A major tax incentive designed to encourage investors to back startups and other small businesses in California has just evaporated. If you sold stock in a so-called “qualifying small business” (QSB) in 2012, you won’t be able to exclude or defer any of your gains when you fill out your state income tax return this spring, as you formerly could under California law.

That may sound like a relatively minor matter, especially if you don’t own startup shares or aren’t an active investor. And in light of California’s financial woes, it would certainly be intellectually understandable if the state had decided to drop the exemption going forward. But the changes don’t stop there. Under the California Franchise Tax Board’s interpretation of a 2012 state Court of Appeals ruling, which found part of the tax law to be unconstitutional, anyone who acted in good faith to claim the now-deceased QSB incentive on their 2011 California return owes the state back taxes on the excluded or deferred income.

And the same goes for 2010. And 2009. And 2008.

And, what’s more, these taxpayers will also be hit with back interest and possible penalties.

If you’re unsettled by the idea of owing additional taxes, interest, and maybe penalties on a completely legitimate return you submitted four years ago, you aren’t alone. “These taxpayers followed the law when they filed their tax returns,” says Gina Rodriquez, vice president of tax policy at the California Taxpayers Association, a non-profit advisory organization in Sacramento. “For [the Franchise Tax Board] to come out four or five years later and say, ‘You followed the law, but it was unconstitutional, and now we are going to hit you with back taxes and interest’—and the interest can be huge—that is just not fair tax policy.”

The retroactive nature of the tax change, which was announced by the Franchise Tax Board on the eve of the Christmas holiday, has taken plenty of California taxpayers by surprise. In fact, the changes went largely unremarked outside a small community of accountants and tax attorneys until Xconomy published a guest editorial about the FTB notice by Brian Overstreet, the co-founder of drug safety monitoring startup AdverseEvents.com, on Jan. 15.

Since that article appeared, the FTB’s retroactive clawback decision has begun to generate national press coverage, not to mention pained outcries from many other California entrepreneurs and investors. It’s unclear exactly how many taxpayers will ultimately be affected: the FTB puts the number at just 500 people per tax year, or as many as 2,500 altogether, who might owe a cumulative $150 million in back taxes, while Los Angeles law firm Manatt, Phelps & Phillips says the impact could be much larger, affecting “countless taxpayers” who have claimed the QSB exclusions since 2008.

But regardless of the exact number of people now in line to receive tax bills from the FTB, the change is sparking angry protest from critics who say the tax board overreacted to the Court of Appeals ruling and didn’t need to make the remedy retroactive. Moreover, observers in the tax and investing communities say the reversal of the QSB incentive—coming on the heels of big income tax increases imposed by Proposition 30, which voters approved in November—could erode the state’s image as a haven for innovators, ultimately driving investors and entrepreneurs to take their money and their talent to other states with lower income tax rates.

“Whether it’s the QSB stuff, or whether it’s Proposition 30, all of it is part of a pattern, and the cumulative impact is chilling,” says Bob Ackerman, founder of San Francisco-based venture firm Allegis Capital. “I have had conversations with a number of entrepreneurs as well as a number of venture firms who have indicated that they are seriously rethinking where they invest and where they build companies.”

In the court case that prompted the change, the FTB argued that California has the prerogative to use tax incentives to encourage in-state investing. (The specific issue in the case was whether the incentives were set up in a way that discriminated against taxpayers who invested in multi-state businesses.) Observers say it’s ironic that the board has now gone to the opposite extreme—not just nullifying the QSB incentives for 2012 and future tax years, but penalizing taxpayers who took advantage of them before 2012.

But there may be an even bigger irony in the episode: the plaintiffs who originally argued that the tax incentives were unconstitutional—and who persuaded the Court of Appeals to agree—say the FTB’s response is the opposite of what they’d hoped for.

