Ben Franklin said nothing is certain except death and taxes. He was wrong about the latter. Tax authorities are rarely certain about next year’s tax rules, but at least you can be certain about the rules for years past. That is, unless you run a business in California. 

A few weeks ago, the state decided to cancel a key tax exclusion. As a result, this tax season many entrepreneurs will be facing a big retroactive tax bill. 

There Goes an Important Incentive 

The federal government has long had a Qualified Small Business (QSB) provision in the tax code designed to encourage entrepreneurship and small business formation. It provides two benefits to equity investors in a QSB: 

  • Rollover. If you sell your stock in one small business and re-invest the proceeds in another, you can defer taxes on any gains until you subsequently sell your stake in the second business.
  • Exclusion. If you don’t re-invest, you can exclude half (or sometimes more) of your gain from your tax return, although the excluded gain is subject to the alternative minimum tax. 

I have used the rollover provision multiple times, using gains from PayPal to help start PassMark Security, and gains from PassMark Security to help start Personal Capital. It’s a very effective way to incentivize entrepreneurs to start more businesses and create more jobs. 

California has long had a sister QSB provision, but the benefits were limited to small businesses with at least 80% of their employees in the state. Year ago, someone who failed that in-state-employment requirement sued California claiming that it was unconstitutional. They won, and California was faced with two options: (1) Allow everyone to use the QSB provision, or (2) allow no one to use it. 

Incredibly, they chose “no one”. (Not so incredibly, I guess, given the ongoing budget crises that have battered the state.) As a result, not only is the California QSB provision unavailable in the future, but anyone who has used it since 2008 (the statute of limitations) must now file amended returns without QSB for each year and pay the additional tax plus interest. 

So, certainty on taxes--even past taxes--has gone out the window. 

Tax Responsibly 

Taxes are necessary, but they can be productive or destructive to the economy depending upon how they are implemented. Well-run businesses must plan for the future--particularly growing businesses that are buying, building and hiring. There’s been a chorus of business leaders calling for tax certainty--the notion that having certainty about tax rates and rules is more important that what those rates and rules actually are. Certainty allows us to plan and get on with it. 

By now, we’re used to last-minute uncertainty about next year’s taxes, but California’s action elevates this to a whole new level. The state is changing the rules from five years ago! 

It’s time for the feds and the states to tax responsibly. Raise the necessary revenue, but please make it clear what the rules are and will be. Then get out of the way and let entrepreneurs do what they do best--take risk and build businesses.