California Court Of Appeal Holds Statute Allowing Deferral Of Gain From Qualified Small Business Stock Sales Is Unconstitutional

The California Court of Appeal has held that a personal income tax statute that allows a taxpayer to defer capital gains on the sale of qualified small business (QSB) stock if the taxpayer uses the gain to purchase stock in another QSB violates the Commerce Clause.1 The Court found the statute to be unconstitutional because the deferral is limited to situations where the stock sold and purchased was issued by corporations that use at least 80 percent of their assets to conduct business in California and maintain at least 80 percent of their payroll in California.

Background

The taxpayer sold stock that he had acquired in an Internet start-up company (US WEB) and used some of the proceeds to purchase stock in several other small businesses. The US WEB stock did not meet the statutory active business requirements because the company did not maintain 80 percent of its assets and payroll in California. On his California personal income tax return, the taxpayer deferred that part of the gain from the sale of the stock that he invested in three other small businesses. The California Franchise Tax Board (FTB) disallowed the gain deferral and stated in its notice of proposed assessment that the US WEB stock was not QSB stock.2 The taxpayer filed a protest and asserted that the US WEB stock met all of the statutory requirements for deferring gain. Also, the taxpayer argued that the statute violated the Commerce Clause because it discriminated against investors in companies that conduct some of their business outside California.

The FTB denied the taxpayer's protest and affirmed the proposed assessment. The California State Board of Equalization subsequently denied the taxpayer's appeal and sustained the FTB's action. The taxpayer appealed this decision to the California Court of Appeal.

Deferral of Gains in California

Under federal law, a taxpayer does not recognize gain on the sale of small business stock if the taxpayer purchases stock in other qualified businesses within 60 days.3 This rollover provision does not apply to California personal income tax.4 Instead, California has its own statutes deferring gains on QSB stock that are similar to the federal provisions,5 but California limits the incentive to gains on investments to small businesses that are based in California.6 The California statute requires that "[a]t least 80 percent (by value) of the assets of the corporation [must be] used by the corporation in the active conduct of one or...