BILL ANALYSIS Ó SENATE GOVERNANCE & FINANCE COMMITTEE Senator Lois Wolk, Chair BILL NO: AB 1369 HEARING: 7/6/11 AUTHOR: Gatto FISCAL: Yes VERSION: 5/18/11 TAX LEVY: Yes CONSULTANT: Miller PERSONAL & CORPORATE INCOME TAXES: DEDUCTIONS: ILLEGAL ACTIVITIES Denies deductions for expenses incurred from illegal activities. Background and Existing Law 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. Federal law 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. Proposed Law AB 1369 -- 5/18/11 -- Page 2 Assembly Bill 1369 disallows deductions for income derived by a taxpayer from specified illegal activities. This bill 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. This bill 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. The bill also 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. 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. AB 1369 takes effect immediately and applies to any taxable year that has not been closed by a statute of limitations, res judicata, or otherwise. State Revenue Impact The Franchise Tax Board (FTB) staff estimates that this bill would result in an annual gain of $50,000 in 2010-11, $150,000 in 2011-12, $250,000 in 2012-13, $350,000 in 2013-14, and $450,000 in 2014-15. Comments 1. Purpose of the bill . According to the author, this bill expands the definition of illegal activates subject to the disallowance of claimed expenses or the cost of goods AB 1369 -- 5/18/11 -- Page 3 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. 2. Insurance Fraud . According to the proponents of this measure, insurance fraud is a $5 billion business in this state and the Department of Insurance estimates that fraud adds an additional $500 to the cost of an insurance policy. Insurance fraud is deliberate and seriously undermines the insurance business. The proponents claim that this bill will act as a disincentive to these criminals and mitigate some of the costs associated with fraud. AB 1369 -- 5/18/11 -- Page 4 Assembly Actions Assembly Revenue & Taxation Committee: 8-0 Assembly Appropriations Committee:17-0 Assembly Floor: 75-0 Support and Opposition (6/30/11) Support : Association of California Insurance Companies; Liberty Mutual Group. Opposition : Unknown.