BILL ANALYSIS                                                                                                                                                                                                    



                                                                  AB 1369
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          Date of Hearing:   May 16, 2011

                     ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
                                Henry T. Perea, Chair

                 AB 1369 (Gatto) - As Introduced:  February 18, 2011

                                      VOTE ONLY

          2/3 vote.  Tax levy.  Fiscal committee.

           SUBJECT  :  Personal income and corporation taxes:  deductions:  
          illegal activities. 

           SUMMARY  :  Disallows deductions for expenses attributable to 
          income derived by a taxpayer from specified illegal activities.  
          Specifically,  this bill  :  

          1)Expands existing law by additionally denying deductions for 
            expenses, including deductions for costs of goods sold, 
            attributable to the taxpayer's gross income directly derived 
            from certain criminal profiteering activities.  Specifically:

             a)   Describes the criminal profiteering activities to 
               include any act or omission punishable under the 
               "California Control of Profits of Organized Crime Act" of 
               Penal Code (PC) Section 186.2, dealing with a controlled 
               substance enumerated in the Health and Safety Code, and 
               unlawful referrals (insurance fraud) specified in the 
               Insurance Code. 

             b)   Denies deductions to any taxpayer from gross income 
               earned from any activity that directly tends to promote or 
               to further, or are directly connected or associated with, 
               those specified acts or omissions of criminal profiteering 
               activity. 

          2)Specifies that a prior, final determination by a court of 
            competent jurisdiction in any criminal proceedings, or any 
            proceeding in which the state, county, city, or other 
            political subdivision was a party on the merits of the 
            legality of the taxpayer's activities, is required in order 
            for this bill's provisions to apply. 

          3)Applies to any taxable year that has not been closed by a 








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            statute of limitations, res judicata, or otherwise. 

          4)Repeals existing law that denied a taxpayer deductions related 
            to illegal activities, as described by reference to certain 
            crimes. 

          5)Takes effect immediately as a tax levy. 

           EXISTING FEDERAL LAW:

           1)Provides that all income, from whatever source derived, is 
            included in a taxpayer's gross income, including income 
            obtained from illegal business activities, actual crimes or 
            unethical or immoral business practices.  

          2)Allows a taxpayer to deduct from the gross income all ordinary 
            and necessary business expenses, including expenses 
            attributable to an illegal business.  Notwithstanding the 
            general rule, illegal payments such as bribes and kickbacks 
            are not deductible, nor are losses from illegal activities 
            allowed if there is a clear public policy that supports 
            denying the deductions.  Special rules apply in the case of 
            business activities involving drug trafficking.  In those 
            cases, all deductions are expressly disallowed.

          EXISTING STATE LAW  is similar to federal law but further denies 
          deductions from gross income if the income is directly derived 
          from or directly tends to promote or further illegal activities 
          relating to lotteries, gaming, or horse racing.  Similar 
          restrictions apply to disallow deductions, including cost of 
          goods sold, from gross income for other specified illegal 
          activities including pimping or pandering, larceny, obscene 
          matter, robbery, burglary, illegal sales of controlled 
          substances, embezzlement, and indecent exposure.

          FISCAL EFFECT  :  The Franchise Tax Board (FTB) staff estimates 
          that this bill would result in an annual gain of $50,000 in 
          fiscal year (FY) 2010-11, $150,000 in FY 2011-12, $250,000 in FY 
          2012-13, $350,000 in FY 2013-14, and $450,000 in FY 2014-15. 

           COMMENTS  :  

           1)Author's Statement  .  The author states that, "This legislation 
            would amend Sections 17282 and 24436.1 and repeal Sections 
            17281 and 24436 of the Revenue and Taxation C]ode to allow 








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            the Franchise Tax Board to deny a deduction for expenses, 
            including costs of goods sold, derived from criminal 
            profiteering activity or illegal profits against insured 
            property and insurers.  This bill expands the definition of 
            illegal activities subject to the disallowance of claimed 
            expenses or the cost of goods sold.  This bill would ensure 
            public expenditures provided through the state tax system are 
            reserved for legitimate business expenses and remove loopholes 
            that allow criminals to avoid paying taxes for "business" 
            conducted while engaged in illegal activities.

