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 code 54A;5-1



Speci.



Kansas: Income earned within the state's boundaries bv
nonresidents generally is subject to tax However, no
statutory provision or annotation explidliy states thai
Kansas taxes ihe retirement income of nonresidents.



All Other States

The ovenvhelming maforitv of the states have not
announced e.xpliat rules with respea to whether or not
they consider retirement income of nonresidents to be
subject to their income taxes Most of these stjtes do.
however, have provisions of law which generally regard
retirement income as indudible in gross income subject to
tax and which generally subject nonresidents to their
income taxes if the nonresidents earn income as the result
of the performance of personal services within their
boundaries. These states are:



Arizona

Arkansas

Georgia

Indiana

Maine

Maryland



Minnesota Oklahoma

Missouri Rhode Isle.

New Mexico S. Carolina

North Carolina Utah

North Dakou Vermont



Ohi.



Virginia
W Virginia



States That Protect Residents' Personal
Property From Liens Placed bv Source



Arizona
Colorado
Florida



Taxing States

Louisiana

Nevada

New Mexico



Texas
Washingto



Information was provided in part by the Congressional
Research Service Report for Congress: 'Sute Taxation of
Nonresidents' Retirement Income". Robert Burdette.
December 21. 1992



52

Mr. Gekas. I thank the gentleman and turn to Mr. Duncan.

STATEMENT OF HARLEY T. DUNCAN, EXECUTIVE DIRECTOR,
FEDERATION OF TAX ADMINISTRATORS

Mr. Duncan. Thank you very much, Mr. Chairman.

My name is Harley Duncan, and I am executive director of the
Federation of Tax Administrators. The federation is an association
of the principal tax administration agencies in each of the 50
States, the District of Columbia, and New York City. I would like
to make five points this morning.

First, this is not a question of the legal authority of the States
to tax the pension income of former residents. It is well established
that States may tax such income. The income in question here was
earned within the State, and the tax on it was simply deferred.
Moving out of State should not automatically convert this deferral
into an exemption. States must maintain their ability to tax income
earned within their borders if they are to retain their sovereignty
within our Federal system and serve the needs of their citizens.

Second, the amount of misinformation on State practices in this
area is extreme and it serves, in my estimation, to cloud the de-
bate. A review of State practices that was undertaken at the re-
quest of this committee last year, and which we are in the process
of updating even as we speak, indicates that there are approxi-
mately 15 States whose statutes permit them to tax some portion
of the deferred income of a former resident. There are four impor-
tant facts in this area.

First and most important, there is only one State, the State of
California, that has an active program of enforcing — the tax obliga-
tion on annuity payments of former residents.

The second important fact is that, of the remainder, probably 10
to 12 of those generally tax, if not exclusively tax, only distribu-
tions from nonqualified deferred compensation programs.

Instructive in this regard is the State of Pennsylvania which, as
you know, Mr. Chairman, has a broad exemption for retirement in-
come of its residents and its nonresidents. There are court cases in
Pennsylvania indicating that certain types of nonqualified deferred
comp plans don't count as retirement income in Pennsylvania and
they would assert the right to tax a nonqualified distribution to a
nonresident.

The third important point: No State, to my knowledge, imposes
a reporting obligation on a plan sponsor that falls outside of the re-
quirements of the Internal Revenue Code.

It is further my belief that the Employee Retirement and Secu-
rity Act, ERISA would probably clearly preempt those sorts of re-
porting obligations.

The fourth important fact: The direction is in States moving
away from taxation of nonresident pension income instead of into
that area. As Mr. Hoffman pointed out, Iowa recently repealed its
law. New Jersey a couple of years ago repealed its law, in large
part because of exactly the practical difficulties that you have
pointed out and that Professor Smith indicated.

The third point in my testimony is that State tax administrators,
I believe, have worked in good faith with the sponsors of this legis-



53

lation to arrive at a compromise that addresses the problems that
are inherent here and, second, preserves State sovereignty.

