State tax challenges of deferred compensation

Deferred compensation plans can be a powerful tool for long-term wealth building, but their tax implications aren’t limited to federal rules. With professionals increasingly relocating or working across multiple states, understanding how different states tax deferred income is more important than ever.

Key state personal income tax considerations for deferred compensation include how various states treat the timing of income recognition and the sourcing of retirement income. This includes the taxation of deferred compensation plans themselves, as well as how distributions are taxed depending on a taxpayer’s state of residence at the time of both deferral and payment.

Residency matters

First, establish whether an individual is a resident or nonresident of a particular state. States can tax their residents on their worldwide income, but can only tax nonresidents’ income from sources within their state. As a result, individuals who work and/or live in more than one state need to understand the sourcing rules that govern various types of income. They have to evaluate how they might be taxed by states in which they are nonresidents and consider their overall state tax liability.

With the exception of states that have reciprocal agreements between them, and states that use the notorious “convenience of the employer rule,” the rest source wages to the state where the work was physically performed. While deferred compensation is considered wages under the Internal Revenue Code, it contains notable distinctions. Unlike regular wages, the income from deferred compensation is earned for services performed over several years and possibly in multiple states. This raises questions about how non-qualified deferred compensation is taxed and whether deferred compensation is taxed as ordinary income.

Allocation periods

Absent special rules, income from non-qualified stock options (recognized in the year of exercise) may be allocated using the percentage of in-state workdays during the year of exercise. However, some states allocate this kind of income using the percentage of in-state workdays during the period of time (called the “allocation period”) over which the individual earned the right to the income. Some states, such as New York, even use highly specialized forms for tracking all such items.

To illustrate these concepts, Minnesota serves as a good example. Minnesota Revenue Notice #08-10 cites three main sources of deferred income from wages:

1. Severance pay: This is assigned to Minnesota to the extent that work connected with employment from which the payment is received was performed in Minnesota.
2. Equity-based awards: These may include nonstatutory stock options, stock appreciation rights or restricted stock.
   • Allocation period begins on the date equity-based award is granted and ends at the earlier of the award substantially vesting or the award is sold.
3. Other nonstatutory deferred compensation: The allocation period is the time during which an employee accrued the right to the deferred compensation.
   • Absent special rules, income may be allocated using a percentage of days worked in-state during the year of exercise.
   • Some states source the income by apportioning it times the percentage of days worked in-state during an allocation period.

This Minnesota publication sheds light on the type of information individuals who earn deferred compensation need to track to comply with their individual state taxes. Even though Minnesota uses an allocation period of the later of grant or vest date to the sale date, other states may use a different allocation period. As a result, individuals must ensure that they are using the allocation period required by the rules in the state(s) where they work.

Although this kind of allocation-based sourcing might seem cumbersome, New York’s Michaelsen case illustrates why paying attention to these kinds of details may result in significant tax savings. In 1986, the New York Court of Appeals (the state’s highest court) in Michaelsen (496 N.E.2d 674) asked whether income from an incentive stock option (ISO) was from a profession carried on in New York state, within the meaning of NY Tax Law Sec. 632(b)(1)(B) (later changed to Sec. 631(b)(1)(B)).

• The case held that the only portion of ISO-related income subject to the state’s sourcing rules for wage income was the difference between the fair market value (FMV) of the option and the option price on the date of exercise.
• The case held that any additional gain caused by increases in the FMV of the stock between exercise and sale were characterized under NY Tax Law Sec. 632(b)(2) (later changed to Sec. 631(b)(1)(B)), i.e., as “intangible income.”
• For nonresidents, the court held that this type of income was not sourced to (taxed by) New York State.

As a result, the type of person who might save quite a bit of money by looking into the Michaelsen case would be an individual who has relocated out of the state from which they previously worked and received statutory stock options. This case highlights the importance of understanding the tax treatment of deferred compensation, especially when moving states.

A major carveout from this type of allocation-based sourcing for compensation applies to compensation that is considered retirement income. Under federal law, 4 U.S.C. 114 (enacted in 1995), largely in response to lobbying from retirees who spent their careers in California, then retired to Florida, and saw California still trying to tax their retirement income, state taxation of retirement income paid to nonresidents is prohibited. This law, also known as the Pension Income Tax Limits Act (PITLA), has significant implications for states not taxing retirement income and states that tax retirement income.

Retirement income in this case refers to:

• Qualified pension plans, qualified annuity plans or qualified individual retirement plans.
• Non-qualified plans that would have been qualified plans had applicable income thresholds not been exceeded.
• Non-qualified plans where payments are made in at least 10 substantially equal annual installments or over the life of the ex-employee.

How Wipfli can help

If you’re unsure whether your compensation qualifies as retirement income or how your deferred compensation plan tax treatment might be affected by moving states, contact a Wipfli advisor to discuss your concerns. Our team has deep experience helping clients optimize state and local tax treatment and navigate complex tax issues related to deferred compensation. We can assist with tax planning strategies, such as bunching deductions or exploring tax-advantaged retirement plans, to help lower your state taxes and manage your overall tax liability.