BILL ANALYSIS                                                                                                                                                                                                    

                                                                  AB 1369
                                                                  Page  1

          Date of Hearing:   May 27, 2011

                                Felipe Fuentes, Chair

                     AB 1369 (Gatto) - As Amended:  May 18, 2011 

          Policy Committee:                              Revenue and 
          Taxation     Vote:                            8-0

          Urgency:     No                   State Mandated Local Program: 
          No     Reimbursable:              


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

          1)Expands existing law by 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.

          2)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. 

          3)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. 

          4)Takes effect immediately as a tax levy.

           FISCAL EFFECT  

          The Franchise Tax Board (FTB) 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 


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          2013-14, and $450,000 in FY 2014-15.


          1)Purpose  .  The author states this bill would allow FTB to deny 
            a deduction for expenses, including costs of goods sold or 
            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.  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."

           2)Background  .  Existing federal law 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.  A taxpayer is allowed 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.  

            State law is similar to federal law but goes further, denying 
            deductions from gross income if the income is directly derived 
            from 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 

           3)Support  .  On December 4, 2002, FTB voted 2-0 to support the 
            language included in this bill, with the Director of Finance 
            abstaining.  Tax evasion cases prosecuted on behalf of the FTB 
            in recent years highlighted the need to expand the denial of 


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            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 could be limited.

           4)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 on a 46-1 vote. 

           5)There is no registered opposition to this bill  .

           Analysis Prepared by  :    Roger Dunstan / APPR. / (916) 319-2081