The federal exclusion for Qualified Small Business Stocks (QSBS) serves as a catalyst for investments in US small businesses, offering a dual benefit of capital infusion for these enterprises and tax advantages for investors aiming to mitigate capital gains taxes. Under federal law, investors holding qualified small business stock for at least 5 years can exclude up to $10,000,000 or more of their recognized capital gains from taxable income, provided certain criteria are met.
However, each state holds its own stance on QSBS gains at the state income tax level, resulting in varied implications for investors. States typically adopt one of three approaches regarding QSBS:
- Full Conformance: Some states fully align with federal QSBS guidelines, allowing a complete exemption if the stock meets Section 1202 QSBS criteria. Conversely, states without income taxes have no QSBS implications at the state level.
- Partial Conformance: Certain states partially conform to federal QSBS guidelines, meaning capital gains from QSBS are exempt if additional criteria, beyond federal guidelines, are satisfied. This may entail exemptions only for gains from businesses operating within the state.
- No Exclusion: Lastly, some states disallow any capital gains exclusions for QSBS.
In the context of California, while the state previously aligned partially with federal guidelines, it ceased to allow tax exemptions for QSBS. The exclusions, formerly outlined in California Revenue and Taxation Code sections 18152.5 and 18038.5, were repealed in 2013. These sections had specified criteria for eligible gains, defining qualified small businesses and outlining stock-related criteria.
During the period between January 1, 2008, and December 31, 2012, various exclusions were permitted under specific conditions. For instance:
- Shares purchased at original issue on or before February 17, 2009, enjoyed a 50% exclusion.
- Shares bought at original issue between February 18, 2009, and September 27, 2010, benefited from a 75% exclusion.
- Shares acquired at original issue between September 28, 2010, and December 31, 2011, were 100% excluded from taxation.
However, these provisions were contingent upon certain conditions, including the allocation of at least 80% of payroll to employees within California and utilizing at least 80% of assets for business operations within the state.
The repeal of Sections 18152.5 and 18038.5 in 2013 subjected all capital gains to taxation in California. Unlike some states that differentiate between short-term and long-term capital gains, California taxes all capital gains at the same rate as an individual’s regular income. The state employs a progressive tax system with ten income tax rates, ranging from 1% for incomes below $8,809 annually to 13.3% for incomes exceeding $1,000,000.
For married couples filing jointly, tax rates mirror those of single taxpayers but are doubled based on joint income thresholds.
The history of the California QSBS repeal dates back to a ruling by the California Court of Appeal in August 2012, which deemed the 80% requirements discriminatory. Consequently, the California Franchise Tax Board deemed the entire law invalid, leading to the introduction of Senate Bill 209 in February 2013. This bill, which amended and repealed Sections 18038.5 and 18152.5, was passed by both the State Assembly and the State Senate in September 2013 and approved by the governor in October of that year.
The bill added language to clarify the eligibility criteria for QSBS exemptions and set specific repeal dates for the amended sections. Additionally, a new section, Section 18153, was introduced to address tax situations arising before January 1, 2013, if the amended section 18152.5 was deemed invalid.
As of January 1, 2013, capital gains from the sale of qualified small business stock are no longer eligible for state tax exclusion in California.
Learn more: Robert Hall & Associates | Los Angeles Tax Preparation & Consulting
