LOS ANGELES—After eight years with the notorious title of the least business-friendly state, California is now driving away one of its last bright spots—its startup community—by taking away a popular tax break and requiring small business owners and investors to pay back the benefits they received in the past four years.
The Qualified Small Business (QSB) tax exclusion, which started 20 years ago, attracted entrepreneurs and early investors to start and keep businesses in California by cutting taxes on stock sales by a half.
In 1998, the California Franchise Tax Board (FTB) denied the exclusion to Frank Cutler because his company did not meet the requirement that it maintain 80 percent of its assets and employees in California. Cutler sued the FTB, saying the requirement was an unconstitutional violation of the federal interstate commerce clause.
After more than a decade in court, the California Court of Appeals sided with Cutler in August 2012. In response, the FTB decided to cancel the entire exclusion and announced in December it would be collecting the taxes of anyone who had benefitted from the break since 2008, including interest and possible penalties. A total of about 2,000 small business owners and investors now owe $120 million in back taxes.
The FTB claims it didn’t have a choice: By ruling the requirement unconstitutional in Cutler’s case, the court disqualified the entire law. To level the playing field for companies both in and out of state, the FTB says it has to collect those taxes.
Brian Overstreet, the CEO of AdverseEvents, broke the story in an article for Xconomy last month after he realized the huge bill he owed the FTB for co-founding Sagient Research Systems, an enterprise-focused data company, in 1999. He wrote, “[For] 13 years we tinkered, triumphed, failed, and even tempted bankruptcy. But through it all, we worked hard, we worked fairly, and we grew.” He sold the company in 2012, which by then employed nearly 40 people in California.
Overstreet said he understood the importance of all people paying their fair share, “But in this instance 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.”
Retroactive taxes are legal, courtesy of a 1994 U.S. Supreme Court case that allowed Congress and state lawmakers to collect taxes when a legal deduction is repealed. For instance, California’s Proposition 30, which was approved by voters in November and increased state income tax up to 13 percent for Californians making more than $250,000, is retroactive to 2012.
Joe Vranich of Irvine, Calif.-based Spectrum Location Solution, which specializes in the relocation of businesses, said he has received more calls than usual from business owners reacting to Proposition 30 and what he calls the state’s continued “business bashing.”
“This has caused people who own businesses to call me and speak about how they have a stronger motivation than ever to leave,” Vranich said. “As one business owner put it, ‘How dare they increase my taxes retroactively? At least let me know so I can plan for it.’”
Vranich said that businesses can save 20 to 40 percent in operating costs by moving out of California, and in 2011 he counted 254 companies that left California.
And the rest of the country isn’t sitting back and waiting. In early February, Texas Gov. Rick Perry took a tour of the Golden State, visiting business leaders in northern and southern California. Vranich said 15 states are now trying to lure California companies to their more tax-friendly environments.
As for the retroactive startup tax, Overstreet and other entrepreneurs and investors affected by the tax reversal have created a group called California Business Defense, which has the support of several state lawmakers who are looking to change the 1993 law.
Sen. Ted Lieu, D-Torrance, believes the FTB can reverse its demand for retroactive taxes without new legislation.
“California should not punish innocent, law-abiding taxpayers retroactively just because it may have the power to do so,” Lieu wrote in a letter to the FTB. “California residents and businesses need the confidence of knowing that their government will not punish them for relying upon the law.”