Definition of eligible retirement benefit plan and application of Pennsylvania personal income tax: December 19, 2003.

On December 19, 2003, Tax Executives Institute filed comments with the Pennsylvania Department of Revenue on Personal Income Tax Bulletins 2003-1 through 2003-5. The comments were prepared under the aegis of TEIs State and Local Tax Committee, whose chair is Baraba Barton of Electronic Data Systems Corp.

Tax Executives Institute has reviewed Personal Income Tax Bulletins 2003-1 through 2003-5 (Discussion Drafts Revised 10/03/2003) (Draft Bulletins) and respectfully submits the following comments. We appreciate the Department of Revenue's making the Draft Bulletins available for comment. In sum, TEI believes the proposed definition of "Eligible Retirement Benefit Plan" is problematic and the proposed application of Pennsylvania's constructive receipt rules in respect of nonqualified deferred compensation plans is misguided.

Tax Executives Institute

Tax Executives Institute (TEI) was established in 1944 to serve the professional needs of business tax professionals. Today, the Institute has 53 chapters in the United States, Canada, and Europe, including our Harrisburg, Philadelphia, and Pittsburgh chapters in Pennsylvania. Our more than 5,400 members are accountants, attorneys, and other business professionals who work for 2,800 of the leading companies in North America and Europe. As a professional organization, the Institute is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the costs and burdens of administration and compliance to the benefit of taxpayers and government alike. The Institute is committed to maintaining a system that works--one that builds upon the principle of voluntary compliance, one that taxpayers can comply with, and one in which the state taxing authorities can effectively administer the tax laws without unduly burdening taxpayers.

Definition of Eligible Retirement Benefit Plan

TEI believes the definition of Eligible Retirement Benefit Plan should follow the pattern of the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA) and hence treat plans that are retirement plans under those statutes as retirement plans for Pennsylvania Personal Income Tax (PIT) purposes.

The proposed nine-factor test in Section F, Part IV, of Draft Bulletin 2003-4 effectively excludes many defined contribution plans and all unfunded retirement plans from the definition of Eligible Retirement Benefit Plan. Regrettably, this approach is contrary to the approach taken in the federal IRC and ERISA. Rather than exclude certain types of plans from the definition, the Department should include plans that are commonly recognized as retirement plans, and focus on the timing and circumstances of payouts to determine whether distributions from particular plans are taxable under the PIT. The nine-factor test would tender ineligible some plans with fairly common features that would otherwise be qualified plans for federal purposes. Harmonizing Pennsylvania's rules with the abundant federal authority in this area will hot only facilitate administration and compliance for employers, but also employees, plan administrators, and the Department.

Many defined contribution plans accord the participant an election to take distributions in the form of employer securities, and many employers with both defined contribution and defined benefit plans allow a distribution from the defined benefit plan to be rolled over into the employer's defined contribution plan. As currently drafted, distributions from a defined contribution plan with an employer security distribution option would not be treated as received from an Eligible Retirement Benefit Plan. Accordingly, they would be subject to current tax. This treatment would even apply to distributions of amounts attributable to benefits accrued under a defined benefit plan and rolled over into a defined contribution plan (which are treated as tax-deferred for federal purposes). The variant treatment likely engenders significant administrative burdens, added reporting complexity, and increased recordkeeping burdens not only for employers, but also for plan administrators and fiduciaries. Penalizing such distributions is not justified from a policy perspective, since such distributions qualify for favorable treatment federally as well as in many other states.

The definition of Eligible Retirement Benefit Plan excludes excess benefit plans and unfunded executive retirement plans that accrue benefits similar to those accrued under qualified defined benefit pension plans. For example, a pension restoration plan that pays benefits in excess of those allowed under the IRC for a qualified base plan would not meet the definition of an Eligible Retirement Benefit Plan, even though the base plan would meet the definition of an Eligible Retirement Benefit Plan. Similarly, an executive retirement plan that provides a benefit based on years of service times final average pay is hot an Eligible Retirement Benefit Plan, even though a qualified plan with the same benefit formula is an Eligible Retirement Benefit Plan (such plans generally would satisfy the Draft Bulletins' definition of Eligible Retirement Benefit Plan but for restrictions imposed by the Internal Revenue Code and ERISA that prevent them from being funded.). Since excess benefit plans and traditional executive retirement plans are commonly recognized as retirement plans, they should qualify as Eligible Retirement Benefit Plans, and distributions from such plans should be accorded the same treatment under the PIT as they would federally, i.e., subject to tax in the same manner on the basis of actual receipt of payment by an employee.

