BILL ANALYSIS SB 455 Page 1 Date of Hearing: July 14, 1997 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Louis Caldera, Chair SB 455 (Alpert) - As Amended: July 10, 1997 Majority vote required. Fiscal Committee. SENATE FLOOR VOTE 38-0 SENATE REVENUE AND TAXATION8-0 SUBJECT : Income taxes; conformity. As amended, conforms California income tax laws to selected counterpart provisions of the federal Internal Revenue Code added to federal law between January 1, 1993 through January 1, 1997. SUMMARY : Specifically, this bill as amended: 1) Conforms to selected counterpart provisions of the federal Internal Revenue Code (IRC) described under Comments 1/1A/1B/1C/1D/1E, below. EXISTING LAW : Existing law [R&T Code Section 17024.5(a)(1)(J)] provides that the federal Internal Revenue Code in effect January 1, 1993 governs parallel provisions in the Personal Income Tax (PIT) and Bank & Corporation Tax (B&CT) Laws, unless differences from the federal Internal Revenue Code are specified. Thus, many federal Internal Revenue Code changes made in 1993, 1994, 1995 and 1996 do not now apply under California's two income tax laws. FISCAL EFFECT : Based on Franchise Tax Board (FTB) Economic & Statistical Research Bureau estimates for specific proposals, the following fiscal year revenue losses or gains are projected by the FTB: FY 1997-1998 1998-1999 1999-2000 1) Spreadsheet $10 m. loss $ 3 m. loss $23 m. loss 2) CIAC $ 2.5 m. loss $ 2.5 m. loss $ 2.5 m. loss TOTAL: $12.5 m. loss $ 5.5 m. loss $ 25.5 m. loss 1) The revenue loss/gain estimates for the various provisions in this bill are included in the attached FTB spreadsheet ["SB 455 (Alpert)], except for "CIAC." 2) The revenue loss estimate for the "CIAC" provision (discussed under Comment 1E(viii), below) is contained in the attached May 12 FTB memo ("CIAC Conformity Estimates - Effective Date Issue"). COMMENTS : SB 455 Page 2 1) The provisions in this bill conform California income tax law to the federal IRC in the following areas: 1A) Small Business Job Protection Act of 1996 ("SBJPA") : (i) Estimated penalty relief : SBJPA and this bill include provisions waiving penalties for underpayment of estimated taxes where, at the time the estimated payment was made, the payment was sufficient under the law that existed at the time, prior to the conformity with federal provisions. (ii) Small business expensing : SBJPA and this bill for Personal Income Tax (PIT) Law filers only , increase the amounts small businesses may immediately deduct in a year from the existing law amounts of $12,500 in 1997/$15,000 in 1998 to: 1997 -- $18,000 1998 -- $18,500 1999 -- $19,000 2000 -- $20,000 2001 -- $24,000 2002 -- $25,000 Note: This bill does not extend this federal conformity for small business expensing to B&CT Law filers . (iii) Storage of product samples : Treats home storage of product samples as eligible for the existing federal/California law deductions for business use of the taxpayer's home. (iv) Dues paid to agricultural/horticultural organizations : if annual membership dues to a tax-exempt agricultural/horticultural organization do not exceed $100, then no portion of the dues will be treated as "unrelated business income." (v) Fish purchasers for resale must report cash over $600 : Persons who buy fish for resale from a person in the business of fishing must submit information returns to the federal Internal Revenue Service (IRS) and under this bill, the FTB. (vi) Involuntary conversions in disasters : Business owners who are forced by a presidentially declared disaster to change businesses no longer have the conversion treated as a "taxable event", meaning that any gain must be recognized; under this bill, the conversion due to a declared disaster only would be treated as a continuation of the pre-disaster business. (vii) Adjusted basis on involuntarily converted property : When property is involuntarily converted (e.g., an insured business is destroyed by fire), and SB 455 Page 3 the taxpayer replaces the destroyed property by purchasing stock in a business, instead of acquiring the replacement property outright, the taxpayer is deemed, for tax purposes, to have purchased the stock at the same price that he purchased the destroyed but insured business. (viii) Gas station depreciation : All gas stations get 15-year depreciation, regardless of whether food/convenience items are sold at the station; prior IRS practice gave 15-year treatment only if 50% of both sales and square footage were gas-related. [The California Independent Oil Marketers Association (CIOMA) supports this bill because of this provision]. (ix) Abandoned lessee improvements : Lessor who disposes of improvement made by lessor for the lessee gets the adjusted basis of the improvement in determining the gain if the improvement