One of our employees was granted non-qualified stock options while working in Illinois, but relocated to another state before all the options vested and were exercised -- do we need to withhold Illinois income tax when those options are later exercised?

Subject

Non-Resident Withholding

Plain-English summary

A company was updating its multistate procedures for employees holding non-qualified stock options (NQSOs) and wanted to know when Illinois withholding applies. Its example: an employee is granted stock options while living and working in Illinois, but only 2 of 5 tranches vest before the employee relocates to another state. The remaining 3 tranches vest and are exercised after the employee has moved away. The company asked whether Illinois withholding applies to all the shares (because the options were granted in Illinois), only the shares that vested while the employee was still in Illinois, or none of the shares (because they were exercised only after the employee relocated).

The Department's answer: no withholding is required once the employee is a nonresident when the compensation is paid. NQSO income is included in federal adjusted gross income -- and therefore Illinois base income -- in the year it is exercised (IITA Section 203). If the employee is no longer an Illinois resident at the time of exercise, that income is still allocated to Illinois to the extent it's treated as compensation for past service: under 86 Ill. Admin. Code 100.3120(c), such compensation is presumed earned ratably over the employee's last five years of service, and each year's portion is Illinois-source to the extent the employee met Illinois's compensation-sourcing tests (IITA Section 304(a)(2)(B)) for that year.

But Illinois-source income and a withholding obligation are two different things. Even though the employee may have Illinois-source income from the exercised options, 86 Ill. Admin. Code 100.7010(c) does not require the employer to withhold Illinois income tax if the deferred compensation is paid to the employee while the employee is a nonresident. So in the company's example, the withholding obligation turns on the employee's residency status at the time of exercise (payment) -- not on where the options were originally granted, and not simply on which tranches vested while the employee still lived in Illinois.

What the ruling did not decide. The GIL doesn't purport to determine, for every fact pattern, exactly how much of a given nonresident's option income is Illinois-source (that depends on applying the 5-year ratable allocation and the Section 304(a)(2)(B) tests to the specific facts). It answers the narrower question actually asked: whether Illinois withholding is required on NQSO income paid after the employee has become a nonresident, and it says no.

What this means for you

Employers and payroll teams administering multistate stock option plans

Track each employee's residency status as of the exercise date, not the grant date or vesting date. If an employee has become a nonresident of Illinois by the time non-qualified options are exercised, Illinois withholding is not required on that exercise income under 86 Ill. Admin. Code 100.7010(c) -- even if the options were originally granted while the employee lived in Illinois or some tranches vested while the employee was still an Illinois resident.

The withholding question is separate from the taxability question

No withholding does not mean no Illinois tax exposure. The exercised option income can still be allocated to Illinois as compensation for past service under the 5-year ratable rule in 86 Ill. Admin. Code 100.3120(c). Employees who have relocated out of Illinois may still owe Illinois tax on a portion of their option income (typically reported by the employee directly), even though the employer isn't required to withhold on it.

HR and accountants documenting multistate mobility

Because the ratable allocation looks back over the employee's last five years of service, keep records of where the employee worked and resided during that period -- that history determines how much of the eventual option income is Illinois-source, separate from the withholding question this GIL answers.

Common questions

Q: Do we need to withhold Illinois income tax when a former Illinois employee exercises non-qualified stock options after moving to another state?
A: No. Under 86 Ill. Admin. Code 100.7010(c), withholding is not required on deferred compensation, including NQSO income, paid to an employee while that employee is a nonresident of Illinois.

Q: Does that mean the option income isn't taxable to Illinois at all?
A: Not necessarily. The income can still be Illinois-source to the extent it's allocated to Illinois under the 5-year ratable allocation rule in 86 Ill. Admin. Code 100.3120(c) -- the ruling addresses only the withholding obligation, not the employee's ultimate tax liability.

Q: Does it matter that the options were originally granted while the employee lived in Illinois?
A: The ruling focuses on the employee's residency status at the time the compensation is paid (exercised), not on the grant date, in determining whether withholding is required.

Q: What about the tranches that vested while the employee was still an Illinois resident?
A: The ruling doesn't separately address withholding on those tranches; it addresses the withholding question based on the employee's nonresident status when the deferred compensation is actually paid (exercised).

