Leaving New York? Plan for the Taxation of Deferred Compensation
March 01, 2021
Into the Fire
Let’s play a game of “Guess Who?”[i]
Here are the clues:
- the legislature has called for an investigation into his mishandling of the crisis brought on by the pandemic,[ii]
- he has stated that he doesn’t trust the advice of health experts,[iii]
- members of the opposition party, as well as his own, are calling for his impeachment,[iv]
- members of his own party are moving to strip him of certain powers,[v]
- women are accusing him of improper advances,[vi]
- he is described as having made a threatening phone call to an elected official of his own party during which he insisted that the official “issue a new statement clarifying his remarks,” which were critical of him;[vii]
- he is from Queens, New York; and
- he attended Fordham University as an undergraduate.
Did you say former President Trump? Nope. Try again. Give up? Please see the answer at endnote “viii.”[viii]
But “why should we care about the answer?” you ask.
Taxes: Cuomo vs the Legislature
It’s ironic, but if you’re the owner of a closely held New York business, the personality described above may be the last line of defense against a legislature that is eager to raise existing taxes and to enact new taxes.
Governor Cuomo has consistently argued that the State cannot tax its way out of the current fiscal crisis, though his proposed budget – in an attempt to assuage Albany’s more vocal advocates for tax increases – does provide for increased income tax rates (in the form of “temporary surcharges”) for certain high-income taxpayers.[ix]
In addition, Mr. Cuomo has long been concerned about driving wealthy New Yorkers and their businesses out of the State by increasing their tax burden.[x] Until this year, his ability to veto tax legislation without being overridden by his own political party – the Democrats controlled the State Senate but did not have a supermajority in that chamber – has acted as a check on tax increases. That changed last November; beginning with 2021, the Democrats now have supermajorities in both chambers.
Even before Mr. Cuomo’s recent troubles, however, the New York Senate and Assembly have seen the introduction of many revenue-raising proposals, including the following:
- stock transfer tax[xi]
- pied-a-terre tax[xii]
- inheritance income tax[xiii]
- mark-to-market tax on capital assets[xiv]
At the same time, the future of New York’s “convenience of the employer” rule[xv] may be in doubt, thanks to a challenge filed with the U.S. Supreme Court by New Hampshire against the Massachusetts version of the rule.[xvi] Under this rule, New York sources a nonresident employee’s wages to New York, and taxes them accordingly, if the employee’s office or primary work location is in New York, notwithstanding that the employee may perform most of their work outside the State.
Under the foregoing circumstances, the Governor’s ability to negotiate with the legislature in the hope of tempering the harshness or reach of any tax proposals may be compromised.
For some business owners, and their key employees, who may have been counting on Mr. Cuomo’s powers of persuasion to keep Albany’s tax hounds at bay, a withdrawal from New York may suddenly seem inevitable.
Although there are many issues that these individuals will have to consider in planning their move, a relatively recent advisory opinion[xvii] published by the Department of Taxation (the “Dept.”) offers some welcome guidance to both employers and employees regarding the taxation of deferred compensation that is payable to a nonresident.
The taxpayer to which the opinion was issued (“Taxpayer”) asked whether payments from its nonqualified deferred compensation plans to individuals who, at the time of payment, were nonresidents of New York were New York source income for personal income tax purposes and subject to income tax reporting and withholding.
Taxpayer maintained offices and transacted business in various states, including New York. Taxpayer maintained a 401(k) Plan and a Pension Plan, both of which qualified for favorable tax treatment under the Code.[xviii] Because of their tax-favored status, the Code limits the contributions and benefits that participants can receive under such plans.[xix]
Taxpayer also maintained two unfunded plans that were nonqualified deferred compensation plans.[xx] The sole purpose of the nonqualified plans was to supplement participants’ qualified plan benefits by providing benefits in excess of the statutory limits that apply to the qualified plans.[xxi] The first nonqualified plan provided for elective deferrals, company matching contributions, and several types of non-elective company contributions.
This plan generally provided for payment following a participant’s termination of employment. Payments may be made in the form of a single lump sum or between two and ten annual installments. If a participant died before benefits have been paid in full, the remainder of the participant’s benefit is paid to one or more designated beneficiaries in a single lump sum payment.
