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

state escapes the tax imposed on retirees who chose continuing residence. The con-
cern, an issue of tax neutrality, is whether the State income tax system causes retir-
ees to alter their behavior with respect to their decision where to live. Here effi-
ciency analysis dovetails with equity. If the State of retirement fully taxes the re-
tirement income of the new resident, there is no efficiency problem. But often this
will not be the case, and for reasons of efficiency as well as equity the tax system
should not influence a retired employee's decision as to where to retire. It should
not penalize retirees who elect to stay a resident, nor should it create a tax windfall
for those who load the moving van.

Practical Difp^iculties

The conclusion that there is no theoretical justification for prohibiting States from
taxing nonresidents pension income earned within their borders does not mean that
legislation barring States from doing so is necessarily bad policy. There are practical
problems raised by State taxation oi nonresident pension income that may neverthe-
less justify the proposed congressional restraint.

Distinguishing taxable deferred compensation from nontaxable deferred investment
income. Pension income reflects more than deferred compensation. Retirement ac-
counts start with initial or periodic employer or taxpayer contributions, which pure-
ly constitute deferred compensation, but over time investment income, consisting of
interest, dividends, and the like, accumulates on the taxpayer's deferred compensa-
tion. For many retirees, in monetary amount the accumulated investment income
is much larger than the sum of the contributions reflecting deferred compensation
due to the time value of money and the long time accumulations accrue for retire-
ment plans that are funded for decades prior to retirement. Accumulated investment
income in tax-qualified retirement olans is tax deferred, both at the federal and
State tax level, just as is the deferrea compensation itself.



27

This fact that pension payments include deferred compensation components and
investment income components creates a serious practical complication in State tax-
ation of nonresident pension income. For while States clearly possess the power to
tax income from personal services performed by nonresidents in the State as well
as investment income earned by residents, they clearly lack the power to tax invest-
ment income earned by nonresidents unless it has an in-State source. See Molter
V. Department of Treasury, 505 N.W.2d 244 (Mich. 1993) (former resident not tax-
able on interest accrued on contributions to qualified deferred compensation plan).

Because States generally lack the constitutional power to tax tne portion of a
former resident's pension income that reflects accumulations after the taxpayer's
change of residence, States must limit their taxation of nonresident pension income
to the deferred employment income and the income accumulated prior to the retir-
ee's change of residence. As a practical matter, it may be difficult, if not impossible,
for a State (or for an employer with State withholding tax obligations) to determine,
on a pension-check-by-pension-check basis, what proportion of the payment reflects
deferred payment for services rendered in the State and what proportion represents
investment income that accrued while the taxpayer was a nonresident of the State.

Deferred Compensation involving more than two States. Americans are very mo-
bile, now more than ever. Often more than two States will have plausible claims
to a taxpayer's pension income due to the fact that the taxpayer has worked in more
than one State prior to retirement or has earned income in a State other than his
State of residence. In such multistate situations, jurisdictional tax claims may pro-
liferate. Each State is obligated to limit its pension tax to deferred compensation
from services performed in the taxing State or while the retiree was a resident. And
for investment income accumulating in the retirement plan, each State is obligated
to exclude from its pension tax any investment income accumulated while the tax-
payer was a nonresident of the taxing State. With these two obligations coupled to-
gether, the problems of implementing a constitutionally acceptable nonresident pen-
sion tax may be insuperable.

Possible State Responses to Congressional Legislation

If Congress were to bar State taxation of nonresident pension income, the States
will not necessarily roll over and play dead. There are several different approaches
they could adopt with respect to deferred pension income. Each approach raises tax
policy concerns, and some present constitutional issues as well.

State repeal of deferred recognition generally. One reaction States may take is sim-
ply to uncouple their taxing regimes from the federal model and end deferral of in-
come paid into qualified pension plans and the like in order to preserve their reve-
nue bases. The States are constitutionally free to take such action, and a number
of States have elected not to follow federal rules for deferring retirement income.
For example, Georgia for a number of years taxed employee contributions to retire-
ment plans and did not allow a full deduction for IRAs. Although Georgia presently
tracks the federal system, it could choose again to curtail deferral.