is abandoned at the end of the lease . (NOTE: Identical to AB 1155 (Shelley) (passed by the Assembly 77-0 and now pending in the Senate). (x) Employee housing at medical centers : Excludes from income housing provided to employees at medical centers; similar to existing law income exclusion for university employee housing. (xi) Lump sum distributions from pension plans : Effective 1999, repeals ability to average over 5 year period. (xii) Death benefit exclusion : Repeals exclusion-from-income treatment for employer-provided death benefits. (xiii) Pension plan provisions : conforms to federal SBJPA methods of taxing annuity distributions; states that persons aged 70.5 who are not retired are not required to take distributions from pension plans (IRA distributions remain mandatory); conforms to federal definition of "highly compensated employee" used to determine whether plans discriminate in favor of highly paid employees; modifies participation requirements so that only 2 employees need participate; allows nondiscrimination test to be made on the basis of prior-year, rather than current-year, deferrals made by non-highly-compensated employees; changes definition of "compensation" to include deferrals made to 401(k), 457 or cafeteria plans; eliminates special aggregation rules for retirement plans maintained by self-employed individuals; expands the definition of "rural electric cooperative" to include public utility district; allows rural co-op retirement plans to permit distributions after age 59.5 or on account of hardship; modifies limits on contributions and benefits in defined benefit plans administered by governments; allows SB 455 Page 4 continued employer contributions on behalf of disabled employees as long as such contributions are available for all employees, regardless of compensation; indexes in $500 increments the dollar limit on contributions to "457" plans maintained by governments and tax-exempt organizations; corrects interest rate and actuarial assumptions used in adjusting benefits and retirement limitations that were originally contained in federal General Agreement on Tariffs & Trade (GATT) legislation; salary reduction agreements for 403(b) plans given the same compensation limit rules as 401(k) plans; allows participant and participant's spouse to waive the 30-day minimum waiting period for distributions; repeals overall limit on contributions for persons who simultaneously participate in "defined benefit" and "defined contribution" plans; clarifies that "457" plan length-of-service requirements do not apply to length-of-service awards to volunteer firefighters; makes technical changes to nondiscrimination rules used in certain pension plans; makes technical changes regarding pension plans administered by churches; permits self-employed ministers to set up a qualified church pension plan. (xiv) Savings Incentive Match Plans for Employees (SIMPLE) : conforms to federal law allowing employers with 100 or fewer employees to set up SIMPLE retirement programs, in which employers must match employee contributions; employees may contribute up to $6000, and employers can match up to 3% of salary, or as little as 1% in any 2 of 5 years, or 2% each year. (xv) Tax-exempt organizations can offer 401(k) savings plans : they couldn't under prior federal law; this change conforms California law to the federal SBJPA which allows them to do so. (xvi) Requires that "457" retirement plans maintained by governments must be held in trust for exclusive benefit of employees . (xvii) Modifies the "income forecast" depreciation method , which is the method generally applicable to motion pictures, books, patents, sound recordings and video games, by: (i) including all income estimated to be generated by the property; (ii) allowing costs incurred more than 10 years after the property is placed in service to be written off in the year incurred; and (iii) requiring that in the third year after the depreciated property is placed in service (i.e., after the movie is released), the claimed depreciation is compared with the depreciation that would have been claimed had the actual income been known at the beginning. (xviii) Clarifies that punitive damage awards are included in income . (xix) Repeals partial exclusion from income for subsidies provided by a utility for installing energy conservation SB 455 Page 5 measures in nonresidential structures . California's income exclusion for residential structure energy conservation measures expired January 1, 1995, and has not been renewed. AB 873 (Takasugi) (now a 2-year bill) attempts to address these and related issues. (xx) Financial Asset Securitization In v estment Trusts . Known as "FASITs", these entities facilitate the securitization of credit card receivables, auto loans, and home