“It’s throwing the baby out with the bathwater,” says Marty Dakessian, an attorney at law firm ReedSmith who represented private investor Frank Cutler in the decade-long case. “We thought the appellate court decision would be a big win for taxpayers. By ending the discriminatory nature of the incentive, it should have expanded the pool of startups and small businesses that qualified for the benefits. But we were taken aback by the FTB’s approach. You would have hoped that they would recognize the intent of the legislation, which was to encourage investment and foster the entrepreneurial spirit and innovation in the private sector—all the things that people in Sacramento love to talk about.”

In interviews with investors, entrepreneurs, lawyers, and tax policy analysts, Xconomy has reconstructed the complex history of Cutler v. Franchise Tax Board and the FTB’s response to the appellate court decision. We asked sources what other options might have been available to the FTB after the ruling; what ripples the decision is likely to send through California’s innovation ecosystem; and whether opposition to the new policy might snowball into some kind of organized political response. For the details, read on.

Property, Payroll, and the Commerce Clause

A tax change that could end up costing technology investors hundreds of millions of dollars began 15 years ago when one man, Newport Beach resident Frank Cutler, sold some of his stock in a high-flying Silicon Valley startup, US Web.

One of the first big Web design, marketing, and hosting companies, US Web went public in December 1997. In 1998, Cutler, an early investor and board member at the company, sold shares worth about $2.3 million. (This and other details of the case are spelled out in the Aug. 28 ruling by the California Second District Court of Appeal, which was written by Associate Justice Elizabeth Grimes.)

Cutler rolled some of the money from the stock sale into three other small businesses, and on his 1998 state income tax return, he deferred that portion of the gain—that is, he didn’t report it as income. California’s tax code provided for just such a scenario: individuals were allowed to defer gains on the sale of stock in a qualified small business as long as they reinvested the proceeds in another qualified small business within 60 days.

The real trouble started brewing five years later, in May 2004, and it had to do with the definition of “qualified.” The Franchise Tax Board had reviewed Cutler’s 1998 return—which was still open to additional assessment under the statute of limitations—and in its view, US Web couldn’t be classified as a qualified small business. So it disallowed Cutler’s 1998 deferral and sent him a bill for $200,000 in unpaid taxes and $47,600 in penalties.

The FTB’s main argument was that because US Web had extensive operations outside California, it didn’t meet the “property and payroll” requirement in the state tax code. Under this requirement, an investment didn’t qualify for the tax break unless the company had at least 80 percent of its property and 80 percent of its payroll expenses in California. (At the same time, the FTB said Cutler had failed to demonstrate that the three new companies in which he invested in 1998 also met those requirements—more on that in a moment.)

Cutler filed a formal protest against the tax assessment, saying that US Web did meet the 80 percent requirement. And even if it didn’t, Cutler argued, the requirement was unconstitutional under the Commerce Clause of the U.S. Constitution.

This clause has been interpreted by federal courts over the years to mean that states can’t impose regulations or taxes that impede interstate commerce or that favor local businesses by burdening out-of-state competitors. Cutler’s position was that the 80 percent requirement was discriminatory. For fairness’ sake, his legal team argued, the QSB incentive should also be available to taxpayers who invest in companies that do a large portion of their business outside California.

In February 2007 the FTB denied Cutler’s protest. He appealed to the State Board of Equalization, the body that handles income tax appeals in California. The board sustained the denial, and in July 2009 Cutler finally paid the overdue taxes, penalties, and interest, which amounted by then to $442,000.

But the story wasn’t over. In September 2009 Cutler sued the FTB in the Los Angeles Superior Court, demanding a full refund, on the same constitutional grounds. He lost, and appealed the decision to the state Court of Appeals. And that’s where it began to look like Cutler might score his first win.

To decide the case, the appeals court had to review the constitutionality of the property and payroll requirement, which the lower court had found unobjectionable. Citing earlier case law—specifically, a 1996 ruling, Fulton Corp. v. Faulkner, in which the U.S. Supreme Court found that a North Carolina state income tax law favoring in-state investment violated the Commerce Clause—Justice Grimes eventually concluded that Cutler and his attorneys had been right all along.

Because taxpayers weren’t eligible to defer income from the sale of stock in corporations that have property and payroll outside California, the incentive was discriminatory on its face, Grimes wrote in her decision. She reversed the trial court’s judgment.

