California Imposes 5-Year Retroactive Tax Bill on Startup Investors

Thanks to an entrepreneur, Brian Overstreet, we in California are just starting to learn that the state Franchise Tax Board has cancelled the Qualified Small Business (QSB) tax benefits and is retroactively denying the benefits for the past five years.

Overstreet explained in a column in Xconomy that the QSB was designed to incentivize people starting business to keep them in California. If so, founders and early investors could exclude 50 percent of the taxable gain on the sale of their stock—meaning about 4.5 percent instead of 9 percent (now nearly 13 percent due to Proposition 30).

“Without the QSB provision, we might have decamped to a more tax- and business-friendly state,” he wrote. “After we completed the sale, I paid both my federal and state estimated taxes computed with the QSB exclusion. I thought I was clear until April 2013.”

But, on December 21, the FTB retroactively disqualified all exclusions and deferrals going all the way back to 2008.

How this came about is due, in part, to the FTB overreacting to a court ruling.

“What does this mean for you?” asks Overstreet.

1. If you are a business founder or early investor who sold stock since 2008 and took the QSB exclusion: Surprise! You are going to get a bill from the FTB for the 50 percent of the taxes you excluded plus interest plus possible penalties.

2. If you are a business founder or early investor and have not yet sold stock: Rethink your business and tax planning strategies. Consider whether it’s fiscally prudent to stay in California.

3. If you a contemplating starting or investing in a California business: Think long and hard. Consider out-of-state alternatives.

He adds, “Just at the moment when California is retroactively taxing entrepreneurs, the federal government is extending the federal QSB benefit.”

Those affected will pay no federal capital gains tax, and in some states, no state taxes—but in California will pay up to 13 percent.

“Why in the world would any smart business person start or invest in a new California company facing that kind of penalty?”

“California changed the rules after the fact, and that’s just not right. More importantly, the FTB’s radical action is going to send a terrifying message that will have the unintended consequence of driving young, growing businesses to friendlier environments.”

Overstreet is correct—when is it right or moral to penalize  taxpayers who did nothing wrong? Nonetheless, my instincts tell me that entrepreneurs, inventors, investors and venture firms better pay those bills on time.

Congratulations to Xconomy for breaking this story, which still has gone under-reported.

See Brian Overstreet’s column at “California To Hit Startup Founders with Big Retroactive Tax Bills.”

An excellent story that explains the series of events written by Wade Roush, Xconomy’s chief correspondent and editor of Xconomy San Francisco, is “The Surreal, Ironic Story Behind California’s Retroactive Tax on Small Business Investors.”

The court decision is Cutler v. Franchise Tax Board.

Deloitte issued an alert entitled “California Franchise Tax Board Notice Implements Court of Appeal Decision Involving Qualified Small Business Stock Gain Exclusion/Deferral.”

More on the story in U-T San Diego.