equity loans. As a flow-through entity, all income or losses to the FASIT pass through to the owner. Because the FASIT device accelerates the recognition of income, it results in FTB-estimated revenue gains of $3 million in FY 1997-1998; $2 million in FY 1998-1999; and $500,000 in 1999-2000. However, FTB projects losses which would "approximate $1 million by 2005-06, and increase roughly an additional $200,000 each year thereafter." (xxi) Conversion of common trust funds to Regulated Investment Companies (RICs). Allows bank common trust funds to be converted to mutual funds (Regulated Investment Companies) without a gain or loss being recognized by either entity. Common trust funds and RICs are similar in that both are pass-through entities where income and losses are passed through to the shareholders. [The California Bankers Association supports this bill because of the provisions described in (xx) and (xxi) above]. (xxii) Adoption assistance : excludes from income up to $5000 per year in employer-provided adoption assistance, or up to $6000 in employer-provided adoption assistance for the adoption of a special needs child. (NOTE: depending upon the taxpayer's bracket, this is the equivalent of a $750-$2400 federal tax credit, or at the 9.3% California PIT rate, a $450-$550 state tax credit.) 1B) Health Insurance Portability and Accountability Act of 1996 ("HIPAA") (i) Excludes self-insurance payments for personal injury or sickness from taxable income : thus, self-insured get the same income exclusion available to persons who buy insurance and receive payouts. (ii) Long-term care insurance is added to the category of insurance which qualifies for the existing law 25% deduction available to the self-employed. (iii) Excludes from taxable income long-term care insurance benefits . (iv) Imposes information reporting requirements on companies paying long-term care benefits . SB 455 Page 6 (v) Allows penalty-free IRA withdrawals for medical expenses or for insurance that exceed 7.5% of Adjusted Gross Income (AGI) by individuals unemployed for 12 weeks or more. 1C) Revenue Reconciliation Act of 1993 (President Clinton's Deficit Reduction Legislation) . (i) Purchases of Specialized Small Business Investment Company (SSBIC) securities . Allows individuals and "C corporations" to "roll over" any capital gains generated from the sale of publicly traded stock if the proceeds of the sale are used to purchase stock in a SSBIC within 30 days of the stock sale . (ii) Real estate investment by pension funds is permitted to a greater extent than under previous federal/California law. (iii) Substantiation requirements for charitable donations : conforms to federal law, and provides that California law is satisfied if the federal requirement is met. (iv) Provisions to prevent conversion of ordinary income into capital gains : The 1993 federal law made five changes which treat as ordinary income the income which results from transactions designed to move otherwise ordinary income (taxed at 40% in the highest federal bracket) to capital gain income (taxed at a maximum rate of 28% under federal law). These transactions are known as conversion transactions, market discount transactions, stripped preferred stock, investment interest transactions, and partnership inventory transactions. (v) Estimated tax penalties for high income individuals : requires penalties if estimated tax payments do not equal at least 110% of prior year tax liabilities, if taxpayer has income of $150,000 per year or more. (vi) Accuracy-related penalties : permits existing law penalties for substantial misstatement of income items by large taxpayers to be avoided only where there is a "reasonable basis" for the taxpayer to have taken the position. Also, reduces from $10 million to $5 million the threshold for application of the "substantial valuation misstatement" penalty relating to transfer pricing adjustments. 1D) General Agreement on Tariffs & Trade Act of 1994 : (i) Excess pension assets can be used for retiree health benefits without subjecting the employer to tax. (ii) Rounding rules for cost of living allowances in pension plans; indexes benefits/additions in $5000 increments, and limits on elective deferrals in $500 increments. SB 455 Page 7 (iii) Partnership distributions of securities : when partnership distributes marketable securities to a partner, the partner is taxed on the amount represented by the fair market value of the security on the date of the distribution, plus any money received, minus the partner's basis in the partnership interest. (iv) Substantial understatement penalty : for corporate taxpayers with "tax shelter items", penalties for "substantial understatement" will apply unless the taxpayer demonstrates reasonable cause for the understatement and good faith. (v) Pension plan funding : incorporates federal law changes regarding funding levels required of defined benefit pension plans. 