State Taxation of Nonqualified Deferred Compensation

Nonqualified deferred compensation (NQDC) is a method for employers to provide future payments to key employees, often years after the compensation is earned. These arrangements allow executives to defer a portion of their income and the associated income tax until a future date, such as retirement. This provides an opportunity for tax-deferred growth on the deferred amounts.

The complexity of NQDC arises when employees work in one or more states while earning this income but retire to an entirely different state. This mobility raises the question of which state has the legal authority to tax the distributions. The core issue is whether the state where the income was earned or the state where the individual resides at the time of payment has the primary right to tax the NQDC, a question governed by intersecting federal and state laws.

The Federal Limitation on State Taxation

A federal law, 4 U.S.C. Section 114, establishes a baseline for how states can tax certain retirement funds, including some forms of NQDC. Enacted in 1996, this law was designed to prevent states from taxing the retirement income of their former residents. Its purpose is to provide certainty to retirees who move across state lines by ensuring their retirement income is taxed only by their new state of residence. This federal protection is not automatic and applies only if specific conditions are met.

The law defines “retirement income” broadly, encompassing payments from qualified plans like 401(k)s and IRAs, as well as certain NQDC plans. For an NQDC plan to fall under this federal protection, its payments must satisfy one of two criteria. The first is that distributions are made in a series of “substantially equal periodic payments” at least annually over the recipient’s life expectancy or for a period of not less than 10 years.

The second path to protection is for payments made from an “excess benefit plan.” These are NQDC plans designed to provide benefits that would have been available under a company’s qualified plan but were limited by Internal Revenue Code restrictions. If an NQDC distribution is received after employment ends and meets either the periodic payment or excess benefit plan test, the federal law prohibits the former work state from taxing it.

If a plan’s payout structure does not align with these federal requirements, such as a lump-sum distribution from a plan that is not an excess benefit plan, the protection does not apply. In these cases, the state where the compensation was earned may assert its right to tax the income, even if the individual is no longer a resident.

Allocating NQDC Income to a Source State

When federal law does not prevent a former work state from taxing NQDC payments, the income must be attributed to that state. This process, known as sourcing or allocation, connects the compensation to the specific location where services were performed. States have the right to tax income generated within their borders, and NQDC is treated as wages earned over a period of years, requiring a detailed analysis of an individual’s work history.

To perform this allocation, several documents are needed:

• The NQDC plan document outlining the compensation terms
• Detailed work history records with dates and locations of employment
• Payroll records and employment contracts
• Historical travel logs to establish workdays in each state

Consider an executive who worked for a company for 20 years before retiring with a $1 million NQDC payout that does not meet federal protections. For the first 10 years, she worked exclusively in State A, and for the subsequent 10 years, she worked exclusively in State B. Upon retirement, she moves to State C. In this scenario, the allocation is straightforward: 50% of the income, or $500,000, would be sourced to State A, and the other 50% would be sourced to State B.

The calculation becomes more complex if the executive’s work location varied. If, during her 20-year career, she spent 75% of her workdays in State A and 25% in State B, the allocation would reflect this proration. State A would have a claim on $750,000 of the NQDC income, while State B could source $250,000. This calculation requires careful record-keeping, as the burden of proof for the allocation falls on the taxpayer. Without sufficient documentation, a state may presume that 100% of the income was earned there if the employee was based in that state.

Common State Tax Treatments and Conflicts

While the federal framework provides some clarity, its limitations lead to varied state tax treatments. Most states adhere to the federal rule and will not tax protected NQDC payments made to former residents. If the payments do not qualify for this federal protection, these states will assert their right to tax the portion of income sourced to their jurisdiction.

A significant area of conflict emerges from states with assertive sourcing rules, such as the “convenience of the employer” rule. Under this doctrine, wages earned by a nonresident are allocated to the employer’s state unless working outside the state is a necessity for the employer. This can result in days worked from a home office in another state being re-allocated to the primary office state, increasing the NQDC income subject to tax there.

This environment can lead to double taxation. The source state, where the work was performed, will tax its allocated share of the NQDC payment. Simultaneously, the employee’s new state of residence at the time of payment will tax all of the individual’s income, regardless of where it was earned. This sets the stage for potential double taxation, where the same dollar is taxed by both the old work state and the new home state.

For instance, an executive who earned NQDC while working in California and retires to a state with an income tax will face this issue. The new home state will tax the NQDC payments as retirement income. If the payments are not federally protected, California will also tax its sourced portion, leading to a direct tax conflict that the taxpayer must resolve.

Filing and Compliance for Multi-State Scenarios

The primary tool for mitigating the impact of double taxation is the credit for taxes paid to another state. This credit is claimed on the tax return of the individual’s resident state. It allows a taxpayer to reduce their home state’s tax liability by the amount of tax they paid to a nonresident source state on the same income.

The practical application involves a sequence of tax filings. The individual must first file a nonresident tax return in the source state where the NQDC was earned. On this return, they report and pay tax only on the portion of the NQDC income allocated to that specific state. After, the taxpayer files a resident tax return in their current home state, reporting all income, including the full NQDC distribution, and claims the credit for taxes paid to the source state.

Maintaining comprehensive records is needed to substantiate these tax positions, especially in an audit. In addition to allocation documents, proof of the change in residency is required. This includes documents that demonstrate the intent to establish a new permanent home:

• A new driver’s license
• Voter registration
• Property deeds or lease agreements
• Utility bills in the new state

The credit for taxes paid is limited to the amount of tax the resident state would have imposed on that same income. For example, if the source state’s tax on the NQDC is $10,000 but the resident state’s tax on that income would have only been $8,000, the credit will be capped at $8,000. This means the taxpayer may not be fully compensated if they move from a high-tax state to a lower-tax one.