Tax Law Loophole on Stock Sales May Cost State Millions in Refunds

Hundreds of California taxpayers are claiming millions of dollars in refunds for state income taxes paid on sales of stocks of small companies, thanks to a little-noticed loophole in California tax law.

The loophole--stemming from a tax break designed to encourage investment in California small business--already has forced the state to cough up nearly $50 million in refunds and interest during the past year or so, state officials say.

Total lost tax income to the state could eventually run well over $100 million, which, although small compared to the entire state budget, is still significant, state officials say. No attempt is being made in the Legislature to close the loophole. A previous effort failed.

Small-business interests defend the break as rewarding entrepreneurs and venture capitalists who founded now-successful companies years ago. Those exploiting the break are shareholders or founders of small businesses ranging from computer companies to garbage disposal firms. Some taxpayers are quite wealthy--having sold shares in fast-growing profitable companies for large profits--and are earning individual refunds in some cases approaching as much as $1 million.

“When I got the refund, I was as happy as a lark,” said a retired Laguna Niguel businessman who received a refund of more than $100,000, stemming from taxes he paid on profits from selling his metal fabrication business a few years ago. “I didn’t have any tax shelters, and I’ve paid a lot of money in taxes.”

“Most founders of closely held businesses in California may qualify for the refund,” said Douglas K. Ammerman, a partner in the Costa Mesa, Calif., office of the accounting firm of Peat, Marwick, who first exploited the loophole for clients. (Closely held companies are generally owned by a small number of shareholders, and their stock generally is not traded on public stock markets).

Ammerman noted that one of his clients has requested a refund of nearly $900,000. Even shareholders or founders of some fast-growing companies that now gross billions of dollars in revenue and sell stock to the public, such as Apple Computer, may be eligible for refunds, Ammerman said.

The loophole stems from an oversight in the writing of a law enacted by the Legislature in 1981 to encourage investment in small California businesses. The law granted favorable tax treatment on capital gains resulting from sales of stock in small California companies meeting certain criteria.

The favorable tax treatment, among other things, exempted people selling stock in such firms from the state capital gains tax of up to 5.5%, as well as a 2.75% special preference tax targeted at shareholders with large tax deductions.

To qualify for the special tax treatment, it was intended that taxpayers generally must have acquired the stock after Sept. 16, 1981, and held it more than three years. The stock also, at the time of purchase, must have been in companies that employed fewer than 500 workers; conducted business primarily in California; did not have publicly traded stock; did not derive more than 25% of their gross revenues from rents, interest, dividends, sales of assets or other “passive” sources, and did not engage primarily in owning land, Ammerman said.

However, when the law was actually drafted, the 1981 date was omitted in the section dealing with the exemption for the special 2.75% preference tax.

That meant that anybody who acquired stock in qualifying companies, regardless of the date of acquisition, became eligible for a tax break. (However, shareholders buying stock before Sept. 16, 1981, still had to pay the 5.5% capital gains tax; thus, they get a smaller tax break than shareholders of newer companies, who, if qualified, do not have to pay either the capital gains tax or the preference tax.)

‘Sloppy Drafting’

Thus, thousands of taxpayers who paid the preference tax on stock sold in hundreds of qualifying California companies could now claim a refund. And those selling stock of qualifying companies in the future will not have to pay the tax in the first place.

“It was sloppy drafting,” said Robert Franzoia, a consultant to state Sen. Robert B. Presley (D-Riverside), who introduced the original 1981 bill creating the tax break.

He and Franchise Tax Board officials suggested that drafters of the law assumed that it was clear that the date should apply to the preference tax exemption as well. “Everybody in the world looked at it . . . and it (the mistake) never occurred to anybody,” said Carol Horowitz, director of the Franchise Tax Board’s legislative services bureau.

Peat, Marwick’s Ammerman first attempted to exploit it by filing for a refund for a client, Magnus F. Hagen, a Laguna Beach businessman who sold stock in a company he co-founded that manufactured ball-bearing slides. The refund was disallowed by the Franchise Tax Board, which contended that the intent of the original law was to provide the tax break only for those acquiring stock after Sept. 16, 1981.

Hagen and Ammerman then took the case to the state Board of Equalization, the final arbiter of grievances brought before the Franchise Tax Board. To Ammerman’s surprise, the Board of Equalization ruled in favor of Hagen and also rejected a subsequent appeal by the Franchise Tax Board.

A later attempt by Presley to close the loophole died in the Legislature last year, failing to win passage before the session adjourned for the year. State officials who supported closing the loophole suggest that the bill died due, in part, to lobbying pressure from small-business interests supporting the tax break.

The Board of Equalization decision and the Legislature’s failure to close the loophole now mean that the Franchise Tax Board is obligated to make refunds, said David Lew, the Franchise Tax Board’s attorney in the Hagen case.

About 2,300 taxpayers so far have filed claims for $69 million in tax refunds and interest, Franchise Tax Board spokesman Will Bush said. Of that, about $47 million in refunds and interest to about 1,900 taxpayers has already been paid, he said.

Peat, Marwick’s Ammerman said taxpayers entitled to such refunds for taxes paid in the 1982 tax year should file for refunds quickly, as the four-year statute of limitations for 1982 returns expires April 15. Those seeking refunds for the tax years since 1983 have more time, he said.

Bush, however, said most requests for 1982 tax year refunds probably have been filed.

Franzoia, of Presley’s office, said he and Franchise Tax Board officials hope to close the loophole by passing omnibus legislation under consideration this year that would bring California tax law into conformity with new federal regulations under the Tax Reform Act of 1986.

Under federal tax reform, capital gains from sales of stocks will be taxed the same as ordinary income, starting in 1988.

“We are very much interested in (closing) that loophole,” Franzoia said.