As a way of encouraging entrepreneurs and investors to start companies in California, the state has long offered a tax deduction for those who start, invest in, and eventually sell companies.

This tax deduction allowed entrepreneurs and angels to exclude 50% of any gain on the sale of "Qualified Small Business" stock.

California's capital gains taxes are a high 9%, so the deduction reduced the capital gains rate to 4.5%. This encouraged the entrepreneurs to start and keep their companies in California, instead of decamping to lower-tax states.

And, for many years, California entrepreneurs and investors have taken advantage of the deduction.

But now the state has apparently decided that it no longer needs to encourage entrepreneurs to start and keep their companies in California.

So it is eliminating the tax deduction.

Far more startling, the state is eliminating the deduction retroactively--going all the back to 2008.

In other words, anyone who sold their California company in the past 5 years and took advantage of the tax deduction is now going to have to pay the tax.

With interest!

A California entrepreneur named Brian Overstreet wrote about this tax decision over at Xconomy. Overstreet sold his company last year, which means he's going to get socked with the tax. As he observes, however, this absurd decision will have a far-reaching impact. And it might well encourage lots of companies to rethink locating themselves in California:

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. That’s the last thing that the state of California needs right now.

The FTB’s retroactive sucker punch isn’t just about me. It’s about everyone in the startup community. It’s going to be a very painful time for entrepreneurs and investors in California over the next few months as these potentially debilitating tax bills start showing up in mailboxes all across the state.

My company was not a big, faceless corporation. We were good corporate citizens with a small but vibrant, local workforce. We were the epitome of a Qualified Small Business.

And we just got screwed. And so did you.

Read Brian's whole post at Xconomy >