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State tax challenges of deferred compensation

Nov 10, 2022

The pandemic has had a game-changing effect on remote work. While it’s easier than ever to work from anywhere, state taxation has become more complicated than many people realize when they live and work in different states — and sometimes multiple states. This increased mobility has added a layer of complexity for individuals with deferred compensation.

We’ll explain the major state personal income tax considerations that apply to deferred compensation or retirement income.

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.  

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.

Allocation periods

Absent special rules, income from nonqualified stock options (recognized in the year of exercise) may be allocated using the percent of in-state workdays during the year of exercise. However, some states allocate this kind of income using the percent 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 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 rightsor 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 percent of days worked in-state during the year of exercise.
    • Some states source the income by apportioning it times the percent 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. The table below provides a cross section of the types of allocation periods that states use for sourcing stock option income:

State Allocation period Authority
California Grant to exercise
FTB Pub. 1004
Idaho Grant to vest
Idaho Rule 35.01.01.271.02.b
Illinois Presumed earned ratably over last five years of service
86 ILAC 100.3120(b)(1)
Minnesota Grant to later of vest or sale
Rev. Not. 08-10
Oregon Grant to exercise
O.A.R. 150-316-0165(3)(d)(B)

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 in to the Michaelsen case would be an individual who has relocated out of the state from which they previously worked and received statutory stock options.

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.

Retirement income in this case refers to:

  • Qualified pension plans, qualified annuity plans or qualified individual retirement plans
  • Nonqualified plans that would have been qualified plans had applicable income thresholds not been exceeded
  • Nonqualified 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, 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.

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Author(s)

Mandy R. Riles, CPA
Tax Manager
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