We tried to estabHsh four principles here: First, to try to pre-
serve to the maximum extent possible the source tax principle; sec-
ond is not to create opportunities for substantial tax avoidance;
third is to design legislation that meets the problems at hand and
not a series of hypothetical s; and the fourth is that the law be ca-
pable of being administered.

The law that the House of Representatives passed last year, H.R.
546, which would have exempted the first $30,000 in withdrawals
from any type of qualified plan, met these criteria, and we did not
oppose that. We are willing to accept that bill this year. We would
encourage you to go back to that.

We retain our commitment to bills like H.R. 546 that were intro-
duced and considered last year. The State of California has testi-
mony indicating likewise.

The fourth point to make is that the federation does oppose H.R.
394 as it has been introduced this year, principally because of the
inclusion of nonqualified deferred compensation plans within the
preemptive purview of the bill.

The addition of nonqualified plans creates the opportunity for
substantial tax avoidance by highly compensated individuals.
These plans are often not considered retirement plans and are gen-
erally available only to executives and highly compensated employ-
ees. If States are preempted fi-om taxing diistributions from such
plans, these individuals will be able to structure their earnings in
a fashion which would allow them to avoid substantial amounts of
State tax by simply deferring income and moving to a non-income-
tax State.

Moreover, the inclusion of the nonqualified plans is not necessary
to address the problem at hand which, as recently as 2 weeks ago
on the "CBS Morning News," was described as helping fixed-income
seniors and normal Americans who don't know about their obliga-
tions.

Finally, I would point out to you that the Unfunded Mandates
Act of 1995 does come into play, would come into play were it in
effect. This is an unfunded mandate, and Congress ought to en-
courage people to work it out with the State legislatures.

Thank you.

[The prepared statement of Mr. Duncan follows:]

Prepared Statement of Harley T. Duncan, Executive Director, Federation
OF Tax Administrators

Mr. Chairman and members of the Committee, thank you for inviting me to
present the Federation of Tax Administrators' position on proposals to preempt state
taxation of nonresident pensions.

The Federation of Tax Administrators (PTA) is a nonprofit corporation comprised
of the principal tax and revenue collecting agencies in each of the fifty states, the
District of Columbia, and New York City. The Federation is governed by a 15 mem-
ber Board of Trustees elected by the 52 member agencies. The policy of the Federa-
tion with respect to this issue was embodied in Resolution Sixteen adopted unani-
mously by the membership at its June 1994 Annual Meeting in Clevelana, Ohio.

Introduction

To begin, let me commend the Committee for asserting jurisdiction on this issue
and holding this hearing. Frequently, Congress has limited state taxing authority



54

without consulting the afTected states. Because state taxation is a highly specialized
subject, these preemptions have created problems for state governments without
necessarily implementing Congressional intent. The expertise to understand the
complexities of these issues exists within the House Judiciary Committee, and we
always appreciate receiving a proper hearing.

As a general matter, the Feaeration urges the Congress to move cautiously in con-
sidering legislation to restrict the ability of states to tax retirement income paid to
former residents. Any such legislation should: (1) preserve to the maximum extent
possible the source taxation principle undergirding state income tax systems; (2) not
create opportunities for substantial tax avoidance; (3) be designed carefully to ad-
dress the issues present in today's environment and not a series of hypothetical situ-
ations which someone might conjure; and (4) be capable of being administered by
being precisely drawn and based upon references to current laws or understood con-
cepts where possible.

As such, the Federation would encourage the Subcommittee, if it feels legislation
is necessary and warranted, to return to H.R. 546 as was approved by the Judiciary
Committee and House of Representatives last year. That measure meets the criteria
outlined above. It intrusiveness into state affairs was minimized. It did not create
opportunities for tax avoidance and was addressed to real burdens associated with
the manner in which states today tax retirement income of former residents. It also
defined the protected income with reference to the Internal Revenue Code so that
the sources of protected income are clear and the measure was capable of being ad-
ministered.

