BILL ANALYSIS Ó AB 1173 Page 1 Date of Hearing: May 6, 2013 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Raul Bocanegra, Chair AB 1173 (Bocanegra) - As Amended: March 21, 2013 Majority vote. Tax levy. Fiscal committee. SUBJECT : Personal income taxes: nonqualified deferred compensation plan SUMMARY : Reduces the excise tax penalty from 20% to 5% on an amount deferred under a nonqualified deferred compensation (NQDC) plan that is not subject to a substantial risk of forfeiture and does not meet the requirements of Internal Revenue Code (IRC) Section 409A (Section 409). Specifically, this bill: 1)Modifies provisions that conform California law to IRC Section 409A by substituting 5% in lieu of 20% of excise tax penalty. 2)Takes effect immediately as a tax levy. EXISTING FEDERAL LAW : 1)Provides, generally, that all amounts deferred under a NQDC plans are currently includible in income to the extent not subject to a substantial risk of forfeiture and not previously included in income, unless the following requirements are satisfied: a) Distributions from a nonqualified plan are made upon the separation from service, death, a specified time (or pursuant to a fixed schedule), a change in control of a corporation, an occurrence of an unforeseeable emergency, or if the participant becomes disabled. [IRC Section 409A(a)(2)]. b) Distributions, generally, may not be accelerated. [IRC Section 409A(a)(3)]. c) Subject to exceptions, the election to defer compensation must be made by the close of the taxable year AB 1173 Page 2 preceding the year in which the services are performed. In the case of any performance-based compensation based on services performed over a period of at least 12 months, such election may be made no later than six months before the end of the service period. [IRC Section 409A(a)(4)]. 2)Provides for a 20% additional tax if an amount deferred under a NQDC plan is not subject to a substantial risk of forfeiture and does not meet the requirements under Section 409A. [IRC Section 409A(a)(1)(B)]. 3)Imposes an interest at the underpayment rate plus one percentage point on the underpayments that would have occurred had the deferred compensation been includible in gross income for the taxable year in which first deferred or, if later, the first taxable year in which such deferred compensation is not subject to a substantial risk of forfeiture. [IRC Section 409A(a)(1)(B)]. 4)Provides that IRC Section 409A is generally effective for amounts deferred in taxable years beginning after December 31, 2004. EXISTING STATE LAW : 1)Conforms to Subchapter D of Chapter 1 of Subtitle A of the IRC, which contains IRC Sections 401 through 420. [Revenue & Taxation Code (R&TC) Section 17501]. 2)Provides for an additional 20% tax rate penalty if an amount deferred under a NQDC plan is not subject to a substantial risk of forfeiture and does not meet the requirements under Section 409A. (R&TC Section 17501). FISCAL EFFECT : The Franchise Tax Board (FTB) estimates revenue losses of $4.7 million in fiscal year (FY) 2013-14, $3.2 million in FY 2014-15, and $3.4 million in FY 2015-16. COMMENTS : 1)The author has provided the following statement in support of this bill: AB 1173 lowers the potential tax penalty rate from 20% to 5% for nonqualified deferred compensation plans that are AB 1173 Page 3 subject to Internal Revenue Code Section 409A (Section 409A). A nonqualified deferred compensation plan refers to compensation that a worker earns in one year but that is not paid until a future year. In general, Section 409A requires that the timing of the nonqualified deferred compensation payments be established in advance of when the services are performed. If these payments do not meet strict limitations, Section 409A increases the federal income tax rate by an additional 20%. The code section was created after Enron Executives accelerated nonqualified deferred compensation payments as the company was going bankrupt. It is meant to prevent powerful executives from manipulating the timing of their compensation. Treasury regulations have, however, interpreted Section 409 broadly, possibly reaching into entertainment and general service contracts. Specifically, California's entertainment industry has been adversely affected by Section 409A. Movie studios often enter into agreements with actors, directors, producers and writers whereby the talent provides services in one year with a right under the agreement to receive compensation in a later year, upon the occurrence of one or more events (e.g., a film achieving a specified level of box office receipts). Arrangements like these may be considered deferred compensation plans, potentially covered under Section 409A. As a practical matter, it is common for parties in the entertainment industry to restructure the compensation under a prior contract in connection with the expansion of the original project or the addition of a new project. In some cases, studios accelerate the payment of original contracts as an incentive to obtain the actor's services on new projects. However, distributions under these types of contract modifications, may fall under Section 409A and be subject to an increase of the federal income tax rate by an additional 20%. Making things worse, California's automatic incorporation of the federal pension rules doubles the potential tax liability in Section 409A, by imposing an additional 20% penalty under California income tax law. The potential taxes, interest, and penalties may potentially exceed 100% of the total payments received. Therefore, as a way of mitigating losses, AB 1173 lowers the penalty tax rate under California tax law from 20% to AB 1173 Page 4 5%. 