Under the second nonqualified plan, a participant’s plan benefit equaled the benefit the participant would have accrued under the Pension Plan without regard to the above-referenced limitations under the Code, minus the Pension Plan benefit the participant actually accrued under the Pension Plan.
Plan generally provides for payment following a participant’s termination of employment. Payments may be made in the form of a single lump sum, a single-life annuity, or a joint and survivor annuity. Different portions of a participant’s Plan benefit may be paid in different forms.
The nonqualified plans were subject to the requirements of Sec. 409A of the Code. In order to comply with Sec. 409A, any deferred compensation must be paid upon a participant’s “separation from service,” as that term is defined for purposes of Sec. 409A. In limited circumstances, a participant’s “separation from service” is not the same as the date the participant terminates employment with Taxpayer for other purposes.[xxii]
In accordance with terms of the nonqualified plans, all amounts payable under such plans constituted general unsecured obligations of Taxpayer and were payable out of Taxpayer’s general assets. The sole purpose of the nonqualified plans was to allow participants to make elective deferrals and/or receive company-provided benefits that they were unable to make or receive under the qualified plans because of the limitations imposed under the Code.
Taxpayer stated that when distributions are made from the plan they are reported on Form W-2, Box 1, are subject to federal income tax withholding and are considered supplemental wages for federal income tax withholding purposes.[xxiii]
The Dept.’s Analysis
The Tax Law provides that the New York source income of a nonresident individual shall be the sum of the net amount of items of income, gain, loss and deduction entering into the nonresident’s federal adjusted gross income derived from or connected with New York sources, including those items attributable to a business, trade, profession or occupation carried on in the State.[xxiv]
The Tax Law also requires that every employer maintaining an office or transacting business within New York, and making payment of any wages taxable under the State’s personal income tax, must deduct and withhold from the employee’s wages an amount of tax substantially equivalent to the New York State personal income tax reasonably estimated to be due resulting from the inclusion in the employee’s New York adjusted gross income or New York source income of their wages received during the calendar year.[xxv]
Payments that are considered wages for Federal income tax withholding purposes also are considered wages for payments of withholding for New York State personal income tax.[xxvi] Every employer required to deduct and withhold taxes from wages under the personal income tax must file a New York State withholding tax return and pay over the taxes required to be deducted and withheld.[xxvii]
Under Federal law (the “Pension Source Law”),[xxviii] no state may impose an income tax on any retirement income of an individual who is not a resident or domiciliary of such state. This legislation was enacted in 1996 in response to the attempt by many states (including New York) to tax the retirement income of former residents.
According to the accompanying committee report,[xxix] the states have typically followed the Federal practice of deferring income taxes on pension contributions and related investment earnings until they are distributed to the taxpayer after their retirement.
Objections arose, however, when at that point the retired taxpayer had relocated to another state; after all, wasn’t the deferred income earned while the individual was a resident of the state, and wasn’t the deferral of recognition a matter of legislative grace?
Congress rejected these positions, citing what it described as the “unreasonable” burden that source taxation of retirement income imposed upon the retired former resident.
For purposes of the Pension Source Law, the term “retirement income” means any income from qualified plans.[xxx] However, it also includes income from any nonqualified plan[xxxi] if such income (i) is part of a series of substantially equal periodic payments,[xxxii] not less frequently than annually, made for the life or life expectancy of the recipient, or the joint lives or joint life expectancies of the recipient and the designated beneficiary of the recipient, or a period of not less than 10 years, or (ii) is a payment received after termination of employment and under a 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 on contributions or benefits imposed by the Code with respect to qualified plans.[xxxiii]
The Dept. observed that, in earlier opinions, it had determined that, under the Pension Source Law, lump sum payments to nonresident employees from a nonqualified deferred compensation plan maintained by their employer were not New York source income for New York State personal income tax purposes.[xxxiv] Like Taxpayer’s nonqualified plans, the nonqualified plan referenced in those opinions provided a benefit in excess of the benefit the employee was entitled to receive from a tax-qualified profit-sharing plan, due to the application of various limits under the Code, and provided for payment following the employee’s termination of employment.