On the other hand, the Federation cannot accept certain of the bills which have
been introduced on this subject this year. In particular, H.R. 394 removes the ceiling
on protected income and adds "non qualified deferred compensation" arrangements
to the list of plans from which the states are preempted. These unwarranted expan-
sions eflectively prohibit all taxation of nonresident retirement income by the states,
and they open the avenue to substantial tax avoidance by highly compensated indi-
viduals.

Source Tax Principle

There should be no question regarding the legal authority of states to tax the pen-
sion income of nonresidents. * The basis of current state income tax systems is that
a state may tax income that is derived from "sources" within the state, regardless
of whether it is earned by a resident of the state or a nonresident engaging in in-
come-producing activities within the state. In-state sources are defined generally to
in dude the performance of services in the state, the conduct of a trade, business
or occupation in the state, or the receipt of income from property owned within the
state.

State authority to tax nonresident income from in-state sources was validated by
the U.S. Supreme Court over 70 years ago in Shatter v. Carter 252 U.S. 37 (1920)
when it wrote:

. . . we deem it clear, upon principle as well as authority, that just as
a State may impose general income taxes upon its own citizens and resi-
dents . . . , it may, as a necessaw consequence, levy a duty of like char-
acter, and not more onerous in its effect, upon incomes accruing to non-resi-
dents from their property or business within the State, or their occupations
carried on therein. . . .

As the Shaffer court noted, and as has been developed in subsequent cases, the
essential constraint on the states in the taxation of nonresident income is that the
nonresident not be taxed to a greater degree than a similarly situated resident of
the state and may not be discriminated against by virtue of the nonresident status. ^



^Throughout the testimony, references to nonresident pension or retirement income should be
read to refer to that portion of any deferred compensation arrangement which is attributable
to services performed in the state at an earlier point in time. A state would not have authority
to tax pension income of a nonresident If it did not arise from services or other activities per-
formed in the state.

2 With respect to nonresident pension income in particular, states take the position that the
pension income is simply deferred income or compensation for services f>erformed at an earlier
point in time. This issue has not been addressed directly by the Supreme Court. The Court's
ruling in Davu; v. Michigan Department of Treasury 109 S.Ct. 1500 (1989) (intergovernmental
tax immunity and 4 U.S.C. Ill prevent a slate from taxing federal pensions to a greater degree
than they do state and local pensions), however, certainly supports the state interpretation that
pensions are deferred income paid for services performed previously.



55

It is also clear that states have authority to tax all income received by a resident,
regardless of the source of that income.^ To avoid double taxation, however, all
states with a broad-based income tax* provide a tax credit to residents for income
taxes paid to another state on income which is also included in the tax base of the
state of residence.^ This system of reciprocal credits generally prevents retirement
(and other) income from being taxed in both the state in which it is earned and in
the state of residence.^

Thus, the authority of states to tax retirement income of former residents is clear.
This is income that was earned within a state, and the tax on that income was de-
ferred. Simply moving out of state should not automatically convert this deferral
into an outright exemption. States must be able to maintain their ability to tax in-
come earned within tneir borders if they are to preserve their sovereignty within
our federal system and to handle their responsibilities — responsibilities, I might
add, that Congress is rapidly increasing.

Current State Practices

The amount of misinformation on state practices in this area is absolutely appall-
ing, and it seems eminently clear that this misinformation, intentionally or uninten-
tionally, is being used to tout the debate and to obfuscate the issues. There is no
widespread state taxation of nonresident retirement income, and there is no
groundswell of activity that should lead one to believe that if Congress does not act
immediately that a large number of states will enter this area. State taxation of
nonresident retirement income is limited to a relatively small group of states. Most
importantly, these states in most cases limit their taxation to a discrete category
of deferred income not commonly defined as retirement plans. Finally, states are not
moving to enter into this area of taxation. Instead, the movement is actually in the
opposite direction with states moving away from taxing any nonresident retirement
income.''