If congressional action prompts States to repeal deferred recognition, nonresident
retirees gain but a Pyrrhic victory. In terms of tax policy, however, State repeal of
deferral would not necessarily be bad. With continuing residents and former resi-
dents treated identically, equity and efficiency concerns are completely satisfied. But
this outcome does have a cost. It adds complexity for taxpayers when they must re-
port deferred income to their State but not to the federal government. This adds
work for preparing tax returns not only when the taxpayer is working, earning the
income, but also during retirement, when the taxpayer will have a basis in the re-
tirement plan for State income tax purposes but not for federal purposes.

State repeal of deferred recognition for nonresidents. Alternatively, States might
seek to preserve tax deferral for continuing residents, but deny it to those departing
retirees who are on the eve of obtaining congressional immunity. States may try to
tax deferred personal service income of departing residents, making the change of
residence an event that triggers recognition of income. Such an approach could also
extend to nonresidents who work within the State, with cessation of in-State em-
ployment serving as the tax trigger. The tax code of at least one State — California —
already appears to call for such treatment for departing residents. Cal. Rev. & Tax.
Code § 17554 (West 1994).

Such a strategy, however, creates thorny federal constitutional problems. The es-
sential claim is that the statutory denial of nonrecognition treatment discriminates
against nonresidents in violation of the privileges and immunities clause. The
State's response would be that there are compelling "independent" reasons for deny-
ing tax deferral on pension income for departing residents. Specifically, the State
would contend that the denial of deferral to departing residents is a rough but ad-



28

ministratively feasible means of achieving equality between residents and non-
residents. This argument may be strengthened substantially were Congress to pro-
hibit States from taxing nonresidents' pension income. Then the States would face
a statutory bar on their Jurisdiction, rather than substantial administrative prob-
lems which might in fact be capable of solution.

Merits of Different Approaches for Federal Legislation

Two of the bills, H.R. 371 and H.R. 394, simply prohibit all State taxation of non-
resident pension income. H.R. 744, in contrast, prohibits the taxation of pension in-
come received in the form of annuities with a payment period either for life or for
a fixed period of at least 10 years. Lump-sum payments and shorter term annuities
remain taxable, subject to a one-time $25,000 exemption. There are three reasons
why the differential treatment proposed in H.R. 744 may be appropriate. First, this
treatment may serve to curtail tax avoidance by highly compensated individuals. If
States cannot tax large lump-sum distributions or short-term periodic payments
from qualified plans, then taxpayers who plan to retire to other States in the near
future might convert ordinary comf)ensation to retirement income. Receiving the de-
ferred compensation after the date of change in residence would strip the State of
taxing jurisdiction. While such tax planning is still possible to some extent under
voluntary retirement plans even if the taxpayer must select a long-term annuity,
abuses are much less likely if the taxpayer must forgo what would nave been ordi-
nary compensation for a substantial time period.

A second and related potential justification for the differential treatment is the
taxpayer's ability to pay, or need. A retiree who elects a long-term annuity arguably
is more likely to need that income for living expenses than a retiree who "cashes
out" of a plan quickly. But the relationship between ability to pay and length of pay-
out may oe rather indirect. Some well-to-do retirees will receive high payments in
the form of long-term annuities, and some lower-income retirees will cnoose lump-



sum settlements or short-term annuities.

If the differential treatment is justified either on the basis of minimizing tax
avoidance by highly compensated individuals or on the basis of probable need of tax-
payers receiving long-term annuity payments, a different strategy is desirable. It
makes more sense to tackle these issues directly by utilizing an annual exemption,
such as $20,000 or $30,000, that shelters pension income regardless of form or
length of the pay-out period.