That doesn’t mean Cutler is going to get his refund—not yet, anyway. The aspect of the case dealing with whether the rolled-over gains actually went into qualified small businesses wasn’t decided in the appeal, and was sent back to the lower court for resolution. (Cutler claimed a deferral on the gains, rather than an exclusion, so he isn’t eligible for a refund on that basis either.) So the litigation continues.

Still, Cutler’s lawyers were happy with Grimes’ ruling, which definitively invalidated the property and payroll requirement.

“The way the FTB had been implementing it for all these years, it was essentially penalizing businesses for expanding outside California,” says Dakessian. “When you take on the State of California, it’s always fraught with risk, but I have a team of lawyers with me at ReedSmith that believe in Frank and believe that what the FTB was doing was just wrong. So we were very pleased that the Court of Appeals recognized that there was a discriminatory component to this incentive.”

“Invalid and Unenforceable”

But as convoluted as the story of Cutler v. Franchise Tax Board may seem, this is the part where it gets truly twisty. The appellate court had deemed the disputed section of the tax code to be invalid as written—a decision that would obviously apply not just to Cutler, but to everyone who wanted to claim a QSB deferral on their state tax returns. But exactly how it would apply was up to the FTB.

Gina Rodriquez, of the California Taxpayers Association, says the board had several options open to it under previous case law. One path would have been to leave the spirit of the statute intact and fix the unconstitutional bit by treating investments in multi-state or out-of-state companies the same way as investments in in-state companies. In other words, the FTB could have extended the option to defer or exclude gains on the sale of stock to anyone who invested in a small business, no matter how much of its operations were outside the state.

Or it could have disallowed deferrals on rolled-over gains—the specific section of the statute at issue in Cutler—while still allowing taxpayers to take advantage of the other option provided in the tax break law, a 50 percent exclusion on gains from the sale of stock in QSBs.

It had gone a similar route before. In another Commerce Clause case, Hunt-Wesson v. Franchise Tax Board (2000), the U.S. Supreme Court struck down an FTB rule that allowed corporations to deduct interest expenses from in-state income, but not from out-of-state income. The board responded by extending the deduction so that it also applied to out-of-state income as well.

But Rodriquez says early hints caused her to fear that FTB would look to a different precedent. In yet another Commerce Clause case, Farmer Bros. v. Franchise Tax Board (2003), the state Court of Appeals affirmed a trial court judgment that a section of the state tax code dealing with dividend deductions was unconstitutional. Under that section—which, like the QSB statute, had been intended to encourage investment in California companies—allowable deductions were computed on a sliding scale. The higher the amount of corporate taxes a dividend-issuing company paid in California, the larger the deduction taxpayers who received the dividends were allowed to claim.

The plaintiff, a coffee company called Farmer Bros., successfully argued that the scheme was unconstitutional and that it should be allowed to claim the top deduction on dividends, no matter how much of the dividend-paying company’s business was outside California. The FTB could have responded to the ruling simply by allowing the deduction and granting a refund to Farmer Bros. But instead—saying that the entire statute was now “invalid and unenforceable”—it decided to disallow the dividend deduction for all taxpayers.

To Rodriquez, the clue that the FTB might be contemplating taking the Farmer Bros. approach to the Cutler decision, rather than the Hunt-Wesson approach, came in the form of a draft version of the filing instructions FTB was preparing to accompany 2012 tax forms. The same language it had used after the Farmer Bros. case showed up there. “An unconstitutional statute is invalid and unenforceable,” the FTB said. “Therefore, the California deferral and exclusion [on gains from QSB stock sales] are not available.”

“I saw their draft 2012 forms, and they were clear they were going to disallow everything,” Rodriquez says now. “That was the way they were headed, and it was bothersome because there was no policy discussion. They didn’t ask anybody. They just said, ‘Here’s how we are implementing it.”

The California Taxpayers Association warned members that the decision might break this way in its December 21 newsletter. Ironically, the FTB issued its official notice to taxpayers—explaining that it would respond to the Cutler decision by disallowing the QSB exclusion for all tax returns going back to 2008—on the same day.