          "The purpose of this bill is to prohibit taxpayers that 
            perpetrate crimes from claiming deductions on their tax return 
            for expenses incurred in criminal behavior.  Although existing 
            law denies deductions for certain criminal activities, recent 
            tax evasion cases prosecuted on behalf of the Franchise Tax 
            Board highlighted the need to expand the list of covered 
            activities."

           2)Arguments in Support  .  The proponents of this bill argue that 
            fraudulent claims "account for a significant portion of all 
            claims received by insurers, and cost billions of dollars 
            annually," and that those who commit insurance fraud "should 
            not be able to profit from a tax deduction for expenses 
            attributed to income derived from their criminal activities."

           3)Background  .  On December 4, 2002, FTB voted 2-0 to support the 
            language included in this bill, with the Director of Finance 
            abstaining.  Existing law already denies deductions for 
            certain criminal activities; however, tax evasion cases 
            prosecuted on behalf of the FTB in recent years highlighted 
            the need to expand the denial of deduction to other criminal 
            activities.  In cases involving crimes against the elderly and 
            insurance fraud, FTB investigators were required to allow 
            deductions for expenses directly related to the income from 
            the illegal activity to determine taxable income.  State 
            attorneys prosecuting the cases were frustrated and concerned 
            about the limited nature of California's existing disallowance 
            provisions.  Absent specific inclusion of the crime charged in 
            the list of crimes for which deductions are denied, the 
            penalties available to prosecutors with respect to the tax due 
            from the criminal endeavors might be limited.

           4)The Scope of this Bill  .  Existing state law provides an 
            inconsistent tax treatment of income derived from, or related 








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            to, illegal activities.  Thus, the law specifically prohibits 
            a taxpayer from deducting expenses, including the costs of 
            goods sold, from income derived from certain criminal 
            activities, such as pimping or pandering, larceny, obscene 
            matter, robbery, illegal sales of controlled substances, 
            embezzlement and indecent exposure.  Similarly, a deduction of 
            ordinary and necessary business expenses is disallowed if it 
            is claimed to offset income derived from illegal activities 
            related to lotteries, gaming, gambling or horse racing.  
            However, a taxpayer is entitled to claim a deduction for the 
            costs of goods sold in an illegal business related to 
            lotteries, gaming, gambling and horse racing.  Furthermore, a 
            taxpayer may claim deductions for expenses attributable to 
            other illegal activities, not specifically enumerated in the 
            statute.  

          AB 1369 would expand current rules disallowing deductions for 
            expenses attributable to certain crimes or criminal activities 
            to include all crimes punishable under the "California Control 
            of Profits of Organized Crime Act (PC Section 186.2) as well 
            as illegal activities involving insurance fraud.  Crimes 
            enumerated in the California Control of Profits or Organized 
            Crime Act include arson, child pornography, kidnapping, 
            murder, corporate securities violations, money laundering, 
            human trafficking, theft of personal identifying information, 
            theft of motor vehicles, and abduction or procurement by 
            fraudulent inducement for prostitution, among others.  By 
            providing the same consistent tax treatment to taxpayers 
            involved in all types of criminal profiteering activities, 
            this bill would further the legislative intent of punishing 
            and deterring crimes and would reserve state funds to help 
            legitimate businesses and/or various state programs.

           5)FTB's Suggested Amendments  .  The author accepted the technical 
            amendments proposed by the FTB staff to clarify the taxable 
            years to which this bill's provision would apply.   The 
            amendments are being drafted by the Legislative Counsel's 
            Office and will be presented to the Committee members at the 
            hearing on May 16, 2011.

           6)Related Legislation  .  

          AB 1746 (Revenue and Taxation Committee), introduced in the 
            2007-08 legislative session, is almost identical to this bill. 
             AB 1746 failed passage on the Assembly Floor. 








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           REGISTERED SUPPORT / OPPOSITION  :   

           Support 

           Association of California Insurance Companies
          California Tax Reform Association
          Franchise Tax Board
          Liberty Mutual Group



           Opposition 
           
          None on file 
           
          Analysis Prepared by  :  Oksana Jaffe / REV. & TAX. / (916) 
          319-2098