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

a claim to as the result of work performed within that state. Military retired pay
is deferred income, the result of years of relatively low pay and sacrifice far above
what most people experience. Military retirees serve a career, with the expectation
of a secure retirement income after their last assignment. Source taxation is just
plain wrong.

Keep in mind that most enlisted members served in numerous states during their
careers. In each case they paid taxes like any other citizen. For those who served
in more than one state that practices source taxation, it is the most unfair. Again,
these retirees did so under government orders. To lose parts of their retirement to
more than one state is most burdensome. At worst, enlisted retirees should be taxed
by the state where they currently reside and receive services.

Mr. Chairman, we have seen a growing ajgreement that source taxation is a fun-
damental unfairness that must be ended. There is legislation before Congress to
stop it. We need your help to make it happen. As always, AFSA is ready to assist
you in matters of mutual concern.



Prepared Statement of J. Randolph Babbitt, President, Air Line Pilots
Association

On behalf of the Air Line Pilots Association, representing 43,000 commercial pi-
lots at 35 air carriers, I wish to express our strong support for H.R. 394, Represent-
ative Vucanovich's bill to prohibit states from taxing the retirement income of non-
residents. This practice, more commonly known as "source taxation," is in the purest
sense taxation without representation.

State taxes create state revenue. State revenue is then allocated to provide serv-
ices to state residents. This process is all determined by elected state omcials. How-
ever, nonresidents do not enjoy the benefits of this allocation process, nor can they
affect the process through the ballot box. AI-PA believes that this is fundamentally
unfair and that Congress must act to stop it now.

During their careers, airline pilots, by the nature of their profession, may reside
in many different states before they are required to retire. If taxation of retirement
income of nonresidents were to expand beyond the current few states that currently
practice it, an administrative nightmare would be created that not only would bur-
den the individuals, but also, the companies that employed them.

Congress clearly has the authority to enact legislation to curb this practice. In
fact, on three previous occasions. Congress has prevented the states from taxing the
earnings of nonresidents, such as flight crews, military personnel and, of course, its
own members. The case for retirees who move to another state is no less compelling.



81

Opponents of H.R. 394 argue that a cap should be placed on the pension income
that is exempted from source taxation or that only income from a qualified plan
should be exempted. We do not agree with either of these alternatives because this
tax is unfair to all retirees regardless of their income. Furthermore, since Congress
has frequently changed the pension laws in recent years to raise revenue, individ-
uals have been forced to move more of their retirement income into unqualified
plans — a legitimate way to provide for retirement income. They should not be penal-
ized twice.

In conclusion, Mr. Chairman, ALPA strongly supports H.R. 394 and urges its
swift enactment. I respectfully request that tnis letter be made part of your Sub-
committee's hearing record of June 28, 1995.

Thank you for your consideration.



Prepared Statement of Matthew P. Fink, President, Investment Company
Institute

The Investment Company Institute ^ supports the bill introduced by Congress-
woman Barbara Vucanovich (H.R. 394) that would prohibit "source state" taxation.

"Source-state taxation" is the assessment of state income tax on pension distribu-
tions made to a nonresident on the basis of the portion of the total pension that
was earned while the retiree worked in that state (the "source state"). There cur-
rently is no uniformity among the states regarding the taxation of source state pen-
sion income of nonresidents. While many states have laws on the books that tech-
nically call for income taxes to be paid on such nonresident pension distributions,
enforcement of those laws has been inconsistent.

The U.S. mutual fund industry strongly supports the proposed legislation. It ad-
dresses our concern that multiple state taxing authorities not require mutual funds
to file reports on or withhold source state income taxes where they do not have ac-
cess to the information needed to comply. Mutual funds typically have no means of
tracking the states in which pension plan participants and IRA owners earn their
pension and the amount earned in each state. Inasmuch as those determinations are
central to source state tax calculations, mutual funds ordinarily are not going to be
able to allocate pension distributions by source state.

Compromise bills, that propose to exempt only some portion of a person's retire-
ment income from source state taxation, would only complicate this problem. Dis-
tributions from a mutual fund often represent only one part of a person's total re-
tirement distributions. Mutual funds, therefore, in addition to being unable to iden-
tify source states, ordinarily will not be able to determine whether the pension dis-
tributions they make are in excess of any partial tax exclusion.

