California slashes 409A state tax penalty from 20% to 5%

Published on 20 Oct, 2013

New York, October 20, 2013: In what could be termed as good news for Californian taxpayers, the California State has reduced its additional state tax on income failing to comply with Section 409A from 20% to 5%, effective for taxable years beginning January 1, 2013. Governor Edmund G Brown Jr. signed into new bill AB 1173, Chapter 536, which substitutes the phrase ‘five per cent’ in lieu of the phrase ‘20 percent’ as the additional income tax penalty for violations of Section 409A.

While the overall penal tax implications for non-compliance with Section 409A regulations still remain significant owing to with 20% Federal Tax (plus interests, other charges); this is welcome relief to employees and employers in California. They were quite unfairly over-burdened compared to any other state as CA Revenue and Taxation Code had incorporated its own parallel income tax of 20% on top of federal tax.

Section 409A – intended to regulate deferred compensation – was added to the Internal Revenue Code by the American Jobs Creation Act of 2004. 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 generally causes the amounts in question to be subjected to accelerated income taxation and an additional 20 percent Federal Income Tax under Section 409A.

Since its enactment in 2004, Internal Revenue Service (IRS) has issued thousands of pages of guidance in an attempt to interpret the 409A and apply this broad legislation to many industries. Despite that, the application of this complicated legislation remains challenging, particularly for VC backed start-ups and emerging growth companies.

Particularly, Section 409A provisions require companies to issue stock options to at strike price that is equal to or above the Fair Market Value of underlying stock as of the grant date. Failure to do so could result in potentially dramatic tax consequences for the option recipient (employees), which is bit paradoxical as generally the burden of compliance lies with the Company.

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