In an interesting turn of events, the Pennsylvania General Assembly has recently passed legislation, House Bill 176, that would substantially undermine the Pennsylvania Commonwealth Court's recent decision in Ignatz v. Commonwealth of Pennsylvania, 2004 WL 1057453 (Pa. Commw. May 12, 2004). Whether Governor Rendell will sign this legislation into law remains uncertain at this time, as the governor has informally expressed his concern over the loss of revenue to the state resulting from this change in Pennsylvania's personal income tax laws. The governor has until November 30, 2004, to sign the House Bill.
House Bill 176
Under the provisions of the House Bill, the definition of the term "receipt" for purposes of Pennsylvania's personal income tax law has been clarified to follow federal tax rules. Specifically, the bill revised the definition of "receipt" to provide that:
" ... compensation income of a cash basis taxpayer shall be considered as received, earned or acquired" if the income is 'constructively received' as defined and construed by the regulations and other federal authority under the Internal Revenue Code of 1986."
For this purpose, however, Pennsylvania's Tax Reform Code defines the term "Internal Revenue Code of 1986" to mean the Internal Revenue Code of 1986, as amended to January 1, 1997. Accordingly, the revised definition would not appear to incorporate the recent federal changes to nonqualified deferred compensation plans contained in The American Jobs Creation Act of 2004.
The House Bill also expressly provides that: (i) the amendment is intended to "clarify and confirm the original intent of the General Assembly" in defining the term "received"; and (ii) the amendment shall apply retroactively to causes of action which arose prior to the effective date of this paragraph. Accordingly, this approach should act as a reprieve to employers who have failed to withhold income taxes on prior deferrals and allow for refund opportunities to taxpayers who paid income taxes on prior deferrals.
Ignatz v. Commonwealth of Pennsylvania
In Ignatz, which was decided 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 were 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). 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.
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 caught the attention of many employers because of its potential application to a broad range of nonqualified elective deferral arrangements. It also raised a number of compliance and employee relations issues for employers sponsoring deferred compensation arrangements by potentially requiring the application of divergent tax principles at the federal and state levels. Currently, the parties to the Ignatz decision have filed exceptions with the court regarding its decision, and oral arguments are scheduled for February 2005.
What Should Employers Do Now?
In light of House Bill 176 and the court's determination in Ignatz, employers are faced with the decision of what, if any, action should be taken at this time. The Pennsylvania Department of Revenue, as part of its ongoing efforts in this area and in response to its recent success in Ignatz, was on the verge of releasing guidance to employers regarding their withholding obligations with respect to nonqualified deferred compensation arrangements. The release of this guidance is currently on hold in light of the recent legislative developments. Accordingly, while employers should continue to evaluate their exposure under existing programs, a wait-and-see approach merits consideration in light of the potential legislative relief that may be forthcoming. To the extent that House Bill No. 176 is enacted, employers and plan participants will need to explore refund opportunities with respect to current and prior years' deferrals.
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