In short, mutual funds and similar financial institutions simply are not able to
serve as vehicles for the collection of state income taxes on pension distributions
made to nonresidents. The Vucanovich bill would solve this problem by providing
a blanket prohibition on any State imposing income taxes "on any retirement in-
come of an individual who is not a resident or domiciliary of such State (as deter-
mined under the laws of such State)."

The Institute strongly supports the Vucanovich bill. It is a straightforward, un-
complicated measure that would eliminate significant administrative and oper-
ational problems for mutual funds and other third party payors of pension distribu-
tions.



Prepared Statement of Robert T. Scully, Executive Director, National
Association of Police Organizations

My name is Robert T. Scully and I am the Executive Director of National Associa-
tion of Police Organizations (NAPO). I am also a former Detroit police officer retir-
ing 2V2 years ago after 26 years. NAPO is a national law enforcement organization
representing over 185,000 sworn law enforcement officers and 3,500 police associa-
tions and unions throughout the country. NAPO represents its members through
federal legislation, education and legal advocacy.



^The Investment Company Institute is the national association of the American investment
company industry. Its membership includes 5,604 open-end investment companies ("mutual
funds"), 470 closed-end investment companies and 11 sponsors of unit investment trusts. Its mu-
tual fund members have assets of about $2,325 trillion, accounting for approximately 95% of
total industry assets, and have over 38 million individual shareholders.



82

I would like to thank Chairman Gekas and the members of this subcommittee for
holding a hearing on an issue that could alTect the retirement of every American
who relies on income from a qualified pension.

The problem of certain states imposing tax upon the pension payments of non-
resident retirees presents serious concerns such as taxation without representation.
Thus, retirees are asked to pay taxes to a state that provides them with no govern-
ment services for which they have no recourse at the ballot box during elections.

In addition, these retirees are being double-taxed because they must also pay
taxes to the state in which they currently reside. And, in non-income tax states like
Washington, there is no way for them to credit source taxes paid on their income
tax return.

NAPO has a resolution in strong support of the legislation pending before the
Subcommittee that would limit the ability of the states to tax the disbursements of
qualified pension plans. In the past, NAPO has supported the efforts by Representa-
tive Vucanovich and others to limit these source taxes which pose an enormous
threat to retired public sector employees.

Legal experts have determined that Congress has the authority to limit source
taxes and legislation has passed both Houses of Congress in the past, but unfortu-
nately never was signed into law.

Law enforcement officers, like other public and private sector employees, plan
their retirement on a certain number of years worked and pension income earned.
To add to a fixed pension the burden of another state tax is both unnecessarily puni-
tive and ludicrous.

This issue is particularly alarming to law enforcement Officers as municipal and
state public employees because their paymaster has the ability to withhold taxes be-
fore disbursement.

Again, I thank you Chairman Gekas, for giving the National Association of Police
Organizations the opportunity to express our views on an issue of great importance
to current and future retired law eniorcement officers in this country.

On behalf of our members throughout the country, we urge you to expeditiously
report legislation to limit taxation of non-residents' pension income.



Prepared Statement of Carolyn M. Kelley, Director of Government Affairs,
American Payroll Association

The American Payroll Association is submitting these comments in support of
H.R. 394 and its companion bill in the Senate, S. 44, proposed legislation which
would limit the ability of states to tax the pension income of non-residents. We be-
lieve that this legislation is necessary to protect both retirees and their former em-
ployers from the unreasonable burdens associated with the efforts of certain states
to tax these payments.

The American Payroll Association is a nonprofit professional association rep-
resenting 11,000 companies and individuals on issues relating to wage and employ-
ment tax withholding, reporting, and depositing. Over 85% of the gross federal reve-
nues of the United States are collected, reported and/or deposited through company
payroll withholding. Under our system of voluntary compliance, we are the nation's
tax collectors. We nave previously voiced our support for K.R. 394 and S. 44 as a
co-signatory (along with a large number of groups and individuals) of a letter sup-
porting the legislation because of the negative impact state non resident taxation
has on retirees. In addition, we support tnis legislation because of the substantial
concerns of payroll tax administrators about the increasing burdens imposed on em-
ployers by states' enforcement of "source taxation."