TEI urges the Department to treat all qualified plans under the IRC, as well as employee pension benefit plans under ERISA, as Eligible Retirement Benefit Plans. Moreover, although unfunded executive retirement plans and unfunded excess benefit plans are exempt from coverage under sections 201 (participation and vesting requirements), 301(funding requirements) and 401(fiduciary responsibility requirements) of ERISA, they are nevertheless ERISA retirement plans. These plans are used to attract and retain high quality executives, are intended to be exempt from substantial parts of ERISA, and are commonly recognized as retirement plans. They should be treated as Eligible Retirement Benefit Plans for PIT purposes. This does net mean, however, that the Department should treat all distributions from such plans as nontaxable retirement income. Rather, TEI recommends that the Department take an approach that focuses on the timing and circumstances of the distributions to determine whether they are taxable, as is the case federally. The Department should establish a bright line of taxing distributions before age 55 and termination of employment with the plan sponsor for most corporate plans. Distributions after termination of employment and attainment of age 55 should not be taxable under the PIT. In the case of certain union and government plans that allow retirement after a period of years without regard to age, distributions after attaining the plan threshold for retirement should not be taxable.

Nonqualified Deferred Compensation Plans and Constructive Receipt

TEI believes the Bulletins misapply Pennsylvania law on constructive receipt in respect of nonqualified deferred compensation plans. The term "nonqualified deferred compensation" commonly refers to compensation arrangements that defer payment of compensation beyond the time that the services are performed, but that do not, and are not intended to, satisfy federal provisions such as IRC [section] 401(k), which addresses qualified cash or deferred arrangements. (1)

Nonqualified deferred compensation plans are simply promises by employers to pay compensation in the future. Since they are hot subject to the strict federal qualified plan requirements, nonqualified deferred compensation plans can be voluntary or elective (i.e., involving amounts which employees may elect in advance to have deferred and paid in the future), and also can be involuntary (i.e., involving amounts which are always deferred for future payment and with respect to which employees have no choice whether to defer). Nonqualified deferred compensation plans are commonly unfunded; trusts or other segregated funds are generally not involved (other than rabbi trusts, the assets of which are treated for tax purposes as assets of the employer because they are subject to the claims of an employer's general creditors). Unfunded nonqualified deferred compensation should not be taxed for PIT purposes at the time it is earned, but should be taxed in accordance with the authorities and policies discussed below.

The starting point for analysis is the Pennsylvania regulation on receipt of income, which provides in pertinent part:

   (c) Constructive receipt of
   income. Income although
   not actually reduced to
   possession shall be constructively
   received by him
   in the taxable year during
   which it is credited to his account,
   set apart for him, or
   otherwise made available so
   that he may draw upon it at
   any time. However, income
   may not be constructively
   received if the control by
   the taxpayer of its receipt is
   subject to substantial limitations
   or restrictions. Therefore,
   if a corporation credits
   its employees with bonus
   stock, but the stock is not
   available to the employees
   until some future date, the
   mere crediting on the books
   of the corporation does not
   constitute receipt....

Pa. Code 61 [section] 101.7 (c).

Pennsylvania courts have held that the foregoing definition of constructive receipt is identical to federal law:

   Department Regulation [section]
   301(q)-2 (now [section] 101.7) was
   taken verbatim from Treas.
   Reg. [section] 1.451-2(a) promulgated
   under the United States
   Internal Revenue Code, and
   we therefore seek guidance
   from treasury department
   rulings and federal case law
   interpreting the application
   of the constructive receipt
   doctrine to payments from
   profit sharing trusts.

Gosewisch v. Commonwealth, 397A.2d 1288, 1293 (Pa. Cmwlth. 1979).

