BILL ANALYSIS Ó
AB 1173
Page 1
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 |
|-----+--------------------------+-----+--------------------------|
| | | | |
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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
FN: 0000752