We believe that, to be truly beneficial, any legislation limiting state taxation of
non-resident compensation must be at least as broad as H.R. 394 and S. 44. ^ These
bills provide the relief necessary to alleviate the problems facing employers by ex-
empting all payments from qualified employer pension plans. If Congress adopts
legislation to exempt only annuity distributions from qualified pension plans (like
the bills proposed in 1994), or if the 1995 legislation applies only to payments of
certain typxjs of qualified and nonqualified deferred compensation made after the
law is enacted, all employers will remain exposed to state payroll audits with re-



1 Even these bills may not be broad enough to cover all of the payments an employer may
make aOer an employee is no longer a state resident. Although the legislation includes pay-
ments from "any plan, program or arrangement described in section 3111(v) (2) (C)," the IRS
may, by regulation, exclude such payments as stock options, vacation pay, and bonuses which
arc deferred for a short period of time from the definition of deferred compensation under Code
section 3III(v). In that event, employers may still have to deal with state reporting require-
ments for non-resident former employees.



83

spect to payments to former state residents of retirement benefits not covered by
the legislation. Any Congressional override of state source tax enforcement that may
be adopted should be applied not just to all future payments of retirement income
to former employees who nave moved out of state, but also to all such benefits which
are reported after the date of enactment, or, better yet, to all state payroll audits
with respect to retirement income of nonresident former employees which may be
conducted after the date of enactment.

Background. Currently, many states impose income tax on post-termination pay-
ments of pensions and non qualified deferred compensation that was earned and de-
ferred while an individual was a resident of that state even though, by the time the
f)ayments were made, the individual had moved to another state (often one with
ower or no income tax). These states base their right to tax non-resident retirees
on the "source-tax" rule, i.e., a state may tax income earned within its borders. As
a result, the state establishes a right to tax that portion of the individual's benefits
attributable to the period of time that the individual worked in the state.

As a corollary to the imposition of income tax on these post-termination payments,
many state income tax laws require employers to withhold on these payments. Less
than a dozen states currently enforce tnese "source" taxes, but state revenue con-
straints have caused more states (and cities) to conduct payroll audits of employers.
Instead of attempting to collect unpaid income taxes directly from former residents,
states recognize that it is more efticient to audit (and assess a liability against) a
single employer than to audit dozens (or hundreds) of that employer's employees in-
dividually. Employers are liable, (and thus potentially subject to audit) both (1) for
failing to report pensions and other deferred compensation based upon the state(s)
where the employee worked or lived while the compensation was earned, and (2) for
under withholding "source taxes." Also, the penalties assessed on employers may ex-
ceed the amount of taxes that would have been owed by the employees. ^

The potential impact on employers from this attempt by states to extend their
reach to tax the retirement income of individuals who no longer live in the states
is expected to be costly and far-reaching, both in the substantial administrative ex-
penses the employers will incur to maintain the necessary records and in the liabil-
ity they may face if they fail to withhold the amount of source taxes the state has
determined is appropriate.

Administrative costs. The costs to employers of compiling the data on pension ac-
cruals (and interest on previously vested accruals) on a state-by-state basis will be
staggering. Compliance is very expensive because employers face huge administra-
tive expenses of tracking and allocating pensions (and any other types of deferred
compensation) based on the employee's residence (or job location) when the services
were performed, and applying myriad state withholding laws to these computations.
Employers also worry that federal guidelines will create an incentive for more states
to tax what federal law allows them to tax.

The following simple example illustrates the complexities that employers will face
if each state is allowed to continue taxing pension and other post-termination pay-
ments of compensation based on the state that the employee worked in when the
payment was earned" where an employee has worked for the same employer in two
separate states. (Consider the employee who worked for a company for 40 years
(from age 20 to age 60). After working for the company for 10 years in State A, the
employee is transferred to State B, where he continued to work for the next 30
years. At the time of the employee's transfer, the company's recordkeeping system,
like many companies' systems, was not automated. Also assume that, as with many
pension plans, the employee's pension is based on a maximum of 30 years of service,
and is calculated as a percentage of his final pay. When the employee started with
the company 40 years ago, he was making $4,000 per year; when he left, he was
making $50,000 per year. He now receives a pension of $3,000 per month. Each
state in which the employee worked imposes a tax on his pension income based on
its "source taxation" rules. Both State A and State B have placed the ultimate bur-
den on the employer to determine how to allocate the "source" of the employee's pen-
sion income. To do this, the employer must resolve a multitude of questions, and
each state will probably demand that the employer answer them in the way that
is most beneficial to that state. For example, if" there is a 30-year service cap under
the pension plan and the employee worked for 40 years, do the last 10 years of the
employee's service in State B count as a factor in determining the "source"? The em-

Sloyee had already reached the maximum percentage of final compensation under
is employer's plan after only 20 years in State B. But the employee's pension is
based on his final compensation, which, as with most employees who worked
through years of high inflation, is substantially greater than his compensation in



2 See the discussion below of "Employers' liability for non- withheld taxes."



84

his first 10 years of employment. So should State A receive little or no allocation
under the "source taxation" theory? And what if, as many pension plans do, the em-
ployee's plan offered an early retirement subsidy to employees who retired after age
55? Does this tip the balance in favor of State B? And if State A and State B dis-
agree, who must suffer?

