Cutler v. Franchise Tax Board and FTB Notice 2012-03 – What it Means for Taxpayers

The Franchise Tax Board (FTB) issued FTB Notice 2012-03 (Notice) on December 21, 2012 outlining the procedures the FTB will use to apply the California Court of Appeal’s decision in Cutler v. Franchise Tax Board (2012) 208 Cal.App.4^th 1247. 

In Cutler, the Court of Appeals held that Revenue and Taxation Code (RTC) Sections 18038.5 and 18152.5, which allowed taxpayers to defer gain on certain qualified small business stock (QSBS) dispositions as applied to California-based businesses, violated the Commerce Clause of the U.S. Constitution. In response to the Court of Appeal’s decision, the FTB issued the Notice stating that since RTC Sections 18038.5 and 18152.5 were deemed unconstitutional, the statutes are invalidated and no taxpayer may defer gains from the disposition of QSBS.

QSBS

The Internal Revenue Code (IRC) allows taxpayers to exclude or defer gain from the sale or exchange of certain QSBS. California generally adopted the federal language for QSBS treatment; however, it requires that at least 80% of the taxpayer’s payroll at the time the stock was purchased must be within California and 80% of assets and payroll must be within California during the taxpayer's holding period for the stock in order to qualify for a QSBS gain exclusion or deferral.

Cutler

In Cutler, the taxpayer argued that California’s QSBS statutes violated the U.S. Constitution because it favored California-based taxpayers over out-of-state taxpayers. The taxpayer in Cutler sold stock from a start-up company and used a portion of the proceeds to acquire interests in several small businesses. Pursuant to RTC Sections 18038.5 and 18152.5[1], the taxpayer deferred the gain on the sale of the QSBS on his 1998 California return. Upon audit by the FTB in 2004, the taxpayer’s gain deferral was denied because the FTB argued that the taxpayer failed to meet the requirements under RTC Sections 18038.5 and 18152.5. The taxpayer sued the FTB in 2009 asserting that the sale did meet the applicable requirements. Alternatively, the taxpayer argued that the QSBS provisions violated the U.S. Constitution’s Commerce and Due Process Clauses. The trial court, agreeing with the FTB’s motion for summary judgment, held that the QSBS deferral provisions did not violate the U.S. Constitution and that the taxpayer failed to meet the requirements of RTC Sections 18038.5 and 18152.5.

On appeal, the Court of Appeals reversed the lower court’s decision and held that RTC Sections 18038.5 and 18152.5 violate the Commerce Clause of the U.S. Constitution because the provisions favored California corporations over out-of-state corporations. The Court of Appeals remanded the case to the trial court to determine the appropriate remedy.

FTB Notice 2012-03

In response to the Court of Appeal’s determination that RTC Sections 18038.5 and 18152.5 violate the U.S. Constitution, the FTB issued Notice 2012-03 that invalidated RTC Sections 18038.5 and 18152.5 for all taxpayers. The FTB, relying on the remedy provided in River Garden Retirement Home v. Franchise Tax Board (2010) 186 Cal.App.4^th 922 and McKesson Corp. v. Florida Alcohol & Tobacco Div. (1990) 496 U.S. 18, stated that similarly situated taxpayers should all be treated alike and therefore, the deferral provision is invalid for taxable years beginning on or after January 1, 2008 (within the four-year statute of limitations). The QSBS position taken by taxpayers on returns for taxable years before January 1, 2008 is unaffected as are any existing closing agreements and settlement agreements with the FTB.

Procedurally, the Notice states that accepted returns and returns that are currently in audit, protest, claim for refunds, or pending appeals in front of the Board of Equalization will have the above-mentioned remedy applied by FTB staff. Furthermore, taxpayers may proactively self-assess any additional tax and remit the amounts to the FTB.

Commentary

While the FTB has taken a hardline position on the appropriate remedy as a result of Cutler, taxpayers should keep in mind that the Court of Appeals remanded the case to the trial court to determine the appropriate remedy. While the FTB has invalidated statutes in the past after they were deemed unconstitutional by a court, the FTB has also been compelled to remedy a Constitutional defect by applying the statute in an unoffending manner.[2] The court in Cutler may recommend that the FTB revise RTC Sections 18038.5 and 18152.5 by excising only the language that violates the U.S. Constitution leaving the benefit intact. Due to the uncertainty surrounding the appropriate remedy, taxpayers should consider whether to claim the QSBS benefit based upon their particular facts and circumstances. Additionally, taxpayers may consider filing amended returns in the event they did not take the benefit on their originally filed return in order to preserve a possible claim for refund.

[1] RTC Sections 18038.5 and 18152.5 provide an elective deferral of gain for individuals on the disposition of QSBS (1) held for more than six months; (2) amount realized was used to purchase QSBS within a 60-day period beginning on the date of the sale; and (3) the QSBS sold and purchased was issued by "domestic corporations" (i.e., corporations that use 80% of their assets in the conduct of business in California and maintain 80% of their payrolls in California).

[2] See Ventas Finance I, LLC v. Franchise Tax Board (2008) 165 Cal.App.4th 1207 and FTB Notice 2009-04.