Federal legislation on state taxation of nonresident pension income.

On November 30, 1995, Tax Executives Institute filed the following comments concerning pending legislation with the Subcommittee on Commercial and Administrative Law of the House Committee on the Judiciary concerning proposed legislation to restrict the States' imposition of source-based taxes levied against the retirement income of nonresidents. TEI's comments were prepared under the aegis of its State and Local Tax Committee, whose chair is Christopher W. Baldwin of Gannett Co., Inc. Legislation restricting the States' right to tax nonresident pension income was signed into law by President Clinton on January 10, 1996.

Description of Source Tax Issue

Many States have enacted statutes to impose an income tax on pensions and nonqualified deferred compensation that was earned and deferred while an individual was a resident of a State but paid after that individual retired and moved to another State.(1) Under the "source principle," a State may tax that portion of the deferred compensation or pension benefit attributable to the value of the services performed while the individual was resident within the State. In some cases, the States have augmented enforcement of source taxation of nonresident pensioners by imposing reporting or withholding requirements upon the individual's former employer.

Several proposals have been introduced in this and preceding sessions of Congress to circumscribe the States' authority to tax nonresident pension income. In particular, H.R. 394 and its Senate companion, S. 44, would prevent the States from imposing an income tax on the retirement income of an individual who is not a resident or domiciliary of the State.(2) Another bill, H.R. 371, would similarly preclude the States from imposing an income tax on "pension income" of any individual who is not a resident or domiciliary of the State. H.R. 371, however, does not define "pension income" so its scope is unclear. H.R. 744, in contrast to both H.R. 394 and 371, provides relief from source taxation only for annuity payments from qualified plans and only to a maximum of $25,000 per year in retirement benefits.

Tax Executives Institute acknowledges that the source tax principle allows the States to achieve legitimate state tax policy goals. Nonetheless, permitting the States to layer a patchwork of regulations on top of the substantial recordkeeping burdens already imposed by the Department of Labor and Internal Revenue Service upon qualified pensions would be inimical to interstate commerce and the national pension policy evinced by ERISA. As a result, TEI recommends that Congress enact legislation to clarify that, at a minimum, distributions from qualified plans, trusts, or similar arrangements, may not be subjected to state or local taxation except in the retiree's state of domicile or residence. In addition, Congress should consider enacting legislation that circumscribes state source taxation of all forms of retirement income.

Background

Tax Executives Institute is a volunteer, professional association of approximately 5,000 accountants, lawyers, and other professionals who are responsible for managing the tax affairs of their companies. TEI members must contend daily with business tax laws, including those affecting the taxation of pensions, from tax planning, recordkeeping, and tax compliance perspectives. TEI represents a cross-section of the business community (including companies with diverse and mobile workforces). We are 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 cost and burden of administration and compliance to the benefit of taxpayers and the government alike.

The Institute is firmly committed to maintaining a tax system that works -- both for taxpayers and tax administrators. We believe the diversity and training of our members enable us to bring a uniquely balanced and practical perspective to your attention.

Constitutional Authority

The two primary bases of state taxing authority are residence and source.(3) In the absence of congressional action preventing the States from taxing the pension income of nonresidents attributable to employment in a State where the individual once worked or resided, many States claim the right to tax that income. The Due Process requirements of the Constitution are likely satisfied as long as the States tax only the portion of the income earned while the individual enjoyed the benefits, rights, and privileges of residence.

Nearly all States, however, link their income tax policy to the federal policy, thus permitting deferral of taxation on pension income. In doing so, the States grant an additional benefit of residence because they could, if they wish, tax the pension income at the time the benefit accrues or an amount is contributed to the plan. Hence, in the case of nonresident pensioners, when a State imposes a source tax on a pension payment of a former resident, it is merely "recovering" the previously deferred tax. Where that is so, the departure of a former resident has no bearing on the State's constitutional authority to tax the income derived from personal services rendered while resident in the taxing State.

On the other hand, Congress has broad authority under the Commerce Clause of the Constitution to regulate transactions within the stream of interstate commerce, including imposition of restrictions on the States' power to tax. Congress has exercised its authority to regulate the States' power to tax in instances where the burden of state taxation is deemed inimical to the free flow of goods and services in interstate commerce. Public Law No. 86-272's proscription against subjecting sellers of tangible personal property to state taxation for mere solicitation activities within a State is but one area where Congress has exercised its authority to restrict state taxation.(4) The nonresident pension income that States seek to tax under the source principle is clearly within the stream of interstate commerce because both the recipient and the pension payment cross (or have crossed) state lines. As a result, Congress may, if it deems it necessary to promote and protect interstate commerce, restrict the States' taxation of nonresident pension income.

Consequently, the focus of the debate over source taxation of nonresident pension income is properly shifted to whether the States should exercise their inherent authority to tax nonresident pensions and, if exercised, whether Congress should intervene to limit the State's authority. The principal arguments that the States muster in favor of taxing nonresident pension income are (1) state sovereignty, (2) equitable treatment of resident and nonresident retirees earning comparable benefits while employed in the taxing State, and (3) a desire to limit an employee's opportunity to convert state tax deferral into permanent tax avoidance by moving to a State that chooses not to tax retirement income.

The sovereignty argument does little to clarify the issue because it merely restates the principal power accorded to States: the power to tax. The argument does not justify the exercise of that sovereign power in the face of its deleterious effect on interstate commerce and the federal policy under ERISA to maximize national savings through private-sector pensions.

The latter two arguments, concededly, raise legitimate state tax policy concerns, but their effect should not be exaggerated. Only a very small portion of the nation's workforce moves away from a home state upon retirement -- and it is a smaller number still whose migration is tax motivated. Thus, we believe the number of retirees who might convert tax deferral to tax exemption is generally quite small. Should the number of individuals retiring to non-income tax States rise beyond the currently negligible number, the States would undoubtedly reexamine their policies coupling state deferral with federal tax deferral on pension income.(5) Further diminishing the force of the State's concerns of permanent tax deferral is that the amount of qualified plan benefits that any one individual may accrue is limited by the Internal Revenue Code.(6)

Perhaps the most telling rebuttal of the State's concerns, though, is that only one State rigorously enforces its source tax against nonresidents -- California. This confirms that the amount of forgone state revenue is insignificant (especially when weighed against other considerations). Moreover, some States, in an independent exercise of their sovereignty to protect their residents (and their fiscs), have erected legal barriers against the enforcement of source taxes imposed by other States.

Finally, the States' arguments do not address whether the pension income should be taxed because they gloss over both the high cost to the States to administer and collect the tax, and the tremendous burden on the affected retirees to comply with the complex tax scheme -- especially where multiple States assert their coextensive sovereignty to impose income tax on the same pension income. Very little revenue is actually collected by the States on nonresident pension income because the amount of dollars to be collected from each recipient is generally small and because it is difficult for the States to track nonresident pension recipients.(7) Nonetheless, TEI is concerned about the potentially heavy cost imposed on employers and plan administrators as the States attempt to shift the administrative burden through reporting or withholding requirements.

Administrative Burdens Cannot Be Justified

General Comments

States may tax only that portion of a nonresident retiree's pension attributable to services performed while resident in the State. Obversely, a State may not tax a nonresident pensioner on retirement payments earned for services performed outside of its jurisdiction. Thus, a retiree who served in multiple locations during his or her working years is confronted with the task of allocating the deferred income among the States. In addition, earnings on the deferred compensation amounts have on occasion been deemed investment earnings rather than compensation for services, further complicating the determination of which State or States are entitled to tax such amounts.(8) As a result, a retiree's retirement income must be allocated not only among several States, but also between deferred compensation and investment earnings on the deferred amounts. Notwithstanding that obligation, there is no uniform method for allocating pension income or earnings among the States. Indeed, among the States applying the source tax principle, there is no uniform definition of residence, no uniform methodology for applying the "source" rules to allocate the pension income, and no uniform method of segregating the deferred compensation pension amounts from the investment earnings on such amounts.

Lacking a uniform method for allocating pension income by State of residence, it is entirely impractical to expect employees, employers, or plan administrators to maintain the records necessary to permit the proper sourcing of pension payments.(9) What is more, given the States' previous inaction in pursuing nonresident pensioners on the basis of source-tax principles, retirees, employers, and plan administrators have heretofore never had reason to keep records of lifetime earnings by State of residence or domicile and likely do not possess information from which to reconstruct such an earnings history. Hence, retirees will likely be unable to obtain helpful records from former employers to permit them to calculate source taxes.

Example 1: Defined Contribution Pensions

Assuming that earnings records were available, retirees would face a daunting task in ascertaining the proper amount of pension income to source to each State. Consider the following example involving a defined contribution plan, which illustrates the enormous difficulty confronting retirees, employers, and plan administrators.

Example 1: Employee A begins

employment with X corporation

in California. After

three years in California, A

is transferred to New Mexico 

for a five-year assignment.

Following that, the employee

is transferred overseas for

three years. Next, the employee

returns to the company's

New York headquarters

for a two-year assignment.

