Pennsylvania businesses are now required to withhold and report on compensatory payments to non-employee Directors who do not reside in Pennsylvania (Non-Resident Directors).1 These changes went into effect on January 1, 2018.
Overview of Act 43 of 2017
New Withholding Obligations
Under Section 316.2 of the Tax Reform Act of 1971, as amended by Act 43 of 2017 (Act), Pennsylvania businesses must withhold taxes at the applicable income tax rate (currently 3.07 percent) on payments to a Non-Resident Director for services performed in Pennsylvania (PA source income). Withholding is optional, however, if the total amount of such payments is less than $5,000. The Act also provides that Pennsylvania businesses liable for the amount of any unpaid taxes that were not properly withheld. Accordingly, in situations where the total amount of payments to be made in a year is unclear, the Pennsylvania Department of Revenue (PADOR) encourages businesses to withhold taxes from all payments made to the Non-Resident Director.
New Form 1099-MISC Reporting Requirement
Under the Act, Pennsylvania businesses are also required to file with the PADOR a copy of the Federal Form 1099-MISC issued to a Non-Resident Director. In this regard, the copy of the Federal Form 1099-MISC filed with the PADOR must separately report the amount of Pennsylvania source income and related tax withholding in Boxes 16 through 18.
Confusion and Uncertainty (Sourcing Rules)
Serving in the capacity of a Director is viewed as an independent “business or profession,” and the net income therefrom is reported on a PA Schedule C. Unlike the apportionment rules applicable to non-resident employees, the net income from a business is required to be apportioned and allocated to Pennsylvania based on the taxpayer’s books and records. By making Pennsylvania businesses directly liable for failing to withhold taxes, the Act effectively places the burden on the payor to determine the proper amount of compensation to be apportioned to Pennsylvania.
Moreover, Directors frequently receive numerous forms of compensation, including meeting fees, retainer fees, committee & chair fees, stock options, RSUs and deferred compensation. Most businesses, however, do not currently maintain adequate records by which to properly apportion such income, particularly if the compensation is earned over one or more Board years. Accordingly, Pennsylvania businesses may find themselves in the untenable position of either over-withholding, or potentially being liable for unpaid Pennsylvania income taxes, interest and penalties.
The PADOR is currently in the process of drafting guidance to address the uncertainties raised by this new law. It is unclear, however, whether this guidance will provide any clarity as to the manner in which businesses should withhold on the various types of compensation paid to a Non-Resident Director.
Delayed Effective Date/Attempts to Repeal
In light of the uncertainties caused by the Act, the Pennsylvania Institute of Certified Public Accountants (PICPA) has asked the PADOR to delay the effective date of the withholding obligation until January 1, 2019. Recent legislation has also been introduced to repeal this withholding requirement in its entirety. It is not clear at this time whether either of these measures will be successful.
Action Items – It’s Not Too Late
Pennsylvania Voluntary Disclosure Program
While the obligation to withhold on payments made to Non-Resident Directors is new for 2018, the obligation of a Non-Resident Director to report and pay income tax on PA source income is not new. If a Non-Resident Director has failed to file a non-resident return in one or more prior years, the statute of limitations for collecting unpaid taxes for such year will remain open. In this situation, the Non-Resident Director should consider participating in Pennsylvania’s Voluntary Disclosure Program.
Review Existing Directors’ Compensation Policy
Existing compensation policies should be reviewed to determine whether any changes can be made in order to segregate PA source income. For example, if Directors are paid a single retainer fee that is intended to cover all of their duties, consideration should be given to establishing one or more separate fees covering separate duties in order to segregate such income from PA source income, particularly if the Non-Resident Director performs a significant portion of his or her duties outside of Pennsylvania on non-meeting days.
Establish Withholding Procedures
Pennsylvania businesses must act quickly to establish procedures by which to comply with the Act’s withholding obligations. In light of the various forms of compensation provided to Non-Resident Directors, a one-size-fits-all approach is not likely to work in all situations. Rather, a concerted effort should be made to properly identify and withhold on PA source income (unless the business is certain the total PA source income will be less than $5,000).
1 While this advisory focuses principally on payments to Non-Resident Directors, the new withholding and reporting requirements also apply to compensatory payments made to non-resident individuals who serve as independent contractors in other capacities (e.g., consultants and advisors), as well as compensatory payments made to single member LLCs with a non-resident member.