1E) Other Conformity Issues In This Bill : (i) Amortization of child care facilities : repeals existing California law permitting five-year amortization (write-off) of certain child care facilities; parallel federal law provision repealed in 1981. (ii) Deferral of deposits for ship building : is eligible for vote off the Suspense File May 19, 199: conforms to federal law deferral of tax on deposits into/interest earned by capital construction funds earmarked for merchant marine and commercial fishing vessel construction. (iii) Exempt Polish bonds from Original Issue Discount (OID) treatment : federal law provides special treatment of interest from bonds with below-market interest rates issued by Israel and Poland. Existing California law conforms with the treatment for Israeli bonds, but not with Polish bonds. This bill/SB 455 would conform with federal treatment of interest from Polish bonds. (iv) Political convention program advertising denied deduction : conforms with existing federal law, which disallows a business expense deduction for advertising which appears in political convention programs and similar publications. (v) Seven-year amortization of forest land improvements : Maximum $10,000 in forest land improvements may be written off over seven years; existing California law has no dollar cap and allows a five year write off. (vi) Required filing of federal information return by officers of controlled foreign corporations : Officers, directors and certain major shareholders of foreign personal holding companies would be required to file a copy of the federal Form 5471 information return. (vii) 100% corporate estimated payments starting in 1998 : SB 455 Page 8 1993 federal law required corporations to make estimated payments based on 100% of the current year's tax. Last year's SB 38 (Lockyer) conformed to this requirement, but only in 1999, and allowed 1998 estimated payments to be based on 98% of current year's tax. This bill would accelerate the 100% estimated payment requirement by one year, from 1999 to 1998; to put it another way, corporate taxpayers in 1998 will have pay 2% more "up front." (viii) Eliminating the tax on contributions in aid of construction for water utilities; provision is sponsored by the California Water Association (CWA). The federal SBJPA repealed 1986 federal law which included contributions in aid of construction (CIAC) in the gross income of water utilities; before 1986, CIAC had been treated as a contribution to capital rather than as taxable income under federal law. California law prior to a 1991 FTB ruling treated CIAC as a contribution to capital; the 1991 FTB ruling held that CIAC were income, and should be treated as income retroactively to 1977. AB 1757 (Klehs) (Statutes of 1991, Chapter 604) provided that CIAC should be treated as income only prospectively. This bill as amended would treat CIAC as contributions to capital, and not as taxable income . Water utilities are highly capital intensive. Historically, both privately-owned and publicly-owned water utilities have received capital for new construction directly from new customers (sometimes real estate developers), in order to protect existing customers from rate increases; this transfer of property is known as a CIAC. The California Public Utilities Commission (CPUC) requires water utilities to collect the taxed portion of CIAC from the developers/new customers; thus, this bill as amended will relieve water customers from the burden of paying this tax . As indicated above, CIAC is no longer taxed under federal law. This bill as amended will eliminate the need for water companies to record CIAC under two different tax systems. 2) The following provisions in AB 1044 (Revenue & Taxation Committee), as passed by the Assembly Committee on Revenue & Taxation May 19, 1997, are not in this bill : A) immediate deductibility of expensing for incorporated small businesses under the Bank & Corporation Tax (B&CT) Law; B) conformity for calendar year 1995 only regarding sales of stock to employee stock ownership plans or worker-owned cooperatives; and, C) denying deductions for club dues, and/or executive compensation in excess of $1,000,000 per year. These provisions are explained in greater detail under Comments 2A/2B/2C, below. These provisions -- and the SB 455 Page 9 provisions that are parallel to this bill's provisions -- were removed by the Assembly Committee on Appropriations, and intent language was substituted. In intent language form, AB 1044 passed the Assembly 47-24. AB 1044 has been amended in the Senate to include all provisions removed by Assembly Appropriations, technical amendments suggested by FTB, and the R&D credit conformity provisions from AB 1499 (Caldera). 