Alert - Qualified Small Business Stock (QSBS) Retroactive Tax

September 27, 2013
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In 1993, California adopted a statute which provided for the exclusion or deferral of gain from the sale or exchange of qualified small business stock ("QSBS"). In order to qualify as QSBS, the stock must be in a domestic C corporation which has aggregate gross assets of less than $50,000,000. In addition, at least 80% of the C corporation's business must be an "active business," rather than investment activity or certain service provider businesses. The California statute generally mirrored the federal tax statute, but added a requirement that at least 80% of the company's payroll at the time that the stock was purchased be within California and at least 80% of the assets of the company be located within California during the holding period for the stock in order to qualify for the QSBS exclusion or deferral.

In August of 2012, a California Court of Appeal ruled the California statute unconstitutional because the 80% asset and payroll requirements violated the commerce clause of the U.S. Constitution. (See Cutler v. Franchise Tax Board (2012) 208 Cal. App. 4th 1247). In December of 2012, the Franchise Tax Board declared that the entirety of the QSBS statutes were entirely unenforceable and disallowed retroactively any QSBS benefits for any open tax years. This meant that many California taxpayers faced potential tax bills going back as far as 2008, even though they were in compliance with the QSBS statutes in effect at the time.

The Franchise Tax Board ("FTB") has stated that the retroactive tax will affect approximately 2,000 small business owners and investors within the state. FTB is actively attempting to collect close to $120 million in back taxes. If you own stock in a domestic C corporation within California, which is engaged in an active trade or business, and conducted a sale or exchange of said stock in the taxable years beginning after January 1, 2008, you may be impacted.

As a result of the unfair implications of this retroactive disallowance from the Franchise Tax Board, California Senate Bill 209 (SB 209) has been proposed, which provides for retroactive relief for any taxpayers facing a tax bill as a result of the QSBS disallowance. California taxpayers who disposed of QSBS between 2008 and 2012 would still be able to exclude or defer gain, provided that they were in compliance with the 80% California-based requirements at the time that the QSBS was acquired. However, under the proposed legislation, the burden would fall onto the taxpayer to demonstrate that the criteria were met.

In addition, SB 209 suspends the QSBS rules for sales and exchanges of QSBS stock for the tax years 2013 through 2015. Starting in 2016, the exclusion and deferral rules will be reinstated, absent the California-based requirements. The California Legislature recently voted to pass SB 209 and the bill was forwarded to Governor Brown for his signature. Governor Brown has until October 13, 2013 to sign SB 209, veto it or allow the measure to become law without his signature. We will continue to monitor the status of SB 209 and provide updates as they occur.

Earlier this year, the Franchise Tax Board began issuing Notices of Proposed Assessments and also instructed affected taxpayers to file amended returns. However, taxpayers should continue to monitor the status of SB 209, not only for the retroactive tax relief, but for the suspension of the exclusions or deferral of gain of QSBS sales or exchanges during the tax years 2013 through 2015. If you are contemplating a sale or exchange of QSBS stock in the future, SB 209 may have a substantial impact on the tax ramifications of the subject transaction. Owners of QSBS may wish to give special thought to the proper timing of said sales or exchanges, taking into consideration the implications of SB 209 and the potential reinstatement of the statute in 2016.