The important facts regarding the state income taxation of nonresident income
are as follows:^

There are 13 states^ whose statutes permit them to tax some portion of de-
ferred income from a nonresident. Nine of those states generally, if not exclu-
sively, tax income from nonqualified deferred compensation arrangements, not
plans recognized as qualified pension arrangements under the Internal Revenue
Code;

Only one state — California — has any program in place to enforce tax compli-
ance by nonresidents on annuity payments From Qualified retirement plans;

No state imposes an extraordinary reporting obligation on any retirement sys-
tem administrator or plan sponsor, as it relates to a taxpayer not domiciled in
that state, beyond those required under the Internal Revenue Code. Further, it
seems likely that the Employee Retirement and Income Security Act of 1976
(ERISA) would preempt states from imposing such requirements.^"



^New York ex. rel Cohn v. Graves, 300 U.S. 308 (1937) and Lawrence v. State Tax Commis-
sJon< 286 U.S. 276 (1932).

* Forty-one states and the District of Columbia levy a broad-based personal income tax. New
Hampshire and Tennessee levy an income tax on limited types of interest, dividend and capital
gains income. Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming do not
levy a personal income tax.

"Maine and Virginia do not grant such a credit on retirement income. Neither state, however,
includes retirement income from non-state sources in the tax base of the resident.

^Certain groups of states do not use such a system of credits. Instead, they have reciprocal
agreements under which all income is taxed by the state of residence rather than the state in
which it is earned. (This also avoids taxation by two states.) These agreements are most preva-
lent in the Virginia-D.C. -Maryland, Pennsylvania-New Jersey, and Ohio-Indiana-Illinois areas.

^New Jersey and Iowa have within the last several years enacted legislation to cease the tax-
ation of nonresident retirement income. Similarly, Connecticut in establishing its income tax di-
rected a policy of not taxing nonresident retirement income.

^This information was gathered in 1994 at the request of the House Committee on the Judici-
ary. It was obtained by the Federation of Tax Administrators through phone calls with adminis-
trators in each state. States selected for phone calls were those that had been identified at least
once as taxing nonresident retirement income in one of several published sources. Survey results
have been made available to the Committee and are available from the Federation upon request.

^California, Kansas, Louisiana, Or^on, New York, Colorado, Delaware, Michigan, Wisconsin,
Connecticut, Massachusetts, Minnesota and Vermont .

10 In Fort Halifax Packing Company Inc. v. Coyne, 482 U.S. 1 (1987), the US. Supreme Court
said ERISA preempts states from enacting statutes relating to benefits plans that squire an em-
ployer to develop and implement an ongoing administrative program in order to comply with
its obligation under the statute. Requiring an employer to withhold state income taxes or report

Continued



56

Prior Legislative Efforts

State tax administrators — including those from California — have worked hard and
in good faith with the sponsors of these bills and with representatives of interested
groups to find a compromise that addressed the problem and was precisely struc-
turea to not leave state governments wide open to abuse. Those compromises and
agreements were embodied in bills before the Senate and the House oi Representa-
tives last year. We remain committed to those agreements and do not oppose meas-
ures that are similar to or based on those bills.

In this area, the Federation has worked from four principles:

1. Any federal legislation should preserve to the maximum extent possible the
source taxation principle undergirding state income tax systems. State tax sov-
ereignty and the ability to provide services to the citizenry require that states
have the ability to tax income earned within their borders.

2. Any federal legislation should not create opportunities for substantial tax
avoidance by not creating an incentive to enter into arrangements which allow
large amounts of income to be recategorized as protected retirement income.

3. Any federal legislation should be designed carefully to address the issues
present in today's environment and not a series of hypothetical situations which
someone might conjure up.

4. Any federal legislation should be drafted in a manner which is as dear and
understandable as possible. In particular, it should define the types of income
being protected by references to current federal law or otherwise understood
concepts where possible.

Based on these principles, the Federation would encourage the Subcommittee to
return to the measure (H.R. 546) as approved by the Judiciary Committee and the
House of Representatives last year if it feels federal legislation is warranted. That
measure provided that states could not tax the first $30,000 in annual withdrawals
from a list of qualified pension plans under the Internal Revenue Code.

