BILL ANALYSIS Ó
AB 1173
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Date of Hearing: May 13, 2013
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Raul Bocanegra, Chair
AB 1173 (Bocanegra) - As Amended: March 21, 2013
SUSPENSE
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)].
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c) Subject to exceptions, the election to defer
compensation must be made by the close of the taxable year
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:
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AB 1173 lowers the potential tax penalty rate from 20% to
5% for nonqualified deferred compensation plans that are
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.
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Therefore, as a way of mitigating losses, AB 1173 lowers
the penalty tax rate under California tax law from 20% to
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:
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a) Background : In 2004, in response to perceived deferred
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
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(2012)]. Unless these very technical requirements were
met, any amounts deferred became immediately includable in
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
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requires that taxpayer providing the service remain a
general unsecured creditor. In other words, the future
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
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% of the amount includible in income on early withdrawals
from those plans, which is roughly 25% of the federal
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
Agricultural 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 Society of CPAs
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California Taxpayers Association
CBS Corporation
Del Taco
Dreyer, Edmonds & Robbins
Executive Compensation Solutions
Loeb & Loeb, LLP
LTC Performance Strategies, Inc.
Mahoney & Associates
Meyer-Chatfield Corp.
Mezrah Consulting
Motion Picture Association of America, Inc.
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