BILL ANALYSIS SENATE REVENUE & TAXATION COMMITTEE Senator Lois Wolk, Chair SB 876 - Florez Amended: January 10, 2010 Hearing: May 12, 2010 Tax Levy Fiscal: Yes SUMMARY: Conforms California Law to Federal Law to Allow Taxpayers to Carry Back and Carry Forward Net Operating Losses from Investment Fraud Schemes. EXISTING LAW authorizes net operating loss deductions, where taxpayers that generate a loss in one taxable year may use that loss to deduct income from another taxable year. Current law allows limited net operating loss (NOL) carrybacks to the preceding two taxable years, and extended carry-forwards to 20 years for net operating losses attributable to 2010 and later (AB 1452, Committee on Budget, 2008). Also, that measure limited a taxpayer with net business income greater than $500,000 from applying deductions for net operating loss carryforwards and tax credits to 50% of liability for the 2008 and 2009 taxable years. EXISTING FEDERAL LAW provides, in general, that a NOL can be carried back 2 years and forward 20 years and deducted. Special rules are provided for the carryback of NOLs relating to issues such as specified liability losses, casualty or theft losses, disaster losses of a small business, and farming losses. SB 876 - Florez Page 4 Recent changes in federal law extend the carryback period up to five years for specified losses. The American Recovery and Reinvestment Act allows certain taxpayers to make an irrevocable election to carry back applicable 2008 losses for up to 5 years. The Worker, Homeownership, and Business Assistance Act of 2009 allows taxpayers, other than taxpayers that received benefits under the Troubled Asset Relief Program, with business losses to make an irrevocable election to carry back losses incurred in one year (ending after 2007 and beginning before 2010) for up to 5 years. In March, 2009 the Internal Revenue Service (IRS) issued Revenue Ruling 2009-9 and Revenue Procedure 2009-20. Revenue Ruling 2009-9 defines losses on fraudulent investment schemes as business losses; a NOL resulting from a fraudulent investment loss is eligible for the extended NOL carryback period. Revenue Procedure 2009-20 provides a safe-harbor method of computing and reporting the losses. THIS BILL would conform California to federal law with respect to the net operating loss carryback and carryforward treatment currently allowed under the Internal Revenue Code for Ponzi-like scheme investment fraud. Specifically, this bill: Allows the "safe harbor" treatment for determining a fraudulent investment loss as set forth in the IRS's Revenue Procedure 2009-20, when the same procedures are applied for both state and federal purposes. Allows a state NOL resulting from the application of the terms of the Revenue Procedure the same carryback and carryforward periods as would be allowed SB 876 - Florez Page 4 by federal law for the same tax year and would conform by reference to the federal statute of limitations rules with respect to NOL carrybacks for losses attributable to application of the Revenue Procedure. Exempts NOLs arising from a fraudulent investment loss from the existing suspension period. Precludes the Franchise Tax Board (FTB) from challenging the treatment of a loss determined under the terms of the Revenue Procedure. FISCAL EFFECT: The Franchise Tax Board (FTB) estimates that this bill would result in a revenue loss of $9.9 million in fiscal year (FY) 2009-10, $8.7 million in FY 2010-11, $500,000 in FY 2011-12 and $30,000 in FY 2012-13. COMMENTS: A. Purpose of Bill The author provides the following statement: "SB 876 is a tax relief measure that will return erroneously paid tax dollars back to victims of Ponzi schemes. During these tough economic times, several people have fallen victim to fraudulent money schemes. The most prevalent being the Bernard Madoff Ponzi scheme. While there has been much attention given to the prominent names of investors who were hurt by the Madoff scandal, there are many people of average means in California who invested with Bernard Madoff Investment Securities and are now facing devastating financial futures. SB 876 - Florez Page 4 The other untold story is that several of these victims paid taxes on income they never received. The IRS has recognized the additional losses suffered by these victims and has provided major tax relief to qualified investors that paid taxes on phantom income - income they never received due to fraud. Unfortunately, California's tax code does not afford similar relief. SB 876 would conform California's tax code to the federal rulings and procedures so that victims in California will be treated similarly on their state tax returns as they would on their federal returns. In essence, this tax relief measure will ensure that the State does not victimize these folks once again." B. Background On March 17, 2009, in response to the losses resulting from the collapse of Bernard Madoff's decades-long Ponzi scheme, the IRS issued Revenue Ruling 2009-9 and Revenue Procedure 2009-20 to provide guidance to taxpayers who are victims of fraudulent investment schemes. The Revenue Ruling clarifies the income tax law governing the treatment of losses from such schemes, including the nature of such losses (theft losses), the amount of such losses to be allowed, and the year of deductibility. The Revenue Procedure simplifies compliance procedures for taxpayers by providing an optional safe-harbor means of determining the year in which the losses are deemed to occur, and a simplified method of computing the amount of the loss. Federal and state laws are generally the same with respect to the deduction of theft losses. In general, SB 876 - Florez Page 4 where state law is in substantial conformity with the Internal Revenue Code, federal regulations, rulings and procedures are applicable for state purposes. Accordingly, Revenue Ruling 2009-9 and Revenue Procedure 2009-20 are applicable for state purposes to the extent federal and state laws are the same. However, California law does not currently allow carrybacks of NOLs generated prior to the 2010 tax year, and carryforwards of such losses have been suspended until the 2010 tax year. (NOL carrybacks to the preceding two taxable years will be allowed for operating losses attributable to 2010 and later.) Consequently, victims of Ponzi schemes that claim net operating loss carrybacks on their federal returns in accordance with Revenue Ruling 2009-9 and Revenue Procedure 2009-20 cannot claim comparable carrybacks for California purposes, and may be unable to use carryforwards as allowed under Federal law until 2010. SB 876 would conform California to Federal law with respect to the NOL carryback and carryforward treatment currently allowed under the Internal Revenue Code. C. Slippery Slope? Under the recently issued IRS rules, victims of the Madoff Ponzi scheme are receiving some favorable federal tax treatment that is allowing them to recover at least some of their losses. This kind of relief is unusual, as in most cases where people lose property in a casualty or theft-related loss there aren't special exceptions and new rules that apply under the tax code. There have been many Ponzi schemes, including the eponymous Charles Ponzi and the match-king of Sweden, Ivar Krueger, before which cheated many people out of money, reporting fake income, and now have nothing to show but their losses. Also, ordinary taxpayers who haven't necessarily invested in a Ponzi scheme, but have lost money in cases like AIG, suffered capital losses that appeared theft-like. It is a SB 876 - Florez Page 4 slippery slope to pass laws and rules intended to protect just one class of taxpayers. The committee may wish to consider if SB 876 amends the California tax code to favor one group of taxpayers over another, thereby making the tax code less fair overall. Support and Opposition Support: None received. Oppose:None received. --------------------------------- Consultant: Meg Svoboda