The Dept. indicated that although the facts in the present matter were, in some respects, substantially similar to the facts set forth in its earlier advisory opinions, in that the purpose of the nonqualified plans in both cases was to allow participants to make elective deferrals and/or receive company-provided benefits that they were unable to make or receive under the employer’s qualified plans because of the limitations imposed under the Code.
However, the plans in the present matter differed from the plans considered in those earlier opinions because, in order to comply with Sec. 409A of the Code, the plan benefits in this matter may in certain situations be received by participants prior to termination of their employment.
The Dept. concluded that the payments made by Taxpayer to nonresident former employees after termination of employment from Taxpayer’s plans that are maintained for the sole purpose of providing employees benefits in excess of the compensation limitations for qualified plans under the Code conformed to the definition of “retirement income” under the Pension Source Law.[xxxv] Therefore, those payments will not be subject to New York State income tax, income tax withholding or reporting.
However, payments made by Taxpayer to nonresident employees prior to termination of employment do not come within the definition of “retirement income” and are not protected by the Pension Source Law. Therefore, any income, gain, loss or deduction derived from New York sources with respect to the distributions to the nonresident individuals from these plans will be subject to New York personal income tax.
Moreover, since the payments received by the nonresident from the nonqualified deferred compensation plans are considered wages for Federal income tax withholding purposes, the payments also will be considered wages for New York State withholding tax purposes and Taxpayer must deduct and withhold from these payments an amount of tax substantially equivalent to the New York State personal income tax reasonably estimated to be due and file a New York State withholding tax return and pay over the taxes required to be deducted and withheld.
As indicated above, the Dept. concluded that the payments made to nonresidents after termination of employment conformed to the definition of “retirement income,” and were not subject to New York State income tax withholding and reporting. However, payments made to nonresidents prior to termination of employment did not conform to the definition of “retirement income” and were subject to personal income tax reporting and withholding.
Based on the foregoing, a highly paid employee (including certain owner-employees of a New York corporation) who may be considering a move away from New York and toward a warmer, and tax-friendlier, climate, may want to review their deferred compensation arrangements right away. If these arrangements do not qualify for the “retirement income” exclusion from New York income, described above, it may still be possible to redress any shortcomings.
[i] Published by Milton Bradley.
[ii] https://www.nytimes.com/2021/01/28/nyregion/nursing-home-deaths-cuomo.html .
[iii] https://www.nytimes.com/2021/02/01/nyregion/cuomo-health-department-officials-quit.html .
[iv] https://thehill.com/homenews/state-watch/540859-albany-billboard-calls-for-cuomos-impeachment-amid-controversies .
[v] https://www.nytimes.com/2021/02/17/nyregion/cuomo-nursing-homes-deaths.html .
[vi] https://www.nytimes.com/2021/02/27/nyregion/cuomo-charlotte-bennett-sexual-harassment.html .
[vii] https://www.nytimes.com/2021/02/17/nyregion/nursing-homes-cuomo-ron-kim.html .
[viii] New York’s Governor Cuomo.
I confess, I had high hopes.
In Plato’s Republic (VI, 491-d, 491-e and 492-a), Socrates warns us of the very talented:
“We know it to be universally true of every seed and growth, whether vegetable or animal, that the more vigorous it is the more it falls short of its proper perfection when deprived of the food, the season, the place that suits it. . . .
“So it is, I take it, natural that the best nature should fare worse than the inferior under conditions of nurture unsuited to it. . . .
“[S]hall we not similarly affirm that the best endowed souls become worse than the others under a bad education? Or do you suppose that great crimes and unmixed wickedness spring from a slight nature and not from a vigorous one corrupted by its nurture, while a weak nature will never be the cause of anything great, either for good or evil?” . . . .
“Then the nature which we assumed in the philosopher, if it receives the proper teaching, must needs grow and attain to consummate excellence, but, if it be sown and planted and grown in the wrong environment, the outcome will be quite the contrary unless some god comes to the rescue.”
Whatever the source of Mr. Trump’s appeal, Plato would never have applied the foregoing to him.
[ix] https://www.taxlawforchb.com/2021/01/taxes-in-new-yorks-fy-2022-budget/ . Also included in the budget is the legalization and taxation of cannabis and gaming.
