Non-Qualified Plan Distributions: State Income Tax Sourcing Rules
Feb 14, 2018
Are distributions from Non-Qualified Deferred Compensation Plans subject to state income “source” tax (i.e. can the state in which the income was earned impose its state income tax on the distributions from the plan, even though the recipient resides in a different state when receiving the distribution)? The answer is “yes” unless the distribution meets one of two requirements: (1) it is part of a series of substantially equal annual (or more frequent) payments which will be paid for life (or joint lives) for at least 10 years; or (2) it is a distribution from a plan maintained solely for the purpose of restoring benefits lost due to various tax law restrictions.
State income tax laws on taxation of employee compensation can become complicated to apply when two (or more) states are involved. The situation often arises when an employee is domiciled in one state and earns income in one or more other states. Numerous states have enacted so-called “source tax” laws which authorize them to impose state income taxes on compensation which was earned while the employee was physically present in their state. As a result, it is possible for several states to attempt to impose state income tax on the same employee compensation. Resolving the conflict of laws and taking advantage of offsets in one state’s law for taxes paid on the same compensation in another (thereby avoiding “double taxation”) can be complicated. The situation can become even more complicated when compensation is deferred.
Generally, states have mirrored federal income tax law with respect to compensatory income which is deferred pursuant to any of several valid deferral arrangements (e.g. “qualified” retirement plans and non-qualified deferred compensation arrangements), and investment income attributed thereto. That is, similar to federal income tax law, employees are generally not subject to income tax at the state level when payments are earned. They will be subject to state income tax when payments are made. At that time, the state in which the recipient is domiciled at the time of payment will apply its state income tax laws (if any) on the distributions as they are made. However, states with “source tax” laws will attempt to impose state income tax on distributions of deferred compensation to the extent that the compensation deferred was originally earned in their state.
While the issues are essentially the same as with current compensation when an employee earns compensation in one state and lives in another, their application to post-retirement distributions are particularly thorny, largely for public policy reasons. First, the conflict between states is likely to arise more frequently after an employee has retired because many retirees relocate permanently, or at least change their legal domicile, to other states. Second, many retirees relocate to states without an income tax, and feel it is unfair to be subjected to state income tax on retirement plan distributions arising from compensation earned in their former state of residence, or the state of location of their former office. Such retirement plan distributions often constitute the majority of the retirement income for many retirees. Finally, the cost and complexity of administration caused by state income “source tax” has been raised by plan administrators.
In 1995, Representative Barbara Vucanovich (R-Nev.) and Senator Harry Reid (D-Nev.) proposed legislation (H.R. 394) to address these public policy concerns. While Congress recognized that states have the right to raise revenue in many ways, and that some states have the statutory right to tax many types of nonresident retirement (deferred) income, it also determined that the practice of taxing nonresidents’ pension income is too great a financial burden on retirees. Accordingly, the bill passed both the House and Senate and was signed into law by President Clinton (4 USC Section 114) on January 10, 1996. The law was entitled the Pension Income Tax Limits Act (“PITLA”) and applies to qualifying distributions from deferred compensation plans received after December 31, 1995. PITLA prohibits a state from imposing income taxes on certain retirement income of individuals who are not residents of or legally domiciled in that state. The determination of an individual’s residence or domicile for purposes of applying PITLA is made in accordance with the laws of the taxing state(s).
There are numerous categories of “qualifying distributions” which are protected from “source tax” imposition by PITLA. All distributions from qualified trusts under IRC Section 401(a)(“qualified plan” distributions), annuity plans under Sections 403(a) and (b), IRA distributions, eligible IRC Section 457 plan distributions, and IRC Section 408(k) SEP distributions are protected. PITLA also protects from state “source taxation” certain distributions from non- qualified deferred compensation plans, programs, or arrangements. These protected non-qualified plan distributions fall into two categories.
First, distributions from non-qualified plans described in IRC Section 3121 (v)(2)(C) of Chapter 21, the Federal Insurance Contributions Act (or “FICA”), Subchapter C, General Provisions, are protected from “source taxation” if the income is part of a series of substantially equal periodic payments, not less frequently than annually, made for either: (a) the life of the recipient (or the joint lives of life expectancies of the recipient and the recipient’s designated beneficiary) or (b) at least 10 years. Second, distributions received after termination of employment from any plan, program, or arrangement (to which such employment relates) maintained solely for the purpose of providing retirement benefits for employees in excess of the limitations imposed by one or more of: IRC Section 401(a)(17) (limiting the total amount of compensation which may be considered in qualifying for a “qualified plan”— $200,000 beginning in 2002), Section 401(k) (limiting deferrals due to anti-discrimination testing), 402(g) (limiting deferrals to 401(k) plans), Section 415 (limiting benefits from defined benefit plans and contributions to defined contribution plans), and any other limitation on contributions or benefits in the Internal Revenue Code on plans to which any of these sections apply.
Ramifications on Non-Qualified Plan Design
PITLA utilizes the IRC Section 3121(v) definition of “non-qualified deferred compensation plan” which essentially covers any plan or other arrangement for deferral of compensation other than a “qualified plan or annuity.” Therefore, a distribution from virtually any type of deferred compensation plan or defined benefit/defined contribution SERP will qualify for protection from state “source taxation” if it meets one of the two criteria established in the Act. Most plans are not maintained solely for the purpose of restoring lost benefits due to tax law constraints, although this is not uncommonly a component of well-designed non-qualified plans. Therefore, in order to ensure that distributions are protected under PITLA, it is advisable that the broader deferred compensation plan provide that distributions may be provided either: (a) over
the life (or joint lives) of the participant/beneficiary no less frequently than annually (a life annuity), or (b) in at least 10 annual installment payments. Good non-qualified plan design allows a participant to elect a payment schedule for retirement or termination payments and permits installment payments which are made at least annually for ten (10) years or longer, and which are either “substantially equal” or are determined with reference to the account balance which the participant continues to control with respect to investment earnings.
Alternatively, the plan could be designed so that it is essentially two plans: (1) a plan which provides “solely” excess benefits, and (2) a supplemental retirement or deferral plan. As an aside, to qualify as an “excess benefit plan” for purposes of PITLA, the plan may provide for benefits in excess of any of the IRC Sections mentioned above (as compared to ERISA’s more restrictive definition of “excess benefit plan” which covers plans which provide benefits in excess of IRC Section 415 only). Distributions which are made from the excess benefit portion of the plan will qualify regardless of the form or length of payment. Therefore, lump sum or short term installment payments could be permitted (or even made mandatory) for such distributions. Distributions which are made from that portion of the plan which did not qualify as an “excess benefit plan” should follow the plan design recommendations made above.
Newport Group, Inc. and its affiliated companies do not render tax or legal advice and the material contained within should not be interpreted or relied upon as constituting tax or legal decisions.