California Starts Sending Big Bills To Startup Investors For $120 Million In New Retroactive Taxes

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Many startup entrepreneurs and investors in the state of California are now starting to receive big bills in the mail for back taxes that they never expected to owe.

That’s because in late December, when many of us were heading out for the holiday break, the state’s Franchise Tax Board eliminated a deduction that had been available since 1993. This tax break was available to people who made money from selling stock they’d held in California-based small businesses for at least five years, as long as they reinvested their gains in other small businesses in the state. Essentially, it encouraged many people to repeatedly invest in small businesses — potentially a big deal for entrepreneurs and angel investors.

Perhaps the most shocking thing about this is that the FTB is implementing the change retroactively, so it doesn’t just eliminate the break going forward: Anyone who used the tax break on the sale of startup stock from 2008 to today is now required to pay that money back, plus interest.

This stands to affect some 2,500 people and account for some $120 million in previously-legal tax breaks. That’s why many angel investors have started to receive big bills in the mail in recent days — and some of the people impacted are starting to fight back individually and through newly-organized groups such as the California Business Defense.

Why did this happen? It all traces back to a legal complaint filed against the Tax Board by an Orange County businessman named Frank Cutler, alleging that the tax break as it stands was unfair since it prioritized companies based in California over other states (Cutler was denied using the break back in 1998 because he sold stock in a company that wasn’t majority-based in California — yes, the court system is often ridiculously slow.) After years of back and forth, this past August a court ruled in Cutler’s favor, finding the tax break unconstitutional. And several months later, in December, the Franchise Tax Board announced that they’d honor the ruling by retroactively eliminating the tax break — meaning that anyone who benefited from it from January 2008 until now has to pay up.

This is obviously a huge issue for many people in the TechCrunch community, and in many ways it’s a complicated one. So we sat down with some experts to help explain the situation in video format.

Watch the edited video embedded above to hear from entrepreneur Brian Overstreet, who was one of the first to really speak out about the tax change in an article on Xconomy.com, about how this change is going to affect him and other California business owners. We also had the opportunity to sit down with David Herbst, a partner specializing in tax, compensation and capital markets at Silicon Valley law firm Manatt, Phelps, and Phillips to discuss the legal details of the case and possible ramifications.

Now, the video above is a five minute long edited-down version to convey the main facts as efficiently as possible. But if you want to dig deeper my full interviews with both Herbst and Overstreet were wide-ranging and quite informative. Here they are in their entirety: