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 30, 2013 Consultant: Robert Ingenito 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 amount. 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 AB 1173 (Bocanegra) Page 1 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 AB 1173 (Bocanegra) Page 2 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.