State taxation of nonresidents' pension income : hearing before the Subcommittee on Commercial and Administrative Law of the Committee on the Judiciary, House of Representatives, One Hundred Fourth Congress, first session, on H.R. 371, H.R. 394, and H.R. 744, June 28, 1995 online

rights to tax this income upon receipt, and effectively turns a deferral of taxation
into a complete tax exemption, then it could force a major shift in State tax policy
regarding pensions. If the implied contract between the State and the pension plan
participant is going to be abrogated by the Federal preemption, then eliminating the
deferral may be California's only recourse if revenues are to be maintained. Elimi-
nation of the deferral would run contrary to the current debate in Washington about
devising means to increase the nation's savings rate and helping our citizens to be
financially secure for their retirement years.

Pending Federal Legislation

Typically, legislation offered in previous years attempted to confine the remedy
to limiting the source tax burden on low income retirees. There are numerous sto-
ries of low income retirees receiving a very burdensome tax bill from the FTB on
a source tax liability that had accumulated over several years. Last year, the Judici-
ary Committee reported out a bill that prohibited State source taxation of the first
$30,000 in income from qualified pension plan arrangements on an annual basis,
be they periodic payments or lump sum distributions. This measure was similar to
legislation considered in the California Legislature and supported by the FTB. Al-
though the FTB believes that these matters are best handled by our State Legisla-
ture, we would not oppose a Federal bill that provides source tax relief to low in-
come former residents.

However, the new proposal by Rep. Vucanovich is so broad as to provide tax free
income to even the wealthiest retirees. H.R. 394 has no cap on the amount that
would be exempt from tax so it is not limited to just modest income retirees. Fur-
ther, the Vucanovich bill adds to the list of pension income certain compensation
arrangements that benefit highly compensated employees. Nonqualified deferred
compensation arrangements [Section 3121(vX2XC)] are often used by highly com-
pensated employees to defer significant income through a nonqualified deferred com-
pensation plan. The employees then take lump sum payments that, under the terms
of this bill, could be taxed only by the State of residence, even thou^ all services
giving rise to the deferred compensation were performed in another State. This
would allow large amounts of compensation to be moved, in the final years of em-
ployment, to a lump sum payment. The payment would then be withdrawn imme-
diately upon establishing residency in a State with no income tax.

The bill sponsored by Rep. Stump, H.R. 371, also does not contain a cap on the
amount that would be exempt from State tax. The bill does not define pension in-
come, allowing taxpayers and States to interpret the term. The lack of clear defini-
tions would inevitably cause lengthy and costly disputes between taxpayers and the
State regarding whether the State is prohibited from taxing pension income.

The bill sponsored by Rep. Pickett, H.R. 744, is similar to legislation approved by
this Committee last year. However, this bill excludes the first $25,000 in lump sum
payments from the source tax, and completely excludes annuity payments. Applying
the $25,000 exclusion only to lump sum payments made from a Qualified plan cre-
ates an inequity between similarly situated taxpayers. For example, taxpayers who
receive annuity payments from a qualified plan will not be required to pay source
tax (due to the unlimited exclusion) while taxpayers who receive lump sum pay-
ments from a qualified plan would be required to pay source tax on amounts re-
ceived in excess of $25,000.



76

The annual revenue loss for California from excluding distributions from qualified
pension plans and annuities derived from California source and received by mil year
nonresidents is estimated to be $25 million at 1995 levels. This estimate does not
account for distributions from nonqualified deferred compensation arrangements
which are reported on the tax return as wages or salary bonuses.

Unfunded Mandates

The unfunded mandates legislation passed earlier this year contained a provision
specifically stating that Federal measures to restrict the revenue raising abilities of
State and local governments would be considered an unfunded mandate. If Federal
legislation contains limits on revenue raising abilities above the $50 million thresh-
old, then that measure is to be subject to a point of order before consideration by
either Chamber. Pending legislation is estimated to cost just the State of California
$25 million in lost revenues annually. When the revenue impact on other States
that have the authority to collect taxes on former residents is added, the total
should easily exceed the $50 million threshold. I would therefore request that the
Subconrmiittee ask the Congressional Budget Office to prepare a revenue estimate
of the impact on State and local governments of these measures before moving for-
ward on tnese bills.

