State tax incentive issues at play in California

One of the things that has helped us as a country is a sense of fairness. It sometimes seems to get lost in the confusion of events and heat of expediency, but it is always there, sometimes a soft voice, sometimes a loud one, telling us when something isn’t right.

It is our sense of fairness that makes a distinction between being correct and being right, a distinction that is often needed when our legal system is involved. Justice and fairness, while they have their differences, have the same father.

For most of America, so used to things happening near-instantly, the justice system often seems to operate in a different dimension, a tortoise-like world where time-lapse photography is needed to detect motion of any sort. And sometimes it is this tortoise-league speed itself which clashes with our sense of fairness.

In 1993, which we can stipulate was twenty years ago, the California Legislature passed a law which provided a tax incentive to small businesses that kept eighty percent of their assets and payroll in the state — in other words, substantially home-state businesses or “domestic corporations” in the state’s tax code lingo.

The incentive was a bit complicated, as most are, but essentially it allowed owners of a small business that met the asset and payroll criteria a tax break when they sold stock if they re-invested the proceeds in another California small business that also met the same criteria.

The purpose of the incentive was to encourage California employers to stay there instead of moving to more tax-friendly states such as Nevada, Arizona, and Texas. California has a history of being very aggressive about taxes, and as the state’s expenditures grew, these taxes became increasingly burdensome — prompting many business owners to look for alternative locations.

The intent of the legislation is clear, but intent turned out not to be the legal issue involved. It was the U.S. Constitution.

The legal battle began in 1998, fifteen years ago, when an entrepreneur who had taken advantage of the tax deferral covering stock sales in these small businesses received a notice from the state rejecting his deferral on the grounds that his stock sale didn’t meet all of the criteria in the revenue code. He also received a tax bill for over $440,000.

The taxpayer paid the money, but also filed a lawsuit claiming that his stock sale did meet the criteria and that, even if it didn’t, the law was unconstitutional. The following year, a trial court denied his claim on both issues.

Moving at breakneck speed, fourteen years later, in August, 2012, the California Court of Appeals, Cutler v. Franchise Tax Board decided that the taxpayer was correct; the law violated the Commerce Clause of the U.S. Constitution and was unconstitutional on its face. It was the correct decision, but it had the unintentional effect of a retroactive law.

Four months later the California state tax folks sent out notices about the decision to about 2,500 taxpayers who had taken advantage of the stock sale provisions of that law in the past five years — the rest escaped under the statute of limitations. And in January of this year the bills for back taxes, penalties, and interest were sent out.

The California Franchise Tax Board says that the decision left them with no legal option other than collecting the taxes now owed retroactively. They are probably correct.

The taxpayers involved are probably not the most sympathetic group, at least in the weepy, camera-ready, heart-goes-out-to-them sense. They are, after all, business owners, and in today’s warped, media-driven sensibility they can seem more like “them” than “us.”

Still, there is something about this process that isn’t right, and that voice inside Americans is saying, “It isn’t fair. That’s not how justice should work.” Nobody should be getting a bill for taxes, penalties, and interest on a five year old tax return filed in good faith and full compliance with the law at the time.

The voice, as always, is right. A retroactive law gives off the same aroma as a back-dated check. Exactly what’s wrong, and how wrong it is, may not be clear, but something isn’t right.

The California Franchise Board’s responsibility is to collect taxes in the state, and there is absolutely no doubt that they will end up taking the blame for this situation. Like the IRS, though, the Board doesn’t make the law, it just enforces it. The remedy is in the hands of the Legislature.

The old tax bills represent a sizeable chunk of money. Whether the Legislature in California will have the courage to ignore the revenue loss and listen to the voice saying “it isn’t fair” remains to be seen.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Herald Business Journal.

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