An even more fundamental and daunting task than answering these questions
may face many employers who must substantiate the portion of the retiree's income
which is allocable to each state. Before an employer can allocate income to a par-
ticular state, it must accumulate the records necessary to determine the state in
which the income was earned. While most employers maintain the records necessary
to calculate an employee's pension, such as his years of service and possibly even
his compensation record, it is unlikely that any employer will have a record of the
state in which the employee worked in any given year, especially if the employer
is asked to retrieve records that are 40 years old (or more). Absent this information,
it is likely that each state will assess a tax on the entire retirement benefit and
require the taxpayer or the employer to prove that the amount is incorrect.

Employers' liability for non-withheld taxes. Most states have provisions (resem-
bling Federal tax penalties) which impose penalties on employers for failure to with-
hold income taxes. The Federal penalties equal 100% of the non-withheld income
taxes (calculated at a rate of 28%), plus up to 20% of the income not reported on
an information return,^ plus possible additional penalties for inaccurate quarterly
payroll tax returns, totaling as much as 55% of the unpaid taxes. The employer's
liability for the income taxes (but not the other penalties) can be abated if the em-
ployer proves that the employee actually reported the income. However, where in-
come is never reported on any information return, very few employees ever volun-
tarily declare (and pay tax) on that income to that state. Assuming that the states
have audit penalties similar to the federal penalties, employers are very concerned
that they will be penalized (instead of the retirees) for their failures to withhold
state income taxes on post- termination payments to former workers.

Unclear reporting guidelines. The concern over the possibility that states will im-
pose excessive recordkeeping requirements on employers or assess substantial pen-
alties against them has caused employers to seek relief from this burden. Some em-
ployers have argued that, by merely moving the pension trust monies to a state in
which the employer does not do much business, and hiring an out-of-state tax ad-
ministrator, the employer is no longer liable to file Copy 2 of Forms W-2 with any
states where the trust and plan administrator do not "do business," because the
state has no jurisdiction where the business nexus is lacking.

Single wage reporting may give more states information to audit employers. The
necessity of enacting legislation which eliminates the ability of states to tax non-
resident pensions has been heightened by the expanding availability of Federal in-
formation to the states. Attached is a brief article which provides just one example
of the implications of such information sharing in the W-2 area, where states might
legitimately expect employers to provide state information, if a single state found
5,000 employers (not individual employees) who had not complied with reporting
procedures regarding current wages and income, it is reasonable to assume that an
overzealous state might attempt to establish a multitude of violations when auditing
an employer's reporting of each state's allocable share of a retiree's pension income.
As the Internal Revenue Service begins to implement its new "simplified tax and
wage ref)orting system" ("STAWRS") (which combines state and Federal information
returns, and will give states access to the Federal government's data bank on wage
and income information), the states will have a vastly expanded data base in which
to audit employers for their potential errors in underreporting and under withhold-
ing state taxes. Moreover, if any state can assess large taxes and penalties on em-
ployers for years in which single wage reporting is in effect, it may also try to collect
similar taxes and penalties from the same employers for the open years preceding
the adoption of single wage reporting.

For all the reasons listed above, the American Payroll Association supports H.R.
394 and S. 44, suggests broadening the efiective date of these bills, and urges the
members of the House of Representatives and the Senate to support and cosponsor
this legislation. This action is badly needed because the potential impact of state
"source taxation" of pensions on retirees and their former employers is extensive



3 Code §6722 impoees a penalty of up to 10% of any income not reported on an employee's
paper copy Form W-2; Code §6711 impoees an additional penalty of up to 10% of any income
not reported on the IRS copy of the Form W-2 (or on the IRS magnetic media tape). Although
the IKS typically assesses only one of these penalties, technically both penalties could be as-
sessed.



85

and troubling. We would be pleased to testify at any future hearings which may be
held on this proposed legislation.

Mr. Gekas. The subcommittee stands adjourned.
[Whereupon, at 11:45 a.m., the subcommittee adjourned.]



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