Clearly, Congress has spoken on its intention to prevent further erosion of State
and local government revenue bases in the unfunded mandates legislation. The FTB
supported that legislation, and although the law does not go into efiect until next
year, I am confident that members of Congress intend to comply with its spirit. This
includes not enacting any measures to restrict the ability of State and local govern-
ments to set their own revenue policies. Especially now, when the Federal govern-
ment is handing over to the States the responsibility for many well established Fed-
eral progranns, this is not the time or the place to take away our revenue base. If
the supporters of Federal legislation would re-direct their energies to State legisla-
tive arenas, where this issue belongs, I would gladly work with them to develop
State level solutions to this problem.

Expatriates Proposal Applies to Source Taxation of Pension Income

Congress this year debated closing a tax loophole that has allowed wealthy expa-
triates to renounce their U.S. citizenship in order to avoid paying U.S. taxes. The
argument by supporters of closing this loophole is that income and assets earned
in this country should be subject to tax by the U.S. Those citizens who renounce
their citizenship and no longer reside in the U.S. and take with them their U.S.
sourced income and assets cannot avoid their tax obligations. This is precisely the
same set of circumstances under which people earn income in one State, move to
another State and contend their tax obligation to the State where they earned in-
come no longer applies.

The Senate passed the expatriates measure and the House Ways and Means Com-
mittee is considering the matter. Supporting the expatriates measure in order to
protect the Federal tax base while opposing the States' right to protect their revenue
base on the same principle would be as onerous as the thinking that leads to un-
funded mandates.

The hyperbole surrounding source taxation of former residents' pension income
has been extreme. I have faith that the Subcommittee will focus on the principles
at stake in this issue and act accordingly. I would gladly offer any assistance to the
Subcommittee as these proposals are considered.



Prepared Statement of the Military Coaution

The Military Coalition would like to express its appreciation to the Chairman and
distinguished members of the House Committee on the Judiciary for the opportunity
to present this statement for the record in furtherance of your oversight hearing on
the fairness of state taxation of nonresident's pension income in cases where those
being taxed used to live and work in the taxing state.

The statement provided herein represents the collective views of the following
military and veterans organizations known as the Military Coalition, representing
approximately 3.75 million members of the seven uniformed services, officer, en-
listed, active, reserve and retired, plus their families and survivors: Air Force Asso-
ciation, Air Force Sergeants Association, Association of Military Surgeons of the
United States, Association of the United States Army, Chief Warrant Officer and
Warrant Officer Association, United States Coast Guard, Commissioned Officers As-
sociation, Enlisted Association of the National Guard of the United States, Fleet Re-



77

serve Association, Jewish War Veterans of the United States of America, Marine
Corps League, Marine Corps Reserve Officers Association, Military Chaplains Asso-
ciation of the United States of America, National Association for Uniformed Serv-
ices, National Guard Association of the United States, National Military Family As-
sociation, Naval Enlisted Reserve Association, Naval Reserve Association, Navy
League of the United States, Non Commissioned Officers Association, Reserve Offi-
cers Association, the Retired Enlisted Association, the Retired Officers Association,
United States Arrnv Warrant Officers Association, USCG Chief Petty Officers Asso-
ciation & USCG Enlisted Association, United Armed Forces Association, the Na-
tional Order of Battlefield Commissions — Associate Member, Army Aviation Associa-
tion of America — Associate Member.

Mr. Chairman, the Military Coalition as well as other concerned organizations
have been working diligently for the past several years to remedy what we collec-
tively consider to oe a grave injustice. This injustice allows a state to continue to
tax the pension or retirement incomes of former residents once they leave that state
to go to another jurisdiction.

