in California).
The FTB disallowed the deferral on the grounds that the stock sold by the taxpayer did not meet the definition of QSBS as provided in RTC Section 18152.5(c), and further, did not meet the statutory requirements of RTC Section 18038.5. The taxpayer filed suit in Los Angeles Superior Court, asserting that: (1) the transaction met California’s statutory requirements, (2) the payroll and property requirement set forth in RTC Section 18152.5(c) was unconstitutional under the Commerce Clause because it unfairly discriminates against investors in companies that conduct a certain portion of their business outside California, and (3) the Due Process clause of the Fourteenth Amendment required a full refund. The trial court granted the FTB’s motion for summary judgment finding that the payroll and property requirement under RTC Section 18038.5 was not unconstitutional.
On appeal, the FTB argued that the property and payroll requirement does not violate the Commerce Clause because it does not tax out-of-state goods or services. The California Court of Appeal rejected the FTB’s contention and reversed the trial court’s determination declaring that RTC Section 18038.5 favors domestic corporations in violation of the Commerce Clause. However, citing the FTB’s claim that the taxpayer did not meet the other requirements of the QSBS statute separate from the property and payroll requirement, the court declined to decide whether the taxpayer should be afforded the refund requested or whether some other appropriate remedy, if any, should apply.
The Court of Appeal remanded the case to the trial court to determine an appropriate remedy but noted that such remedy should fall within one of three categories in accordance with McKesson Corp. v. Florida Alcohol & Tobacco Div., 496 U.S. 18 (1990): (1) refund to taxpayer the difference between the tax it paid and the tax it would have been assessed were the taxpayer extended the same tax treatment for the sale of a domestic corporation’s QSBS; (2) assess and collect back taxes from taxpayers that benefited from the QSBS statutes, or (3) a combination of a partial refund to taxpayer and a partial retroactive assessment on taxpayers who benefited from the QSBS statues to reflect a scheme that does not discriminate against interstate commerce, each subject to applicable statutes of limitation.
Implementation of FTB Notice 2012-03
The FTB Notice is remarkable insofar as the taxpayer in Cutler won on the argument that the limitations under the QSBS statutes favoring domestic corporations were unconstitutional. Nonetheless, the FTB is now penalizing a broad class of taxpayers, and has effectively preempted the trial court’s decision on remand by adopting a variation of the third approach cited above, i.e., refund for years in which most taxpayers are foreclosed by the statute of limitations and retroactive assessment for those taxpayers who benefited from either exclusion or deferral in a year in which the statute of limitations is still open. In taking such approach, the FTB has relied upon another Court of Appeal decision, River Garden Retirement Home v. Franchise Tax Board, 186 Cal. App. 4th 922 (2010), which sanctioned corrective retroactive assessment.
For tax years beginning before January 1, 2008, the FTB Notice provides that the FTB will allow the benefit of the QSBS statutes to apply to sales of stock for all corporations, including foreign corporations (i.e., for the very few individuals who disputed this issue before the limitations period expired, while all other taxpayers who thought their QSBS sales did not qualify are time barred from filing an amended return or a claim for refund). For all other tax years, 2008 to present, the FTB has declared as unconstitutional the QSBS statutes in their entirety (which, incidentally, was not the pronouncement of the Court of Appeal in Cutler) for California personal income tax purposes. As such, the FTB will seek to assess additional income taxes on all stock sale transactions for which taxpayers claimed exclusion or deferral under the QSBS statutes rather than issue refunds to taxpayers selling non-California stock. Those taxpayers who benefitted from the exclusion or deferral will be notified by the FTB, and additional taxes (plus interest) will be assessed.
The FTB Notice recommends that all affected taxpayers self-assess by filing amended returns, paying applicable taxes due or taking other steps that could allow partial abatement of interest.
The FTB Notice is expected to affect countless taxpayers who have benefited from the QSBS statutes since 2008. Any and all such taxpayers should expect to receive notices of deficiency from the FTB in the coming months.
The appropriate response to an FTB notice of deficiency is dependent upon each taxpayer’s particular facts and circumstances. Some taxpayers may wish to forego responding until the Cutler trial court releases its opinion on remand. Other taxpayers, however, may wish to immediately file a protective refund claim to preserve open tax years in the event any undecided issues are favorably resolved by the trial court. Whereas other taxpayers who claimed exclusion or deferral pursuant to the QSBS statutes on their 2008 returns may benefit by waiting for the FTB to issue a notice of assessment before responding so as to take advantage of interest abatements (applicable only to the portion of interest assessed more than 36 months after the return was filed). Depending upon when such taxpayers filed their 2008 returns, the statute of limitations could potentially run before the FTB issues a notice of assessment.
In summary, because the FTB Notice may affect taxpayers differently, it is recommended that taxpayers consult with their tax advisors before responding to an FTB notice of deficiency. Lastly, it should be noted that the FTB Notice has no impact on federal QSBS exclusions and deferrals, which remain in effect.
If you have any questions or would like more information concerning the FTB Notice, please do not hesitate to contact us.