Pennsylvania Commonwealth Court Holds That Voluntary Employee Deferrals Under Non-Qualified Deferred Compensation Plans Are Subject To PA Personal Income Tax
In 2003, the Pennsylvania Department of Revenue ("Department") issued Proposed Regulation Section 113.3(c)(3) and Personal Income Tax Bulletin 2003-4 (Discussion Draft -10/3/2003) in response to the Department's concern that taxpayers and employers were not properly reporting certain payments under Pennsylvania's constructive receipt rules. The Proposed Regulation and the Bulletin received significant attention from employers and tax professionals as the Department of Revenue formally asserted its position that an employee is subject to PA personal income tax on monies that the employee voluntarily defers under a non-qualified deferred compensation arrangement. While the Proposed Regulation and the Bulletin have not been finalized due to the overwhelming amount of negative comments received by the Department on the merits of the Proposed Regulation and the Bulletin, the Department has recently scored a significant victory in the non-qualified deferred compensation arena.
On May 12, 2004, the Commonwealth Court of Pennsylvania ruled, in a question of first impression, that voluntary employee contributions to an unfunded, non-qualified deferred compensation plan are constructively received for purposes of Pennsylvania personal income tax 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 involved two unrelated taxpayers who challenged the Board of Finance and Revenue's (the "Board") determination that voluntary deferrals under the Giant Eagle Executive Deferred Compensation Plan and the Mellon Bank Corporation Elective Deferred Compensation Plan were constructively received in the year the compensation was earned. Under both plans, participants were permitted to defer the receipt of a portion of their compensation (e.g., salary, bonus or incentive pay) until retirement, death, disability or termination of employment. All elections were irrevocable and were required to be made in the year prior to the year in which the compensation was earned. Both plans paid benefits from the general funds of the employer, and participants had the status of unsecured general creditors of the employer with respect to amounts deferred.
While the Court in Ignatz acknowledged that Pennsylvania's constructive receipt rule was virtually identical to the federal constructive receipt rule contained in Treasury Regulation § 1.451-2(a), the Court rejected the taxpayers' argument that federal tax principles governing constructive receipt should apply. Rather, the Court agreed with the Board's position that the taxpayers' ability to elect to defer all or a portion of their compensation established the taxpayers' requisite control over the compensation thereby resulting in constructive receipt. Accordingly, the Court affirmed the Board's determination assessing additional personal income tax, including interest, on the taxpayers.
The Ignatz decision has the potential to cover a broad range of elective deferral arrangements in addition to traditional unfunded deferred compensation arrangements like those exhibited in the Giant Eagle and Mellon arrangements. For instance, the Court decision will potentially apply to: (i) voluntary deferrals deposited into rabbi trust arrangements; (ii) voluntary deferrals to purchase stock options or restricted stock; and (iii) voluntary deferrals in connection with the exercise of stock options or the vesting of restricted stock. However, the Ignatz decision did not address nonelective deferrals imposed upon an employee by the employer—e.g., nonqualified "golden handcuff" arrangments—and such nonelective deferral should continue to avoid current income recognition because the employee has no power to elect to receive the accrued benefits currently.
While the Court's determination in Ignatz is almost certain to be appealed, employers are faced with the decision of what, if any, action should be undertaken at this time. Currently, Pennsylvania offers a Voluntary Disclosure Program pursuant to which employers may disclose and correct reporting and withholding deficiencies involving employment taxes. The Voluntary Disclosure Program has a three-year look-back period and allows for employers to remit back taxes while avoiding penalties (interest must still be paid). Alternatively, in light of the Department's lack of prior guidance in this area and its lack of audit resources, the Department may be inclined to develop an amnesty program to encourage compliance. For example, in 2003 the Department contemplated implementing a new "closing agreement" program covering contributions to deferred compensation arrangements. The proposed "closing agreement" program contained several items of particular interest:
- First, the program provided a three (3)-year look-back period for purposes of establishing liability. Accordingly, unless a tax liability was timely assessed, the employer would not be liable for tax that was required to be withheld prior to the start of such three-year period;
- Second, the program abated the employer's potential tax liability to the extent the employer properly included the compensation on the employee's Form W-2 or 1099-R; and
- Third, the program contemplated the ability of the employer to remit the prior uncollected taxes by collecting the taxes prospectively from the employee; provided, however, that the employer could not withhold more than 10% of the employee's compensation at any one time to recoup the past due taxes.
Accordingly, while a wait-and-see approach merits consideration, employers should begin to evaluate their exposure under existing programs and the alternative correction procedures available to the employer.
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