(1)The Personal Income Tax Law does not conform to specified provisions of federal law relating to the taxation of specified trusts. Existing law exempts from tax for the taxable year any charitable remainder annuity trust or charitable remainder unitrust, subject to specified requirements, including that the value of the charitable remainder interest must be at least 10% of the initial fair market value of all of the property placed in trust.

This bill would, for taxable years beginning charitable remainder annuity trusts formed on or after January 1, 2018, require that the charitable remainder interest must be at least 40% of the initial fair market value of all of the property placed in trust.

(2)The Personal Income Tax Law and Corporate Tax Law provide, in modified conformity with federal law, that for purposes of calculating the gain or loss upon the disposition of property, generally the basis of property acquired from a decedent is the fair market value at the date of death.

This bill would revise this provision with regard to decedents who died on or after January 1, 2018, to provide that no adjustment shall be allowed where the person who acquires the property has an adjusted gross income or net income over specified amounts.

(3)The Corporation Tax Law allows various deductions in computing the income that is subject to the taxes imposed by that law. That law, in modified conformity, applies provisions of the Internal Revenue Code relating to business or trade deductions. The Internal Revenue Code provides that a publicly held corporation may not deduct, as a trade or business expense, applicable employee remuneration, as defined, paid to the chief executive officer or other specified employees to the extent that the amount of that compensation exceeds $1,000,000 in the taxable year. The term applicable employee remuneration does not include any compensation payable solely on account of the chief executive officer based on commission or on meeting certain performance goals, thereby allowing a deduction for that compensation even if it exceeds $1,000,000.

This bill, for taxable years beginning January 1, 2017, 2018, would eliminate those deductions for compensation payable to the chief executive officer for based on commission or on meeting certain performance goals under the Corporation Tax Law, thereby no longer conforming to federal income tax law.

(4)This bill would include a change in state statute that would result in a taxpayer paying a higher tax within the meaning of Section 3 of Article XIIIA of the California Constitution, and thus would require for passage the approval of ²/₃ of the membership of each house of the Legislature.

This bill would take effect immediately as a tax levy.

(1)The Personal Income Tax Law does not conform to specified provisions of federal law relating to the taxation of specified trusts. Existing law exempts from tax for the taxable year any charitable remainder annuity trust or charitable remainder unitrust, subject to specified requirements, including that the value of the charitable remainder interest must be at least 10% of the initial fair market value of all of the property placed in trust.

This bill would, for taxable years beginning January 1, 2018, require that the charitable remainder interest must be at least 40% of the initial fair market value of all of the property placed in trust.

(2)The Personal Income Tax Law and Corporate Tax Law provide, in modified conformity with federal law, that for purposes of calculating the gain or loss upon the disposition of property, generally the basis of property acquired from a decedent is the fair market value at the date of death.

This bill would revise this provision with regard to decedents who died on or after January 1, 2018, to provide that no adjustment shall be allowed where the person who acquires the property has an adjusted gross income or net income over specified amounts.

(3)The Corporation Tax Law allows various deductions in computing the income that is subject to the taxes imposed by that law. That law, in modified conformity, applies provisions of the Internal Revenue Code relating to business or trade deductions. The Internal Revenue Code provides that a publicly held corporation may not deduct, as a trade or business expense, applicable employee remuneration, as defined, paid to the chief executive officer or other specified employees to the extent that the amount of that compensation exceeds $1,000,000 in the taxable year. The term applicable employee remuneration does not include any compensation payable solely on account of the chief executive officer based on commission or on meeting certain performance goals, thereby allowing a deduction for that compensation even if it exceeds $1,000,000.

This bill, for taxable years beginning January 1, 2017, would eliminate those deductions for compensation payable to the chief executive officer for based on commission or on meeting certain performance goals under the Corporation Tax Law, thereby no longer conforming to federal income tax law.

(4)This bill would include a change in state statute that would result in a taxpayer paying a higher tax within the meaning of Section 3 of Article XIIIA of the California Constitution, and thus would require for passage the approval of ²/₃ of the membership of each house of the Legislature.

This bill would take effect immediately as a tax levy.

(1)The Personal Income Tax Law does not conform to specified provisions of federal law relating to the taxation of specified trusts. Existing law exempts from tax for the taxable year any charitable remainder annuity trust or charitable remainder unitrust, subject to specified requirements, including that the value of the charitable remainder interest must be at least 10% of the initial fair market value of all of the property placed in trust.

This bill would, for taxable years beginning January 1, 2018, require that the charitable remainder interest must be at least 40% of the initial fair market value of all of the property placed in trust.

(2)The Personal Income Tax Law and Corporate Tax Law provide, in modified conformity with federal law, that for purposes of calculating the gain or loss upon the disposition of property, generally the basis of property acquired from a decedent is the fair market value at the date of death.

This bill would revise this provision with regard to decedents who died on or after January 1, 2018, to provide that no adjustment shall be allowed where the person who acquires the property has an adjusted gross income or net income over specified amounts.

(3)The Corporation Tax Law allows various deductions in computing the income that is subject to the taxes imposed by that law. That law, in modified conformity, applies provisions of the Internal Revenue Code relating to business or trade deductions. The Internal Revenue Code provides that a publicly held corporation may not deduct, as a trade or business expense, applicable employee remuneration, as defined, paid to the chief executive officer or other specified employees to the extent that the amount of that compensation exceeds $1,000,000 in the taxable year. The term applicable employee remuneration does not include any compensation payable solely on account of the chief executive officer based on commission or on meeting certain performance goals, thereby allowing a deduction for that compensation even if it exceeds $1,000,000.

