thank you for your question.
OK so here is the deal.
I see where the Franchise board is coming from.
In the U.S. you can not avoid fling the state tax returns (or federal) even if you have suffieint capital losses to avoid tax. In order to take advantage of those losses you have to go thruogh the process of filing the state returns.
You are also limited in how much losses you can take in carry forward.
during the tax years in question, california only allowed capital losses to be taken against capital gains. so you would still be able to end up with some taxable income related to the interest.
Another potential element that California may be looking at is the kind of stock options you had and your timing in the exercise of them. it is possible to encur taxable income for stock options that are issued as compensation. It is not necessary to explore your kinds of options and the treatment of them, because that would be to complicated here. If they were new optiosn this year, I could do it. THE Franchise tax board has the information and you would have to deal with that. You would have to find out why they think you owe that much money. BUT I see possibilities.
california capital gains and capital loss carry over rules are found in this document: http://www.ftb.ca.gov/forms/06_forms/06_540dins.pdf
to fix this, you need to pull a copy of your Federal 2005 return, and file a state return to figure the actual tax. If it is different, then you would appeal it. (you have to do the math). You can fist appeal with a letter, addressing each years tax.
(yor 2005 california return will affect your 2006 return, so if you filed a state return for 2006, you would now have to file an amended return.)
File an appeal and include the 2005 reutrn and the amended 2006 return. Ask them to please refigure the tax based on the enclosed returns.
Alternatively you can ask for an audit. (not recommended, if you never filed the 2005 return).
California, generally, only allows a capital loss carryover of 3,000 dollars per year. So you may still owe taxes, even though you have hugh losses.
You can find a copy of your California rights and appeal process here: http://www.ftb.ca.gov/aboutftb/taxpayer_advocate/index.shtml