It is no secret that the ranks of retired people in the United States are growing.
With improvements in health care and treatment, retirees are living longer, more
active lives. They move more readily from one locale to another, bringing with them
very little except their retirement incomes. Often this pension or retirement check,
earned over many years of hard work, is all they have to live on. Yet, Mr. Chair-
man, we have states today, who reach out and grab a portion of that retirement
income, regardless of whether they have a continuing fiscal need to provide for these
citizens or not.

The vehicle or method states use for this "grab" has come to be known as a
"source tax." Simply put, a source tax is an income tax levied on the total income
earned by a former state resident, regardless of what or where the source of that
income may be — either from sources within or without the taxing jurisdiction!

Mr. Chairman, we strongly urge the Committee's favorable consideration for the

f)light of these retirees and of legislation which seeks to abolish this tax for the fol-
owing reasons:

It would abolish a blatant form of "taxation without representation." Since
the affected retirees no longer live in the state, derive no benefit from the state
and can no longer vote in that state, they should not be taxed by that state;
In many cases, the moneys put into a retirement fund are taxed by the state
at the outset. To allow the same state to tax it again is a form of double tax-
ation;

With regard to military personnel and some federal retirees, oftentimes the
only reason they were ever in the taxing state was as a result of their federal
or militarv employment or assignment. Additionally, these people are subjected
to multiple moves during the course of their careers, often living and working
in several different states. Under the source taxing authority presently extant
in these states, it is entirely possible that, at the end of their careers, these peo-
ple could have source taxes applied on their retired incomes by each of these
states — simultaneously — and yet not reside in any of them nor derive any bene-
fit from them;

A tax of this nature has a totally chilling efTect on the individual's constitu-
tional right to freedom of movement and that freedom of choice enjoyed by aU
Americans. It makes former residents of source tax states virtual prisoners of
those states by imposing a continuing liability on their pensions — no matter
where they go.
Mr. Chairman, we would like to close with iust one of the many stories we've re-
ceived on this subject. An individual has worked hard all of his life, paid taxes to
his respective state of domicile, saved whatever was left and invested in a modest
retirement plan. Now the day comes to retire and realize a life's dream. The individ-
ual moves to a state with no income taxes and lives there for several years. Then
one day, upon opening the mail, he finds a letter from his former state announcing
that several thousand dollars in back taxes are owed, demanding immediate pay-
ment and threatening the loss of home and property, credit rating, etc., if payment
is not received. Furthermore, he is informed that taxes will be owed on this retire-
ment income for the rest of his or her life, because part or all of it was earned while
working in the former state. The individual then asks himself why; why does he owe
taxes to a state in which he hasn't lived for several years? Didn't he pay enough
taxes while he lived and worked there? What is the former state doing for him? Is
he going to have to live out his days constantly facing this tax burden? How is he
going to live on the small pension he has earned if he has to pay these taxes every
year as well as possibly having to pay additional taxes on any social security annu-
ity received?



78

Mr. Chairman, we in the Military Coalition strongly believe that the only way to
remedy this depressing and frustratine dilemma facing many senior retired Ameri-
cans is to afTord them the protection tney have eamea and deserve. And that way,
Mr. Chairman, is to determine that such taxation is patently unfair to retirees, does
directly or indirectly restrict their freedom of movement and freedom of choice in
where they may live and that, therefore these forms of taxation should be legisla-
tively prohibited.



Prepared Statement of the American Institute of Certified Public
Accountants

Introduction

We appreciate this opportunity to submit written testimony on the state taxation
of nonresident pension income. The American Institute of Certified Public Account-
ants (AICPA) is the national professional organization of CPAs, with more than
320,000 members. Many of our members are tax practitioners who, collectively, pre-
pare income tax returns for millions of Americans.