This bill, for taxable years beginning January 1, 2017, would eliminate those deductions for compensation payable to the chief executive officer for based on commission or on meeting certain performance goals under the Corporation Tax Law, thereby no longer conforming to federal income tax law.

(4)The Corporation Tax Law allows corporations to elect whether their income is determined on a waters-edge basis or on a worldwide unitary basis.

This bill would remove the waters-edge election for taxable years beginning on or after January 1, 2017, and would specify that existing electors would be unable to elect to file using the waters-edge method for taxable years beginning on or after January 1, 2023.

(5)This bill would include a change in state statute that would result in a taxpayer paying a higher tax within the meaning of Section 3 of Article XIIIA of the California Constitution, and thus would require for passage the approval of ²/₃ of the membership of each house of the Legislature.

This bill would take effect immediately as a tax levy.

 THIRD READING  

Bill No: SB 567

Author:

:

Vote:

SENATE GOVERNANCE & FIN. COMMITTEE: 5-2, 5/17/17

AYES: McGuire, Beall, Hernandez, Hertzberg, Lara

NOES: Nguyen, Moorlach

SENATE APPROPRIATIONS COMMITTEE: Senate Rule 28.8

SUBJECT:

SOURCE: Author

DIGEST:

This bill decouples state tax law from federal law in three areas: basis step-up on inherited property, deductibility of executive pay, and charitable remainder trusts.

ANALYSIS:

Existing law:

1. Does not automatically conform to changes to federal tax law, except for specific retirement provisions. Instead, the Legislature must affirmatively conform to federal changes either as individual bills to conform to specific federal tax changes, or as one omnibus bill that provides that state law conforms to federal law as of a specified date, currently January 1, 2015 (AB 154, Ting, Chapter 359, Statutes of 2015).
2. Provides that all income, including wages, capital gains, dividends, and interest, is taxed at the same marginal rate according to the taxpayer’s taxable income.
3. Allows various income tax credits, deductions, and sales and use tax exemptions for taxpayers that incur certain expenses, such as child adoption, or to influence behavior, including business practices and decisions. Some tax expenditures conform to similar federal provisions, such as charitable deduction and income exclusion for employer provided health care, while others do not have a federal counterpart.
4. Provides, generally, in conformity with federal law, that a capital gain is realized and generally taxable at the time of sale of a capital asset, and is generally equal to the asset’s sales price minus its basis. Federal law, to which the state conforms, contains general rules for determining an asset’s basis, which is usually the taxpayer’s cost to acquire the asset, as well as specified exceptions from these general rules, such as:
   1. “Carryover basis,” where a taxpayer receiving a lifetime gift from another taxpayer assumes the same basis from the taxpayer making the gift.
   2. “Stepped-up basis on inherited property,” which provides that when an estate passes property to a decedent, the property’s basis is generally adjusted to equal its fair market value as of the date of the death.
5. Allows, generally, business taxpayers to deduct from income any ordinary and necessary business expenses, including wages and salaries paid to employees. Pay must be reasonable, provided in exchange for services performed, and can be disallowed to limit dividends paid disguised as deductible salary and wages.
6. Provides that federal law, to which the state conforms, caps deductible pay to $1 million per taxable year to “covered employees,” which includes chief executive officers (CEOs) or employees of publicly-traded corporations whose compensation must be reported as one of its four other highest compensated officers. The limit applied to all remuneration for services, regardless of when the income was earned, except for:
   1. Qualified commissions,
   2. Pre-existing binding contracts in effect as of February 17, 1993, and
   3. Other performance-based compensation, which includes remuneration based on the attainment of one or more performance goals, set by a compensation committee of the board of directors which must include at least two outside directors, who must certify that the performance goals were satisfied. Additionally, the material terms of the performance-based compensation must be disclosed to shareholders to be deductible.
7. Provides that federal law, to which the state conforms, allows for charitable remainder trusts (CRTs), which enable taxpayers to avoid taxes to the benefit of charities.
   1. To create a CRT, taxpayers make an irrevocable transfer of assets or cash to a trust formed on behalf of specified charitable beneficiaries.
   2. Allows taxpayers creating CRTs and any other designated beneficiaries to receive taxable income from the trust within certain limits for a specified period or until death, with any remainder transferred to the charity or charities named in the trust agreement.
   3. Requires the charitable remainder to exceed 10% of the assets’ value to qualify as a CRT.

This bill:

1. Repeals the state’s conformity to basis step-up on inherited property for taxpayers with more than $2 million (joint)/$1 million (single) in income in the taxable year in which property is inherited. The change applies to property acquired or inherited on or after January 1, 2018. This bill applies the change to both the Personal Income and Corporation Tax. SB 567 additionally precludes the taxpayer from adding any estate tax paid to the basis of any inherited assets they receive.
2. Provides that state law does not conform to federal law’s exceptions from the general rule precluding firms from deducting remuneration paid above $1 million to CEOs and other covered employees, beginning in the current taxable year. As a result, taxpayers could not deduct performance-based or commission compensation above $1 million for state tax purposes. The change applies commencing in the 2018 taxable year.
3. Increases the charitable remainder requirement from 10% to 40% for CRTs formed on or after January 1, 2018.

Background

Basis Step-Up on Inherited Property. Basis is generally calculated by starting with the taxpayer’s cost, which is usually the price paid for the asset; however, basis can be adjusted upward (when the taxpayer incurs costs improving property) or downward (when the taxpayer claims tax benefits on the property, such as depreciation). For example, a taxpayer purchasing a rental property for $150,000 and spending $50,000 in improvements has a basis of $200,000. If the taxpayer subsequently sells the property for $300,000, she has a taxable capital gain of $100,000.

