Court Rules that California Can’t Discriminate on Small Business Stock Tax Deferrals

If you sell stock in a small business (one with $50 million of assets or less), and then take the proceeds and reinvest them within 60 days in another small business, you can defer the gain. California law has a similar provision, but it has the proviso that both companies must have at least 80% of their assets and payrolls within California.

Frank Cutler invested in a start-up company, and sold his shares in 1998 and reinvested those shares within the allotted 60 days. The start-up shares he sold didn’t meet the California provision (the companies he reinvested in did). Mr. Cutler took the deferral on both his federal and California returns. California’s Franchise Tax Board–the income tax agency in California–denied his deduction. Mr. Cutler went through the administrative appeals and lost. He then paid his tax and filed a claim for refund which was denied. He then took his case to court and lost at the state superior court level. The result of his appeal was handed down yesterday.

The problem with the law according to Mr. Cutler was the commerce clause — specifically, the dormant commerce clause. As the Court noted,

Fulton tells us that in this negative aspect—also referred to as the dormant commerce clause—the clause “ „prohibits economic protectionism—that is, “regulatory measures designed to benefit instate economic interests by burdening out-of-state competitors.” ‟ ” [The Fulton is the US Supreme Court case Fulton Corp. v. Faulkner (1996) 516 U.S. 325, 330]”

And on this issue the Court could not see how the California law was not discriminatory:

The deferral of taxation occurs in connection with a sale (and subsequent purchase) of qualified small business stock, rather than in connection with dividends on the stock, and the deferral of gain is provided only for individual taxpayers, not for corporations. But we are unable to see how these distinctions could in any way sustain a departure from the analysis—and the conclusion—dictated by Fulton and the body of commerce clause jurisprudence that preceded and followed Fulton. The fact remains that the purpose and effect of the statute is, as Fulton forbids, to “favor investment in corporations doing business within the State” (Fulton, supra, 516 U.S. at p. 343), and the statute operates as a “disincentive . . . to buying stock in corporations doing business out of state.” (Id. at p. 341.) As in Fulton, the statute “favors domestic corporations over their foreign competitors in raising capital among [California] residents and tends, at least, to discourage domestic corporations from plying their trades in interstate commerce.” (Id. at p. 333.)

The Board insists the California property and payroll requirement does not discriminate against interstate commerce. But it offers no cogent analysis to support its assertion.

Mr. Cutler hasn’t won a refund yet–the case was remanded back to superior court for a ruling on the correct remedy. Other individuals who took similar positions on their tax returns (and whose deferrals were denied by the FTB) may wish to consider making protective claims for refund depending on the ultimate resolution of the Cutler case. It is possible that the case could be appealed to the California Supreme Court, too.

One final note: The court decision is quite readable even for the layperson. A news story on the case is also available.

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