Golden State Investors Lose Biased Tax Benefit

     (CN) – Californians can no longer defer capital gains on the sale of in-state business stocks when they use the gain to purchase stock in another in-state business, a state appeals court ruled.
     California’s Revenue and Taxation Code does not count capital gains from the sale of qualified small-business stocks if the seller purchases stock in another qualified small business within 60 days. To qualify, both businesses must use 80 percent of their assets to operate in California and maintain 80 percent of their payroll in the state. The gains must still be considered when calculating personal income tax.
     But when the state denied the benefit to one taxpayer, Frank Cutler, he filed suit, claiming that the law discriminated against out-of-state businesses.
     Cutler had sold his stock in an online start-up company called U.S. Web Corp. for more than $2 million, then used the money to purchase stock in other small businesses, including several that qualify for the deferral.
     After Cutler deferred part of the U.S. Web sale on his 1998 tax return, the Franchise Tax Board told him that U.S. Web did not meet the in-state presence requirements to qualify for the deferral.
     Though he subsequently paid California $442,000 to settle the tax, penalties and interest assessed, Cutler claimed in court that U.S. Web did qualify or that the state tax scheme violated the commerce clause of the U.S. Constitution.
     Los Angeles County Superior Court Judge Michael Stern disagreed, but the 2nd District Court of Appeal reversed Tuesday.
     The court said it was bound by the U.S. Supreme Court’s 1996 rejection of a similar North Carolina law in Fulton Corp. v. Faulkner.
     “Because the statute affords taxpayers a deferral for income received from the sale of stock in corporations maintaining assets and payroll in California, while no deferral is afforded for income from the sale of stock in corporations that maintain assets and payroll elsewhere, the deferral provision discriminates on its face on the basis of an interstate element in violation of the commerce clause,” Justice Beth Grimes wrote for a three-member panel.
     California’s law violates the dormant commerce clause’s prohibition against economic protectionism, the panel found.
     In Fulton, the court found: “A regime that taxes stock only to the degree that its issuing corporation participates in interstate commerce favors domestic corporations over their foreign competitors in raising capital among North Carolina residents and tends, at least, to discourage domestic corporations from plying their trades in interstate commerce.”
     Grimes rejected arguments from the Tax Franchise Board that the law was distinct.
     Though the benefit is a deferral of taxation, rather than an outright exemption or deduction, and it does not directly prevent businesses from freely engaging in interstate commerce, its effect is still discriminatory, according to the court.
     Despite a favorable ruling, Cutler may still not receive any refund.
     “Since we cannot decide the amount of refund, if any, to which plaintiff may be entitled, we see no reason to opine on the appropriate remedy in a case where it has not yet been established that the plaintiff is entitled to any remedy,” Grimes wrote.
     Fulton has also led California’s 4th District Court of Appeals to shoot down two other state tax laws on commerce clause grounds.
     In Ceridian Corp. v. Franchise Tax Board (2000), a state appeals court struck down a corporate tax deduction for dividends paid from a company’s California-based insurance subsidiaries. In Farmer Bros. Co. v. Franchise Tax Board (2003), the court upended a law that provided tax deductions for dividends only by corporations subject to California state taxes.

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