The employee returns to California

for a five-year stint,

and then transfers to Georgia

for eight years before retiring

to Arizona. In respect

of the assignments, X contributes

to a defined-contribution

pension for A the following

respective amounts:

$3,000, $7,500, $7,500,

$8,500, $36,000, and

$95,000. In addition to these

contributions, cumulative

earnings credited to the retirement

account during the

employee's 26-year career

amount to $150,000.

Even if complete records are available to determine the amount of pension contribution made (or how much base salary was earned) by State of residence, ascertaining what portion of each distribution payment is attributable to services performed in each State remains problematic for the best of tax advisors. For example, is California, where A worked for eight years, entitled to tax 30.8 percent of each retirement payment? Or is California entitled to tax only approximately 24.7 percent of each payment or some other amount?(10) To Should the "principal" part of each payment be allocated differently from the "earnings" portion? If so, what portion of the total investment earnings on the contributions is attributable to California? Is the retiree to assume the investment earnings accrue ratably with respect to each dollar contributed or is each contribution to be accounted for as a separate deposit, with the earnings credited to each separate deposit amount? If the pension plan permits multiple investment options, the number of separate credited subaccounts requiring records and allocation by State escalates rapidly.

What if X's plan accepts rollover contributions from other employer plans and A rolls over a $5,000 pension account balance from the previous employer's plan? In such a case, is X, A, or A's former employer responsible for maintaining records of the State where the pension income was earned? To date, the States have provided little if any guidance on such issues.

Moreover, on the facts presented in Example 1, Georgia (or any of the other States of residence) may well apply a different allocation rule to determine which portion of the pension payments is attributable to services performed there. Consequently, the potential for multiple taxation of a nonresident's pension income is quite high.

In response to the threat of multiple taxation, the States will contend that the problem is alleviated by the granting of credits for taxes paid to other States. This argument, however, facilely ignores that the credit provides an imperfect offset unless the States competing to tax the income agree on the allocation method. In addition, the States' argument ignores the real and complex burdens imposed upon a retiree to (1) maintain correct records of lifetime employment earnings, (2) learn and understand the differing state allocation and tax-credit rules, and (3) calculate the proper amount of tax credits. Moreover, some States restrict the availability of the credit in a fashion that substantially diminishes its utility.(11) Finally, while it may be theoretically possible -- as was assumed in Example 1 -- to determine the amount of a distribution from a defined-contribution plan that is allocable to particular earnings periods, employees generally lack (or lack access to) the records to make such a determination.

Example 2: Defined Benefit Pensions

Determining the portion of each distribution payment attributable to a particular State of residence is nearly impossible in the case of a traditional defined-benefit plan. The problems are illustrated in the following example:

Example 2: Employer Y provides

a defined-benefit pension

plan that grants Employee

B a pension benefit

determined under a formula,

which provides a benefit

equal to percent of the

employee's final average

earnings multiplied by the

number of years of service,

to a maximum of 30 years of

credited service. Final average

earnings is defined as the

average compensation during

the employee's final five

years of service. Assume B

works in five States, each

having a source tax statute,

during a 40-year career.

Assume further that, as with many employees, B's average earnings were the highest during the final five years of employment with Y. As a result, an argument could be made for overweighting the pension income to be allocated to the final State of residence. At the same time, since B already reached the limit on the maximum number of years of credited service before moving to the final State (30), should not the allocation to the final State of residence be underweighted, if it is to be counted at all?

Moreover, under a defined-benefit pension plan it is simply not meaningful to distinguish between amounts contributed to a plan and the investment earnings on the contributions; the plan formula provides each employee a prescribed amount of benefit without regard to the actual returns on the amounts invested. Numerous actuarial assumptions, including an assumption about earnings on the plan's assets, permit employers to calculate the amount of contributions necessary to fund the defined-benefit obligation for its covered workforce as a whole. It is not meaningful to view B as having an interest in any portion of the funds contributed to a defined-benefit plan. Indeed, B's benefit is generally not even calculable until just prior to retirement.

As a result, assigning some portion of the benefit payment to services performed in various States as long as 40 years ago requires mind-boggling assumptions. To illustrate, assume B worked in California during the first 10 years of employment, earning $5,000 per year. During the final five years of employment in Florida, B annually earned $50,000. Based on the maximum of 30 years of credited service, B is entitled to a straight annuity of $22,500.

