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
AB 1173 - 3/21/13 -- Page 2
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,
AB 1173 - 3/21/13 -- Page 4
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.