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.
According to FTB spokeswoman Denise Azimi, only about 500 taxpayers filed for the tax break in each of the years 2008 through 2011.
One local accountant has two clients who used the tax break. He suspects that the 500 number represents only a small portion of those who could’ve benefited.
“Many people simply had no idea this tax break existed,” said Jeffrey Engler, director of tax at Weinberg & Co. in Century City.
Engler said it’s not just angel investors who could have benefited: A lot of people hired at startups accept stock for compensation.
“At startups, the entrepreneurs often do their own tax returns and probably most had never heard of this,” he said.
Court decision
The chain of events leading to the tax break’s disappearance began with a court case. Frank Cutler, who had sold stock in a small business in the L.A. area, had claimed the tax break, known as Qualified Small Business Stock. The tax board disallowed the claim, saying the small business did not have 80 percent of its assets and employees in California.
Cutler challenged that 80 percent rule, claiming it violated federal interstate commerce laws by favoring in-state companies over out-of-state competitors. He lost, but appealed. In August, a state appellate court ruled in his favor.
In response to that ruling, the FTB eliminated not just the 80 percent rule but the entire tax exclusion. But the ruling made no mention about invalidating the tax break retroactively; that was an interpretation made by the FTB.
The Business Journal asked the FTB’s Azimi why the agency decided to make the elimination of the tax break retroactive. She responded with this statement:
“Because the Court of Appeal determined that law at issue was ‘discriminatory on its face and cannot stand under the commerce clause,’ the law, as written, cannot be applied. Coupled with U.S. Supreme Court and other case law precedent requiring that, once discrimination has been found to exist, that discrimination must be cured, this all led the FTB to reach this remedy.”
The year 2008 was the extent of the statute of limitations in California for tax cases.
Obviously, Cutler did not get the intended result from his lawsuit.
“The irony here is that while Cutler won his case, he lost the war,” accountant Engler said. “The entire tax break has now been wiped out.”
Engler said that one of his clients will now likely have to pay an additional $20,000 in taxes.
As for the broader impact, some in the angel investment community said that startups lose a tool that they could have used to attract investors.
“It changes the investment return calculus for investors that get compensated in shares of stock,” said Scanlon, chair of the Pasadena angel investor group.
But the bigger impact is likely to be in the perception that California is not friendly to business.
“People here followed the law when they realized large gains,” Engler said. “Those people have relied on those gains and even invested them in other companies. Now it’s been invalidated retroactively. It continues to send a message that this is not a business-friendly state.”
