Friday, January 18, 2013

Tax Break for Startup Founders (But Not So Much for Californian Founders)

The tax code contains several tax breaks for the stock of certain qualifying small businesses:

1. If the stock is acquired between late-2010 and December 31, 2013, the federal tax rate is 0% for any gain on stock held for more than five years (Internal Revenue Code section 1202),
2. The federal capital gains rate is reduced by 50% to 75% for stock acquired at other times, and
3. Even if there is taxable gain, the gain is deferred if the taxpayer invests in another qualified small business (section 1045).

The Californian tax code did not follow the same rules, but it contained similar tax breaks that applied only to Californian small businesses, which must have at least 80% of its payroll and assets be in California.  California taxed the gain at a rate of up to 6.65% (half the normal California top tax rate of 13.3%), and gain was deferred if the taxpayer invested in another Californian small business.  Both the federal and California rules were originally enacted in 1993.

California could use a time machine
(invented by a small business).
But on December 21, 2012, the California Franchise Tax Board revoked all of the above tax breaks retroactively to 2008 (pdf).  Any taxpayer who saved Californian taxes when selling Californian small business stock in 2008 and later must pay back the tax savings plus any interest and penalties.  The only reason California did not cancel the statute all the way back to 1993 was due to the the four-year-statute of limitations.

The reason for the drastic tax change in California was the Franchise Tax Board's loss in Cutler v. Franchise Tax Board (2012), which declared that the requirement that 80% of payroll and assets be in California to be unconstitutionally discriminatory against other states.  The taxpayer Cutler was a California resident who in 1998 sold stock in an Internet start-up that operated in other states and who deferred the gain by investing in three other small businesses. 

Following the defeat, California could have followed 40+ other states and allowed the tax breaks for all qualifying small businesses that operated in any state.  Instead, it took its ball and went home by cancelling the tax break for everyone for the past four years.

An affected Californian entrepreneur might consider challenging the constitutionality of the retroactive order, since the California Franchise Tax Board seems to have a poor track record in that front.

The complex definition of a "qualifying small business" and why it cannot be a motel or restaurant will be the topic of a later post.

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