Reporting on Non-qualified Deferred Compensation Plan distributions.

[Guest Monster]

How are distributions from these plans treated? Is there mandatory 20% tax withholding at the time of distribution?

Are these distributions reported on tax form W2 or 1099?

Any reference material you can refer me to would be appreciated.

[Guest rpolete]

Distributions from these types of accounts are treated as wages, deferred compensation.

They require W2's.

The tax on this is tricky and has been unclear from the IRS regs. W4's for withholdings are advisable; however, you can use a standard of 28% withholding on federal if the particiapant does not fill out a w4 for the plan. You must know if the employer took the deferred comp into account in the year in which it was earned or not. Otherwise you should take the amount into account at the time when there is no substantial risk of forfiture of the funds. IRS ss 31.3121 deals with nonqualified plans. State tax withholdings are even stranger. Some states think that because the income was earned in their state that they should be able to tax it. I believe every state that has argued this has lost. Some states are manditory withholding states and you use the wage tax tables for withholding. If you have access to the Panel Publishers answer book on cd rom they have 15 chapters on nonqualified plans. On line you can find some information through searches. Also some spicific information is at www.benefitslink.com/index.shtml and at www.us.kpmg.com/compben/march99.

Once you get you feet wet get some legal advice.

[This message has been edited by rpolete (edited 01-07-2000).]

[This message has been edited by rpolete (edited 01-10-2000).]

[This message has been edited by rpolete (edited 01-10-2000).]

[401 Chaos]

I just wanted to follow up on rpolete's reply below to see if anybody had any recent experience with states attempting to go after distributions from nonqualified plans to individuals who worked in the state when the compensation was deferred under the plan but have moved out of state and are nonresidents of the former "work state" when distributions are actually made.

My understanding is that the Pension Source Act (4 U.S.C. § 114) prohibits such efforts by states with regard to distributions from most qualified pension plans and even some nonqualified deferred compensation plans; however, in order to qualify as a nonqualified deferred compensation plan, the distributions must generally be made in equal periodic distributions over (i) the individual's lifetime, or (ii) a period of at least 10 years.

We have a nonqualified deferred comp plan that permits lump sum distributions or distributions in equal installments over a period of up to 15 years. As a result, we have some participants with distributions over less than 10 years who would presumably not be protected by the Pension Source Act.

Curious if any states are still attempting to go after such distributions or if that activity has generally gone away. Thanks.

[Guest Harry O]

Are you reporting these distributions to the work state if they are for less than 10 years? Most states require you to report. If so, this will trigger state attention. Of course if you are not reporting, it makes it difficult for the state to track down. But if you are not reporting, you are putting the company at risk because the state will go after the company for the taxes that were not withheld. This leaves you chasing down the former employee who probably paid tax on 100% of the payment to his state of residence (assuming we are not talking about FL, TX, etc.). These former employees will tell you to buzz off and your choice will be to sue them or write off the payment.

Companies should think long and hard about whether they should report and withhold taxes to the work state for distributions that don't meet the 10 year exception.

P.S. I assume that your plan is not a "mirror" NQ plan that simply makes up benefits under a qualified plan. If so, it is exempt from work state tax regardless of whether payments are made in a lump sum, less than 10 years, etc.

[401 Chaos]

Harry,

Thanks for your comments. I was under the impression (probably erroneously) that some states had more or less voluntarily given up on going after nonqualified deferred compensation amounts paid out to former residents over less than 10 years following enactment of the Pension Source Act. However, I have not been able to find any surveys of various state tax positions on this subject. Is it your experience that all states generally impose income taxes on amounts not exempted by the Pension Source Act or will we simply need to look at each state in which we have employees separately. Thanks

[Guest Harry O]

I can't say what the "general" rule of thumb is out there. Many states do conduct payroll audits of companies and do ask how the company reports post-termination payments. I'm in the Northeast where tax rates are high and more people are leaving than coming into the state. So, as you would expect, the tax authorities are interested in this issue.

Unfortunately, if you start looking state-by-state you will find that you have a statutory obligation to withhold if you really read the relevant law closely. You'll end up making a judgment whether it is worth the hassles of complying. We've generally taken the position that we will report to the last state worked and the state of residence. We may miss some states in between if the employee moved around but it is just too burdensome to do anything more.

Good luck. This area quickly can become a morass.

[Guest mjb]

What liabilty risk does a corp run if it has no presence in the work state of the employee. Eg. employer operates business in in TX but has NY employee who accumulates Def comp. What is corp liability to NY if it does not w/hold tax when employee retires to FL since it has no presence in NY?

[Guest Harry O]

How does a company not have a taxable presence in the employee's work state?

In your example, the TX company has a NY employee presumably performing services for the TX company in NY. Depending on the nature of the employee's duties, it is hard to see why the TX company doesn't have "presence" in NY and a withholding and reporting obligation to NY in this case for both current and deferred wages.