2A) Immediate deductibility for equipment purchases made by small businesses extended to B&CT Law filers . This bill permits Personal Income Tax law filers only to immediately deduct from taxable income the amounts set forth in the federal SBJPA. AB 1044 includes not only this bill's provisions, but also extends them to B&CT Law filers . Thus, under AB 1044 -- but not this bill -- all small businesses (incorporated, unincorporated, subchapter S, limited liability companies) will be able to immediately deduct the federal law equipment purchase amounts on both federal and California returns , as follows: 1998 -- $18,500; 1999 -- $19,000; 2000 -- $20,000; 2001 -- $24,000; 2003 -- $25,000. NOTE: Immediate deductibility is more favorable to the taxpayer than any depreciation schedule, because the taxpayer can deduct the entire amount of the qualifying purchase all at once. FTB projects the following revenue losses: FY 1997-1998: $30 million FY 1998-1999: $20 million FY 1999-2000: $15 million See FTB E&SRB Memo of January 31, 1997 to Committee staff ("Bank & Corporation Tax"). 2B) Treatment of sales of stock to Employee Stock Ownership Plans (ESOPs) and worker-owned cooperatives . This provision is sponsored by The Wornick Company and is supported by The ESOP Association of America. ESOPs and worker-owned cooperatives allow employees to become partial, or in some cases, full, owners of the company which is their employer. ESOPs specifically allow employees as a group to voluntarily invest in the corporate stock of their employer as part of their retirement plan; the company's earnings are used to buy the ESOP stock for the employees commensurate with their compensation. The ESOP concept was developed by University of California economist Louis Kelso, who along with associate Ron Ludwig started a seedbed of ESOP industries in San Francisco; the concept later spread nationwide. Existing federal law (IRC sections 1042 and 404(k))) gives tax incentives for ESOP formation, by allowing: (i) employers to SB 455 Page 10 deduct from taxable income dividends paid to the ESOP or cooperative; and, (ii) for closely held, non-public companies, employers to sell stock to the ESOP or cooperative without recognition of gain if the ESOP or cooperative immediately reinvests the proceeds of the sale in other corporate stock. As part of SB 38 (Lockyer/Pringle) (Statutes of 1996, Chapter 954; Revenue & Taxation (R&T) Code sections 18042/24611), California conformed to these provisions, effective January 1, 1996. Prior (1988) legislation conformed to these provisions effective January 1, 1990, but ending December 31, 1994. Thus, for calendar year 1995 only, California does not conform to federal law tax treatment of ESOPs . This provision would so conform. By enacting SB 38 and its 1988 predecessor, the Legislature has already given its seal of approval to ESOPs. The 1988 legislation conformed on a sunset basis through the end of 1994. In 1996, California again conformed, but the SB 38 language making the re-enactment of conformity effective January 1, 1996 left ESOPs formed in 1995 out of conformity for one anomalous year. This occurred only because SB 979 (Solis) did not pass the Assembly Appropriations Committee in August 1996; instead, the provisions of SB 979, without the January 1, 1995 effective date, were included in SB 38 . See Chris Micheli and James Clark, "California Conforms Again on ESOPs -- But Not For '95", State Tax Notes , October 21, 1996, at 1155-1156. FTB estimates a one-time $4 million revenue loss from this provision in FY 1997-1998, and zero losses thereafter. FTB E&SRB Memo of May 27, 1997 to Committee staff. 2C) Denial of deductions for club dues, and executive compensation in excess of $1 million . These provisions are identical to AB 1291 (Strom-Martin), as introduced. AB 1044 conforms California income tax laws (PIT & B&CT Laws) to the federal Revenue Reconciliation Act of 1993 (Public Law 103-66) ("RRA"), by denying taxpayers business expense deductions for: (i) club dues; and (ii) in the case of a publicly held corporation, employee pay in excess of $1 million to the Chief Executive Officer (CEO) or the next four highest compensated officers, if their salaries are required by federal securities law to be reported to shareholders. Existing California law does not conform to either federal RRA provision , meaning that: (i) employee pay in any amount is fully deductible; and (ii) club dues are deductible if the taxpayer proves that the dues are "directly related" to the conduct of the taxpayer's business; and (ii) the club does not restrict membership on the basis of race, color, religion, ancestry, national origin, sex or age. FTB projects the following revenue gains from these provisions: Clubs $ 12 m. GAIN $ 8 m. Gain $ 8 m. GAIN SB 455 Page 11 Ex Pay $ 4 m. GAIN $ 4 m. Gain $ 5 m. GAIN TOTAL GAIN: $ 16 m. $12 m. $13 m. See FTB Bill Analysis of AB 1291 (Strom-Martin) as introduced. AB 1291, as amended, passed the Assembly 41-37, and is now pending in the Senate. AB 1291 as amended denies all deductions for executive compensation in excess of $1 million, and any deduction for club dues in excess of $500 per year . 