There is an extensive body of federal law (including IRS rulings and case law) interpreting the constructive receipt rules. Under IRS Revenue Ruling 60-31, "(a) mere promise to pay, hot represented by notes or secured in any way, is not regarded as a receipt of income within the intendment of the cash receipts and disbursements method." Rev. Rul. 60-31, 1960-1 C.B. 174. A leading treatise in the area explains: "Under Revenue Ruling 6031 and later rulings based thereon, a deferral is effective for tax purposes if made before the services are rendered without regard to whether the employer would have been willing to pay the deferred amount currently." Boris I. Bittker, Martin J. McMahon & Lawrence A. Zelenak, Federal Income Taxation of Individuals [section] 40.02[3][a] (3rd ed. 2003). It is irrelevant that the election is voluntary; indeed, all elections are by definition voluntary. It is well-established under the federal rules that the mere fact that an individual has a choice to defer future compensation does not cause him to be in constructive receipt of that compensation. Likewise, an unsecured promise to pay is not a payment or contribution constructively received since it provides no present economic benefit. (2)

Department evidently believes that the Pennsylvania Supreme Court's clear holding in Gosewisch was overruled by AMP Products Corp. v. Commonwealth, 593 A.2d 1 (Pa. Cmwlth. 1991). TEI does net concur: AMP did net even cite or discuss, much less overturn, Gosewisch. AMP did net address Gosewisch, because AMP did net address whether Pennsylvania's doctrine of constructive receipt is coextensive with the federal rule. Rather, AMP addressed only whether an employee contribution to a 401(k) plan was taxable to the employee when it was made. The court noted that although federal law overrides the federal doctrine on constructive receipt for contributions to a 401(k) plan, Pennsylvania has no corresponding override provisions:

   Although the Federal government
   does net tax contributions
   to a retirement benefit
   plan when those contributions
   are made, the Federal
   scheme is inapplicable to
   Pennsylvania. As a sovereign,
   the Commonwealth
   can impose its own scheme
   of taxation and has chosen
   to tax such contributions
   at the time they are made.
   AMP's argument that the
   deferred compensation is
   not constructively received by
   the participating employee is
   inapposite. Pursuant to 61
   Pa. Code [section] 101.6(c)(8)(ii)(B),
   contributions are net excludable
   from the employee's
   income.

AMP, 593 A.2d at 3. The court explained the rationale underlying this aspect of Pennsylvania's tax scheme as follows:

   For federal income tax purposes,
   salary deductions
   made by an employee to a
   qualified retirement plan
   are not taxed at the time
   the deductions are made.
   Rather, retirement pensions
   are taxed later when paid to
   the then-retired employee.
   For Pennsylvania income
   tax purposes, deductions
   made by an employee to a
   retirement plan are taxed at
   the time the deductions are
   made. Retirement pensions
   are not subject to the Pennsylvania
   income tax.

Id. In short, AMP held that: (1) Pennsylvania has no law comparable to the federal provision overriding the otherwise applicable constructive receipt doctrine for contributions to a 401(k) plan, and (2) the general doctrine of constructive receipt does net overrule the specific Pennsylvania provision in 61 Pa. Code [section] 101.6(c)(8)(ii)(B) that an employee contribution to a retirement plan is taxable.

AMP has no deferred pursuant to a nonqualified deferred compensation plan, because at the time that income is shown on the employer's books as owing to the employee, there has been no contribution by anyone to anything. This distinction is critical. The Department and the opinion in AMP are correct that Pennsylvania does not have the same special rules that federal tax law has excluding employee contributions to a retirement plan from tax. Pennsylvania rules regarding actual contributions to a retirement plan, however, have no relevance when there has been no contribution. In the case of unfunded deferred compensation, the general rule of regulation [section] 101.7(c) prevails as the mere promise by an employer to pay compensation in the future is neither an actual payment nor an economic benefit that is taxable for PIT purposes.

The Board of Finance and Revenue rejected the Department's position in George W. and Jean Spencer, BF&R Docket No. 9808872 (Order dated Aug. 24, 1999). In Spencer, the Board held that awards under nonqualifying plans did net constitute contributions to a fund and therefore are net taxable. (3) As noted, such a plan typically will be non-qualifying precisely because federal law generally requires that there be actual contributions in order for the plan to be qualified.