[Steelerfan]

For example in NY, an "employer" is defined as "any person or organization . . . having an office or doing business in New York, whether or not a paying agency is kept in New York. (emphasis added)" (Reg. 171.2). Therefore, in accordance with HarryO's conclusion, virtually any employee of an out of state employer doing his "employer's business" in NY is subject to state taxation for $ earned while standing on NY soil. As a practical matter, in NY, there would be no withholding obligation on the ER as long as work days are less than 15 days, but the EE could still be subject to income tax for one day spent in NY if he earns wages greater than his personal exemption amount. (reg 171.6(b)(4)).

As pointed out above, the general rule would seem to be that every state with a personal income tax will want to tax any employee who "works" there as a nonresident, however most payroll systems cannot currently handle such a burden. With the proliferation of long-distance telecommuting, this issue will no doubt be more on the radar screen, as a state by state analysis would have to be done-tracking where the employee is every single day of the year. Some states, like PA and NJ have reciprocal agreements so that if an employer withholds, reports and pays income tax to the state of residence, they are ok in the work state.

In addition, the issue with nonqualified deferred comp may hinge on whether the state follows the federal rules for income taxation or tries to tax the $ when earned. This was an issue in PA prior to a recent change in the law that now puts PA in line with the federal income taxation rules on NQDC (income taxation on distribution). Prior to this change, PA argued that personal IT should be paid when the $ is earned. This would have caused problems for individuals whose ERs did not withhold PA income tax and then moved to Fla and took a distribution. I would hope that now PA could not or would not try to tax NQDC plan distributions to a non-resident of PA even if they earned the $ in PA, since they were not taxable by law when they were earned.

This may be an area where Congress will have to intervene, like the NY commuter tax.

I don't understand the second post in this thread as it jumps from income taxation for FICA taxation without any transition?

[Guest mjb]

You are ignoring the basic problem of how the state in which the employee works will enforce its withholding rules if the employer does not have an office in the state and merely has an employee. Many corp employees perform services in states where the employer does not maintain an office.

NY requires that an out of state employee who telecommute into an office in in NY must pay NY state taxes and withholding. If the employee performing services in NY is a contract employee for an out of state employer there will be no tax record that the employee ever worked in NY.

[Steelerfan]

In general your point is a valid one. New York State statute sec. 674 requires an employer to file a NY state return of tax withheld on Form WT-1. If the employer doen't file, how will the taxing authorities find out? A taddle tale, I guess?

Isn't the same true where an employee who works all his life for cash under the table and, obviously, the employer never withheld taxes and the employee never filed a federal return? How does the IRS catch these people? I don't know. There is an element of the honor system to obey the law and if you fail to do so and get caught you should be prepared to pay the costs.

This is all about the practicality and burdens of the executive branch of governent administering statutory law.

[Guest mjb]

There are a lot of taxpayers who would disagree with the opinion of the NYS state tax dept that they owe NY state tax on wages paid if they telecommute to a NY employer when they work from home outside of NY instead of mailing the work product to the company from home. It doesnt make sense to tax an out of state worker based upon the means used to communicate with the employer.

[Steelerfan]

There are a lot of taxpayers who would disagree with the opinion of the NYS state tax dept that they owe NY state tax on wages paid if they telecommute to a NY employer when they work from home outside of NY instead of mailing the work product to the company from home. It doesnt make sense to tax an out of state worker based upon the means used to communicate with the employer.

The issue isn't how they get the work to the NY employer, it's that the state wants the income unless the work cannot conceivably be performed in NY. The "convenience of the employer" rule is used to "pretend" that the out of state employee lives in NY and therefore is deemed to be performing the work in NY.

It isn't just the state tax Dep't--the NY courts are adhering to this view and hold that it is U.S. constitutional. You may disagree, but you will lose your tax case. Hopefully federal legislation in the works will solve this.

[Guest mjb]

You have any authority for that statement? Presence in a state is the touchstone for income taxation, e.g., a non resident who works in an office of the employer in a state is taxed the same as a resident. Professional athletes of visiting teams are taxed pro rata for those games they play within a state because they have a physical presence in the state. There is no principal under the law that exempts income from taxation only if it is not possible for the work to be performed in the state where the employer is located because all services could could conceivably be performed there. However a non resident working from home has no physical presence in the state where the employer is located. Dialing up a computer to connect to employer creates no more presence in the state where the employer is located than transmitting the information by a fax and it is fiction to claim that the employee's connection to the employer via a telephone line to a computer terminal creates a "presence " in such state any more than a retailer that fills an order received on line from a resident in another state has a presence that requires the collection of the sales tax in the state of the customer.

Under your logic any communication device which is used by an employer and a worker in different states creates a presence in the state where the employer is located whether it is by telephone, fax, computer or even the US mail and would apply to independent contractors since there services could conceivabley be performed in the state where the employer is located.

