The State of California Seeks Back Taxes from Small-Business Shareholder – Not So Fast

A closer look at federal constitutional case law would seem to indicate that the State of California may not find it so easy to seek back taxes from small-business shareholders after all.

In Cutler v. Franchise Tax Board, the Second District Court of Appeal held that because the purpose and effect of California’s qualified small business stock statues is to favor California corporations over foreign corporations, the statues are discriminatory and cannot stand under the commerce clause of the U.S. Constitution. As such, the Franchise Tax Board has issued a statement that for tax years after January 1, 2008, it will issue Notices of Proposed Assessments to thousands of small businesses who received tax breaks based on small business stock exclusion and deferral statutes.

Is this legal under Federal Constitutional law? Probably not. According to the United States Supreme Court, retroactive legislation is constitutional unless its application is so “harsh and oppressive as to transgress the constitutional limitation.” Welch v. Henry, 305 U.S. 134, 1475 (1938). The United States Supreme Court also formulated a test to determine if retroactive legislation is constitutional. According to the Supreme Court, 1) the retroactive application of the statute must be supported by a legitimate legislative purpose furthered by rational means such that the [Government’s] purpose in enacting the amendment was neither illegitimate nor arbitrary; and 2) the [government] acted promptly and established only a modest period of retroactivity. United States v. Carlton, 512 U.S. 26, 30-31, 32 (1994).

The Ninth Circuit Court of Appeals has stated that a retroactive tax increase to reduce a budget deficit by ensuring higher revenue is permissible and rational. Licari v. Commissioner, 946 F.2d 690, 692 (9th Cir. 1991). Consequently, the retroactive application sought by the FTB plus interest will likely survive constitutional scrutiny as being a rational basis to raise revenue. Where the retroactive claim for a tax refund and interest becomes questionable is the period of time that the state seeks to demand a refund. In this case, the disallowance of a tax incentive amounts to a retroactive tax increase. The retroactive effect of a tax increase has “generally been confined to short and limited periods required by the practicalities of producing … legislation.” Carlton, 512 U.S. at 32-33 quoting United States v. Darusmont, 449 U.S. 292, 296-297 (1981). Though Licari predated Carlton by three years, the Ninth Circuit Court of Appeals in Licari applied the same standard formula in Carlton and found that a four-year period of retroactivity in question was “far longer than required simply by the practicalities of producing … legislation.” Licari, 946 F.2d at 694.

In the present case, the period of retroactivity extends four years. Applying the test enunciated by the Ninth Circuit Court of Appeals in Licari, the four year look-back period would not pass constitutional scrutiny. Arguably, even retroactively seeking refunds from taxpayers for less than four years could run into question under some constitutional authorities. For example, Justice O’Conner stated in her concurring opinion that “a period of retroactivity longer than the year preceding the legislative session in which the law was enacted would raise, in my view, serious constitutional questions.” Carlton, 512 U.S. at 38 (O’Conner, J. concurring).

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