Section 409A of the Internal Revenue Code made news earlier this year (BVWire Issue #127-3) when the U.S. Court of Federal Claims declared that it applied to discounted stock options.

For federal tax purposes, section 409A provides that all amounts deferred under a nonqualified deferred compensation plan represent income if they are not at a substantial risk of forfeiture. Amounts includible in gross income are also subject to interest on prior underpayments and an additional income tax equal to 20%. Besides discounted stock options, section 409A applies to traditional deferred compensation plans, payments under severance agreements, employment agreements, change in control and retention agreements, and other forms of equity compensation.

California twist: A recent California measure adds a state-law dimension to an already complicated piece of legislation. Because California automatically incorporated the federal pension rules, state law allowed for an additional state 409A penalty equal to the federal 20% penalty, imposing a 40% income tax for section 409A noncompliance. But on Oct. 4, 2013, Governor Jerry Brown signed into law a bill that will reduce the state penalty from 20% to 5%.

The new law is effective for tax years beginning on or after Jan. 1, 2013. It does not disturb the federal tax provisions or the California state interest penalty provisions.

Proponents of the measure argued that even if section 409A originally had a legitimate purpose—to prevent executives and directors from manipulating the timing of compensation payments—its broad application, based on Treasury regulations, has harmed all classes of service providers, including low-level employees and many independent contractors. The latter make up a big part of the state’s vital entertainment industry. Movie studios often enter into arrangements with actors, directors, producers, and writers that specify that the talent will provide services in one year but has a right to receive compensation in a later year. If California could not repeal the provision, it could and should mitigate the burden on the entertainment sector and similarly hurt industries by reducing the 20% additional California tax penalty.

Meanwhile the federal section 409A stock option case is awaiting trial on the valuation issue of whether the taxpayer in fact received his options at a discounted price.

A digest of the court’s pretrial decision in Sutardja v. United States, 2012 U.S. Claims LEXIS 126 (Feb. 27, 2013), is available in the June Business Valuation Update.