[x] https://www.foxbusiness.com/lifestyle/new-yorks-wealthy-taxpayers-return-cuomo .
[xi] A.7791 and S.6203. These have prompted threats to leave New York from members of the State’s financial services industry. Financial activities account for almost 30% of the state gross product. https://www.osc.state.ny.us/reports/finance/2020-fcr/economic-and-demographic-trends .
[xii] S.44/A.4540. This bill would authorize the City to impose a tax on expensive second residences located in the City.
[xiii] S.3462. https://www.gothamgazette.com/state/10171-state-legislators-revenue-inheritances-gifts-heirs-tax-rich . The bill also calls for a new gift tax.
[xiv] https://www.taxlawforchb.com/2020/12/new-yorks-proposed-billionaires-tax-bad-idea/ .
[xv] 20 NYCRR 132.18.
[xvi] https://www.taxlawforchb.com/2020/10/new-york-business-nonresident-telecommuters-and-the-taxation-of-wages-earned-remotely/ .
New Jersey and Connecticut have filed amicus briefs in support if New Hampshire. https://www.taxlawforchb.com/2020/12/state-taxation-of-telecommuting-employees-and-their-nonresident-employers/ .
[xvii] N.Y. Dep’t of Tax’n & Fin., TSB-A-20(8)I, 10/06/20. An Advisory Opinion is issued at the request of a taxpayer. It is limited to the facts set forth in the opinion and is binding on the Department of Taxation only with respect to the taxpayer to whom it is issued, and only if the taxpayer fully and accurately described all relevant facts to the Dept.
[xviii] IRC Sec. 401(a).
[xix] IRC Sections 401(a)(17), 401(k), 401(m), 402(g) and 415.
[xx] As defined in IRC Sec. 3121(v)(2)(C). https://www.law.cornell.edu/uscode/text/26/3121 .
[xxi] An “excess benefit” plan.
[xxii] These rules were designed in accordance with IRS rules to prevent abusive arrangements in which participants could avoid “terminating” by working very few hours or taking an extended leave, thereby delaying their payments. Any attempt by Taxpayer or the participant to postpone such payments until the participant terminates employment would trigger substantial tax penalties under IRC Sec. 409A.
[xxiii] Treas. Reg. Sec. 31.3402(g)-1(a)(1)(i).
[xxiv] Tax Law Sec. 631(a).
[xxv] Tax Law Sec. 671(a) and 20 NYCRR 171.1.
[xxvi] 20 NYCRR 171.3(a).
[xxvii] Tax Law Sec. 674(a) and 20 NYCRR 174.1
[xxviii] 4 USC Sec. 114. https://www.law.cornell.edu/uscode/text/4/114 .
[xxix] H. Rept. 104-389.
[xxx] Including IRC Sec. 401(a) and 401(k) plans. See 4 USC Sec. 114(b)(1)(A)-(H).
[xxxi] The term “nonqualified deferred compensation plan” means any plan or other arrangement for deferral of compensation other than a qualified plan. IRC Sec. 3121(v)(2)(C).
[xxxii] The fact that payments may be adjusted from time to time pursuant to such plan, program, or arrangement to limit total disbursements under a predetermined formula, or to provide cost of living or similar adjustments, will not cause the periodic payments provided under such plan, program, or arrangement to fail the “substantially equal periodic payments” test.
[xxxiii] See 4 USC Sec. 114(b)(I).
By contrast, items of nonretirement income derived from New York sources include those attributable to income received by a nonresident related to a business, trade, profession or occupation previously carried on in this state, whether or not as an employee, including but not limited to, covenants not to compete and termination agreements. Tax Law Sec. 631(b)(1)(F).
[xxxiv] TSB-A-00(6)I and TSB-A-01(2)I.
Also, in TSB-A-16(1)I, the Dept. determined that, under the Pension Source Law, a lump sum payment to a nonresident employee after termination of employment from a nonqualified deferred compensation plan maintained by the retiree’s former employer was not New York source income for New York State personal income tax purposes. The nonqualified plan referenced in that opinion provided a benefit in excess of the benefit the employee was entitled to receive from a tax-qualified plan due to the application of the Code limits referenced above.
[xxxv] 4 USC Sec. 114(b)(1)(I)(ii).