2)Proponents of this measure state: Under Section 409A, nonqualified deferred compensation ("NQDC"), which is very broadly defined, is taxed at the time services are performed or, if later, when the NQDC vests (i.e., when it is no longer subject to a substantial risk of forfeiture), unless taxpayers comply with the extensive and complicated requirements of Section 409A. In addition to immediate taxation of the NQDC, Section 409A imposes a 20% additional income tax penalty on the NQDC. Section 409A broadly applies to all classes of service providers, including all levels of employees, directors, teachers, actors, athletes, writers and musicians. The 20% penalty has to be paid by the worker, not the employer. Section 409A penalizes often unsophisticated workers who have little influence over the timing of payments and little ability to navigate complex tax rules. California incorporates the federal pension rules, and, therefore, imposes an identical 20% penalty tax, raising the aggregate penalty for violation of Section 409A to 40% (i.e., 20% Federal and 20% California) for California employees on top of the normal federal and state taxes and interest charges. Thus, for employees in California, the potential taxes, interest and penalties may exceed 100% of the total payments received. California's incorporation of the federal pension rules, adopted in 2002 (AB 1122), was never intended to raise revenue, but was intended to ensure that pension plans were not inadvertently disqualified for California purposes by this state's lack of conformity. Doubling the federal tax penalty on employees who have the least knowledge and ability to influence compliance is neither logical nor fair. No other state imposes such an onerous penalty for Section 409A violations. While the additional 20% federal penalty amounts to more than 50% of the top federal tax rate, the California 20% penalty tax amounts to 200% of the top California tax rate for residents other than millionaires. 3)Committee Staff Comments: a) Background : In 2004, in response to perceived deferred AB 1173 Page 5 compensation abuses by Enron executives, Congress enacted IRC Section 409A, which imposes a significant tax penalty (20%) on deferred compensation arrangements that do not meet the numerous technical requirements under Section 409A. [Gregg D. Polsky, Fixing Section 409A: Legislative and Administrative Options, 57 Vill. L. Rev. 635 (2012)]. Immediately after the demise of Enron, it became clear that several Enron executives had withdrawn substantial funds from Enron's NQDC plans in the months immediately preceding Enron's collapse. [Marla Aspinwall, California Doubling of 20% Federal Tax Increase Under IRC Section 409A, State Bar of California Taxation Section 2013 Sacramento Delegation (2013)]. The Joint Committee on Taxation was asked to prepare a report that would examine Enron's compensation arrangements, including the NQDC plans. According to the report, Enron executives deferred approximately $154 million in compensation from 1998 to 2001. Id. The plans allowed the executives to accelerate withdrawal of all or a portion of the participant's account balance at any time, subject to a "haircut" provision of 10% of the withdrawn funds. In the weeks immediately before Enron's bankruptcy filing, more than $53 million of early distributions were made to over 100 Enron executives. To many, this might have been viewed as top level executives getting away with huge sums of money just as the company was going under. However, under bankruptcy law, accelerated distributions were preferences that could be recaptured. (Polsky, Fixing Section 409A). As such, Enron's executives would have been better off had they simply elected to receive current compensation. The Joint Committee on Taxation report concluded that Enron's NQDC plan provisions, allowing for accelerated distributions, had blurred the lines between nonqualified deferred compensation plans and qualified plans. (Aspinwall, California Doubling of 20%). As a way of combating the perceived abuses, Congress enacted IRC Section 409A, which was immediately characterized as being highly technical, difficult to interpret, and associated with large penalties for failure. [Steve L. Gill and Gerald E. Whittenburg, Section 409A and Stock-Based Compensation: Avoiding Costly Errors, 16 Val. St.14 (2012)]. Unless these very technical requirements were met, any amounts deferred became immediately includable in AB 1173 Page 6 gross income and suffered a 20% tax rate penalty. b) Qualified Deferred Compensation Plans : Qualified deferred compensation plans are plans that comply with the Employment Retirement Income Security Act of 1974 (ERISA). ERISA imposes specific rules on qualified plans, including nondiscrimination requirements that prohibit an employer from providing disproportionate benefits to its employees, and limitations on the amount of contributions that can be made to the plan. These plans may, however, also provide a number of tax benefits: Employers may deduct contributions when they are made; employees may make tax-deferred contributions; earnings of the plan may be tax deferred until they are actually paid; and, distributions are generally eligible to be transferred to another qualified plan, thereby allowing further tax deferral. Qualified plans include IRC Section 401(k) plans, IRC Section 403(b) plans for public education employers, IRC Section 501(c)(3) plans for non-profit organizations and ministers, and IRC Section 457(b) plans for state and local government organizations. c) NQDC Plans : NQDC plans are not subject to ERISA, and differ from qualified plans in several ways. Under a NQDC plan, an employer is allowed to discriminate by only offering plans to its key employees like