Basis-step up allows taxpayers inheriting property to avoid paying taxes on assets that grew in value when owned by the decedent, unless the estate tax applies. For example, if a taxpayer’s grandmother purchased property for $100,000, which grew in value to $500,000 as of the day she died and the asset passes to the taxpayer, the new basis in the property is $500,000. If the taxpayer subsequently sells the property, his or her gain is calculated by subtracting the sales price minus its stepped-up basis. SB 567 repeals basis-step up on inherited property for taxpayers with $1 million (single)/$2 million (joint) in the taxable year they inherit the property. Using the example above, the taxpayer’s capital gain would generally be based on the sales price received from the sale of the grandmother’s house minus $100,000.

Executive Pay. In 1993, Congress limited deductible salaries and wages by enacting the Revenue Reconciliation Act of 1993. The Act capped deductible pay to $1 million per taxable year to “covered employees,” which includes CEOs or employees whose compensation must be reported as one of its four other highest compensated officers. The Act only applies to publicly-traded corporations subject to the Securities Exchange Act of 1934. The state currently conforms to this provision. Congress additionally limited deductions without the above exceptions for compensation above $500,000 for executives in firms where the federal government acquired assets subject to the Troubled Asset Relief Program, or executives of health insurance providers. SB 567 deletes the state’s conformity to federal law, thereby prohibiting publicly traded corporations from deducting performance-based or commission pay above $1 million.

CRTs. CRTs are highly efficient tax avoidance vehicles that help persons with significant assets, such as appreciated property and stock, defer tax until the CRT distributes the income back to the taxpayer or the non-charity beneficiary. CRTs also allow assets transferred to the CRT to appreciate and produce income on a tax-deferred basis, all the while generating charitable deductions for those assets the taxpayer donates to charity. As such, tax law treats CRTs like tax-exempt entities because at least 10% of the assets must go to charity, when they resemble investment funds in most other respects – the taxpayer can even control the CRT’s investments instead of a trustee. SB 567 increases the charitable remainder to increase the overall amount that ends up with the charity.

FISCAL EFFECT: Appropriation: Fiscal Com.: Local:

SUPPORT: (Verified 5/24/17)

American Federation of State, County and Municipal Employees

California Reinvestment Coalition

California Tax Reform Association

Service Employees International Union

OPPOSITION: (Verified 5/24/17)

AdvaMed

Advanced Medical Technology Association

Air Logistics Corporation

Association of California Life and Health Insurance Companies

Biocom

Biotechnology Innovation Organization

California Bankers Association

California Business Properties Association

California Chamber of Commerce

California Life Sciences Association

California Manufacturers & Technology Association

California Tank Lines, Inc.

California Taxpayers Association

Chemical Transfer, Co.

CompTIA

Contra Costa Taxpayers’ Association

Council on State Taxation
Distilled Spirits Council

Family Business Association of California

Kern County Taxpayers Association

National Federation of Independent Business

Orange County Business Council

Orange County Taxpayers Association

Organization for International Investment

San Gabriel Valley Economic Partnership

Solano County Taxpayers Association

Superior Tank Wash, Inc.

West Coast Leasing

Western States Petroleum Association

ARGUMENTS IN SUPPORT: According to the author, “SB 567 will eliminate California’s largest tax loopholes used by the highest income earners. Federal tax law, which California conforms to, provides many opportunities for the wealthiest of our state to avoid paying their fair share in taxes. Millionaires have mastered our tax code to take advantage of popular loopholes like the ‘Basis step-up’ option on inherited property, performance based compensation deductions, and charitable remainder trusts. As a result, the super-rich and the largest corporations in California do not pay their fair share in taxes. Wealthy Californians have financed a sophisticated and astonishingly effective apparatus for shielding their fortunes. Millionaires and billionaires pay a lower federal tax rate than an average worker. Closing these loopholes will provide a fair tax system for all Californians.”

ARGUMENTS IN OPPOSITION: According to a coalition of taxpayer and business groups, “Now is not the time for the state to make significant changes to the state’s tax system, while Congress is debating a federal tax reform package that will have significant impacts on the way California administers its tax system and how taxpayers comply with it. California should take a cautious approach, and wait until federal tax reform is enacted before making changes to its own tax system. Practices prohibited by this bill will continue to be allowed under federal law, thus creating state and federal differences. Tax conformity helps improve California's business tax climate and simplifies tax compliance, both for taxpayers and state government. Additionally, the corporate income tax is supposed to be imposed on net income. To determine net income, expenses associated with earning the income are properly deductible. SB 567 tries to undo this longstanding definition by denying deductions for certain expenses. Disallowing deductions for business expenses imposes the tax on losses by requiring taxpayers to overstate their income. Also, the two personal income tax provisions of this bill – raising the required remainder for charitable remainder trusts and eliminating the “step-up” in basis for inherited property – would increase the state’s overreliance on its highest income earners, thus adding more volatility and uncertainty to the state’s finances. This bill increases the dependence on high earners, and puts the state in an even more precarious position for the next recession.”

Prepared by:

5/25/17 9:39:33

**** END ****

SENATE COMMITTEE ON GOVERNANCE AND FINANCE

Senator Mike McGuire, Chair

2017 - 2018 Regular

Taxation

Decouples state law from federal law in three areas: basis step-up on inherited property, deductibility of executive pay, and charitable remainder trusts.

Background

California law does not automatically conform to changes to federal tax law, except for specific retirement provisions. Instead, the Legislature must affirmatively conform to federal changes. Conformity legislation is introduced either as individual bills to conform to specific federal tax 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, 2015 (AB 154, Ting, 2015).

