California’s Tax War On Business Owners — Part 1

California’s State Capitol in Sacremento – Shutterstock

Over the years, various studies have found that about 70% of the wealth in the United States is in the hands of families that own middle market companies.  And, various sources have put the middle market’s contribution to gross domestic product at about 60 to 70%. And, various sources have put the middle market’s contribution to employment and employment growth at about 70%.  Middle market companies are essential to the U.S. economy and the families that own them risk their personal “everything” every day.

In the old days, the tax code of each state was “its own thing.”  They were different from each other and they were different from the Internal Revenue Code.  In the 1980s, the State of California aligned the income tax portion of its tax code with the Internal Revenue Code.  Income tax return preparation became easier for California residents.

In the early 1990s, the U.S. economy was hit by a triple whammy: 1) the Savings & Loan Crisis, 2) high oil prices as the result of the first Gulf War, and 3) a good-sized recession.  Following that recession, the U.S. economy experienced slow growth. So, recognizing that middle market companies are the primary source of economic growth, Congress amended the Internal Revenue Code to incentivize the creation of new companies — “mainstreet” companies and lower middle market companies.  Subject to certain restrictions, upon sale of the company, founding owners would be able to exclude up to a certain amount of gain.

With California’s tax code “conforming” to the Internal Revenue Code, the same pro-growth incentive would have been available on a business owner’s California income tax return.  But, given the title of this article, it couldn’t be that simple . . . and it’s not.

California denied the exclusion of gain if a company did not have (among other things) a certain percentage of revenue from California sales.  Rewording this statement: California imposed the “regular” tax if a company did not have (among other things) a certain percentage of revenue from California sales.  In terms of the U.S. Constitution, California was imposing a tax on — and, therefore, regulating — interstate commerce, which is a power held exclusively by Congress.

Several years ago, a California business owner did not qualify for the incentive on his California income tax return and sued.  He won. But, did he? In the appellate court’s ruling, it did not strike down the entire statute that granted the incentive — it struck down only the California-specific provisions.  It is absolutely clear what the court said. So, he should have received the incentive on his California income tax return.

But, he didn’t.  The California Franchise Tax Board issued an interpretation of the appellate court’s ruling: the incentive was invalid in total.  The FTB then went back three years — the period during which the state could review a person’s income tax returns — and denied the incentive to ALL business owners who claimed it.  Good gravy! With the juicy pop in tax revenues, the legislature amended California tax code to expressly deny the incentive to everyone.

In our next installment in this series, we will highlight other examples of California’s tax war on business owners.  Now, there is a way to deal with this challenge with proper planning and we will get to it in this series.

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