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FRANCHISE TAX BOARD:
Legislators Ask FTB to Reconsider Retroactive Tax Increase on Specified Small Business Incentives

The Franchise Tax Board is coming under heavy fire from state Senator Ted Lieu and Assemblyman Jeff Gorell for its decision to retroactively require taxpayers to pay the state for claiming qualified small business tax incentives. The FTB decided to go after taxpayers back to the 2008 tax year based on its interpretation of the recently decided Cutler decision.

In Frank Cutler v. Franchise Tax Board, the Second District Court of Appeal held that the current incentive allowing owners of qualified small business stock to exclude or defer specified stock gains is unconstitutional, as it discriminates against out-of-state businesses. Reacting to that court ruling that partially invalidated the incentive statutes, the FTB decided to declare the incentives completely invalid, not just the provision the court held to be unconstitutional, and to deny the incentives retroactively to anyone who claimed them, as far back as the statute of limitations allows.

"California is not a Banana Republic," Senator Lieu wrote in his three-page January 28 letter to the FTB. He added: "California government should not punish innocent, law-abiding taxpayers retroactively just because it may have the power to do so. California residents and businesses need the confidence of knowing that their government will not punish them for relying upon the law. For the above reasons, I strongly urge FTB staff to reverse its decision to deny the Legislature's grant of QSB tax incentives on a retroactive basis."

Senator Lieu wrote: "Unfortunately, the staff of the Franchise Tax Board (FTB) elected to take the most aggressive, unreasonable, and unfair potential remedy by retroactively going backwards five years and denying the QSB tax incentive. Instead of applying the QSB incentive to everyone, the FTB staff decided to apply it to no one, and to do it retroactively."

The senator continued:

"The FTB's Statement of Principles of Tax Administration states the FTB must 'apply the law in a reasonable and practical manner.' FTB staff's decision to change the rules retroactively, and on such a large scale, is neither reasonable nor practical. …

"FTB's Statement of Principles states that FTB staff shall not 'overreach' or adopt 'a strained construction in the belief that he or she is 'protecting the revenue.' It is beyond a strained construction to believe the Legislature would have intended to mislead and then punish taxpayers retroactively in order to protect revenue. A far more reasonable, fair, and practical interpretation would be to not penalize innocent taxpayers retroactively."

Assemblyman Gorell said: “This falls into the category of egregious activity in terms of holding taxpayers accountable for activities they had done many years in the past. This is something we’re going to address.”

Other Capitol observers wondered why Frank Cutler gets to use the incentive on his gain on the sale of small business stock, but others don’t. If the law is unconstitutional, and therefore never existed, as the FTB argues, how can it be operative for Mr. Cutler?

Other observers questioned whether the state law allowing taxpayers to rely on FTB’s written advice when filing returns would help taxpayers avoid the retroactive tax. After all, the FTB advised taxpayers in publications at the time that gains from the sales of qualified small business stock could be excluded or deferred.

Marty Dakessian, attorney for Mr. Cutler, wondered why FTB’s decision to retroactively deny investors the tax exclusion that was legal when tax returns were filed was made at the staff level rather than by the tax board members. Mr. Dakessian added that financial incentives to small businesses are critical as the state works its way through the economic recovery.

Jacob Roper, a spokesman for Controller John Chiang, who chairs the FTB, said the central issue is that a legislative policy has been found to be unconstitutional, and the Legislature must determine the next course of action. “In the meantime, the controller can sympathize with any taxpayer who faces shifting rules and applications of the law,” Mr. Roper added. “Complex and changing tax rules add to a taxpayer’s burden, and this is just one reason the controller thinks a broad tax reform package is overdue.”

In a January 24 story by Xconomy, a blog for business and technology leaders, CalTax Vice President of State Tax Policy Gina Rodriquez said: “These taxpayers followed the law when they filed their tax returns. … For (the FTB) 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 – … is just not fair tax policy.”

Ms. Rodriquez pointed out that the FTB had options 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 multistate 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.”

February 1, 2013
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