BILL ANALYSIS                                                                                                                                                                                                    




                     SENATE GOVERNANCE & FINANCE COMMITTEE
                            Senator Lois Wolk, Chair
          

          BILL NO:  AB 1173                     HEARING:  8/14/13
          AUTHOR:  Bocanegra                    FISCAL:  Yes
          VERSION:  3/21/13                     TAX LEVY:  Yes
          CONSULTANT:  Grinnell                 

           PERSONAL INCOME TAXES: NONQUALIFIED DEFERRED COMPENSATION  
                                     PLANS
          

              Reduces the penalty rate for California tax on NQDC  
                         distributions from 20% to 5%.


                           Background and Existing Law  

          California law does not automatically conform to changes to  
          federal tax law, except for specific retirement provisions  
          contained in Subchapter D of the Internal Revenue Code,  
          sometimes called the "400 series," which guides the tax  
          treatment of pensions and other retirement plans (AB 1122,  
          Corbett 2002/SB 219, Scott, 2002).  Instead, the  
          Legislature must affirmatively conform to federal changes  
          outside the 400 series, unlike other states that have  
          enacted laws that conform its law whenever Congress changes  
          the Internal Revenue Code.  Conformity legislation is  
          introduced either as individual tax bills to conform to  
          specific federal changes, like the Regulated Investment  
          Company Modernization Act (AB 1423, Perea, 2011), or as one  
          omnibus bill that provides that state law conforms to  
          federal law as of a specified date,  currently January 1,  
          2009 (SB 401, Wolk, 2010).  

          Non-Qualified Deferred Contribution Plans (NQDCs) are  
          deferred compensation arrangements that don't comply with  
          the Employment Retirement Income Security Act of 1974, and  
          generally allow employers to discriminate by only offering  
          plans to senior management and highly-compensated employees  
          and unlimited employer contributions, but disallow employer  
          deductions for contributions until distributions are paid.   
          In 2004, Congress added Section 409A to the Internal  
          Revenue Code to limit amounts deferred under NQDCs in  
          response to the Enron scandal, where executives enriched  
          themselves at the expense of the company and its creditors  
          by taking substantial withdrawals from NQDCs immediately  




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          before the firm declared bankruptcy.  The new federal law  
          prohibits any acceleration or change in NQDC payments, with  
          some exceptions.  Any payments that violate the new federal  
          law become taxable income at a penalty rate 20% higher than  
          the taxpayer's applicable marginal rate.

          Because California law automatically conforms without  
          modification, the state applies the same 20% increase in  
          the marginal rate on NQDC distributions that run afoul of  
          the new federal law as a penalty, leading to a potential  
          combined federal and state tax that reaches almost 100% of  
          the income.  For example, a taxpayer in the top marginal  
          rate for federal purposes of 39.6% pays a federal tax of  
          59.6% of the NQDC distribution with the penalty rate, plus  
          a top state tax rate of 13.3% increased to 33.3%.   
          Additionally, because the penalty tax can apply on  
          distributions made in previous taxable years, but is due  
          and payable in the taxable year in which the IRS determines  
          a violation takes place, errors can be very costly.  As  
          many NQDC recipients may not be aware of the increased  
          state tax, tax practitioners want the tax reduced to  
          one-fourth of the federal increase, similar to the penalty  
          on early Individual Retirement Account (IRA) withdrawals.  


                                   Proposed Law  

          Assembly Bill 1173 reduces the penalty rate for California  
          tax on NQDC distributions that violate federal rules from  
          20% to 5%.


                               State Revenue Impact
           
          According to the Franchise Tax Board, AB 1173 results in  
          revenue losses of $4.7 million in 2013-14, $3.2 million in  
          2014-15, and $3.4 million in 2015-16.


                                     Comments  

          1.   Purpose of the bill  .  According to the author, "AB 1173  
          lowers the potential tax penalty rate from 20% to 5% for  
          nonqualified deferred compensation (NQDC) plans that are  
          subject to Internal Revenue Code Section 409A ("Section  
          409A").  A NQDC plan refers to compensation that a worker  





          AB 1173 - 3/21/13 -- Page 3



          earns in one year but that is not paid until a future year.  
           In general, Section 409A requires that the timing of these  
          payments be established in advance of when the services are  
          performed.  Due to the complicated and overbroad  
          application of Section 409A, tax payers may face an  
          additional 20% tax rate if NQDC payments do not meet  
          specified requirements under Section 409A.  Section 409A  
          was originally created after Enron executives accelerated  
          NQDC payments just as the company was going bankrupt.   It  
          was originally designed to go after top level executives.   
          However, Treasury regulations have interpreted Section 409A  
          broadly, applying the section beyond the executives that  
          the law was designed to go after.  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 contractual  
          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 compensations, 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.  
          AB 1173 will mitigate potential losses in employment  
          contracts and NQDC plans by lowering the penalty tax rate  
          from 20% to 5% under California law."

          2.   Crime and punishment  .  In response to executives  
          looting Enron of cash and assets that would have normally  
          been claimed by creditors in bankruptcy, Congress limited  
          the acceleration of NQDC distributions beyond the schedule  
          set in the employment contract.  Under the federal change,  





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          disallowed accelerated distributions triggered a hefty 20%  
          penalty, which is automatically applied to California tax  
          as a result of California's automatic conformity  
          provisions.  As the current state penalty is purely a  
          result of the mechanical nature of its law, taxpayers that  
          violate the law face a penalty well in excess of the  
          offense.  By resetting the rate to  of the federal amount,  
          the bill parallels similar treatment afforded to IRAs.


                                 Assembly Actions  

          Assembly Revenue and Taxation 9-0
          Assembly Appropriations            17-0
          Assembly Floor                78-0


                        Support and Opposition  (08/08/13)

           Support  :  Agricultural Counsel of California; American  
          Council of Life Insurers; Association for Advanced Life  
          Underwriting; Association of California Life, Health, and  
          Insurance Companies; BenefitRFP, Inc.; California Chamber  
          of Commerce; California Employment Law Counsel; California  
          Taxpayers Association; CBS Corporation; Del Taco LLC;  
          Dreyer, Edmonds, & Robbins; Executive Compensation  
          Solutions; Loeb & Loeb, LLP; LTC Performance Strategies,  
          Inc.; Mahoney and 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; 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  :  Unknown.