BILL ANALYSIS                                                                                                                                                                                                    



                                                                  AB 1369
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          ASSEMBLY THIRD READING
          AB 1369 (Gatto and Perea)
          As Amended  May 18, 2011
          2/3 vote.  Tax levy

           REVENUE & TAXATION  8-0         APPROPRIATIONS      17-0        
           
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          |Ayes:|Perea, Donnelly, Beall,   |Ayes:|Fuentes, Harkey,          |
          |     |Charles Calderon,         |     |Blumenfield, Bradford,    |
          |     |Fuentes, Gordon, Harkey,  |     |Charles Calderon, Campos, |
          |     |Nestande                  |     |Davis, Donnelly, Gatto,   |
          |     |                          |     |Hall, Hill, Lara,         |
          |     |                          |     |Mitchell, Nielsen, Norby, |
          |     |                          |     |Solorio, Wagner           |
          |     |                          |     |                          |
           ----------------------------------------------------------------- 
           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; and, 

             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 








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            legality of the taxpayer's activities, is required in order 
            for this bill's provisions to apply. 

          3)Applies to taxable years that have not been closed by a 
            statute of limitations, res judicata, or otherwise, as of the 
            effective date of this bill.  Specifies that the existing 
            provisions would apply to taxable years that have not been 
            closed as of September 14, 1982, except as otherwise provided. 


          4)Repeals existing law that denies 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 








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          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  :  

           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 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."

           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."

           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 








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          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.

           The scope of this bill  .  Existing state law provides an 
          inconsistent tax treatment of income derived from, or related 
          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.  

          This bill 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 assist legitimate businesses and/or 
          various state programs.

           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 








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          Floor. 

           
          Analysis Prepared by  :    Oksana Jaffe / REV. & TAX. / (916) 
          319-2098 



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