senior management. The employer contributions are not limited but the employers may not deduct plan contributions until they are paid. In general, an employee may decide to defer compensation if the tax benefits from deferred compensation outweigh the non-tax costs (i.e., losing the liquidity of the cash had the amount been immediately received and putting future compensation at risk of insolvency). (Polsky, Fixing Section 409A). However, in order to accomplish the deferral of taxation, taxpayers had to address the doctrines of constructive receipt and economic benefit. The constructive receipt doctrine provides that taxpayers are deemed to be in receipt of an item of income before they actually receive the item. This occurs when income is made available to the taxpayer without substantial restriction or limitation. The economic benefit doctrine requires that taxpayer providing the service remain a general unsecured creditor. In other words, the future AB 1173 Page 7 payments must be "unfunded." One of the major abuses found in the Enron scandal was the provision that allowed Enron executives to take an early distribution of payments so long as they forfeited 10% of the funds. The 10% forfeiture was considered to be enough of a restriction to satisfy the constructive receipt doctrine. d) California's Conformity : AB 1122 (Corbett), Chapter 35, Statutes of 2002, conformed California to several provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 relating to pension and retirement accounts. Specifically, California has conformed to Subchapter D of Chapter 1 of Subtitle A of the IRC, which contains IRC Sections 401 through 420. When Congress enacted Section 409A as part of the American Jobs Creation Act of 2004, California automatically conformed to those provisions. In doing so, California imposed its own 20% penalty, without legislative approval, on amounts deferred under a NQDC plan not meeting specified requirements. e) IRC Section 409A : Section 409A requires that the timing of NQDC payments be established in advance of when services are performed, within strict limitations, and prohibits any acceleration or change in the timing of payments by either the employee or the employer, except under very limited circumstances. Distributions are allowed upon the separation from service, death, a specified time (or pursuant to a fixed schedule), a change in control of a corporation, an occurrence of an unforeseeable emergency, or if the participant becomes disabled. Additionally, the election to defer compensation must be made by the close of the taxable year preceding the year in which the services are performed. So long as these requirements are met, deferred compensation will not be subject to immediate taxation with increased tax rate penalties. f) 20% Tax Rate Penalty is Too High : Existing federal tax law imposes a 10% withdrawal penalty on early distributions made from certain qualified deferred compensation plans. California imposes a similar penalty but at the rate of 2 % of the amount includible in income on early withdrawals from those plans, which is roughly 25% of the federal AB 1173 Page 8 penalty. In order to be in line with current penalty practices, California should reduce its tax rate penalty under IRC Section 409A from 20% to 5%. g) Problems with IRC Section 409A : IRC Section 409A introduced an enormous amount of complexity into the law, which makes compliance extremely costly. Additionally, Section 409A is broad in its application, and may even apply to circumstances not traditionally thought of as deferred compensation arrangements. Treasury Regulation Section 1.409A-1(c)(1), defines "plan" as including any agreement, method, program, or other arrangement that may be adopted unilaterally by the service recipient or negotiated between the service recipient and one or more service providers. As an example, a small business owner may promise to give a loyal employee a share of the sales proceeds if and when he/she sells his/her business. This may be considered a violation of IRC Section 409A because the eventual payment date is not a permissible distribution date or event date. (Polsky, Fixing Section 409A). Additionally, a simple bonus declared in 2008 and paid after March 15, 2009, could trigger the 409A penalties. The accidental trigger of Section 409A has also been found in equity-based compensation, such as unqualified stock options, but may potentially apply to all forms of compensation agreements. Id. For example, Section 409A may apply to employment and service contracts, royalties, commission, and participation arrangements. (Aspinwall, California Doubling of 20%). REGISTERED SUPPORT / OPPOSITION : Support Agriculatural Council The American Council of Life Insurers The Association for Advanced Life Underwriting The Association of California Life and Health Insurance Companies benefitRFT, Inc. California Chamber of Commerce California Employment Law Counsel California Taxpayers Association Del Taco Dreyer, Edmonds & Robbins AB 1173 Page 9 Executive Compensation Solutions Loeb & Loeb, LLP LTC Performance Strategies, Inc. Mahoney & Associates Meyer-Chatfield Corp. Mezrah Consulting Mullin Barens Sanford Financial & Insurance Services Munger, Tolles & Olson LLP National Association of Insurance and Finance Advisors of California National Federation of Independent Business Paul Hastings LLP Rex Halverson & Associates, LLC Robin M. Schachter, Akin Gump Strauss Hauer and Feld LLP Skadden, Arps, Slate, Meagher & Flom LLP Spidell Publishing, Inc. Summit Alliance Executive Benefits, LLC Sunkist Growers Inc. Windes & McClaughry Accountancy Corporation Opposition None Analysis Prepared by : Carlos Anguiano / REV. & TAX. / (916) 319-2098