California law allows various income tax credits, deductions, and sales and use tax exemptions for taxpayers that incur certain expenses, such as child adoption, or to influence behavior, including business practices and decisions. Some tax expenditures conform to similar federal provisions, such as charitable deduction and income exclusion for employer provided health care, while others do not have a federal counterpart. The Legislature typically enacts such tax incentives to encourage taxpayers to do something that but for the tax incentive, they would otherwise not do. The Department of Finance (DOF) must annually publish a list of tax expenditures, currently totaling around $57 billion in 2016-17.

Basis Step-Up on Inherited Property. California provides that all income, including wages, capital gains, dividends, and interest, is taxed at the same marginal rate according to the taxpayer’s taxable income. A capital gain is realized and generally taxable at the time of sale of a capital asset, and is generally equal to its sales price minus its basis. Basis is generally calculated by starting with the taxpayer’s cost, which is usually the price paid for the asset; however, basis can be adjusted upward (when the taxpayer incurs costs improving property) or downward (when the taxpayer claims tax benefits on the property, such as depreciation). For example, a taxpayer purchasing a rental property for $150,000 and spending $50,000 in improvements has a basis of $200,000. If the taxpayer subsequently sells the property for $300,000, she has a taxable capital gain of $100,000.

State and federal law contain specific provisions that provide exceptions from the general rules for determining basis, and therefore calculating taxable capital gains, with some exceptions. One such exception is for assets under a lifetime gift from one taxpayer to another, in which case “carryover basis” applies – the taxpayer receiving the gift assumes the same basis from the taxpayer making the gift. However, any gift tax paid by the giver is added to the receiver’s basis. Another exception is “stepped-up” basis on inherited property. When an estate passes property to a decedent, the property’s basis is generally adjusted to equal its fair market value as of the date of the death. For example, if a taxpayer’s grandmother purchased rental property for $100,000, which grew in value to $500,000 as of the day she died and the asset passes to the taxpayer, the new basis in the property is $500,000. If the taxpayer subsequently sells the property, his or her gain is calculated by subtracting the sales price minus its adjusted basis, which allows taxpayers to avoid capital gains taxes on assets that have grown in value, unless the estate tax applies. However, if the fair market value of the property is less than its basis at the time of death, basis is stepped-down to fair market value.

Executive Pay. State and federal law generally allow business taxpayers to deduct from income any ordinary and necessary business expenses, including wages and salaries paid to employees. Pay must be reasonable, and provided in exchange for services performed, and can be disallowed to limit dividends paid disguised as deductible salary and wages.

In 1993, Congress limited deductible salaries and wages paid by enacting the Revenue Reconciliation Act of 1993. The Revenue Act capped deductible pay to $1 million per taxable year to “covered employees,” which includes chief executive officers (CEOs) or employees whose compensation must be reported as one of its four other highest compensated officers. The Revenue Act only applies to publicly-traded corporations subject to the Securities Exchange Act of 1934. The limit applied to all remuneration for services, regardless of when the income was earned; however, Congress allowed exceptions for:

• Qualified commissions,
• Pre-existing binding contracts in effect as of February 17, 1993, and
• Other performance-based compensation.

Performance-based compensation includes remuneration based on the attainment of one or more performance goals, set by a compensation committee of the board of directors which must include at least two outside directors, which must certify that the performance goals were satisfied. Additionally, the material terms of the performance-based compensation must be disclosed to shareholders to be deductible. Congress additionally limited deductions without the above exceptions for compensation above $500,000 for executives in firms where the federal government acquired assets subject to the Troubled Asset Relief Program (Emergency Economic Stability Act), or executives of health insurance providers (Patient Protection and Affordable Care Act).

Charitable Remainder Trusts. Federal and state law allows for charitable remainder trusts (CRTs), which enable taxpayers to avoid taxes to the benefit of charities. To create a CRT, taxpayers make an irrevocable transfer of assets or cash to a trust formed on behalf of specified charitable beneficiaries. Taxpayers and any other designated beneficiary can receive income from the trust within certain limits for a specified period or until death, with any remainder transferred to the charity or charities named in the trust agreement. The charitable remainder must exceed 10% of the assets’ value. The tax benefits of creating a CRT are significant: first, the taxpayer receives a charitable deduction in the year of the donation equal to the value of the assets, less any income they allocate from the trust to themselves. Second, any appreciated assets, such as stock, donated to the trust are not subject to capital gains taxes that would normally apply had the taxpayer sold them. Third, any earnings or gains from the assets in the trust are tax-exempt. Lastly, when the taxpayer transfers the assets, they are no longer part of his or her estate, and therefore not subject to estate taxes.

As Congress considers changes to federal law to reduce rates for corporations and individuals, the author wants to change state law to ensure that high-income Californians pay taxes necessary to fund public services.

Proposed Law

Senate Bill 567 decouples state law from federal law to make three changes:

• Repeals basis step-up on inherited property for taxpayers with more than $2 million (joint)/$1 million (single) in income in the taxable year in which property is inherited. The change applies to property acquired or inherited on or after January 1, 2018. The measure applies the change to both the Personal Income and Corporation Tax. SB 567 additionally precludes the taxpayer from adding any estate tax paid to the basis of any inherited assets they receive.
• Provides that state law does not conform to federal law’s exceptions from the general rule precluding firms from deducting remuneration paid above $1 million to CEOs and other covered employees, beginning in the current taxable year. As a result, taxpayers could not deduct performance-based or commission compensation above $1 million. The change applies commencing in the 2018 taxable year.
• Increase the charitable remainder requirement from 10% to 40% for taxable years, for charitable remainder trusts formed on or after January 1, 2018.

The bill also states the Legislature’s intent to modify the manner in which payments to related parties as defined by specified provisions of the Internal Revenue Code are taxed, and makes technical changes necessary to implement the above provisions.