H.R. 546 preserved tne principle of source taxation and preempted it only in lim-
ited circumstances. It did not create opportunities for tax avoidance because the pro-
tection was limited in amount and confined to a sf)ecified list of commonly known
and used retirement arrangements. H.R. 546 was addressed to real burdens associ-
ated with the manner in which states today tax the retirement income of former
residents in that it would be removed the prospect that the vast majority of Ameri-
cans would ever have to confront the "source tax" issue. Finally, it defined the pro-
tected income with reference to the Internal Revenue Code so that the sources of
protected income are clear and the measure was capable of being administered.

Current Proposals

The Federation of Tax Administrators opposes enactment of H.R. 394 as intro-
duced in the 104th Congress. This measure includes two significant changes from
H.R. 546 approved last year:

It has removed the $30,000 limit on the amounts to be exempted annually
from state tax; and

It has added to the list of protected income all distributions from nonqualified
deferred compensation arrangements.

The Federation opposes H.R. 394 on the following grounds.

Tax Avoidance. By adding nonqualified deferred compensation arrangements to
the list of protected income, the bill creates the potential for substantial tax avoid-
ance by relatively small groups of highly compensated individuals. Nonaualified de-
ferred compensation plans are essentially any arrangement negotiated between an
employer and employee to delay payment for services rendered. They can range
from a simple agreement to pay cash at a later point in time to more complex ar-
rangements imposing conditions on the amounts paid and providing for exotic forms
of payment instead of cash. By their nature, they are generally confined to small
groups of directors, officers, executives and other highly compensated individuals.
They are not the province of the normal working American.

By including nonqualified deferred compensation plans within the preemption,
H.R. 394 would expose the states to opportunities for substantial tax avoidance by
those able to avail themselves of such arrangements. Highly compxjnsated individ-
uals would be able to enter into arrangements to defer substantial amounts of in-
come in the latter part of their career, receive their distributions immediately upon



distributions and other information for nonresident retirees would necessitate an or going ad-
ministrative scheme on the part of the employer to meet its statutory obligation. Such a law
would be clearly preempted under Fort Halifax. (Of course, an employer may always withhold
on a voluntary basis, if the taxpayer chooses to provide the necessary information.)



57

establishing residence in a non-income tax state, and thus avoid all state tax on the
income.

Not Retirement Income. Nonqualified deferred compensation plans are not gen-
erally considered retirement plans per se, but are principally another means of
structuring compensation for services which allows the employer to defer payment
of the compensation (in return for deferring any tax deduction) and the employee
to defer tax on the income (in return for deferring realization of the income.) They
are not retirement arrangements of the kind we normally consider such as wit-
nessed by:^^

There are no requirements for universal coverage of all employees or even
universal coverage of employees within a given class;

There are no pre-funaing or trust arrangements required as with qualified
plans;

There is no minimum age for receiving distributions from such arrangements;
and

There are no limits on amounts which may be contributed to such arrange-
ments.

Beyond intended purpose and demonstrated need. Inclusion of distributions from
nonqualified deferred compensation plans not only creates the potential for tax
avoidance, but it is not necessary to meet the intent of the sponsors as we under-
stand it. Over the years this issue has been discussed, the focus has always been
on minimizing the compliance burden on persons with pension earnings that relate
to a lifetime of work. As Rep. Vucanovich said on CBS two weeks ago, the need is
to help ordinary people who are on fixed incomes and may not even be aware of
the tax burden or be able to deal with ootential complexities. Removing the $30,000
limitation and including nonqualified deferred compensation plans within the pur-
view of the bill are certainly not necessary to achieve this purpose.

Moreover, there has been no showing tnat nonqualified deferred compensation ar-
rangements should be included in the preemption of the bill. There has been no in-
dication of complexities faced by taxpayers. Instead, it appears to be an attempt to