Executive Compensation and Benefits Alert: California Reduces Its 409A Income Tax

Skadden, Arps, Slate, Meagher & Flom LLP

Regina Olshan Erica Schohn Joseph M. Yaffe Michael R. Bergmann Kristin M. Davis Berit R. Freeman Timothy F. Nelson

In a rare piece of good news relating to Section 409A of the Internal Revenue Code, on October 4, 2013, California reduced its additional state tax on income failing to comply with Section 409A from 20 percent to 5 percent. This reduction is effective for taxable years beginning January 1, 2013 and later.

Section 409A was added to the Internal Revenue Code by the American Jobs Creation Act of 2004, and was intended to regulate deferred compensation — that is, compensation in which the right to payment arises in one year but the amounts are to be paid in a future year. Section 409A can apply to compensation arrangements as diverse as employment agreements, severance arrangements and equity awards, as well as to traditional deferred compensation plans. Violation of the provisions of Section 409A generally causes the amounts in question to be subject to accelerated income taxation and an additional 20 percent federal income tax under Section 409A.

California’s Revenue and Taxation Code incorporates a parallel income tax of 20 percent, thereby increasing the total additional income tax imposed on California taxpayers for violating Section 409A to 40 percent, double the rate applicable to taxpayers in other states. This newly announced rate change reduces the 409A income tax applicable to California taxpayers to a level much closer to that applicable to non-California taxpayers.

We encourage any companies that have experienced Section 409A violations giving rise to Section 409A income taxes in 2013 and later years to revisit their calculations to reflect the revised rates. We are available to discuss any questions you may have relating to this new development and to any general Section 409A compliance of your compensation arrangements.

This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws.