New California Reporting Requirement for Qualified Small Business Stock


Editor's Note: The 2012 decision of Frank Cutler v. Franchise Tax Board, (2012) 208 Cal.App.4th 1247, or Franchise Tax Board Notice 2012-03 found California's provision regarding Qualified Small Business Stock Gains ("QSBS") unconstitutional. The court's decision made California's entire QSBS statute invalid and unenforceable. The Cutler decision has no impact on the federal treatment of QSBS. Although the California QSBS treatment going forward from 2012 was invalid, the Governor signed into law (AB 1412) on October 4, 2013 to retroactively allow the California QSBS for tax years 2008 to 2012.

As most of you are aware, stock issued after August 10, 1993, by a Qualified Small Business (a "QSB") may be eligible for special treatment which reduces the effective regular federal income tax rate on the gain from a sale of Qualified Small Business Stock from a maximum of 28% to a maximum of 14%.

Similarly, California's Revenue and Taxation Code provides for a 50% exclusion of the gain on a sale of QSBS from California income tax. In order to be eligible for the California exclusion, a corporation must submit such reports as the Franchise Tax Board may require. Federal tax law empowers the IRS to impose a similar reporting requirement but so far no federal reporting requirements have been imposed.

New California Reporting Requirement

The California Franchise Tax Board has recently adopted Form 3565 ("Small Business Stock Questionnaire") which must be filed by any QSB that has issued QSBS (see "who must file Form 3565," below).

The instructions to Form 3565 state: "Failure to file this form by the corporation's original due date for the current accounting period may disqualify stockholders from excluding 50% of the gain from the sale or exchange of small business stock."

The Audit Dept of Franchise Tax Board takes the position that Form 3565 must be filed by the due date for filing the corporation.s Form 100 (its corporate income tax return) for tax years beginning in 1995. For a calendar year taxpayer, that date would be March 15, 1996. For a taxpayer with a short year beginning in 1995, that would generally be the date that is two months and fifteen days after the close of the accounting period for that short year. No extension is provided for the filing if this form even if there is an extension for the filing of the corporation.s California income tax return.

The Form 3565 filing requirement will not affect the status of QSBS already issued. However, for a corporation to issue additional QSBS on or after the original filing date (without taking into account extensions) for its 1995 income tax return, Form 3565 must be filed.

Who Must File Form 3565

Generally any domestic corporation that, (1) on or after August 10, 1993, issued stock in exchange for cash, property other than stock, or services provided to the corporation, (2) from August 10, 1993 through the date of issuance never had more than fifty million dollars in aggregate gross assets (including amounts received from the issuance), (3) as of the date of issuance at least 80% of the corporation.s payroll as measured by total dollar value was attributable to employment located within California, (4) since issuance was a C-corporation, and (5) since the issuance at least 80% by value of the corporation.s assets were used in the active conduct of one or more qualified trades or business in California, must file Form 3565 in order to be able to issue additional QSBS. If a corporation has not yet issued QSBS it need not file Form 3565.

For California purposes a QSB is:

  1. a domestic C-corporation,
  2. with a tax basis in its aggregate gross assets at all times on or after July 1, 1993, and both before and immediately after the issuance of the stock of no more than fifty million dollars,
  3. that has at least 80% of the corporation.s payroll (as a percent of total dollar value) attributable to employment located in California, and
  4. the corporation agrees to submit such reports as the Franchise Tax Board (the "FTB") may require to be submitted to the FTB and shareholders in order to achieve the purposes of the QSBS exemption.

General Requirements for QSBS

The following is a reminder of the general limitations that apply to QSBS for both California and federal purposes:

  1. The maximum gain that can be excluded in a year from dispositions of stock issued by any corporation is limited to the greater of ten times the taxpayer.s basis in the stock or $10,000,000 (reduced by gain excluded in prior years on sales of the same issuer.s stock).
  2. One half of the excluded gain will be a tax preference item for purposes of the alternative minimum tax.
  3. QSBS is limited to stock issued after August 10, 1993.
  4. The issuer must be a domestic C corporation that does not have more than $50,000,000 in aggregate gross assets, including amounts received upon issuance of the stock. Gross assets means cash and the adjusted basis of other property.
  5. The issuer must use at least 80% of its assets in the active conduct of one or more qualified trades or businesses for substantially all of the holding period of the stock. Assets used in business start up activities and R&D are generally treated as used in an active business.
  6. Certain businesses are not qualified small businesses, including any business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, banking, insurance, financing, leasing, investing, farming, mineral extraction, and operating a hotel, motel, restaurant or similar business.
  7. Although the gross asses test need only be satisfied at all times from August 10, 1993 to the issuance of the qualifying stock, the active conduct and qualifying business tests must be satisfied for substantially all of the holding period of the stock.
  8. Individuals who are partners of investment partnerships that sell or distribute qualified small business stock will generally be entitled to the benefit of the exclusion.

Issuers should be aware of potential pitfalls in the event they repurchase their own shares. This situation occurs most commonly when companies repurchase shares from terminated employees which were originally granted under the company.s stock options or stock purchase plans. Repurchases by a corporation of its own stock can lead to a loss of qualified small business stock status in two situations.

First, stock acquired by an investor will not be treated as qualified small business stock if, at any time during the four year period beginning on the date two years before the issuance of such stock, the issuer purchased (directly or indirectly) any of its stock from the investor or from a person related to the investor. This situation is a pitfall for a terminating employee.

For example, if an employee purchases stock under a four year vesting arrangement, terminates employment within two years, and the corporation repurchases the unvested shares, the vested portion retained by the terminated employee will not constitute qualified small business stock.

Second, stock issued by a corporation will not be treated as QSBS if, during the two year period beginning on the date one year before the issuance of the stock, the issuer made one or more purchases of its stock with an aggregate value (as of the time of the respective purchases) exceeding five percent of the aggregate value of all of its stock as of the beginning of such two year period. Unlike the previous example where only the stock of a single individual is disqualified, in this situation all stock issued by the corporation during the tainted period is disqualified.

Please note that in the latter situation the stock is valued at two different times which will generally work against the corporation. In determining whether the five percent threshold has been exceeded, the numerator is the value of the stock repurchased determined at the time of repurchase.

The denominator is the value of all of the stock as of the beginning of the two year period. This could have particularly harsh results where a founder purchases stock before a financing (when the aggregate value of the corporation - the denominator - is low) and terminates and has his or her unvested stock repurchased after the financing (when the value of the repurchased shares - the numerator - has increased).