There were two welcome tax changes from the California State Legislature and Governor Jerry Brown late in 2013:

California Qualified Small Business Stock

First, a court decision had declared California rules about “qualified small business stock” (QSBS) unconstitutional, because the rules had limited the QSBS benefits only to corporations with significant California connections.

QSBS benefits permit shareholders to pay a reduced tax rate on certain capital gain from the sale of shares in a qualified small business. The court decision, however, mandated that the result of the constitutional violation was to invalidate the California rules in their entirety, meaning that no QSBS benefits were available at all, even for those individuals who had qualified in full under the terms of the California statute as drafted.

The FTB announced that the decision exposed all individuals who had claimed QSBS benefits in the past to tax deficiencies and penalties. Fortunately, new 2013 legislation came to the rescue, providing that the court decision involving the California QSBS rules will not be applied retroactively.

California 409A Penalty Rate Reduced

Second, California has reduced the sanctions that apply to certain kinds of nonqualified deferred compensation. Federal income tax law imposes a penalty of 20 percent of the amount of any deferred compensation that does not comply with the rigid timing rules of Section 409A of the Internal Revenue Code.

California had conformed with its own 20-percent penalty under the California analog to Section 409A. This meant that basic compensation, taxed at normal federal-FICA-California rates approaching 50 percent, could attract supplemental 409A taxes of 40 percent, resulting in a near confiscatory tax rate of 90 percent. The 2013 legislation reduces the California rate from 20 percent to 5 percent, effective as of January 1, 2013. Section 409A sanctions are still formidable, with the potential to tax compensation at a combined rate as high as 75 percent, but a small amount of rationality has been introduced by way of the California rate reduction.

It appears that California’s improved fiscal health in recent months has opened the door to wiser tax policies, even when the policy improvements involve the potential loss of state tax revenue.

This article is an excerpt from the ACBA Business Law Section’s quarterly newsletter, edited by Tom Maier. To read the full newsletter, please click here.

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