Support for H.R. 394

The AICPA supports H.R. 394, which prohibits states from imposing an income
tax on the retirement income of an individual who is not a resident or domiciliary
of the state at the time the pension payment is received. The main reason for our
support is that there is presently no administrable system to consistently, fairly,
and efficiently allocate retirement income based on the state in which it was earned.
We are pleased that H.R. 394:

Applies to both a nonresident's periodic and lump sum distributions;
Covers payments from all retirement, pension, or profit-sharing plans, not
just those that qualify for special tax treatment under the Internal Revenue
Code; and

Does not cap the amount of distributions exempted from the source tax.
We also support the objectives of H.R. 371, but are concerned about the uncer-
tainty created by the bill's failure to clearly define "pension income."

We oppose the narrower approach taken in H.R. 744, which would provide relief
only for certain qualified plans, and then only for benefits paid in certain annuity
or installment forms and only for the first $25,000 in benefits paid in any other form
in a single year. These restrictions prevent H.R. 744 from solving certain significant
problems, aescribed below, created by nonresident state taxation of retirement in-
come earned while a resident of the state.

State Tax Laws

States tax income under two alternate theories: residence and source. The United
States Supreme Court has long recognized the ability of states to tax the income
of their residents based on domicile or residence. The Court has also supported the
principle that states can tax residents on all their income wherever earned, while
states can tax nonresidents on only the income derived from sources within the
state.

For tax purposes, states have typically followed the federal rule in deferring tax-
ation of retirement contributions and the like. At the time when retirement income
is received, however, issues are raised at the state level that are not relevant to the
federal level. For example, the source of the income may need to be considered when
an individual has worked in more than one state or resides in a different state at
the time the payment is received than at the time of contribution. Importantly, upon
becoming a nonresident, the states historically have not taxed the deferred income,
including deferred income from gain on sale of residence and unrealized capital
gains.

Constitutionally, states may not tax the portion of a nonresident retiree's retire-
ment income that accumulated while the retiree was a nonresident. However, some
states assert that they can tax the retirement income that accumulated while the
retiree was a resident. These states have enacted, or are now in the process of en-
acting, laws and adopting regulations to tax the retirement income of former resi-
dents. Notably, they argue that it is irrelevant that a retiree has long since severed
all ties with that state.

Most states understandably view tax-favored retirement plans as deferral mecha-
nisms rather than as avoidance tools. We recognize that it may not be equitable for
a taxpayer to have enjoyed the benefits and opportunities of living in a particular



79

state and then avoid that state's tax on retirement benefits by moving to another
state. If the taxpayer moves to a different state upon retirement, the deferral on
retirement income can lead to reduced tax revenue for the nonresident state, and
if taxpayers move from higher tax states to lower tax states, overall taxes may be
reduced.

However, other states insist they will tax the retirement income of their residents
regardless of where the retirement income was earned. Consequently, many retirees
are now unfairly placed between two or more states, each imposing a tax on retire-
ment income. Given the overwhelming complexities in the current environment,
with a system that is not administrable and does not allow the tax to be allocated
to the states simply, we support H.R. 394 as the best overall solution.

Problems With the Current Environment

As discussed above, many retirees are unfairly entangled in the conflicting tax
rules of various states. These retirees now face an undue compliance burden, need-
lessly incurring burdensome accounting and legal fees to interpret state statutes
and prepare multiple state filings for retirement income that may have been earned
in other states. Taxing retirement income in this manner often results in double
taxation. Further, the record keeping required to track the multistate retirement
earnings would place an undue burden on employers and plan administrators.