You are oblivious to the impossiblity of tracking down people who work out of state in the internet age any more than states can tax on line purchases made to out of state retailers who do not have a physical presence in the state. I also do not think the case you refer to stands for the principle you think it does but applies to a more narrow situation, e.g., an out of state employee who has an office in NY where he is regularily employed cannot exempt income earned on those days when he telecommutes/works from home from NY taxation since he is regularily employed in NY.

[Steelerfan]

I was using NY as an example, because that is the state that we were talking about when this issue was raised. Other than federal tax deductions for travel expenses (IRC 162(a)(2)), NY is the only state I know of that uses this harsh (and maybe ultimately unconstitutional) rule to tax employees who are physically working out of state (i.e. telecommuters). (A parallel issue exists for purposes of travel expense deductions--an employee is "deemed to live" near his principal place of employent even if his residence is located in another state). I never meant to imply that this was a general rule for state income or other taxes. There are many different permutations of facts, and we may not be disagreeing.

As a preliminary matter, for both tax and non-tax legal issues, a physical presence is not the only event that can cause a sufficient nexus (due process) to create a relationship between an entity and a governmental authority (e.g. you can be sued in a state you've never been to if you own property in that state). Also, other factors may or may not create a sufficient nexus as b/w different types of taxes. Since we are talking about income taxation, most states do generally require a presence in their state in order to tax nonresidents who earn money there, as in your example of ballplayers who play a game out state. But the "convenience of the employer test" is used by NY to subject the money earned by nonresident employees of NY-based employers who telecommute to taxation in NY for work performed outside of NY unless the services "of necessity, as distinguished from convenience, obligate the employee to out of state duties in the service of his employer." Sec 631©; reg 132.18(a); Zelinsky v NYS Tax App Trib, 801 NE2d 840 (2003). In other words, the money earned while working at home cannot be allocated to the home state (such as CT) unless the work has to performed at home, and the employee is, in essence, treated as though they live in NY--it's a fiction so that NY can get the tax dollars. There is virtually no way for a telecommuter to meet this test in 99.9% of cases. NY is just peaved that people don't want to live there and they're protecting (or rather IMO extending) their tax base.

Theoretically, the new york state dep't of taxation could try to use the convenience of the employer rule to tax a nonresident telecommuter who has never even set foot in NY, but the department does not try do that. Under the regulations a telecommuter who sets foot in NY for only one day could suject all of his income for the year to taxation in NY. This is a very harsh rule, and as you point out it creates impossible administrative burdens of nightmare proportions, not to mention potential double taxation. The only possible way to avoid double taxation would be for the telecommuter to never set foot in NY all year or win a federal court case. I'm not sure how independent contractors fit into this, but my main concern is the obligation of the ER to withhold, the effect on the EE is a secondary concern, unless I'm the EE.

[401 Chaos]

Can I revive this thread to raise a question touched on above but I'm not sure fully addressed or answered? Would like to know if there is any later or better guidance.

Assume employer with NQ plan in State T (which imposes a state income tax) has employee who moves to State NT (where there is no personal income tax) before receiving distributions from the NQ Plan over a period of 15 years. It appears very likely that the former employee has clearly set up legal residence in State NT and is no longer a resident of State T. As such, the distributions from the NQ Plan would appear to be "protected" from State T taxes by the federal law. The employer has no connections with State NT other than the fact this one individual has moved there--it doesn't have an office there, it doesn't have employees there, it doesn't have other retirees or NQ plan participants there--in fact the states are on opposite sides of the country. What legal obligation, if any, does the employer have with respect to withholding on the distributions. Could the employer report and withhold State T taxes on amounts earned in State T but distributed later and put the burden on the employee for seeking refunds from State T as a result of the federal law. Alternatively, could the employer simply not withhold State T taxes on the distributions based on the federal law and also not take any action in State NT. This is a small employer with small NQ Plan and it does not wish to learn anything about State NT, its tax reporting rules, its residency requirements / determinations, etc.

[Mark Whitelaw]

Saw your other thread in the 409A forum this morning and it intrigued me to do some google searches on the topic. As an example, found a 2012 piece on the state of Michigan’s pension plan. They withhold if the person still resides in Michigan, don’t if they don’t, and have a waiver of withholding form for those in-state that don’t want withholding.

[Eric Taylor]

Just reading the earlier post, it appears the new state of residency doesn't have a personal income tax so there probably isn't much or anything to be done with respect to reporting payments to that state but employer just doesn't want to be bothered. Their preference would be to just report and withhold state income tax payments to the one source state that all their participants have in common rather than having to worry about reporting / withholding to another state (be it taxable or nontaxable). I suspect it's unlikely to be that easy but if their direct question is whether a new state with whom they have no other contacts could legally compel them to report the withholdings, I'm not sure. The federal law prevents states from taxing those amounts but I'm not sure it requires employers to report to states with whom they don't have contacts. Seems for most large, multi-state employers the federal rule could help save them time and hassles but in the case of a single state company it arguably complicates things.