3) When AB 1291 was heard before the Assembly Committee on Revenue & Taxation, opponent California Chamber of Commerce stated in its March 25, 1997 letter to the Committee: "[W]hen there are conformity provisions which increase taxes . . . we believe that they should be used to offset tax cuts from conformity" and that "[the California Chamber of Commerce] believe[s] that California should conform to federal tax laws as much as possible to ease the burden of compliance with two different tax systems." Proponent California Tax Reform Association, it is April 3, 1997 support letter, stated: "We support [AB 1291], which would provide for federal conformity on important pieces of the 1993 [federal] tax act . . . We hope that [AB 1291] becomes part of a counterbalancing federal conformity effort, and we have referenced it with regard to all of the other federal conformity bills which provide for tax losses." AB 1044 arguably supports the positions stated by both the California Chamber of Commerce and the California Tax Reform Association, with respect to AB 1291. 4) AB 1044 as amended June 25, 1997 also includes the Research & Development credit conformity provisions from AB 1499 (Caldera), which passed the Assembly Committee on Revenue & Taxation 10-0 and is now held in suspense at the Assembly Committee on Appropriations. 5) AB 1044 will be heard by the Senate Committee on Revenue & Taxation July 16, 1997. 6) Spidell Publishing, a major publisher of California tax publications, supports this bill (SB 455), stating: "Conformity to federal law simplifies tax return preparation, and allows tax professionals to become proficient at one set of rules. With the lack of a major conformity bill for the past several years, California's tax laws have become increasingly difficult to understand. With this lack of understanding comes an increase in taxpayer noncompliance. This, in turn, results in increased governmental costs associated with tax audits and collections . . . ." The California Society of Enrolled Agents expressed similar sentiments. 6A) The Franchise Tax Board members have voted to support this bill. SB 455 Page 12 6B) The California Taxpayers Association (Cal-Tax) supports this bill, believing that it "is a fair and balanced approach to the conformity problem, bringing the state into closer conformity with federal law, and avoiding divisive issues that could derail the bill." In contrast, Cal-Tax opposes AB 1044, solely because of the "club dues" and "executive pay" provisions discussed in Comments 2C/3 above; see May 22, 1997 Cal-Tax letter to Committee opposing AB 1044. 6C) This bill is supported by the California Chamber of Commerce. 6D) This bill is also supported by Childress Auto Repair, Sacramento CA. Childress wrote the Senate Revenue & Taxation Committee as follows: "We've Been Waiting Twenty-One Years For This ! . . . [this bill] contains a conformity provision for the new federal SIMPLE . . . matching [pension] plan which gives incentive to the employees to share in the responsibility of their own retirement . . . This was such a great opportunity for our employees we immediately implemented the plan. If California does not conform effective January 1, 1997 we will have a slight bookkeeping nightmare. (Emphasis included)." The Assembly Committee on Revenue & Taxation staff has received telephone calls expressing similar sentiments with specific reference to SIMPLE conformity [see Comment 1A(xiv), above] from small business owners referred by Assemblymembers Wally Knox, Sheila Kuehl, and Bernie Richter. 6E) The CIAC provision [discussed in Comment 1E(viii), above] is supported by the California Water Association. 6F) The Department of Finance position on this bill is "neutral, note concerns." Support Franchise Tax Board California Chamber of Commerce Spidell Publishing California Society of Enrolled Agents California Taxpayers Association (Cal-Tax) Childress Auto Repair, Sacramento, CA California Water Association California Association of Life Underwriters (CALU) California Water Association California Independent Oil Marketers Assn. (CIOMA) California Bankers Assn. Neutral, note concerns : Department of Finance Opposition None on file (as of 5:00 p.m., Monday, July 7, 1997). SB 455 Page 13 Analysis prepared by : Steven M. Kamp / arevtax / (916) 322-3730