Third, the practical difficulties of determining how much of each annuity payment
is properly taxable may justify limiting the exemption to long-term annuities. Each
annuity payment received by a former resident has two components: deferred com-
pensation, which in principle is taxable by the State of former residence, and invest-
ment income, which is not taxable to the extent it accrued after the date of change
in residence. With longer annuity pay-out periods, the ratio of investment income
to deferred compensation income is higher. I am not persuaded, however, that the
computational difficulties in making the proper allocations are markedly greater for
such long-term annuities than for short-term (e.g., 3 year) annuities. For a single
lump-sum payment, computing the amount of deferred compensation income may oe
simpler, but even then allocation is necessary if the payment includes investment
income that accrues after the date of change in residence.

These three reasons make the lines drawn between taxable pension income and
nontaxable pension income (whether under H.R. 744 or, as an alternative, an
across-the-board annual exemption) constitutionally defensible, in terms of due proc-
ess and equal protection. Nevertheless, there are substantial downsides. First, the
line drawing is complicated. Both nonresident taxpayers and State tax administra-
tors will have to learn and apply the rules. There is some risk that many non-
resident taxpayers, in their tax planning, will fail to understand the tax implica-
tions of how they choose to receive money from their pension plans. Thus, for rea-
sons of policy — tax simplification — a clear all-or-nothing rule is desirable.

A second downside is that partial exemption of pension income is only a partial
solution to the real problem. If Congress acts at all, the reason for intervention
should be that States are unable to overcome the practical problems of tax adminis-
tration in the area. If the States are permitted to tax some but not all of the pension
income of their former residents, they will still have to solve the same significant
hurdles of distinguishing deferred income which they may tax from investment and
interest income which tney mav not tax. In addition, there will still be the com-
plicated cases involving more than two States to resolve. Thus, although the pro-
posed lines to be drawn between taxable and nontaxable pension income reduce the
number of cases where the States must solve severe administrative difficulties,
many troublesome cases will remain.



29

I would also note, in passing, that if Congress acts because it is persuaded that
it is unfair or inequitable for States to tax the pension income of its former resi-
dents, because they no longer receive benefits from their State of former residence
or for some other reason (arguments which I reject, as stated above), a total exemp-
tion also seems merited. If in principle such taxation is unfair or oppressive, the
amount of income at issue and tne timing of its receipt should not matter.

In conclusion, the considerations that have occurred to me do not clearly illu-
minate the best approach. The line drawing between taxable and shielded pension
income is in part an attempt to intrude on State authority no more than is nec-
essary. And, as I indicate above, there are plausible reasons for permitting States
to tax some but not all of the pension income received by their former residents
from qualified plans. Nevertheless, on balance, if Congress acts I recommend a
bright-line rule, such as the one embodied in H.R. 394, that exempts all "qualified
plan" pension income received by former residents from State taxation. To me, the
virtues of a simple, clear rule, coupled with the purpose of restraining the States
from trying to solve administrative problems that are probably intractable, outweigh
the other considerations.

Mr. Gekas. Yes. Noting the presence of Senator Reid of Nevada,
we will invite him to join you at the witness table, allow him to
make his statement, and then cross-examine both of you at the
same time.

We welcome you. Senator.

STATEMENT OF HON. HARRY REID, A SENATOR IN CONGRESS
FROM THE STATE OF NEVADA

Mr. Reid. I apologize for being late.

Mr. Gekas. You were in nuclear waste land, we heard,

Mr. Reid. Yes, and two of my favorite subjects, source tax and
nuclear waste, and, as a result of that, I rushed back after the nu-
clear waste hearing and missed a vote, which we don't do often
around here, but source tax is worth it, so I am happy to be here.

Mr. Gekas. Please proceed.

Mr. Reid. I would ask that the full statement be made part of
the record.

Mr. Gekas. Without objection.

Mr. Reid. Mr. Chairman, members of the committee, this, as you
know, is an issue that is important to me and I think the people
of this country. This source tax repeal has passed the Senate on
three separate occasions, it has passed the House on one occasion,
and, as you will recall, last year in the waning hours of the session.
Senator Malcolm Wallop from Wyoming killed this in the Senate.

