On October 4, 2013, Governor Brown signed into law AB 1173, a Bill which reduces the California tax penalty on non-compliant Section 409A payments from 20% to 5% for tax years beginning on or after January 1, 2013.
Section 409A of the Internal Revenue Code covers deferred compensation arrangements where the right to compensation arises in one year, but payment is not made until a later year. This can capture severance agreements, stock options, and many forms of equity compensation such as restricted stock units. If the deferred compensation arrangement does not comply with the stringent requirements of Section 409A, the taxpayer may need to recognize the income before any compensation is actually received and, in addition to regular income tax, will be charged a 20% tax penalty at the Federal level.
Section 17501 of California’s Revenue and Tax Code incorporates Section 409A and levies an additional California tax penalty. Prior to AB 1173, the California tax penalty was also 20%, however the new legislation has reduced the rate to 5%.
The new Bill reduces the overall tax penalty on some deferred payment arrangements from 40% to 25%, however it should be remembered that this penalty is in addition to regular income tax and tax may be due before any compensation has been received by the taxpayer. Therefore, taxpayers are usually still better off complying with Section 409A and avoiding the penalties altogether where possible.