BILL ANALYSIS                                                                                                                                                                                                    Ó



                                                                  AB 1173
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          ASSEMBLY THIRD READING
          AB 1173 (Bocanegra)
          As Amended  March 21, 2013
          Majority vote.  Tax levy 

           REVENUE & TAXATION  9-0         APPROPRIATIONS      17-0        
           
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          |Ayes:|Bocanegra, Dahle, Gordon, |Ayes:|Gatto, Harkey, Bigelow,   |
          |     |Harkey, Mullin, Nestande, |     |Bocanegra, Bradford, Ian  |
          |     |Pan,                      |     |Calderon, Campos,         |
          |     |V. Manuel Pérez, Ting     |     |Donnelly, Eggman, Gomez,  |
          |     |                          |     |Hall, Ammiano, Linder,    |
          |     |                          |     |Pan, Quirk, Wagner, Weber |
          |-----+--------------------------+-----+--------------------------|
          |     |                          |     |                          |
           ----------------------------------------------------------------- 
           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.

           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 subject to Internal Revenue Code Section 409A  
               (Section 409A).  A nonqualified deferred compensation  
               plan refers to compensation that a worker earns in one  








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               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  








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               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  








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               top California tax rate for residents other than  
               millionaires.  


          3)Assembly Revenue and Taxation Committee staff comments:

              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  








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               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  
               gross income and suffered a 20% tax rate penalty.

              b)   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.

              c)   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.

              d)   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%. 

              e)   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%).  

           
          Analysis Prepared by  :  Carlos Anguiano / REV. & TAX. / (916)  
          319-2098 


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