We have a procedure there that allows in the final hours of a ses-
sion that someone can put a hold on a bill, and, as a result of doing
that, you can't get unanimous consent to get it passed, and as a
result of this the bill was killed. It should already be the law.

The source tax issue was brought to my attention a number of
years ago by a Carson City, NV, based retirees group that you are
later going to hear from today. This group, called RESIST, was
founded in 1988 to fight the source tax. In less than 4 years RE-
SIST's membership has grown to tens of thousands of members,
with members from every State in the Union. It is nonprofit. It is
a grassroots organization. It operates entirely on volunteers. There
are no salaries paid to anyone.

The credibility of this group has convinced other long established
organizations such as the National Association of Retired Federal
Employees, the Retired Officers Association, American Payroll As-
sociation, Association of Private Pension Welfare Plans, and the



93-421 - 95



30

Profit-Sharing Council to make a commitment to prohibition of the
source tax on pension income.

Furthermore, Congresswoman Vucanovich's and my legislation
have now gained exclusive support from several organizations such
as ERIC, which is the ERISA Industrial Committee. Its president,
Mark Ugoretz, states — and I quote — that they reject other propos-
als that cap pension income exempted from State source taxes or
allow States to tax pensions from nonqualified plans.

Similarly, the American Council of Life Insurance has stated that
our legislation contains the only proposal they can support.

Legislation that limits income level and type of pension plans
that are taxed do not address a basic flaw of the source tax. Huge
numbers of retirees' benefits exceed the cap or nonqualified plans.
The other legislative proposals do nothing for this large number of
employees.

Mr. Chairman, I would hope that you would ask Mr. Hoffman
about some of the examples of just some of the real tragedies that
involve this. The States which collect this source tax do it without
any regard to how much income the people have. We have people
who, literally, it is a matter of life and death, and Mr. Hoffman can
tell you some of those. My statement has in it an example of a
woman from Fallon, NV, who simply was caught between a rock
and a hard place when this collection was initiated.

This legislation, Mr. Chairman, will not cost the Federal Govern-
ment a penny. In fact, the Federal Government will make money
if this legislation passes. The reason for that is that you can have
an offset for the Federal tax that you pay from — the State tax you
pay from your Federal income tax. There would be less State taxes
paid. Therefore, the Federal Government would make additional
money. It wouldn't be a lot of money, but this is a net gain to the
Federal Treasury.

I appreciate tne courtesy of allowing me to appear out of order.

[The prepared statement of Mr. Reid follows:]

Prepared Statement of Hon. Harry Reid, a Senator in Congress From the
State of Nevada

I would like to thank the Chairman and the Members of the Subcommittee for
the opportunity to appear before them today in support of H.R. 394.

As you know, for the past four years, I have sponsored legislation to prohibit
states from taxing the income of non-residents. This year, I have again reintroduced
legislation to stop this unfair taxation. I introduced similar legislation that passed
the House and the Senate in the 103rd Congress and passed the Senate twice in
the 102nd.

Today, many retirees are forced to pay taxes to states where they do not reside.
The retirees pay taxes on pensions drawn in the state where they spent their work-
ing years, despite the fact that they no longer live in that state. As I have said
many times before, this is taxation without representation. Retirees are no longer
participating in the state's medical assistance programs or senior centers, nor do
they use the roads or public parks that these taxes are helping to fund. Most impor-
tantly, they are not allowed to vote in their former state of residence — yet they still
pay taxes to these states.

I have told a story which illustrates the inequity of the practice of source taxing
pension incomes on nonresidents. The story is about a Nevada citizen, but it could
be happening in any state.

