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New law clamps down on non-resident taxation

Recent federal legislation severely limits–in fact nearly eliminates–the ability of states to tax pension income received by non-residents.
The pension income of former state residents now living in another state has been a favorite revenue source of high-tax states like New York and California. It has been politically “easy money.” The only people hurt were no longer residents of the taxing state and no longer voted in the state. Moreover, since the issue only arose for former residents who voluntarily retired to another state, it was almost a “payback” for leaving the state.
Not that states did not have a legitimate argument for taxing this income. The theory went as follows: The income was earned while the individual was a resident and working in the state. Following the federal income-tax rule, the state chose not to tax the income contributed to a qualified pension plan on behalf of the individual at the time the individual earned the money. Nor was the investment income taxed as earned in the retirement-plan trust. Rather, the state waited and taxed the distributions from the plan. If the individual was no longer a state resident when the distributions were paid, this should not matter; since the person earned the money while working in the state, the state should be able to tax it.
New York was fairly typical of high- tax states in pursuing revenue from this type of income. New York formerly taxed all retirement benefits if the benefits were earned while the individual worked in New York, with two exceptions: New York provided an exception for benefits payable solely in the form of an annuity, payable in regular payments over not less than half of the payee’s actuarial life expectancy. Also, New York excludes $20,000 of retirement benefits received each year from taxation, whether the taxpayer is a resident or non-resident of New York.
While these exclusions did protect many benefits, there were many situations where New York sought income taxes from non-resident retirees. For example, a fairly typical arrangement for a retiree is to take a lump-sum distribution from his employer’s pension plan and roll the money into an individual retirement account. While this may be fine planning for many purposes, New York residents found that, having then retired to Florida, the distributions from the IRA would typically be subject to New York income tax. Moreover, for those who worked and earned benefits in several states, calculating the amount of any specific distribution years later would be extraordinarily difficult at best.
It was the aggressive efforts of states like New York and California to tax such income, and the complaints of individuals now residing in states like Florida, that led the federal government to act. The new statute quickly goes straight to the heart of the matter. It states quite simply that no state may impose an income tax on the retirement income of a non-resident individual. It defines “retirement” income to include essentially any distributions from a qualified pension plan, whether in the form of a defined-benefits plan, a defined-contributions plan, an IRA or similar arrangements.
The benefits of the statute, however, are not limited to qualified plans. Two forms of non-qualified deferred compensation are protected from non-resident state taxation as well. First, any deferred compensation paid as part of a series of substantially equal payments for the life expectancy of the recipient or a period of not less than 10 years is protected by the statute. Thus, annuity-like benefits are protected.
Secondly, any payment under a “makeup” plan is protected. A makeup plan is a non-qualified plan for highly compensated employees that is maintained solely to provide retirement benefits in excess of the limitations imposed by the qualified-plan rules. The qualified-plan rules provide a multitude of limitations on amounts that can be deferred on a tax-deductible basis.
As an overly simple example, the code currently imposes a cap of $30,000 on the amount that can be deferred under a defined-contribution plan. It also limits a participant’s compensation to a maximum of $150,000 for purposes of the contribution formula.
Assume for a moment that a corporation’s plan calls for a straight 20 percent of pay to be contributed to the plan on behalf of all employees. Employees with salaries of up to $150,000 will face no problems under the limitation; their contributions will be at or below $30,000. But what of the employee with a salary of $300,000? His regular contribution would be $60,000, but the $30,000 limitation will prevent his contribution from going that high. In a makeup plan, the extra $30,000, which cannot be contributed on a qualified basis, is set aside or promised by the corporation to the employee in a non-qualified deferred-compensation arrangement.
There are numerous other limitations and a multitude of ways in which makeup plans can be designed. But the new statute simply provides that any arrangement “maintained solely for the purpose of providing retirement benefits for employees in excess of the limitations” imposed by the code is entitled to the protection of the statute.
The statute is generally well-drafted and accomplishes most of its goals simply and clearly. For example, essentially all benefits under a qualified plan are protected simply by cross-reference to Internal Revenue Code provisions. In short, if your plan qualifies for federal income-tax purposes under the code, it qualifies for protection from non-resident state taxation under this statute.
However, in the arena of non-qualified deferred compensation, there are no code cross-references, and planning issues are more evident. For example, one area of protection is for makeup plans. The definition of a makeup plan requires that the plan be maintained solely for purposes of providing benefits in excess of the qualified-plan limitations. Many deferred-compensation plans do this and more. That is, they may provide benefits in excess of the qualified-plan limitations, but may also be used as special incentive awards for key executives, or for other purposes. Benefits under such plans will presumably not qualify for the statute’s protection, because they are not designed solely to make up for code limitations.
In such circumstances, the corporation’s non-qualified benefit plan should be restructured to ensure that the statute’s benefits are available. The simplest way to accomplish this restructuring would be to create two plans. The first would be a pure makeup plan, designed solely to provide the excess benefits. The second plan would contain any benefit options the company desires to provide, but which do not fall within the definition of a makeup.
In this way, the benefits provided under the first plan will retain the statute’s protection. While benefits under the second plan may not have such protection, at least they will not prevent the makeup plan from qualifying under the statute. It would also be possible to make benefits under the second plan payable over 10 years in order to meet the test for annuity-type payments.
The new statute provides real simplicity for individuals in retirement. With respect to most retirement income, they will now need to worry about filing returns and paying taxes only in their resident state. If they have moved to Florida or some other state with no income tax, they will have no state income tax on their retirement benefits.
(Michael McEvoy is a partner in the law firm of Harter, Secrest & Emery, where he concentrates his practice on tax matters.)

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