State Revenue Impact

For the 5/3/17 version of SB 567, according to the Franchise Tax Board (FTB), eliminating basis step-up on inherited property results in revenue gains of $1 million in 2017-18, $3.9 million in 2018-19, and $7.9 million in 2019-20, while decoupling state law from federal law regarding executive compensation results in gains of $110 million in 2017-18, $100 million in 2018-19, and $100 million in 2019-20. FTB states that it lacks the data necessary to calculate the revenue effect of the increase in the charitable remainder, but states that it is probable that it would result in revenue losses due to increased charitable deductions because of the bill’s increased remainder requirement. FTB’s revenue estimate of the 5/15/17 version of the bill is pending.

Comments

1. Purpose of the bill. According to the author, “SB 567 will eliminate California’s largest tax loopholes used by the highest income earners. Federal tax law, which California conforms to, provides many opportunities for the wealthiest of our state to avoid paying their fair share in taxes. Millionaires have mastered our tax code to take advantage of popular loopholes like the ‘Basis step-up’ option on inherited property, performance based compensation deductions, and charitable remainder trusts. As a result, the super-rich and the largest corporations in California do not pay their fair share in taxes. Wealthy Californians have financed a sophisticated and astonishingly effective apparatus for shielding their fortunes. Millionaires and billionaires pay a lower federal tax rate than an average worker. Closing these loopholes will provide a fair tax system for all Californians.”

2. Nonconformity. California’s personal income tax significantly relies on the Internal Revenue Code, importing hundreds of definitions, rules, and procedures, among other items. Conformity eases the compliance and administrative burden of tax preparation for taxpayers, tax preparers, and Franchise Tax Board. As a result, any difference between state and federal law can increase cost, complexity, and noncompliance. While state and federal law already differ in many key aspects, SB 567 would increase nonconformity in determining basis, deducting compensations, and establishing CRTs. Under the bill, some taxpayers would have one basis for property under federal law but a different one for state purposes, and firms would not be able to deduct executive compensation above specified amounts for state purposes that would be allowed for federal. Additionally, a charitable remainder trust that qualified for federal purposes by virtue of having a charitable remainder of 10% would not qualify for state purposes unless the remainder was at least 40%. The Committee may wish to consider whether SB 567’s benefits are worth creating more differences between the state and federal tax codes.

3. Inequality. Economic data shows significant inequality in wage income between executives, especially CEOs, and their employees. The Economic Policy Institute (EPI) states that between 1978 and 2015, CEO compensation grew 941 percent while the compensation of a typical worker grew just 10 percent. EPI adds that while CEOs of major U.S. companies earned 20 times more than a typical worker in 1965; this ratio grew to 30-to-1 in 1978 and 59-to-1 by 1989, surging in the 1990s, hitting 376-to-1 in 2000. However, the ratio has since decreased: in 2015, EPI calculated the ratio at 276 to 1. Additionally, firms acting poorly often reward their chief executives: Wells Fargo created fake bank accounts and charged customers undue fees, but its former head of the retail banking business retired with almost $125 million in compensation, mostly stock and options, and its CEO received $155 million in performance pay between 2012 and 2015, although some may be clawed back. While Congress’s action in 1993 was intended to limit executive compensation, median executive compensation levels for S&P 500 Industrial companies almost tripled in the 1990s, mainly driven by a dramatic growth in stock options. According to the Joint Economic Committee, this exception for performance pay results in a federal revenue loss of $50 billion over a ten-year budget window. While SB 567 doesn’t directly regulate executive pay, it would provide that taxpayers could no longer deduct these amounts.

4. Doubling down? California is highly reliant on higher-income taxpayers to fund public services. Currently, taxpayers making more than $1 million in income pay a base income tax rate of 12.3% (Proposition 55, 2016), plus a 1% surcharge (Proposition 63, 2004), for a combined rate of 13.3%. As a result, DOF states that the top one percent of income earners paid 48% of the state’s personal income tax revenues in the 2014 taxable year, and paid at least 40% in ten of the last eleven tax years. This phenomenon largely results from increasing income inequality; FTB statistics show that the total adjusted gross income of the top one percent has increased from 13.8% in 1993 to 24% in 2014. Most other states do not tax high-income earners as much, especially neighboring states like Arizona and Nevada, creating an incentive more affluent taxpayers to make the short trip to relocate to low or no-tax jurisdictions. Additionally, Congress may soon pursue federal tax changes, and both President Trump and Congressional Republicans’ tax plans seek to repeal the deduction for state and local taxes, which reduces the net effect of higher state taxes. SB 567 singles out these taxpayers by denying stepped up basis on inherited property for those making more than $2 million (joint)/$1 million single. However, California’s tax revenue continues to perform well. Additionally, 2016 research from Christobal Young, Charles Varner, Ithai Z. Lurie, and Richard Prisinzano of the Stanford Center on Poverty and Inequality used administrative tax returns for all million-dollar income earners in the last 13 years to measure this potential “tax flight.” Their paper, “Millionaire Migration and Taxation of the Elite: Evidence from Administrative Data” found that “millionaire tax flight is occurring, but only at the margins of statistical and socioeconomic significance.” The Committee may wish to consider whether SB 567 taxes millionaires too much, and if so, whether it could cause high-income earners to leave the state.

5. Related legislation. SB 567 resembles two proposals that have also been before the Legislature in recent years:

• SB 1372 (DeSaulnier, 2013) replaced a publicly traded corporation’s current tax rate of 8.84% with a rate based on a ratio between its top paid employee and the median compensation it pays. The Committee approved the measure, but it subsequently failed passage on the Senate Floor.
• While taking a different approach to taxing the gain in asset values than SB 567, SB 726 (Weiner) proposes to revive the state’s estate tax, repealed by initiative in 1982, contingent on voter approval. The measure is currently awaiting hearing in Committee. Estate taxes are calculated as a percentage of either the total value of a person’s estate at death, or the total value if assets a person inherits, and is usually due and payable at the time of inheritance. SB 567’s stepped up basis doesn’t affect taxpayers until they subsequently sell inherited assets by generally requiring the gain be calculated based on the decedent’s basis. However, taxpayers inheriting assets can have difficulty determining basis, especially for assets purchased many years ago.

