California Wealth Tax May Tax Founders' Voting Interests

Many critics of the proposed California wealth tax, particularly in the tech community, fear that the tax A tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. would be levied based on founders’ voting interests in their companies, rather than just their economic stake—an enormous concern when some founders own “super-voting” shares that allow them to retain control of their companies even though they only own a small fraction of all outstanding shares. The initiative’s drafters, however, insist that this is a misunderstanding. Who’s right?

The only real answer is that no one can be entirely sure. The language of the initiative suggests taxation based on voting shares, but that’s evidently not what the drafters meant to do, and the California Franchise Tax Board (FTB) might well take the narrower view to avoid a result that virtually everyone agrees is undesirable.

But just because it wasn’t the drafters’ intent doesn’t mean it’s not what the initiative says, and just because the FTB might interpret the language in such a way as to avoid an undesirable result does not mean that it will. This is one of the perils of trying to implement such a sweeping tax change through a ballot initiative: drafting errors or ambiguities that would be cleared up with amendments in an ordinary legislative process are baked into the language of the ballot measure, and voters must take it or leave it.

The issue hinges on definitions. The initiative establishes different valuation methods for each class of assets, distinguishing (1) publicly traded assets, (2) sole proprietorships, and (3) “all interests in any business entities, including all equity and ownership interest, all debt interests, and all other contractual or noncontractual interests,” except for publicly traded assets and sole proprietorships. In this third catch-all category, the initiative imposes a valuation floor: “For any interests that confer voting or other direct control rights, the percentage of the business entity owned by the taxpayer shall be presumed to be not less than the taxpayer’s percentage of the overall voting or other direct control rights.”

It all comes down to this: do the non-traded special control shares owned by corporate founders constitute publicly traded assets or not?

The initiative’s drafters, in their efforts to dismiss the concerns that super-voting shares will lead to extraordinary levels of taxation, advance two arguments: (1) that super-voting shares are publicly traded assets and (2) that even if this wasn’t the case, taxpayers could simply submit an alternative appraisal using different valuation rules. But both arguments are unpersuasive.

There is no question that these super-voting shares are for publicly traded companies, but that does not make the control shares publicly traded assets. These special shares, which allow founders to retain large or controlling interests in their companies despite only retaining a minority stake, are restricted and cannot be sold on the open market. It is impossible for a founder to sell the controlling interests, and these super-voting shares cannot be listed on exchanges. Instead, they feature what is called “transfer-based conversion,” meaning that they convert to ordinary shares upon sale, without super-voting privileges.

The initiative’s language speaks of publicly traded assets. It even defines the term: “an asset that is traded on an exchange; traded on a secondary market in which sales prices for such asset are frequently updated; available on an online or electronic platform that regularly matches buyers and sellers; or any other asset that the Board determines has a value that is readily ascertainable through similar means.”

By any ordinary definition, these super-voting shares are not publicly traded assets, even though they confer an interest in a publicly traded company. They are not traded on an exchange or on a secondary market where prices are frequently updated. And their valuation at sale (where they would convert) is different from their valuation with special control rights, a value that is not readily ascertainable. A straightforward interpretation, therefore, is that they are taxed in the catch-all category, with voting interests as a valuation floor.

The FTB might decide that, since these shares can only be sold upon conversion, their valuation is “readily ascertainable” through the ordinary shares on exchanges. It might conclude that even though they are not themselves publicly traded, in sale they would become publicly traded, and this is sufficient. These are all possibilities, and should the initiative pass, one hopes the FTB would take this interpretation—which drafters say is their intent—to avoid excessive taxation that could tank some of California’s largest companies. But it’s a roll of the dice, because it relies on the FTB going beyond the initiative’s plain language.

The initiative’s drafters also contend that even if the shares were initially valued based on voting interests, taxpayers could submit an alternate appraisal that better reflects the actual value of their assets. But this is also cold comfort.

The option of challenging a default valuation is never a sufficient solution to overly aggressive valuation rules, but it’s particularly flawed in this case.

First, since the initiative establishes that some business interests should be taxed based on voting interests, if that’s the default here as well, it could be hard for affected taxpayers to insist that this yields an unconscionable result. However flawed that valuation approach may be, it’s one the initiative insists upon for some business ownership interests.

Second, how do you value super-voting shares? With their present owners, they are clearly more valuable than ordinary shares—voting rights have value—but since they can’t be sold with those rights, whatever value is appropriate to them as special control shares cannot be realized on any market. Should they be valued at a premium or not under an alternative valuation, and if so, at what premium?

Disagreeing with the FTB, moreover, can be costly. The wealth tax A wealth tax is imposed on an individual’s net wealth, or the market value of their total owned assets minus liabilities. A wealth tax can be narrowly or widely defined, and depending on the definition of wealth, the base for a wealth tax can vary. initiative includes draconian penalties for both taxpayers and their appraisers, penalizing taxpayers at up to 40 percent of any understatement of tax liability, and appraisers at up to 4 percent (even though the appraisers are not themselves billionaires, making such a penalty potentially ruinous). These penalties could be imposed if an appraiser certified a valuation based on the value of publicly traded shares in the company and the FTB concluded that this was an unreasonable approach. Will appraisers be willing to take that risk?

(A slightly more detailed analysis of the super-voting shares valuation issue can be found here.)

If tech founders are taxed based on their controlling interests, the mass selloffs necessary to pay the tax would be extraordinarily damaging for those companies, their shareholders, and the broader economy. And due to ambiguous drafting, voters can only guess at the risk.

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About the Author

Expert

Jared Walczak

Senior Fellow Jared Walczak is a Senior Fellow at the Tax Foundation, where he spent five years as Vice President of State Projects, and president of Walczak Policy Consulting.