There is an older woman who lives in Fallon, Nevada and has an annual income
of between $12,000 and $13,000 a year. She is not rich, but she is surviving. One
day the mail carrier delivers a notice from California that says she owes taxes on
her pension income from California, plus the penalties and interest on those taxes.
She can not believe it but, being an honest person, she tells California that she has



31

never paid these taxes in the past and asks why she is being assessed at this time.
To make a long story short, the California Franchise Tax Board went back to 1978
and calculated her tax debt to be about $6,000. This woman's income is only $12,000
a year.

These problems are compounded when more than one state seeks to tax the same
pension income. Residence in a number of states during the working years can lead
to a division of pension income, the filing of separate tax returns for each state, and
the payment of taxes in each state. Furthermore, the administrative burden on cor-
porations to keep track of employees who have worked in several states over the
years can be overwhelming. Therefore, the existence of a state policy of taxing the
pension income of nonresidents may also be a disincentive for corporate head-
quarters to locate within the state. Corporate executives would also be dissuaded
from incorporating in these states because it is expected that they will retire outside
the state.

The source tax issue was brought to my attention several years ago by members
of the Carson City, Nevada-based Retirees to Eliminate State Income Source Tax,
known as RESIST, which was founded in 1988 to fight the source tax. In less than
4 years, RESIST membership has grown to tens of thousands of members. It in-
cludes members of every state of the Union. It is truly a nonprofit, grass roots orga-
nization. It operates entirely on the work of volunteers. No members are salaried.

The credibility of this group has convinced other long established organizations,
such as the National Association of Retired Federal Employees (NARFE), the Re-
tired OfTicers Association, the American Payroll Association, Association of Private
Pension and Welfare Plans, and the Profit Sharing Council to make a commitment
to the prohibition of the source tax on pension income.

Furthermore, Congresswoman Vucanovich's and my legislation has now gained
exclusive support from several organizations, such as ERIC, the ERISA Industry
Committee. ERIC's President, Mark Ugoretz stated that they "reject other proposals
that cap pension income exempted from state source taxes or allow states to tax
pensions from nonqualified plans." Similarly, the American Council of Life Insur-
ance (ACLI) has stated that our legislation contains the only proposal they can sup-
port. Legislation that limits the income level and type of pension plans that are
taxed do not address a basic flaw of the source tax — huge numbers of retirees' bene-
fits exceed the caps or are in nonqualified plans. These other legislative proposals
do nothing for this large number of retirees.

I think it is important to highlight the fact that this legislation has no cost to
the federal government. In fact, it could possibly enhance federal revenue because
of the state tax deduction.

Initially, this issue affected mostly retired government employees because of easy
access to their records. However, as economic times become tougher, and state budg-
ets are straining for additional revenues, the source tax is becoming an ever more
popular revenue source. State budgets are experiencing economic hard times. It will
not take long for states to realize that taxing someone from another state is an easy
way to increase revenues without paying the political price. In other words, unless
mine and Congresswoman Vucanovich's legislation is passed you can be sure that
more and more states will begin to impose this unfair tax for which no one is ac-
countable.

Mr. Gekas. We thank the Senator.

Mrs. Vucanovich and Mr. Stump adequately presented the case
for the border States to Cahfomia. You mentioned in part of your
testimony that perhaps it is an anomaly to talk about caps or some
portion of the pension being subject to the tax while others are not.
It is a question in our minds, or getting to be, that it is either all
or nothing.

Mr. Reid. I would agree, Mr. Chairman.

Mr. Gekas. Otherwise you don't address the basic issue.

Professor Smith, what do you think about that, is it impractical
and if it does have some other legal problems, we shouldn't be di-
viding the question by even discussing caps; is that correct?

Mr. Smith. I think so. The caps to me make sense only if the
prime policy concern is for retired persons who have a relatively
modest retirement income and who are hurt the hardest by it.



32

But as I listen to the testimony and as I have thought it through,
the practical difficulties in administering the tax fairly bear upon
all former residents who are in another State. The measurement
problems are just as severe for those who earn annual retirement
income in excess of the $30,000 annual exemption that was in the
bill passed by the House of Representatives last year.