Dakessian says the legal team at ReedSmith was thunderstruck by the FTB’s notice. “They now have to level the playing field, and the courts have given tax agencies some discretion in how they want to accomplish that,” says Dakessian. “They ought to have gone to the legislature to ask for direction. But they didn’t do that. They picked the most extreme option—the one that would result in the most revenue for the state.” (At least in the short term. In the long term, the decision could actually reduce revenues, if the elimination of the QSB incentive were to prompt investors to take their money elsewhere.)

I contacted the Franchise Tax Board to ask why it went down this path. “We believe this was the only remedy available to us” after the Cutler decision, FTB spokeswoman Denise Azimi told me.

As an administrative body, the FTB “must adhere to decisions handed down by the court,” Azimi continued. “In this instance the Cutler decision ruled that the QSB exclusions were discriminatory and unconstitutional. To implement this ruling and remedy the discrimination found by the court, we determined that we must issue tax assessments to reverse the unconstitutional benefits, and we have to treat all taxpayers the same.”

Azimi says the FTB has already begun sending out notices of back taxes owed, starting with people who claimed the QSB exclusion or deferral on their 2008 returns.

Rodriquez says she still thinks the board had the legal wiggle room to go either way. “The sensible response to Cutler would have been to adopt a Hunt-Wesson approach and preserve the benefits of the QSB statute by eliminating the discriminatory requirements,” says Rodriquez. “It would have preserved the intent of the legislation, which is that we all want more investment in California companies.”

Totally Surreal

Coming, as it did, on the Friday before a four-day Christmas weekend, the FTB notice attracted almost no attention from the business community. Brian Overstreet, who founded Healdsburg, CA-based AdverseEvents.com in 2011, says he wouldn’t have learned about it himself if he hadn’t clicked on a “fairly innocuous e-mail newsletter” the he gets from his legal counsel every two weeks.

“I don’t think I’ve ever opened one of those, but this one had something in the subject line about the QSB tax exclusion, and that let me to the actual FTB announcement, which came across as totally surreal. I said, ‘What is this you’re talking about, rolling this back for five years? How is that even possible?’”

Overstreet had good reason to care about the QSB rules. As he explained in his Jan. 15 commentary, he had sold his previous company, San Diego-based enterprise data startup Sagient Research Systems, in mid-2012. By September, he’d already paid estimated taxes based on the provision, which—as an alternative to the rollover that Cutler had executed—allowed investors in QSBs to exclude 50 percent of the taxable gain on the sale of their stock. Now Overstreet learned he would owe much more.

“I didn’t make so much money on this transaction that I can go live on the beach—I rolled out of bed the next day and went back to my job,” he says. “But at the same time, it was enough that the tax bill I am going to be faced with is a lot of money. And when you start multiplying this across all the potential people who this affects, it’s going to be a boatload.”

Overstreet says that as the holidays wrapped up and the news spread about the FTB notice, he was sure “there would be outrage, but there was nothing. I was checking Google News every three hours, and there was just no information coming out.” Knowing that he wasn’t the only person who’d be affected, Overstreet wrote his commentary and sent it to “several media outlets,” including Xconomy. Only Xconomy responded.

Overstreet is accustomed to being a lightning rod. His startup is focused on cleaning up flaws in the FDA’s database of patients who suffer adverse drug reactions, and as you might imagine, pharmaceutical companies aren’t excited over the prospect of more transparency in this area. But while Overstreet says he’s willing to keep making noise about the FTB policy, he’d rather see someone else take up the mantle.

“As much as I feel like I have a lot of money at stake, there are people who are going to have a lot more at stake, and have a lot deeper pockets,” he says. “For them, fighting this in any arena is going to be worthwhile.”

It’s hard to determine how many people will be affected by the retroactive disallowance of QSB exclusions and deferrals. Azimi, at the FTB, told me that the board estimates that only 500 tax returns per tax year will be subject to additional assessments, with the average assessment being around $60,000.