Under these facts, is 10 percent (or $2,250) of the distribution allocable to California (determined by applying a fraction the numerator of which is Y's average annual California compensation ($5,000) divided by the final average compensation ($50,000))? Alternatively, is California entitled to tax $7,500 (or $5,625) of each benefit distribution?(12) Under a different scenario, the retiree or plan administrator might assume that California is entitled to tax a portion of the benefit payment by taking into account only the facts applicable to the California employment. In other words, California would be entitled to tax only $750 (or $562.50), determined by taking the years of service attributable to California (10), multiplying that by the benefit fraction (1 1/2 percent) and multiplying that amount in turn by the last five years of annual California compensation $5,000).(13)

Assuming that an employer or plan administrator had kept records of compensation by State, differing state rules likely compel employers or plan administrators to allocate more than one hundred percent of the employee's pension income. More important, since few employers have kept the employee earnings history in a fashion permitting state-by-state allocation, each of the affected States might allocate 100 percent of the pension income to their State, leaving the retiree to disprove the presumptively correct allocation.

Congress Should Restrict State Taxation of Nonresident Retirement Income

To safeguard pension benefits, the Internal Revenue Service and Department of Labor impose a formidable array of recordkeeping burdens on pension plan sponsors and administrators. Large employers with operations in all 50 States would face a horrendous administrative burden if forced to comply with a patchwork of regulations and conflicting reporting or withholding requirements for nonresident pensioners. Subjecting the largest employer plans to a plethora of conflicting demands from 50 state revenue departments (and possibly more should municipalities also choose to tax nonresident pensions) would, at a minimum, cause a reduction in benefits available to the employees -- perhaps even termination of the plans. Moreover, exempting employers and plan sponsors from the reporting or withholding tax requirements is by itself an insufficient remedy. As long as one State enforces a source tax against nonresidents, employees whose income may become subject to that tax will demand that their employers provide them with the accounting records to support the proper allocation of income to that particular jurisdiction.

Thus, while TEI recognizes that taxation of nonresident pensions may permit the States to achieve legitimate tax policy goals, we believe that permitting the States to layer a patchwork scheme of regulation concerning nonresident pensioners on top of the substantial recordkeeping burdens already imposed by Department of Labor and IRS would be inimical to interstate commerce and the national pension policy evinced by ERISA. Consequently, TEI recommends that, at a minimum, Congress clarify that distributions from qualified plans, trusts, or similar arrangements may not be subjected to state or local taxation except in the retiree's State of domicile or residence. Moreover, since the administrative burdens of complying with multiple source tax rules extends to distributions from nonqualified plans, Congress should consider extending the ban on state source taxation to distributions from certain nonqualified deferred compensation arrangements.

The broad array of nondiscrimination requirements that qualified plans must satisfy ensure that companies and plan sponsors will not engage in nefarious conduct to assist employees avoid substantial amounts of State taxes. In addition, the States have worked with members of Congress to craft an amendment to H.R. 394 and S. 44 that would limit state taxation of nonqualified plans where the distributions are made over the life of the recipient or ten years. As a result, we believe that a congressional ban against source taxation of retirement income would provide certainty to employers and employees at nominal cost to the States.

The Approach of H.R. 744 Should Be Rejected

Finally, we note that the States collectively do not object to some limitations on source taxation of nonresidents. The Federation of Tax Administrators has voiced the consensus view of state revenue officials that the targeted relief of H.R. 744, which bans source taxation upon annuity distributions of less than $25,000 per annum, is not objectionable to the States. It is objectionable to us. Indeed, while such a ban may provide relief to a number of pension recipients, a cap on the amount of untaxed benefits exacerbates the recordkeeping requirements for employers and plan administrators. Under H.R. 744, the earnings and contributions for all recipients must still be tracked in order to determine whether the cap is exceeded by a single recipient.(14)

Moreover, the issues surrounding the proper allocation of pension payments among multiple States will remain -- indeed, will be compounded -- by the existence of a cap on the exclusion amount. For example, to which State or States is the $25,000 exclusion assigned?(15) What if there are pension distributions from different plans, none of which when considered separately exceeds the exclusion amount, but the aggregate of which exceeds the exclusion? Which pension or pensions is accorded the benefit of the exclusion or is the exclusion prorated among the different plans as well as among the different States?

Again, TEI believes that plan administrators and employers should not be compelled to face the high cost of complying with a patchwork scheme of regulations in order to provide States with the data to collect a small amount of forgone revenue. For this reason, we believe that the approach envisioned under H.R. 744 is worse than the present void of guidance. We urge that it be rejected.

Conclusion

Tax Executives Institute is pleased to have had the opportunity to comment about the various proposals to limit States' taxation of nonresident pension income.

