A California appellate court recently held as unconstitutional the California statutes extending the benefits of selling “qualified small business stock” (QSBS) to California taxpayers. In Cutler v. Franchise Tax Board (2012) 208 Cal. App. 4th 1247, the court held that the QSBS exclusion and deferral statutes – California Rev. & Tx. Cd. §§ 18038.5 and 18152.5 – discriminated against non-California corporations and therefore violated the Commerce Clause of the U.S. Constitution.

As a result of the Cutler decision, the California Franchise Tax Board has determined that these statutes are now invalid and unenforceable and that an appropriate remedy is to deny the exclusion and deferral to taxpayers who benefited from them.

In FTB Notice 2012-03, the FTB has announced that it will allow the exclusion and deferral with respect to the sale of stock of all corporations meeting the tests under the statutes (not just the corporations meeting the unconstitutional 80% California payroll and property tests) – but only for years beginning before January 1, 2008. For those few taxpayers whose pre-2008 tax years are still open, and who otherwise meet the QSBS exclusion or deferral tests, a claim (or protective claim) for refund is available.

However, for all tax years beginning on or after January 1, 2008, all taxpayers will be denied the exclusion and deferral for California state income tax purposes. Those taxpayers who benefitted from the exclusion or deferral will be notified by the FTB, and additional taxes (and interest) will be assessed; estimated tax penalties may also apply. Affected taxpayers should consider filing amended returns.

The FTB’s FAQs can be found at the following link: https://www.ftb.ca.gov/law/Qualified_Small_Business_Stock_and_Cutler_
Decision.shtml.

This development has no impact on the federal QSBS exclusion and deferral, which remain in effect.