6. Good deal. CRTs are highly efficient and perfectly legal tax avoidance vehicles that help persons with significant assets, such as appreciated property and stock, defer tax until the CRT distributes the income back to the taxpayer or the non-charity beneficiary. CRTs also allow assets transferred to the CRT to appreciate and produce income on a tax-deferred basis, all the while generating charitable deductions for those assets the taxpayer donates to charity. As such, tax law treats CRTs like tax-exempt entities because at least 10% of the assets must go to charity, when they resemble investment funds in most other respects – the taxpayer can even control the CRT’s investments instead of a trustee. SB 567 would increase the charitable remainder to provide additional benefits to charities while limiting some of the tax benefits to the trustor.

7. 2/3. SB 567 would change state statute in a way that would increase a tax on any taxpayer for the purpose of Section Three of Article XIIIA of the California Constitution. As a result, Legislative Counsel has assigned the bill a 2/3 vote key, thereby requiring 27 votes on the Senate Floor for passage.

Support and Opposition

(5/5/17)

Support: California Reinvestment Coalition, California Tax Reform Association, Service Employees International Union.

Opposition: Advanced Medical Technology Association, AdvaMed; Air Logistics Corporation; Association of California Life and Health Insurance Companies (ACLHIC); Biocom; Biotechnology Innovation Organization; California Bankers Association; California Business Properties Association; California Chamber of Commerce; California Life Sciences Association; California Manufacturers & Technology Association; California Tank Lines, Inc.; California Taxpayers Association; Chemical Transfer, Co.; CompTIA; Contra Costa Taxpayers’ Association; Council on State Taxation; Distilled Spirits Council; Family Business Association of California; Kern County Taxpayers Association; National Federation of Independent Business; Orange County Business Council; Orange County Taxpayers Association; Organization for International Investment; San Gabriel Valley Economic Partnership; Solano County Taxpayers Association (SCTA); Superior Tank Wash, Inc.; West Coast Leasing; Western States Petroleum Association.

-- END --

SENATE COMMITTEE ON GOVERNANCE AND FINANCE

Senator Mike McGuire, Chair

2017 - 2018 Regular

Taxation

Decouples state law from federal law in three areas: basis step-up on inherited property, deductibility of executive pay, and charitable remainder trusts.

Background

California law does not automatically conform to changes to federal tax law, except for specific retirement provisions. Instead, the Legislature must affirmatively conform to federal changes. 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, 2015 (AB 154, Ting, 2015).

California law allows various income tax credits, deductions, and sales and use tax exemptions for taxpayers that incur certain expenses, such as child adoption, or to influence behavior, including business practices and decisions. Some tax expenditures conform to similar federal provisions, such as charitable deduction and income exclusion for employer provided health care, while others do not have a federal counterpart. The Legislature typically enacts such tax incentives to encourage taxpayers to do something that but for the tax incentive, they would otherwise not do. The Department of Finance (DOF) must annually publish a list of tax expenditures, currently totaling around $57 billion in 2016-17.

Basis Step-Up on Inherited Property. California provides that all income, including wages, capital gains, dividends, and interest, is taxed at the same marginal rate according to the taxpayer’s taxable income. A capital gain is realized and generally taxable at the time of sale of a capital asset, and is generally equal to its sales price minus its basis. Basis is generally calculated by starting with the taxpayer’s cost, which is usually the price paid for the asset; however, basis can be adjusted upward (when the taxpayer incurs costs improving property) or downward (when the taxpayer claims tax benefits on the property, such as depreciation). For example, a taxpayer purchasing a rental property for $150,000 and spending $50,000 in improvements has a basis of $200,000. If the taxpayer subsequently sells the property for $300,000, she has a taxable capital gain of $100,000.

State and federal law contain specific provisions that provide exceptions from the general rules for determining basis, and therefore calculating taxable capital gains, with some exceptions. One such exception is for assets under a lifetime gift from one taxpayer to another, in which case “carryover basis” applies – the taxpayer receiving the gift assumes the same basis from the taxpayer making the gift. However, any gift tax paid by the giver is added to the receiver’s basis. Another exception is “stepped-up” basis on inherited property. When an estate passes property to a decedent, the property’s basis is generally adjusted to equal its fair market value as of the date of the death. For example, if a taxpayer’s grandmother purchased rental property for $100,000, which grew in value to $500,000 as of the day she died and the asset passes to the taxpayer, the new basis in the property is $500,000. If the taxpayer subsequently sells the property, his or her gain is calculated by subtracting the sales price minus its adjusted basis, which allows taxpayers to avoid capital gains taxes on assets that have grown in value, unless the estate tax applies. However, if the fair market value of the property is less than its basis at the time of death, basis is stepped-down to fair market value.

Executive Pay. State and federal law generally allow business taxpayers to deduct from income any ordinary and necessary business expenses, including wages and salaries paid to employees. Pay must be reasonable, and provided in exchange for services performed, and can be disallowed to limit dividends paid disguised as deductible salary and wages.

In 1993, Congress limited deductible salaries and wages paid by enacting the Revenue Reconciliation Act of 1993. The Revenue Act capped deductible pay to $1 million per taxable year to “covered employees,” which includes chief executive officers (CEOs) or employees whose compensation must be reported as one of its four other highest compensated officers. The Revenue Act only applies to publicly-traded corporations subject to the Securities Exchange Act of 1984. The limit applied to all remuneration for services, regardless of when the income was earned; however, Congress allowed exceptions for:

• Qualified commissions,
• Pre-existing binding contracts in effect as of February 17, 1993, and
• Other performance-based compensation.

