Local angel investors say a recent decision to take away a state tax break – and make those who used it pay retroactively – is not only an unfair hit on startups that played by the rules, but also sends a bad signal to those who want to start companies in California or invest in them.

The change could hurt L.A.’s thriving tech community. Even though the tax break wasn’t widely used, it was seen as a valuable tool to encourage businesses to launch here, create jobs and bolster the economy. The claw-back aspect is seen as especially harsh.

“The fact that it is retroactive is unfairly punitive, and not a way to treat those that have taken tremendous risk while supporting the startup ecosystem,” said Michael Green, managing partner of South Street Capital Partners LLC in Century City and president of the Los Angeles chapter of Tech Coast Angels.

The state Franchise Tax Board in late December decided to eliminate a 50 percent state income tax exclusion on the sale of a type of stock that startup companies often use to attract investors. (For more about the tax, see the sidebar.) The decision came in response to an August court ruling that questioned the constitutionality of the tax break.

But the tax board didn’t stop there. It also declared invalid all the tax breaks granted under the provision going back to 2008. The board is notifying the 2,000 or so filers who took the tax break over the past five years that they must file amended returns and pay back the tax break – with interest.

This decision frustrates Kevin Scanlon, chairman of the Pasadena Angel Investment Group. Scanlon said several of the group’s 100-plus members had taken the tax break at some point over the past five years.

“This just adds insult to injury,” said Scanlon, who sold his medical diagnostic company in 2010. “They now want to tax everything going back to 2008. It’s the retroactive nature of this thing that’s so upsetting and makes you wonder: What’s the next claw-back going to be?”

Boosting startups

The state tax break was adopted by the Legislature in 1993, aimed primarily at technology and manufacturing startups. It excluded from taxation 50 percent of income generated by the sale of stock in a C corporation (in which the corporate entity is taxed separately from its owners or shareholders). A similar tax exclusion had long been in place in the federal tax code. The exclusion required that the seller hold the stock for at least five years and that 80 percent of the company’s assets and payroll was in the state.