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nCalifornians are outraged by a surprise retroactive tax law that may cost them millions in unpaid taxes to the state. In addition to the voter-approved income tax increase imposed by Proposition 30, this California Retroactive Tax has forced investors to be more cautious when determining whether or not to support a California-based enterprise. Many people believe that these policies will have a long-term negative impact on California’s economy.

What You Should Know About California’s Retroactive Tax on Small Business Investors

Although federal income tax law now provides for a specific deduction to be claimed on the sale or exchange of eligible small company shares, California enacted its own rules in 1993 that broadly resembled the federal structure. The state of California, on the other hand, provided a tax break to small company investors and creators. This deduction permitted a 50% exclusion of any gain on the sale of “Qualified Small Business” (“QSB”) shares. California’s capital gains tax was decreased from 9 percent to 4.5 percent, encouraging entrepreneurs and investors to remain their businesses in the state.

Many investors took advantage of this deduction, as seen by the enormous number of start-up firms in California, particularly in the Bay Area. Unfortunately for them, the California Court of Appeals’ ruling in Cutler v. Franchise Tax Board in August 2012 deemed the provision that enabled the tax deduction illegal and unenforceable because it discriminated against investors in out-of-state enterprises. California was obliged to cancel this tax benefit, and to make matters worse, it did so retroactively to 2008. (It should be emphasised that the Court of Appeal’s judgement solely affects the California QSB stock regulations and has no effect on any federal tax advantages provided by the Internal Revenue Code.

Essentially, if you sold a California firm during the last five years and used this tax credit, you must now repay the tax…with interest.

If you used the QSB deduction, you must now submit updated tax returns for the years you used the deductions. If you do not comply, the California Franchise Tax Board will contact you and may levy a penalty. Certain taxpayers may benefit from California’s interest suspension rule, which suspends the accumulation of interest if a claim of tax is not made within 36 months following a timely filed tax return. If it has already been 36 months after your tax return was promptly submitted, you may want to consider waiting for the Franchise Tax Board to make an adjustment through Notice of Proposed Assessment rather than submitting an updated return. In any event, you should contact with a tax professional to establish your best course of action in light of this retroactive ruling.