(1) In testimony before the Subcommittee on Commercial and Administrative Law of the House Committee on the Judiciary, the Federation of Tax Administrators stated that 13 States have statutes permitting taxation of a portion of the deferred compensation of former residents. Of those 13 States, 9 impose the tax solely upon distributions from nonqualified plans. Of the remaining four States, only one has an "active" enforcement program to tax former residents on annuity payments from qualified plans. Notwithstanding the attempt by state revenue officials to minimize the scope of the controversy, approximately 40 States have embraced the "source" tax principle. Thus, while only 13 States have specific statutory rules concerning nonresident pension payments, the majority of States could invoke general tax principles to reach the retirement pay of former residents. (2) As amended by the Senate on October 26, 1995 (by way of an amendment to S. 1357, the Budget Reconciliation Act of 1995), and as amended by the House Committee on the Judiciary on October 19, H.R. 394 and S. 44 would limit the state income taxation of nonqualified plans or arrangements where a distribution from such an arrangement is made over the life expectancy of the recipient or a period of not less than 10 years. A similar proposal was incorporated in the House version of the Budget Reconciliation Act ([sections] 12944 of H.R. 2491), but was deleted from the bill approved November 17, 1995. (3) In Shaffer v. Carter, 252 U.S. 37 (1920), the Supreme Court upheld the right of States to tax nonresidents for income attributable to in-state activities so long as the tax is not imposed in a discriminatory fashion favoring in-state activity over interstate or out-of-state activity. (4) See Wisconsin Dep't of Revenue v. William T. Wrigley, Jr., Co., 112 S. Ct. 2447 (1992) (interpreting Public Law No. 86-272). (5) Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming currently do not impose an individual income tax. (6) For example, section 415 of the Code limits to $150,000 the annual compensation that may be taken into account in determining the benefits accruing to any individual. In addition, section 401(k) savings plan deferrals are limited. Furthermore, aggregate annual distributions from qualified plans in excess of a dollar threshold triggers excise taxes over and above normal tax rates. (7) The one high profile enforcement program involves retirees receiving benefits from California's public employee retirement system. In that case, the State imposing the tax also controls records permitting it to track the retirees. (8) See, e.g., Molter v. Michigan Dep't of Treasury, 443 Mich. 537, 505 N.W.2d 244 (1993); Pardee v. State Tax Commn, 89 A.D. 294, 456 N.Y.S.2D (N.Y. App. Div. 1982) (earnings on deferred amounts under a retirement plan constitute investment earnings rather than compensation for services). (9) Indeed, should a plan administrator attempt to establish a state-by-state pension recordkeeping system, it is doubtful whether the system could possibly supply meaningful records that satisfied the myriad state rules on residence and income allocation. (10) In either case, the amount subject to California tax is determined by allocating each "principal" amount of pension payment by a fraction. In the first instance, the numerator of the fraction is the number of years of California service (8) and the denominator is total years of service (26) in this employer's pension plan -- or 30.8 percent. Under the second method, the fractional share of income allocable to California is the dollar amount of pension contributed during the years of California service ($39,000) divided by total employer contributions ($157,500) to the plan on behalf of the participant (24.7 percent). A third alternative would be to apply the ratio of the employee's total lifetime California earnings from this employer to the total lifetime earnings this employee earned from this employer Other issues that must be considered include (1) whether income or years of employment spent outside of the United States (and arguably not subject to any state tax) is to be considered and (2) whether years of employment spent in a non-source tax State is to be included in the denominator for purposes of the source taxing state calculations. (11) For example, a lifelong Iowa resident who retires to Georgia may not be eligible to claim a Georgia tax credit for any pension income source tax imposed by Iowa because Georgia may not view the Iowa tax as being attributable to a "trade or business" in Iowa. Other States impose similar restrictions on the use of tax credits. (12) The $7,500 amount is determined by multiplying the benefit amount ($22,500) by a fraction, the numerator of which is years of California participation in the plan (10) and the denominator is the number of credited years of service (30). In the case of the lesser taxable amount of $5,625, the total years of participation (40) in the plan is used in the denominator. (13) The lesser amount of $562.50 takes into account the entire 40 years of service; the higher amount counts the earlier California service disproportionately owing to the maximum 30 years of credited service. (14) The administrative burdens associated with a cap on the amount protected against source taxes will remain regardless of the amount of the ceiling. Thus, a proposal to limit the applicability of state source tax to distributions in excess of $100,000 per year will still require employers to track deferred compensation amounts for all participants in such arrangements. (15) The FTA's suggested approach is to pro-rate the allocation of the exclusion among the States based on years of service in each State. See response to questions for the record submitted by Harley T. Duncan, Executive Director of the Federation of Tax Administrators, contained in State Taxation of Nonresidents' pension Income, Hearing before the Economic and Commercial Law Subcommittee of the U.S. House of Representatives Committee on the Judiciary, 103d Cong., 1st Sess. 116 (July 22, 1993).