Pennsylvania's Governor Rendell recently signed House Bill 176 effectively overturning the Pennsylvania Commonwealth Court's recent decision in Ignatz v. Commonwealth of Pennsylvania, 2004 WL 1057453 (Pa. Commw. May 12, 2004). Under the House Bill, elective deferrals into nonqualified deferred compensation arrangements will now be taxed at the time of distribution and not at the time of deferral.
Overview of Nonqualified Deferred Compensation in Pennsylvania
In 2004, on a question of first impression, the Commonwealth Court of Pennsylvania ruled that, for purposes of Pennsylvania personal income tax, voluntary employee contributions to an unfunded, nonqualified deferred compensation plan were constructively received in the year earned (i.e., the year in which the services are performed, not the year in which the amounts are ultimately paid). See Ignatz v. Commonwealth of Pennsylvania, 2004 WL 1057453 (Pa. Commw. May 12, 2004) (No. 136 F.R. 2003, 397 F.R. 2003). The Ignatz decision caught the attention of many employers due to its potential application to a broad range of nonqualified elective deferral arrangements.
Pennsylvania Adopts Federal Constructive Receipt Rule
In response to the Ignatz decision, Pennsylvania has enacted House Bill No. 176, effectively overturning the Ignatz decision by adopting federal constructive receipt rules for purposes of applying Pennsylvania's personal income tax. In adopting the federal constructive receipt rule, Pennsylvania has also adopted the rules of Sections 83, 409A, 451 and 457 of the Internal Revenue Code of 1986, as amended.
While the recent changes will be welcome relief to employers, who were looking to obtain parity between the Pennsylvania and federal constructive receipt rules, the House Bill makes clear that elective deferrals into nonqualified plans will not escape income tax indefinitely. Under the provisions of the House Bill, a distribution from a nonqualified deferred compensation plan of elective deferrals (and the earnings thereon) will be considered taxable compensation and will not be eligible for Pennsylvania's exclusion relating to "old age or retirement benefits."
The new provisions are subject to somewhat complicated effective date provisions that are generally favorable to the employer and the taxpayer.
Key provisions include:
- The adoption of the federal constructive receipt rule is generally effective for tax years beginning after December 31, 2002. Accordingly, to the extent an employer has withheld from an employee's voluntary elective deferrals, the employee should be able to pursue a refund of such amounts by filing an amended return or a petition for a refund. Refund requests must generally be made within three (3) years from the date the tax has been remitted to Pennsylvania;
- Effective for tax years beginning after December 31, 2004, distributions of elective deferrals and the earnings thereon will be taxable without regard to Pennsylvania's exclusion for "old age or retirement benefits." Accordingly, employers should begin withholding on such distributions; and
- The requirements that a nonqualified deferred compensation plan must comply with Section 409A applies for tax years beginning after December 31, 2004. While the statutory provisions do not expressly incorporate the IRS' existing guidance under Section 409A, presumably Pennsylvania will follow all federal rules and regulations governing Section 409A, including the rules applicable to grandfathered plans.
To the disappointment of the Pennsylvania Department of Revenue, the House Bill does not define or give further guidance as to the type of plans that qualify for Pennsylvania's exception for "old age or retirement benefits." To bring additional clarity to this issue, it is anticipated that the Department of Revenue will attempt to clarify this exception through the issuance of future regulations.
The House Bill also does not directly affect the taxation of nonqualified deferred compensation plans that do not involve employee elective deferrals. Accordingly, distributions from these plans will continue to be able to qualify for the "old age or retirement benefits" exception.
This newsletter is a publication of Buchanan Ingersoll & Rooney PC and is intended to alert the readers to developments in the tax law. It does not constitute legal advice or a legal opinion on any specific facts or circumstances. The contents are intended as general information only. To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You are urged to consult your own lawyer concerning your situation and specific legal questions you may have.