BILL ANALYSIS                                                                                                                                                                                                    Ó

                   Senate Appropriations Committee Fiscal Summary
                            Senator Kevin de León, Chair

          AB 1173 (Bocanegra) - Personal Income Tax: Nonqualified Deferred  
          Compensation Plan
          Amended: March 21, 2013         Policy Vote: G&F 7-0
          Urgency: No                     Mandate: No
          Hearing Date: August 19, 2013                           
          Consultant: Robert Ingenito     
          This bill meets the criteria for referral to the Suspense File.

          Bill Summary: AB 1173 would reduce the penalty rate for  
          California tax on nonqualified deferred compensation  
          distributions from 20 percent to 5 percent.  

          Fiscal Impact: The Franchise Tax Board (FTB) indicates that the  
          bill would result in a General Fund revenue loss of $4.7 million  
          in 2013-14, $3.2 million in 2014-15 and $3.4 million in 2015-16.  
          The bill would increase the department's costs (modifying tax  
          forms, instructions and information systems) by an unknown  

          Background: In general, a deferred compensation arrangement  
          allows an owner or an employee to set aside a portion of their  
          income to be paid out at a future date. These arrangements are  
          broken down into two basic categories, "qualified" and  
          "nonqualified" deferred compensation arrangements

          Qualified deferred compensation arrangements (also known as  
          "qualified 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.  
          However, qualified plans also provide certain tax benefits:  
          employers are allowed to 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 (for  


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          non-government organizations), 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).

          Nonqualified deferred compensation arrangements (NQDCs) are not  
          subject to ERISA, and differ from qualified plans in many ways.  
          Employers are allowed to discriminate by only offering plans to  
          its key employees (e.g., senior management and  
          highly-compensated employees), employer contributions are not  
          limited, and employers may not deduct plan contributions until  
          they 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 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 percentage points higher than the taxpayer's  
          applicable marginal rate.

          California law automatically conforms without modification;  
          consequently, the State applies the same 20 percentage point  
          increase in the marginal rate on NQDC distributions that violate  
          the new federal law as a penalty, leading to a potential  
          combined federal and state tax that approaches 100 percent of  
          the income.  

          For instance, a taxpayer paying the top federal marginal rate  
          (39.6 percent) pays a federal tax of 59.6 percent of the NQDC  
          distribution with the penalty rate, plus a top state marginal  
          tax rate of 13.3 percent increased to 33.3 percent, or a total  
          rate of 92.9 percent.  

          Proposed Law: This bill would reduce the penalty rate for  
          California tax on NQDC distributions that violate federal rules  
          from 20 percent to 5 percent.

          Staff Comments: Current federal tax law imposes a 10 percent  
          withdrawal penalty on early distributions made from certain  
          qualified deferred compensation plans such as 401(k) plans. The  


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          State imposes a similar penalty, but at a rate of 2.5 percent,  
          or 25 percent of the federal penalty. This bill's reducing the  
          penalty rate on NQDC distributions from 20 percent to 5 percent  
          would be in line with other current penalty practices.