Performance-based compensation includes remuneration based on the attainment of one or more performance goals, set by a compensation committee of the board of directors which must include at least two outside directors, which must certify that the performance goals were satisfied. Additionally, the material terms of the performance-based compensation must be disclosed to shareholders to be deductible. Congress additionally limited deductions without the above exceptions for compensation above $500,000 for executives in firms where the federal government acquired assets subject to the Troubled Asset Relief Program (Emergency Economic Stability Act), or executives of health insurance providers (Patient Protection and Affordable Care Act).

Charitable Remainder Trusts. Federal and state law allows for charitable remainder trusts (CRTs), which enable taxpayers to avoid taxes to the benefit of charities. To create a CRT, taxpayers make an irrevocable transfer of assets or cash to a trust formed on behalf of specified charitable beneficiaries. Taxpayers and any other designated beneficiary can receive income from the trust within certain limits for a specified period or until death, with any remainder transferred to the charity or charities named in the trust agreement. The charitable remainder must exceed 10% of the assets’ value. The tax benefits of creating a CRT are significant: first, the taxpayer receives a charitable deduction in the year of the donation equal to the value of the assets, less any income they allocate from the trust to themselves. Second, any appreciated assets, such as stock, donated to the trust are not subject to capital gains taxes that would normally apply had the taxpayer sold them. Third, any earnings or gains from the assets in the trust are tax-exempt. Lastly, when the taxpayer transfers the assets, they are no longer part of his or her estate, and therefore not subject to estate taxes.

As Congress considers changes to federal law to reduce rates for corporations and individuals, the author wants to change state law to ensure that high-income Californians pay taxes necessary to fund public services.

Proposed Law

Senate Bill 567 decouples state law from federal law to make three changes:

• Repeals basis step-up on inherited property for taxpayers with more than $2 million (joint)/$1 million (single) in income in the taxable year in which property is inherited. The change applies to property acquired or inherited on or after January 1, 2018. The measure applies the change to both the Personal Income and Corporation Tax. SB 567 additionally precludes the taxpayer from adding any estate tax paid to the basis of any inherited assets they receive.
• Provides that state law does not conform to federal law’s exceptions from the general rule precluding firms from deducting remuneration paid above $1 million to CEOs and other covered employees, beginning in the current taxable year. As a result, taxpayers could not deduct performance-based or commission compensation above $1 million.
• Increase the charitable remainder requirement from 10% to 40% for taxable years, beginning in the 2018 taxable year.

The bill also states the Legislature’s intent to modify the manner in which payments to related parties as defined by specified provisions of the Internal Revenue Code are taxed, and makes technical changes necessary to implement the above provisions.

State Revenue Impact

According to the Franchise Tax Board, eliminating basis step-up on inherited property results in revenue gains of $1 million in 2017-18, $3.9 million in 2018-19, and $7.9 million in 2019-20, while decoupling state law from federal law regarding executive compensation results in gains of $110 million in 2017-18, $100 million in 2018-19, and $100 million in 2019-20. FTB states that it lacks the data necessary to calculate the revenue effect of the increase in the charitable remainder, but states that it is probable that it would result in revenue losses due to increased charitable deductions because of the bill’s increased remainder requirement.

Comments

1. Purpose of the bill. According to the author, “SB 567 will eliminate California’s largest tax loopholes used by the highest income earners. Federal tax law, which California conforms to, provides many opportunities for the wealthiest of our state to avoid paying their fair share in taxes. Millionaires have mastered our tax code to take advantage of popular loopholes like the ‘Basis step-up’ option on inherited property, performance based compensation deductions, and charitable remainder trusts. As a result, the super-rich and the largest corporations in California do not pay their fair share in taxes. Wealthy Californians have financed a sophisticated and astonishingly effective apparatus for shielding their fortunes. Millionaires and billionaires pay a lower federal tax rate than an average worker. Closing these loopholes will provide a fair tax system for all Californians.”

2. Nonconformity. California’s personal income tax significantly relies on the Internal Revenue Code, importing hundreds of definitions, rules, and procedures, among other items. Conformity eases the compliance and administrative burden of tax preparation for taxpayers, tax preparers, and Franchise Tax Board. As a result, any difference between state and federal law can increase cost, complexity, and noncompliance. While state and federal law already differ in many key aspects, SB 567 would increase nonconformity in determining basis, deducting compensations, and establishing CRTs. Under the bill, some taxpayers would have one basis for property under federal law but a different one for state purposes, and firms would not be able to deduct executive compensation above specified amounts for state purposes that would be allowed for federal. Additionally, a charitable remainder trust that qualified for federal purposes by virtue of having a charitable remainder of 10% would not qualify for state purposes unless the remainder was at least 40%. The Committee may wish to consider whether SB 567’s benefits are worth creating more differences between the state and federal tax codes.

