The California income tax law largely conforms to federal income tax law and California routinely uses the federal definitions of taxable income or tax deductions.
This was true with the penalty surtax which applies to “nonqualified deferred compensation” under IRC §409A. In plain English, this includes taxation on gains from stock options which were underpriced (that is, options which were priced below the fair market value of common stock at the time of issuance). Federal law applied a surtax of 20% to such gains and California mirrored that with its own 20% surtax.
Governor Jerry Brown signed AB 1173 which changed this surtax from 20% to 5% for taxable years beginning on or after January 1, 2013.
While this seems like good news, it really only lowers the combined federal and state taxes on underpriced option gains from more than 90% to 75%.* Obviously, even 75% taxation is too high to take the risk of underpricing stock options and we recommend that companies comply with IRC §409A by obtaining an independent appraisal every 12 months (or less, if there is a material change) before issuing stock options.
*Computed as follows: highest federal rate 39.6%, plus highest California rate 9.3% (ignoring the rate of 10.3% which applies to income above $1,000,000 for those filing as single or $2,000,000 for those filing as married) plus Medicare of 2.35% (ignoring Social Security of 6.2% on a wage base of up to $113,700), plus federal surtax of 20.0% and California surtax of 20.0% or 5.0%.
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