December 9, 2013

Bracing for End of California Cap-Gains Tax Break

Capital-gains exclusions and deferrals remain in place for federal purposes
(Originally posted on the Wall Street Journal)

By Daisy Maxey

Updated Dec. 5, 2013 9:17 a.m. ET

California FlagFinancial adviser Sanjeev Sardana is surprised he’s not hearing more from his entrepreneurial clients in the Silicon Valley area about the end of a tax break for some who invest in qualified small-business stocks.

But he expects that he may in the near future.

The break permitted qualifying investors to exclude or defer from their California personal income taxes part of the profits made from the sale of certain stocks. Its expiration in the state could curtail some investments in startups, says Mr. Sardana, chief executive at BluePointe Capital Management in San Mateo, Calif., which manages $300 million.

“I’m still surprised that the activity in startups hasn’t declined,” says Mr. Sardana, who works with many technology entrepreneurs and runs an angel-investing forum. “People continue to invest very aggressively…They could say, ‘I’m not getting the exclusion; I’m going to curtail angel investing or investing in startups.’”

California’s provision allowing the exclusion or deferral of capital gains in certain cases has had an unusual progression in the state, with surprising developments over the past few years that have tested the patience of angel investors and challenged financial advisers and accountants to keep up.

California’s Franchise Tax Board rescinded last year the state’s version of federal tax code allowing such capital-gains exclusions and deferrals after a state court of appeals found that part of the provision violated a commerce clause. That left some who had invested in small businesses fuming and facing large, unexpected tax liabilities.

But in October, Gov. Jerry Brown retroactively signed a bill that permitted the tax breaks for 2008 through 2012. The decision was welcomed, and had accountants reaching out to clients to be sure they filed amended tax returns to claim the tax break.

Now, with extended tax deadlines met for 2012, Mr. Sardana and others wonder whether a new effort will soon begin to extend the tax break within the state. California’s version permits certain taxpayers to exclude 100% of the gain realized on the sale or exchange of the qualified small-business stock acquired after Sept. 27, 2010 and before Jan. 1, 2014, and held for more than five years.

“People have just done their 2012 taxes,” says Mr. Sardana. “When they don’t get (the tax break) for 2013, we might hear complaints.”

Tracy Hom, a partner in the San Francisco office of accounting firm Eichstaedt & Lervold LLP, said many California entrepreneurs are pushing to revive the tax break. Large law and investment-banking firms are now researching the provision, she says.

“With the higher tax rates that went into effect this year, it’s pretty beneficial even if just for federal-tax purposes,” says Ms. Hom.

Part of the Internal Revenue Code, the Qualified Small Business Stock provision, remains in place for federal-tax purposes. It applies only to non-corporate taxpayers who invested in a corporation with gross assets of less than $50 million and at least 80% of assets used in a qualified business. It permits such taxpayers to exclude 100% of the gain realized on the sale or exchange of qualified small-business stock acquired after Sept. 27, 2010 and before Jan. 1, 2014, and held for more than five years.

For stock acquired after the end of December, the exclusion falls to just 50%.

The amount of the excluded capital gain is limited in any year to the greater of 10 times the taxpayer’s basis in the stock or $10 million minus the eligible qualified small-business stock gain in previous years.

In addition to the exclusion, taxpayers may defer the taxable gain on the sale of their qualified small-business stock by rolling it over to newly purchased qualified small-business stock. Those who do so needn’t meet the five-year holding period, but must hold the stock more than six months, and acquire the new qualified small-business stock within 60 days after the sale of the old stock.

Mr. Sardana says he’s reminding clients to keep the provision in mind for federal tax purposes, “and roll over any gain within 60 days.”

D. Matthew Richardson, a partner in the Orange County and Los Angeles offices of law firm Sheppard, Mullin Richter & Hamilton LLP, says he expects an effort to revive the tax break in California.

“There clearly are a lot of people who are rather disturbed by the fact that there’s no exclusion or deferral on a go-forward basis,” he says.

But reviving the state tax break will be much tougher than getting it reinstated as the governor had done, says Mr. Richardson, adding that trying to implement it again as new legislation would cost the state money.