3. Inequality. Economic data shows significant inequality in wage income between executives, especially CEOs, and their employees. The Economic Policy Institute (EPI) states that between 1978 and 2015, CEO compensation grew 941 percent while the compensation of a typical worker grew just 10 percent. EPI adds that while CEOs of major U.S. companies earned 20 times more than a typical worker in 1965; this ratio grew to 30-to-1 in 1978 and 59-to-1 by 1989, surging in the 1990s, hitting 376-to-1 in 2000. However, the ratio has since decreased: in 2015, EPI calculated the ratio at 276 to 1. Additionally, firms acting poorly often reward their chief executives: Wells Fargo created fake bank accounts and charged customers undue fees, but its former head of the retail banking business retired with almost $125 million in compensation, mostly stock and options, and its CEO received $155 million in performance pay between 2012 and 2015, although some may be clawed back. While Congress’s action in 1993 was intended to limit executive compensation, median executive compensation levels for S&P 500 Industrial companies almost tripled in the 1990s, mainly driven by a dramatic growth in stock options. According to the Joint Economic Committee, this exception for performance pay results in a federal revenue loss of $50 billion over a ten-year budget window. While SB 567 doesn’t directly regulate executive pay, it would provide that taxpayers could no longer deduct these amounts.

4. Doubling down? California is highly reliant on higher-income taxpayers to fund public services. Currently, taxpayers making more than $1 million in income pay a base income tax rate of 12.3% (Proposition 55, 2016), plus a 1% surcharge (Proposition 63, 2004), for a combined rate of 13.3%. As a result, DOF states that the top one percent of income earners paid 48% of the state’s personal income tax revenues in the 2014 taxable year, and paid at least 40% in ten of the last eleven tax years. This phenomenon largely results from increasing income inequality; FTB statistics show that the total adjusted gross income of the top one percent has increased from 13.8% in 1993 to 24% in 2014. Most other states do not tax high-income earners as much, especially neighboring states like Arizona and Nevada, creating an incentive more affluent taxpayers to make the short trip to relocate to low or no-tax jurisdictions. Additionally, Congress may soon pursue federal tax changes, and both President Trump and Congressional Republicans’ tax plans seek to repeal the deduction for state and local taxes, which reduces the net effect of higher state taxes. SB 567 singles out these taxpayers by denying stepped up basis on inherited property for those making more than $2 million (joint)/$1 million single. However, California’s tax revenue continues to perform well. Additionally, 2016 research from Christobal Young, Charles Varner, Ithai Z. Lurie, and Richard Prisinzano of the Stanford Center on Poverty and Inequality used administrative tax returns for all million-dollar income earners in the last 13 years to measure this potential “tax flight.” Their paper, “Millionaire Migration and Taxation of the Elite: Evidence from Administrative Data” found that “millionaire tax flight is occurring, but only at the margins of statistical and socioeconomic significance.” The Committee may wish to consider whether SB 567 taxes millionaires too much, and if so, whether it could cause high-income earners to leave the state.

5. Related legislation. SB 567 resembles two proposals that have also been before the Legislature in recent years:

• SB 1372 (DeSaulnier, 2013) replaced a publicly traded corporation’s current tax rate of 8.84% with a rate based on a ratio between its top paid employee and the median compensation it pays. The Committee approved the measure, but it subsequently failed passage on the Senate Floor.
• While taking a different approach to taxing the gain in asset values than SB 567, SB 726 (Weiner) proposes to revive the state’s estate tax, repealed by initiative in 1982, contingent on voter approval. The measure is currently awaiting hearing in Committee. Estate taxes are calculated as a percentage of either the total value of a person’s estate at death, or the total value if assets a person inherits, and is usually due and payable at the time of inheritance. SB 567’s stepped up basis doesn’t affect taxpayers until they subsequently sell inherited assets by generally requiring the gain be calculated based on the decedent’s basis. However, taxpayers inheriting assets can have difficulty determining basis, especially for assets purchased many years ago.

6. Good deal. Charitable remainder trusts are highly efficient and perfectly legal tax avoidance vehicles that help persons with significant assets, such as appreciated property and stock, defer tax until the CRT distributes the income back to the taxpayer or the non-charity beneficiary. CRTs also allow assets transferred to the CRT to appreciate and produce income on a tax-deferred basis, all the while generating charitable deductions for those assets the taxpayer donates to charity. As such, tax law treats CRTs like tax-exempt entities because at least 10% of the assets must go to charity, when they resemble investment funds in most other respects – the taxpayer can even control the CRT’s investments instead of a trustee. SB 567 would increase the charitable remainder to provide additional benefits to charities while limiting some of the tax benefits to the trustor.

7. 2/3. SB 567 would change state statute in a way that would increase a tax on any taxpayer for the purpose of Section Three of Article XIIIA of the California Constitution. As a result, Legislative Counsel has assigned the bill a 2/3 vote key, thereby requiring 27 votes on the Senate Floor for passage.

8. Technicals. Committee staff recommends the following technical amendments:

• Clarify that the measure’s provisions relating to charitable remainder trusts apply only to trusts formed on or after January 1, 2018, or else current trusts may lose their classification.
• On P. 4, L.14, before “(m)(4)(C)” insert “162.”
• To remove the potentially retroactive effect of the executive compensation provisions, delay implementation until the 2018 taxable year.

Support and Opposition

(5/5/17)

Support: California Reinvestment Coalition, California Tax Reform Association, Service Employees International Union.

Opposition: Advanced Medical Technology Association, AdvaMed; Air Logistics Corporation; Association of California Life and Health Insurance Companies (ACLHIC); Biocom; Biotechnology Innovation Organization; California Bankers Association; California Business Properties Association; California Chamber of Commerce; California Life Sciences Association; California Manufacturers & Technology Association; California Tank Lines, Inc.; California Taxpayers Association; Chemical Transfer, Co.; CompTIA; Contra Costa Taxpayers’ Association; Council on State Taxation; Distilled Spirits Council; Family Business Association of California; Kern County Taxpayers Association; National Federation of Independent Business; Orange County Business Council; Orange County Taxpayers Association; Organization for International Investment; San Gabriel Valley Economic Partnership; Solano County Taxpayers Association (SCTA); Superior Tank Wash, Inc.; West Coast Leasing; Western States Petroleum Association.

-- END --