Twenty years ago, as California struggled to emerge from what was then the worst recession since the Great Depression, then-Gov. Pete Wilson and the Legislature enacted a tax break to spur capital investment in job-creating small businesses.
The new law allowed investors in firms with no more than $50 million in assets and that had 80 percent or more of those assets and their payrolls in California to pay only half of the ordinary state income taxes on profits when they liquidated their investments.
Within a few years, California saw a boom in high-technology startups. The capital gains tax break played some role, although how big is uncertain.
In 2004, the state Franchise Tax Board disallowed a capital gains exemption claimed by Newport Beach resident Frank Cutler on his investment in a technology company six years earlier, and Cutler took the dispute to court.
Last year, Cutler won his case in the 2nd District Court of Appeal, which ruled that limiting the tax break to investments in California businesses of a certain size was an unconstitutional interference with interstate commerce.
Cutler’s aim was to expand the tax break’s reach, but late last year, the Franchise Tax Board went the other way, declaring not only that the 1993 tax law was invalid, but that those who benefited from its provisions would have to repay their tax savings for the previous four years.
It was a grim Christmas present for several thousand California investors who would be dunned for about $120 million, plus interest and penalties in retroactive taxes. It came just a month after voters had raised income taxes on high-income Californians that also would be retroactive for 2012.
Not surprisingly, those who were targeted for the restorative capital gains taxes screamed that it was unfair since they had just followed the state’s own law. They organized themselves into a political lobbying group and began pressing both the Franchise Tax Board and the Legislature for relief.
The angry taxpayers appear to be gaining political traction. The Franchise Tax Board has put collection of the back taxes on hold, implying that it wants the Legislature and Gov. Jerry Brown to solve the problem.
A couple of bills have been introduced with bipartisan support to re-enact the tax break with modifications and to relieve the affected taxpayers of paying back taxes.
Occurring, as it did, just as the state was raising its top income tax rates, the retroactive capital gains tax issue has garnered national financial press attention, calling into question, once again, whether California’s tax policies discourage job-creating investment.
Ironically, it arises as the state is struggling to emerge from another recession that’s even deeper and longer lasting than the one that spurred the capital gains tax break in 1993.