Error May Cost State $500 Million : Loopholes: A foul-up in a 1981 bill to aid small companies opened the door for some wealthy Californians to seek big tax refunds.

If this were a horror movie, it would be called “The Loophole That Haunts California.”

In 1981, the Legislature wanted to channel investment into small, struggling California companies and away from “non-productive assets” such as gold, silver and antiques. To do so, it passed a bill eliminating the capital gains tax for people who bought stock in such companies after Sept. 16, 1981, and held onto it.

But somebody goofed and left the date out of the bill--a mistake that opened a potential $250-million to $500-million loophole that has become an embarrassment to state tax officials.

Instead of helping struggling companies, the provision may end up allowing wealthy Californians--among them the founders of the Mervyn’s department store chain--to avoid paying capital gains tax on investments that were reaping large returns long before the bill was written.

The matter is being reviewed in court.

“The worst-drafted statute we’ve got is the small-business stock exemption,” said Brad Sherman, president of the State Board of Equalization, the tax agency in charge of interpreting tax law.

Like many tax relief measures, the bill started out well-intentioned and narrow in scope. Sen. Robert Presley (D-Riverside) set out to help draw investors to small California businesses, which he defined as firms with fewer than 500 employees that were not listed on the major stock exchanges.

His solution was to create a new asset classification--small-business stock--and then suspend the capital gains tax for taxpayers selling such stock after three years or more. At the time, analysts concluded that Presley’s bill would cost the state treasury $2 million a year.

Then came Magnus and Denise Hagen, Laguna Beach investors. The couple sought a $53,362 refund on the 1979 sale of small-business stock they had bought five years earlier. They originally paid the tax but filed an amended return after Presley’s bill went into effect in 1982.

At first, administrators at the State Franchise Tax Board denied the claim, citing the Sept. 16, 1981, date that Presley meant to include in the legislation. But the couple won their appeal to the Board of Equalization. “If the Legislature had intended to restrict the application to stock acquired after Sept. 16, 1981, it could easily have done so,” the board said in its 1986 decision.

With that, the floodgates opened.

In one case, James and Susan Lennane of Sacramento applied for a $592,717.01 tax refund on the sale of Systems Integrators Inc. stock they bought during the mid-1970s.

And Mervyn’s founder Mervin Morris, along with family members, filed amended 1987 returns asking for a $1.9-million tax refund for the sale of Dayton-Hudson Corp. stock they received when Mervyn’s was acquired by the Minneapolis firm in 1978.

Mervyn’s was a small business when it was incorporated in 1954, with 5,000 shares of stock. But it had grown into a 2,500-employee chain with sales of $134.2 million in 1975, according to court briefs.

Chagrined lawmakers closed the loophole in 1987.

But that was not before the Lennanes and the Morris family won Superior Court rulings upholding their refunds. Both decisions were reversed on appeal; the Morris case will be heard by the state Supreme Court, and the Lennanes’ lawyers are seeking a similar review.

Meanwhile, nearly 100 other appeals are awaiting the outcome of one case or the other. One involves the family trust of oil scion and philanthropist Gordon P. Getty, which wants a $111.4-million tax refund on the sale of Getty Oil Co. stock.

In all, the state could be forced to refund up to $500 million--a loss 250 times greater than lawmakers had intended.