BILL ANALYSIS                                                                                                                                                                                                    



                                                                  AB 1173
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          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  








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               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  








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               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  








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               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  








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               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  








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               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  








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               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  








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               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
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          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