Substantial practical and equitable problems exist in dealing with the state tax-
ation of nonresident retirement income. Specifically, for taxpayers who worked in
multiple states before they retired, devising an accurate and equitable mechanism
for tracing retirement income to each state is a nightmarish burden. The employer
and employee retirement contributions and the subsequent plan income must be
separately traced and allocated by some reasonable method. Employer and employee
contributions might be allocated to the state where the related employee services
were performed each month. As discussed above, if the state where the services
were performed was not the employee's resident state at that time, both of those
states plus the state of the retiree's residence may claim the right to tax the income
relating to the contributions. Additionally, an increasing number of retirement plans
now accept rollovers from bther plans. To account for the source of distributions, a
plan accepting rollovers would have to account not only for the benefits accrued
under that plan, but also for benefits related to the plans of the participants' prior
employers.

In addition, for many retirees, the investment earnings accumulated in their re-
tirement plans are significantly larger than the plan contributions themselves. Like
the plan contributions, the investment income of a tax-qualified retirement plan is
tax deferred. It is generally agreed that states may not tax a nonresident's invest-
ment income. Yet this is the result of states taxing retirement plan payments that
represent investment income earned while the taxpayer is a nonresident. To correct
this, states would need to limit their taxation of the retirement plan's income to that
portion earned while the taxpayer was a resident of that state. This would create
an even greater level of difficulty in compliance. Consequently, the retirement plan
trustees or retirees would have to allocate income by the retiree's state of residence
at the time the monthly income was earned, instead of by the state where the retir-
ee's services were performed.

We have reviewed the testimony before the Subcommittee on this subject and
agree wholeheartedly with Mr. Randall L. Johnson's assessment of the administra-
tive and recordkeeping burdens of the current system. Although some states have
credit mechanisms for taxes paid to other states on income taxed in the home state,
they are far from perfect because of varying treatment and difTerent rates. As CPAs,
we feel these additional record keeping complications and double taxation results
are not justified. We would reconsider this issue if a system could be developed to
make a source tax more administrable.

Conclusion

Although there are some valid arguments in favor of a source-based tax, the lack
of administrability of such a system causes us to be in favor of prohibiting the tax-
ation of nonresidents' retirement benefits. Unless states are prohibited from taxing
the retirement income of nonresident retirees, more and more retirees will be sub-
ject to double taxation, while an increasing number of employers will be subject to
steep administrative costs and increasingly complex tax accounting problems. There-
fore, we respectfully request that you support H.R. 394, prohibiting states from tax-
ing all nonresident retirement income.



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Prepared Statement of CM. Sgt. James E. Lokovic, USAF (Ret.), Director,
Military and GtovERNMENT Relations, Air Force Sergeants Assocl\tion

Mr. Chairman and distinguished committee members, military members currently
face a tax penalty for serving their nation. The 160,000 members of the Air Force
Sergeants Association ask your assistance in preventing this practice. Currently, a
significant number of military retirees are forced to pay taxes on their military re-
tired pay to states where they were once stationed, but where they are not currently
residents — a practice called "Source Taxation." AFSA represents the millions of en-
listed active and retired, Air Force, Air Force Reserve, Air National Guard members
and their families.

Military retirees are effectively penalized by these states for having been assigned
to serve there. They were stationed in those states by the federal government — not
as a result of their own choice. While stationed there on active duty, they were sub-
ject to paying the taxes where they resided. Once retired, the military retiree is sub-
ject to paying taxes of the state where they currently live. Action must be taken
to prohibit otner states from claiming a legal right to this already-limited retired
pay.

Source taxation is unfair, burdensome and wrong, most especially for enlisted re-
tirees, whose income is the lowest of military retirees. It is the federal government's
responsibility to take action to end the practice targeted against those who served
our nation. This retirement was hard-earned through years of difUcult life, often at
the risk of their personal safety. They deserve to pay no more than other citizens
and in ways no more unfair than the rest. If anything, there should be a break for
those who fought our wars and helped secure our peace — not a penalty.

Military members are unique in that their retired pay was earned dollar-for-dollar
from a career of service to their nation, not to the individual states in which they
served. It is wrong for any state to claim part of a retirement income when the indi-
viduals being taxed no longer live within that state.

AFSA strongly believes military retired pay is not a "pension" that states can lay