The California tax that terrifies tech

February 21, 2013, 12:24 PM UTC

FORTUNE — Entrepreneurs and investors in California can expect to receive a rude shock in the mail if they sold their company in the last four years. Not only did the state’s Franchise Tax Board (FTB) eliminate a tax break on capital gains for small business owners and investors, it announced the tax would be reinstated retroactively. This means those who benefitted from the break can expect a bill for unpaid taxes, plus interest, stretching all the way back to 2008.

Since 1993, California entrepreneurs and early-stage investors have enjoyed a partial state income tax exclusion on sales of stock of a “qualified” small business. This was an incentive for people to start and keep businesses in California. If they sold their company, they would only have to pay half of the regular state tax rate on what they gained — about 4.5% instead of 9%. That could include founders of companies such as Instagram and Yelp (YELP).

The FTB announced its decision last December, and the ruling went into effect earlier this year. Now, not only will stockholders have to pay the full tax rate on capital gains, which has risen to about 13%, but they’ll also be billed retroactively for 50% of the taxes they excluded. The FTB says this will affect over 2,500 people and bring in about $120 million in revenue.

Not surprisingly, the changes have led to concern among entrepreneurs.

“A lot of people who are going to be very affected don’t even know about it,” says Brian Overstreet, entrepreneur and co-founder of AdverseEvents, a pharmaceutical data firm. “This is going to affect our decision to keep jobs and businesses in California.” Overstreet had previously co-founded Sagient Research Systems, a company he sold last year. As a result of the transaction he says he will personally have to pay an additional six-figure amount in taxes and interest.

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Ironically, it was the actions of a small business owner that led to the change. An Orange County businessman named Frank Cutler sued the FTB after being denied the tax break because less than 80% of his business was based in California, one of the incentive’s caveats. The California Court of Appeals sided with Cutler and struck down the provision, saying it was discriminatory. In response, the Franchise Tax Board decided to eliminate the incentive entirely.

Overstreet and a group of California entrepreneurs have formed a group dubbed California Business Defense to fight the ruling, saying the FTB’s actions were too broad. They argue it could have struck down the 80% rule instead of the entire tax break. “The FTB had more than one choice to make here, and our position is that there were other precedents available, which they did not follow,” says Overstreet. “The wheels are going too fast, the process needs to slow down so that cooler heads can prevail.”

Denise Azimi, a representative for the FTB, said it had no choice but to remove the entire benefit. “The benefit would have to be allowed regardless of where the business was located,” wrote Azimi in an email. “While treating all taxpayers the same would cure the discrimination cited by the court, it conflicts with both the letter of the qualified small business stock law and its underlying legislative intent.”

Ethan Anderson, co-founder and CEO of startup MyTime, says the FTB’s actions will make entrepreneurs think twice about setting up a business in the state. “You can’t really plan for the future when the rules of the game are changing retroactively,” says Anderson. “You feel insecure investing in the state, why would you take that additional risk when they’ve set a precedent now showing that anything could happen anytime?”

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Texas governor Rick Perry

Anderson says the ruling felt like “a slap in the face,” especially since entrepreneurs like him have helped drive much of the state’s economy. “Who else is creating the jobs? Why would they hurt us like this?” asks Anderson. “The next time I start a business, it most probably won’t be in California.”

It might just be in Texas. Anderson says he already knew of at least one California entrepreneur who had bought a house there to establish out-of-state residency. The Lone Star state is home to Austin, one of the fastest growing tech hubs in the country. Unlike other hubs like New York and Boston, it offers lower taxes, less regulation, and relatively inexpensive real estate.

California’s discontent hasn’t gone unnoticed by Texas governor Rick Perry, who visited the state earlier this month in an effort to lure businesses to Texas. “Building a business is tough. But I hear building a business in California is next to impossible,” Perry says in a radio ad that accompanied his tour in California. “See why our low taxes, sensible regulations, and fair legal system are just the thing to get your business moving to Texas.”

Chairman of the Austin Technology Council Joel Trammell says that in the wake of the recent income tax hikes and elimination of tax breaks in California, he fields calls every week from entrepreneurs and investors who have either decided to move or are exploring the option of setting up in Austin. “All the major companies have a presence in Austin, so it’s pretty easy for people to switch,” says Trammell.

Apple (AAPL) and Samsung have both recently pledged to expand their presence in Austin while other companies are changing their structure to take advantage of the state. “A lot of companies will set up their headquarters or non-technical staff here while maintaining the rest of the business in California,” says Trammell. Of course, both companies have a massive presence in the Golden state, not to mention other tech giants that call the Bay Area home, from Oracle (ORCL) to Facebook (FB).

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When the time came for him to set up his third company, Xeris Pharmaceuticals in 2010, serial entrepreneur John Kinzell decided he had had enough of California, despite living there for almost 25 years. He launched the company in Austin instead and says a lot of people followed him. “It’s hard to swing a cat around without hitting someone from California who’s moved here or is at least looking,” says Kinzell. “We have more companies here than talent, so they’re having to pull a lot from California.”

He says it’s unlikely he or fellow entrepreneurs will ever move back. “It’s just become a very unfriendly state to run a company,” says Kinzell. “Once that sort of bleed starts, it gets hard to reverse it.”