According to a 2011 estimate from the FTB’s Economic and Statistical Research Bureau, exclusions on the sale of small business stock represented a tax expenditure of $6.6 million in 2008—meaning, the state would have collected $6.6 million more that year if the exclusion hadn’t existed. But the bureau said there’s no way to know how many people actually took the exclusion, since taxpayers have never been required to identify themselves when they do so.

But the psychological impact of the FTB notice may be large, even if the financial one isn’t. I talked with several investors and legal experts who warned that it’s a bad time to be hitting investors—who are already spooked by the increased state income tax rates imposed by Proposition 30—with more tax bills.

“Some of my angel friends are in the process of moving because they don’t want to pay that 13 percent tax,” says Anne DeGheest, founder and managing director of HealthTech Capital, a venture fund focused on health IT companies. “These are high-net-worth individuals who may put 5 to 10 percent of their income into these investments. And what’s interesting is that these are the people who take the earliest risks, starting companies like Facebook. If you take away their disposable income it may kill job creation in California.”

Ackerman, at Allegis Capital, agrees. “The two most mobile resources in the world are capital and talent,” he says. “Both go where they are most welcomed and most rewarded. And increasingly, we are seeing an environment in California that is less hospitable for both investors and innovators.”

The most surprising and disturbing part of the FTB’s action, to many, is the five-year clawback. (The FTB says people who claimed exclusions or deferrals since 2008 can either file amended returns, or wait to receive a bill—but the sooner a taxpayer pays up, the less interest they may owe.) “There is something, dare I say, un-American about a retroactive tax bill with a five-year look-back,” says Overstreet. “Starting and running a company is hard enough. But when you get to the finish line and then you get punched in the gut again, it makes you rethink wanting to do it all over again.”

Overstreet’s commentary has provoked widespread discussion. The article attracted hundreds of comments on Xconomy and Y Combinator’s Hacker News site, as well as more than 600 tweets and 2,000 Facebook Likes. New York-based BusinessInsider jumped on the story with an article entitled “California Screws Silicon Valley: Entrepreneurs and Angels Socked with Absurd Retroactive Tax.” Even Canadians took notice, in a TechVibes story observing that “While this is bad news for Silicon Valley, it may prove good news for Canada: local startups may find fleeing south to be a decidedly less desirable option.”

But despite that firestorm, so far, Overstreet says he doesn’t know of any organized efforts to challenge the policy. State legislators contacted by Xconomy either weren’t familiar with the changes, or didn’t respond. Rodriquez says that only one California legislator has contacted her association about the change, “asking whether what the FTB was doing was legal.” (She says it’s not illegal, just wrong-headed.)

Valerie Dickerson, a partner at Deloitte Tax, LLP, who warned clients about the FTB notice in a Jan. 3 alert, says that in the past, courts and state legislatures have stepped in to repair popular tax breaks that had been rendered unconstitutional. “The court could read the statute in a way that omits the offending language and maintains the rest of the statute,” Dickerson says. “In other situations the legislature has re-enacted a statute without the language. But in at least one case other remedies were litigated and the FTB’s position was ultimately upheld.”

Ironically, one of the loudest protests I heard came from the people who started this whole thing—Cutler’s legal team at ReedSmith.

“To me this is a black eye for California,” Dakessian says. “The entrepreneurial spirit is synonymous with California. The Gold Rush, the Golden Gate Bridge, the Pacific Ocean, that is what we think of when we think of California. This is taking an axe to the incentives that symbolize that very hope.”

Dakessian dropped a hint that his firm might be open to mounting a legal challenge aimed at resurrecting the QSB incentive in some form (as long as it doesn’t discriminate against investors in out-of-state businesses, presumably).

“It’s always difficult to get people spurred into action, but I can tell you that separate from the Cutler case, we are looking very carefully at the FTB’s position, and we are deeply concerned about the legality of its actions,” Dakessian says. “Frankly, the FTB should be too.”

Wade Roush is a freelance science and technology journalist and the producer and host of the podcast Soonish. Follow @soonishpodcast

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