FTB Announces Temporary Reprieve on Retroactive Assessment of Qualified Small Business Stock Taxes

On January 8, 2013, we published a newsletter (a copy of which can be found here) detailing the Franchise Tax Board's ("FTB") questionable legal and policy decision to begin collecting on a retroactive basis approximately $150 million of personal income taxes plus interest from investors who lawfully claimed a 50 percent exclusion or deferral on their returns pursuant to California's qualified small business stock ("QSBS") statutes.  Last week, the FTB indicated that it will continue to issue notices of proposed assessment ("NPAs") to collect taxes on the sale of QSBS after January 1, 2008 (i.e., to prevent the running of the statute of limitations), but if taxpayers agree to waive the statute of limitations, a taxpayer protest can be delayed pending action from the State Legislature in response to the recent California Court of Appeal decision in Cutler v. Franchise Tax Board.  It is unclear at this time how long the FTB will delay issuing NPAs for those taxpayers who have agreed to waive the statute of limitations.

As discussed in our January newsletter, the court held in Cutler that the California property and payroll requirements of California's QSBS statutes were invalid.  These statutes provided a tax deferral or partial exclusion to investors in certain qualified small businesses that had 80 percent or more of their assets and payroll in California (the "80 Percent Requirements").  The court struck down the 80 Percent Requirements on the basis that they violated the Commerce Clause of the U.S. Constitution.

In response to the Cutler decision, the FTB summarily declared in FTB Notice No. 2012-03 (December 21, 2012) (the "FTB Notice") that the QSBS statutes were invalid in their entirety.  Instead of granting refunds to out-of-state businesses that were not able to claim exclusion or deferral under the QSBS statutes or even fashioning a partial refund remedy, the FTB announced that it would issue NPAs to retroactively assess all investors who previously benefited from the QSBS statutes for any open tax years.

The public response to the FTB Notice was swift and generally very critical.  Affected taxpayers, tax experts, various coalition groups, lobbyists and politicians voiced concern about the FTB's unilateral action, which resulted in a bipartisan letter signed by 38 state lawmakers urging the FTB to use its authority to reverse course.  The Governor's office also urged the FTB to reconsider its position while legislative proposals could be considered to address the constitutional defects in the QSBS statutes.

On February 22, 2013, an assembly bill ("AB 901") was introduced by Assemblyman Wieckowski to eliminate the 80 Percent Requirements in the QSBS statutes on a retroactive basis (i.e., to 1997 in the case of deferral of gain on the sale of QSBS, and to 2008 in the case of exclusion of gain on the sale of QSBS).  AB 901 may be heard by the Assembly's fiscal committee as early as March 26, 2013.

On February 27, 2013, the FTB indicated in revised FAQs to the FTB Notice that it will refrain, for the  time being, from trying to collect personal income taxes as a result of Cutler until such time as state legislators can fully consider a legislative fix to Cutler.  The FTB has indicated that affected taxpayers protesting retroactive assessment have the option to "request that the protest be held pending legislative action" so long as they agree to waive the statute of limitations for tax year 2008 (and possibly later tax years, as applicable).  If a taxpayer does not agree to waive the statute of limitations, the FTB will issue an NPA to prevent the statute of limitations from running.  Based on the FTB's revised FAQs, taxpayers are advised to continue to protest assessments timely, but may delay such protest if a valid waiver of the statute of limitations is submitted to the FTB prior to issuance of an NPA.

Although the FTB's announcement does not vindicate those taxpayers who reasonably relied on California's QSBS statutes to their detriment, it is a positive first step.  Whether a legislative fix via AB 901 or another bill will come to fruition remains to be seen, and even if a bill were to pass, it is not clear whether it will include full restoration of the QSBS tax incentives or simply a prohibition on retroactive assessments.  We are cautiously optimistic that a legislative solution can be reached to preserve California's QSBS tax incentive regime so as to encourage continued investment in California's small businesses.

If you have any questions or would like more information concerning the subject matter of this newsletter, please do not hesitate to contact us.