Law That Allows Taxpayer To Defer Capital Gains On Sale Of Small Business Stock With The Subsequent Purchase Of Stock In California Small Business Violates Commerce Clause

A court of appeal recently found unconstitutional a Revenue and Taxation Code provision that allows a taxpayer to defer capital gains when he or she sells stock in a qualified small business if the taxpayer uses the gain to buy stock in another small business as long as the stock sold and purchased was from corporations that maintain 80 percent of their payrolls in California and use 80 percent of their assets while doing business in California.  (Cutler v. Franchise Tax Board, (— Cal.Rptr.3d —-, Cal.App. 2 Dist., August 28, 2012). 


The Revenue and Taxation Code provides that a taxpayer may defer capital gains on the sale of stock in a “qualified small business” where the gain is used to purchase stock in another “qualified small business.”  In order for a business to be a “qualified small business,” under Revenue and Taxation Code section 18152.5, “[a]t least 80 percent (by value) of the assets of the corporation [must be] used by the corporation in the active conduct of one or more qualified trades or businesses in California.”  A corporation will not “meet this requirement ‘for any period during which more than 20 percent of the corporation’s total payroll expense is attributable to employment located outside of California.’”

Frank Cutler (“Cutler”) sold his stock in U.S. Web Corporation (“U.S. Web”) for $2,296,000 and used some of the money he received from that sale to purchase stock in several other small businesses.  U.S. Web did not meet the active business requirement found in Revenue and Taxation Code section 18152.5 because it did not maintain 80 percent of its payroll and assets in California.  However, on his 1998 California tax return, Cutler deferred the portion of the gain he received when he sold his stock in U.S. Web that he had invested in the other small businesses.  The Franchise Tax Board (“Board”) disallowed the gain because U.S. Web was not a qualified small business.  Cutler filed a protest asserting that the US Web stock met section 18152.5’s requirements.  He further asserted that even if the stock did not meet the requirements, section 18152.5 is unconstitutional because it violates the commerce clause of the United States Constitution because it unfairly discriminates against investors who invest in companies that conduct a portion of their business outside of California. 

After the Board denied Cutler’s protest, he appealed to the State Board of Equalization.  However, Cutler paid the state $442,000, which was the amount assessed by the Board for taxes, penalties, and interest.  The State Board of Equalization denied the appeal.  Cutler filed a lawsuit in which he sought a refund of the $442,000 he had previously paid.  Cutler asserted that the property and payroll requirement of section 18152.5 violates the commerce clause because it discriminates on its face against interstate commerce.  The trial court concluded the property and payroll requirement was not unconstitutional and found in favor of the Board.


The court of appeal reversed the decision of the trial court.  The appellate court held that because the statute allows a taxpayer to defer income he or she received from selling stock in a corporation that maintains assets and payroll in California, but provides no deferral for income that comes from selling stock in a corporation that maintains its assets and payroll outside of California, the deferral provision is discriminatory on its face and violates the commerce clause.

The commerce clause, found in the United States Constitution article 1, section 8, grants Congress the power “[t]o regulate commerce with foreign nations, and among the several states, and with the Indian tribes.”  However, the commerce clause “‘has long been seen as a limitation on state regulatory powers, as well as an affirmative grant of congressional authority.”  The negative aspect of the commerce clause, known as the dormant commerce clause, “prohibits economic protectionism—that is, ‘regulatory measures designed to benefit instate economic interests by burdening out-of-state competitors.’” 

A law is discriminatory if the law taxes a transaction “more heavily when it crosses state lines than when it occurs entirely within the State.”  A state law that discriminates against interstate commerce on its face is “virtually per se invalid.”  A state law that discriminates on its face must be invalidated unless the state shows that the law “‘advances a legitimate local purpose that cannot be adequately served by reasonable nondiscriminatory alternatives.’”  There are exceptions to the general rule that a facially discriminatory law is invalid such as where the tax is designed to be a compensatory tax, which is one designed to make interstate commerce bear a burden that is already born by intrastate commerce, or where state is a participant in the market.     

Here, the court found that the tax benefit provided by section 18152.5 violates the commerce clause.  The purpose and effect of the statute is to favor corporations doing business in California.  The statute provides a disincentive for a person to buy stock in a business that does business outside of California.  The court found that the statute is discriminatory on its face and it cannot stand under the commerce clause.

The court concluded that because material facts remain in dispute in this case, it could not determine whether Cutler is entitled to a refund.  The court reversed the judgment of the trial court but remanded the case for the trial court to determine if Cutler is entitled to a refund.


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Linda M. Monje | 661.864.3800