BILL ANALYSIS Ó AB 1369 Page 1 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 ----------------------------------------------------------------- |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 AB 1369 Page 2 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 AB 1369 Page 3 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 ÝC]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 AB 1369 Page 4 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 AB 1369 Page 5 Floor. Analysis Prepared by : Oksana Jaffe / REV. & TAX. / (916) 319-2098 FN: 0000966