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California Retroactive Tax Could Slam Small Businesses

Robert Digitale for the Huffington Post
Tuesday, 30 Apr 2013 | 12:14 PM ET
Jonathan Nourok | Getty Images

Brian Overstreet is more familiar with starting a business than lobbying the Legislature, but a retroactive state tax bill has him crying foul and calling for relief.

Overstreet, 41, a Healdsburg business owner, has emerged as a leader in a statewide effort to stop California from presenting small business owners with retroactive tax bills totaling up to $150 million.

The entrepreneurs, some of whom expect to individually be billed for more than a half-million dollars in back taxes, maintain they already paid what they legally owed as long as five years ago.

Officials for the state Franchise Tax Board insist they had no choice but to seek the extra money from roughly 2,500 taxpayers.

The regulators settled on that path after an appellate court last year struck down parts of a law offering tax incentives linked to the creation of new businesses in California. After the defeat, tax officials maintained they must go as far back as allowed by the statute of limitations and collect the full amount owed without the disputed tax break.

(Read More: Small Business Owners: Can I Get Some Cash, Please)

Business Owners Cry Foul

The business owners respond that it's wrong for the state to adopt new rules after the fact. Doing so, they said, sends a chilling message to entrepreneurs thinking of starting a business in the Golden State.

"This is just patently unfair," said Overstreet, CEO and a majority owner of AdverseEvents, a health care information company based in Healdsburg.

Overstreet faces more than $100,000 in retroactive taxes and interest as a result of the decision.

Hearing This Week

The state Senate this week will hold its first hearing on legislation that would negate the extra taxes and eventually renew the tax incentive for people who start or invest in small businesses. Already 38 legislators from both parties have shown support by signing a letter calling on the state Franchise Tax Board to drop its efforts to collect the extra taxes.

Sen. Ted Lieu, D-Torrance, the author of the proposed law, said the tax board's approach could discourage new business in California because entrepreneurs may conclude they can't trust the state's tax law.

(Read More: The End of Tax-Free Online Shopping Draws Nearer)

The appellate court decision, said Lieu, "doesn't mean the state should be able to go back retroactively for five years and penalize people for following the law."

Overstreet's political journey began in late December when his attorney sent out an update with a small item noting that the state planned to retroactively collect taxes from people who had claimed the Qualified Small Business Stock exemption.

The exemption allowed business owners to pay only half the normal rate of capital gains tax — or in some cases to defer taxes — on the sale of stock in qualified small businesses.

However, the state Court of Appeal last year struck down two criteria the state had used to exclude some investors from the tax break. In the case, Cutler v. Franchise Tax Board, the court ruled those criteria violated the commerce clause of the U.S. Constitution because they discouraged companies from expanding operations outside California.

In response, the Franchise Tax Board said it would retroactively deny the tax break for anyone who had claimed it all the way back to the 2008 tax year -- the longest such period allowed by the statute of limitations. The state subsequently suggested that an average bill would amount to an extra $60,000.

Overstreet realized he had taken the same tax exemption last year due to the sale of Sagient Research, a company he helped found in 1999 in San Diego.

"Of course," he said, "I freaked out because I figured out exactly how much that was going to mean for me."

California Business Defense

Early this year he wrote a blog post about the retroactive tax and had it published on the business information site Exconomy. Within days he was hearing from other entrepreneurs.

Eventually he teamed up with other affected owners to put together a coalition, California Business Defense.

"If somebody didn't take the lead on this," he said, "nothing was going to happen."

The group wants to revive the tax incentive for future investors and owners. Its leaders said the state needs to encourage business startups, pointing to an economist's report that such firms have created all the net job gains in California in the past few decades.

Even so, it is the retroactive tax that clearly animates the business people.

"I think that's the part that's really going to ruin trust in the state of California, said Jim Fowler, founder and CEO of the crowdsource business information site InfoArmy. "You can't do this to entrepreneurs. Entrepreneurs will stop coming here."

Fowler's accountant told him the retroactive tax will cost him $612,000, including $82,000 in accrued interest. It stems from the 2010 sale of Jigsaw, a San Mateo information company that was purchased for $175 million. Ten of the company's 150 employees made $1 million or more on the sale, Fowler said.

In the months since Overstreet first raised his protest, both legislators and tax attorneys have written that the tax board had other options than imposing a retroactive tax.

But regulators still insist they needed a remedy for the discrimination identified by the court, and say they lacked the lawmaking authority to do anything else.

The tax board "carefully studied the court's opinion, weighed it against prior court decisions, and came to what we believed was the only proper conclusion," Franchise Tax Board spokeswoman Denise Azimi wrote last week in an email.

On Wednesday the state Senate Governance and Finance Committee is slated to consider legislation that would stop the retroactive tax.

The bill, SB 209, would allow the tax break back to 2008 for both those who previously claimed it and those who were exempted from taking it earlier due to the criteria struck down by the court. Lieu said that approach would satisfy the need to correct discrimination among taxpayers.

The expansion of eligible investors would result in an estimated $90 million in added tax breaks, Lieu said. To make the bill revenue neutral, the state wouldn't revive the tax break again until 2016.

Lieu and the bill's supporters maintain the retroactive tax is much different from Proposition 30, which last fall retroactively raised taxes for 2012 on wealthier Californians.

'Out of Left Field'

The initiative was approved by voters and news about its possible impact was available for much of last year, they said. In contrast, the business owners affected by the Franchise Tax Board decision had no inkling their actions eventually would result in a hefty tax bill.

"This was coming out of left field," said Eric Miethke, the attorney for the investors' coalition.

Ben Lenail, a member of the coalition, expressed appreciation that Overstreet stepped forward to lead efforts to change the law.

"What I like about him is he's very earnest and he's totally honest and transparent," said Lenail, director of business development for the Sunnyvale solar-related startup Alta Devices.

Lenail and his wife, Laurie Yoler, face an added bill of less than $50,000 for the 2011 sale of stock in Tesla Motors. He admitted mixed feelings on the coalition's efforts.

He said he would rather put the time and energy into other matters, but expressed satisfaction in seeing firsthand that the democratic process offers a way to appeal unfair actions and "a chance that your voice will be heard."

Robert Digitale is a writer for The Press Democrat.

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