A 1999 Opinion of the Department states that principles of uniformity require consistency between contributions to a qualified and nonqualified plan. While this makes sense in respect of a contributory deferred compensation arrangement where amounts set aside for the benefit of an employee are also beyond reach of the employer's creditors, it does net follow that a contributory plan must be treated the same as a noncontributory plan. The issue is net whether a plan is qualified or nonqualified that leads to the difference in result--it is whether there is an actual contribution. Uniformity does not require the same result in the case of a contributory arrangement and a noncontributory arrangement. An employee who agrees prior to earning income that the income will be paid in a later period does net have constructive receipt of the income, as the Department properly acknowledged in its 1999 Opinion. Neither does the employee have a present economic benefit. The employee simply has the promise of the employer to pay, which is no different from the case that the Department conceded.

Thus, neither AMP nor the Department's 1999 Opinion has any bearing on the application of Pennsylvania's constructive receipt rules to an unfunded deferred compensation arrangement. Rather, Pa. Code [section] 101.7 and Gosewisch govern, and, in tandem, make clear that where there is no contribution made, an elective deferral of compensation net set aside for the employee to draw upon at any time is not currently taxable.

Conclusion

In closing, the Draft Bulletins are flawed for several reasons: First, they will introduce unnecessary inconsistencies between Pennsylvania and federal tax treatment. If no compelling reason exists in the PIT regulations or other Pennsylvania authority for a divergence from the abundant federal authority in this area, then adopting inconsistent rules is ill-conceived. Such differences are burdensome for employers and employees, are easily misapplied or overlooked, and are difficult to enforce. In general, states are better off adopting tax principles that are congruent with well-established federal tax principles where possible.

Second, the Draft Bulletins will inevitably lead to harsh and unfair results. If compensation is deferred, by definition it has not been actually received by an employee. An employee can neither sell--nor otherwise realize any benefit from--the unsecured promise of an employer to pay. Thus, the Department will be in the position of imposing tax on income that has not been received. Worse yet, cases will inevitably arise in which an employer defaults on an obligation to pay, through bankruptcy or other exigencies. How will the Department deal with such cases? It is patently unfair to tax an individual on income net received, which indeed may never be received.

Third, the Department is attempting to promulgate by administrative fiat significant rules for retirement and employee benefit plans in Pennsylvania. If such changes are appropriate, they should net be effected through Departmental bulletins, but rather than a more formal regulatory or legislative process that embraces public review and comment.

TEI thanks the Department for considering its comments on the Draft Bulletins, and we would be pleased to discuss out views in respect of these issues with the Department. Any questions about the Institute's views should be directed to Barbara Barton, Chair of the Institute's State and Local Tax Committee, at 972.605.1220, or Gregory S. Matson, Tax Counsel, at 202.638.5601.

(1) The IRC exempts certain employee elective contributions to qualified defined contribution plans (commonly called 401(k) plans) from normal constructive receipt rules. Absent such statutory exemption, such contributions would be treated as constructively received by the employee for whose benefit the contribution is made because the employee had the ability to elect an immediate payment of the amount in cash rather than the contribution.

(2) The IRS has flatly disclaimed the application of the economic benefit doctrine to deferred compensation in such circumstances:

Generally, the economic benefit theory has been used in those situations in which a fund has been created in which the taxpayer has a vested interest. A fund is usually created when an amount has been irrevocably set aside with a third party such as in a trust or escrow account.

In the two cases submitted to us, the participants under the deferred compensation plans have no prior claim to any funds or investments held as a result of the deferral of compensation. Furthermore, such funds and investments remain the property of the employer, available for application to the expenses incurred in its general operation and subject to the claims of the general creditors of the employers.

Accordingly, we do not believe that the economic benefit theory can be applied to the amounts withheld. General Counsel Memorandum 36998 (Feb. 7, 1977) (citations omitted).

(3) The Board recently ruled to the contrary in two cases now on appeal in the Commonwealth Court of Pennsylvania: Craig S. and Sharon L. Ignatz v. Commonwealth of Pennsylvania, Pa. Commw., Docket No. 136 F.R. 2003; and Betty Sue Peabody v. Commonwealth of Pennsylvania, Pa. Commw., Docket No. 397 F.R. 2003.