State Source Taxation of Deferred Compensation: Employers Should Monitor Changes

Employers that maintain deferred compensation arrangements should be aware of state income tax rules regarding compensation earned while an individual is a resident of a particular state. It is also important to understand how these rules intersect with the federal law limiting state source taxation. A recent development in Minnesota provides an example.

Minnesota repealed on March 10 the law that provided an exclusion from state income taxes for compensation paid to nonresidents who earned the compensation while they were residents of Minnesota. Minnesota is still in compliance with federal law limiting state source taxation of deferred compensation—but the prior exclusion was broader than the federal limitation.

This development may have serious implications for Minnesota employers and their employees with respect to various deferred compensation and stock option arrangements.

In general, under the federal source taxation rule, deferred compensation earned by an employee or former employee while a resident of a state, but paid when the individual is no longer a resident of that state, is not subject to that state's income taxes if the compensation is paid over the individual's life or life expectancy or is paid in installments scheduled over 10 years or more, or if the compensation is paid under certain qualified retirement plans or "excess" plans.

The federal source taxation rule is complicated and is subject to a number of ambiguities. Minnesota tax law merely incorporates the federal law by reference. (The federal source taxation law defines the payments to nonresidents that may not be taxed by a state as "retirement income" —but the rule actually applies more broadly to a number of types of deferred compensation payments.)

Prior to the recent amendment, Minnesota law contained a more generous income-exclusion rule. Under this rule, it was simply necessary that (1) the recipient of the wages not be a resident of Minnesota during any part of the year in which the wages were received and (2) the wages were for work performed while the employee was a resident of Minnesota. This exclusion therefore covered additional types of payments that were not covered by the federal source taxation rule, such as compensation from the exercise of stock options and deferred compensation paid in a lump sum payment or short term installments. With the change in Minnesota tax law, such payments are now subject to Minnesota income taxes. The change may also affect other types of compensation, such as severance pay paid to former employees who have moved out of Minnesota.

There is no grandfather rule for this change in Minnesota tax law. Amounts paid any time during 2008 or thereafter under pre-existing compensation arrangements may now be subject to Minnesota income tax. This is so even if prior payments made under those arrangements were not taxed by Minnesota. However, in recognition of the fact that the new law changes the rules in the middle of the year, employers are required to apply Minnesota income tax withholding rules only for payments made after April 1, 2008.

This change presents several practical problems.

• For employers with multi-state operations and employees who have been employed in various states, the employer may not have adequate records regarding the residency of employees at the time various forms of deferred compensation were earned. This will make it difficult for the employer to comply with the Minnesota source taxation rule at the time of payment. Also, for many types of deferred compensation, it may not be clear when the compensation should be considered to be earned, and therefore, when the state residency status should be determined with respect to that compensation. (Keep in mind that these same issues could exist under the tax laws of other states in which the employee has been employed.)
• For employers and employees who would like to change the manner of payment in order to come within the federal rule limiting source taxation (e.g., change from a lump sum payment to annual installments over 10 or more years), compliance with Internal Revenue Code section 409A may be a concern. The rules regarding change of payment elections may limit the ability to change the manner of payment with respect to deferred compensation arrangements subject to section 409A. Changes with respect to payments scheduled to be made in 2008 are particularly problematic.