California To Hit Startup Founders with Big Retroactive Tax Bills

California is a great place to live and work, but it is not a particularly friendly place to start and run a small business.

In 1999, I co-founded Sagient Research Systems, an enterprise-focused data company in San Diego. Over the ensuing 13 years we tinkered, triumphed, failed, and even tempted bankruptcy. But through it all, we worked hard, we worked fairly, and we grew. Slowly, we evolved into a successful business employing nearly 40 people, all in California. In mid-2012, we sold Sagient Research in a transaction that was a good exit for everyone involved.

One of the very few benefits entrepreneurs and early-stage investors can look forward to in California is the partial state income tax exclusion on sales of stock of a Qualified Small Business (“QSB”). This exclusion incentivizes people to start businesses in California and to keep them here. As the law was written, founders and early investors in QSBs can exclude 50 percent of the taxable gain on the sale of their stock—meaning that they pay only half the regular California tax rate on the gain (about 4.5 percent instead of 9 percent).

While the QSB exclusion did not play a role in our decision to start Sagient Research, it justified our decision to stay in California. Although California taxes stock sales at nearly 10 percent (now nearly 13 percent due to Prop 30), we knew as a qualifying QSB, we’d only pay half that amount. Without the QSB provision, we might have decamped to a more tax- and business-friendly state.

After we completed the sale, I paid both my federal and state estimated taxes computed with the QSB exclusion. I thought I was clear until April 2013.

Then in late December, the FTB decided to cancel the QSB tax benefits and RETROACTIVELY deny the benefits for the past five years.

How is that even possible?

It turns out that a few years ago, someone sued the Franchise Tax Board over being denied the right to claim the QSB benefit [Cutler v. Franchise Tax Bd., 208 Cal. App. 4th 1247 (2012)]. The company at issue in that lawsuit did not meet one of the QSB requirements—that it maintain 80 percent of its employees and assets in California. In August of 2012, the California Court of Appeals sided with the plaintiff, ruling that denying him the QSB exclusion based on the “80 percent requirement” was an unconstitutional violation of the interstate commerce clause.

Since the FTB lost the case, you might think that they would strike the unconstitutional requirement and keep the rest of QSB statute intact. Not a chance.

What the FTB did instead was to take their ball and go home. They decided that since they could not impose the “80 percent requirement,” no one would be entitled to the QSB exclusion. They put out an announcement terminating the Qualified Small Business exclusion and retroactively disqualifying all exclusions and deferrals going all the way back to 2008.

What does this mean for you?

1. If you are a business founder or early investor who sold stock since 2008 and took the QSB exclusion: Surprise! You are going to get a bill from the FTB for the 50 percent of the taxes you excluded plus interest plus possible penalties.

2. If you are a business founder or early investor and have not yet sold stock: Rethink your business and tax planning strategies. Consider whether it’s fiscally prudent to stay in California.

3. If you a contemplating starting or investing in a California business: Think long and hard. Consider out-of-state alternatives.

Here’s the real kicker. Just at the moment when California is retroactively taxing entrepreneurs, the federal government is extending the federal QSB benefit.

Per amendments in the new “fiscal cliff” law, if you started or invested in a QSB between September 28, 2010 and January 1, 2013 and ultimately sell stock under the federal QSB provisions, you’ll pay no federal capital gains tax, and in some states, no state taxes. But not California—we’ll pay up to 13 percent!

Why in the world would any smart business person start or invest in a new California company facing that kind of penalty?

I’m not ungrateful or unrealistic. I fully understand the scope of the economic problems at both the state and federal level and the need for everyone to pay their fair share. And as a product of California’s public university system, I fully appreciate the opportunities afforded to me by living and working in the great state of California.

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. That’s the last thing that the state of California needs right now.

The FTB’s retroactive sucker punch isn’t just about me. It’s about everyone in the startup community. It’s going to be a very painful time for entrepreneurs and investors in California over the next few months as these potentially debilitating tax bills start showing up in mailboxes all across the state.

My company was not a big, faceless corporation. We were good corporate citizens with a small but vibrant, local workforce. We were the epitome of a Qualified Small Business.

And we just got screwed. And so did you.

Brian Overstreet is the co-founder and president of AdverseEvents and the former CEO of Sagient Research Systems. Follow @adverseevent