Citations and references

Statutes, regulations, and cases:

• 35 ILCS 5/701 (IITA Section 701 -- withholding on compensation paid in Illinois)
• 35 ILCS 5/302(a) (allocation of compensation to Illinois)
• 35 ILCS 5/202, 203 (net income computation; Illinois base income from federal AGI)
• 35 ILCS 5/304(a)(2)(B) (tests for whether compensation is paid in Illinois)
• 86 Ill. Adm. Code 100.3120(a), (c) (allocating nonresident compensation to Illinois; 5-year ratable presumption for past-service/deferred compensation)
• 86 Ill. Adm. Code 100.7010(c) (no withholding on deferred compensation paid while employee is a nonresident)

Source

• Landing page: https://taxarchive.illinois.gov/research/legal/letter-rulings/income-tax/2023.html
• Original PDF: https://tax.illinois.gov/content/dam/soi/en/web/taxarchive/research/legal/letter-rulings/income-tax/2023/it23-0016-gil.pdf

Original ruling text

IT-23-0016-GIL 08/18/2023 NON-RESIDENT WITHHOLDING
Withholding is not required when deferred compensation is paid while
employee is a non-resident.
August 18, 2023
NAME
ADDRESS
RE:

When withholding is required for non-qualified stock options

Dear NAME:
This is in response to your letter dated August 30, 2021, in which you
requested information about when the company is required to withhold Illinois
income tax on non-qualified stock options. We have no record of providing a
previous response. We regret the delay and any inconvenience it may have
caused. The nature of your letter and the information provided require that we
respond with a General Information Letter (GIL). A GIL is designed to provide
general information, is not a statement of Department policy and is not binding on
the Department. See 2 Ill. Admin. Code 1200.120(b) and (c), which may be
accessed from the Department’s web site at www.tax.illinois.gov.
Your letter states as follows:
I had previously requested information via email on two occasions. After a
month, I finally received a response. However, my questions were not addressed
with no clear answer. When I responded to the comments provided, I was
advised that I would have to send a letter. This is now my third request for
clarification as the information within the state website is not straight forward.
This is my revised request below, similar to the original requests.
I am updating our domestic procedures for holders of Stock Options within
each state. I have gone through your website and have obtained limited
information on the topic. I am trying to determine your policy when state
withholding taxes would apply on Non-Qualified Stock Options and what triggers
them. Is it based on the date of the grant, vesting or when they exercise?
As an example, X Team Member is granted Stock Options while living in
Illinois, however, only 2 of the 5 tranches are vested. X Team Member relocates
to another state where the remaining 3 vestings occur, which are then exercised
while residing in the new domicile.
Would X Team Member be subject to your state withholding taxes on all
vested and unvested shares because the Stock Options were granted in your
state? Would X Team Member only be subject to the shares that were vested in

your state? Or since they were exercised after relocation would X Team Member
not be required to pay withholding taxes to Illinois.
Of course, I understand that while residing in your state withholding taxes
do apply. My concern is if/when a Team Member relocates in or out of Illinois.
Thank you in advance for your guidance.
RULING
Section 701 of the Illinois Income Tax Act (IITA) requires tax to be
withheld upon payment of compensation in Illinois. The Department’s rules on
allocating compensation paid to nonresidents, 86 Ill. Admin. Code 100.3120(a),
provide as follows:
In order for items of compensation paid to an individual who is a
nonresident of Illinois at the time of payment to be allocated to
Illinois, the compensation must constitute "compensation paid in
this State". If the test is met, then all items of the compensation,
and all items of deduction directly allocable thereto, are allocated to
Illinois under IITA Section 302(a) (except items allocated under IITA
Section 301(c)(2), as to which see subsection (d)). Compensation
paid to a nonresident, which is allocated to Illinois, enters into the
computation of the individual's net income under IITA Section 202
and is generally subject to withholding under IITA Section 701 (see
Sections 100.7000, 100.7010 and 100.7020). The tests for
determining whether compensation is paid in Illinois appear in IITA
Section 304(a)(2)(B) . . . .
86 Ill. Admin. Code 100.3120(c) further provides:
For the purpose of determining whether and to what extent
compensation paid for past service is "paid in" Illinois and is
allocated to Illinois under IITA Section 302(a), that compensation is
presumed to have been earned ratably over the employee's last 5
years of service with the employer (or any predecessor or
successor of the employer or a parent or subsidiary corporation of
the employer), in the absence of clear and convincing evidence that
the compensation is properly attributable to a different period of
employment or that it was not earned ratably over the appropriate
period of employment. Compensation earned in each past year will
be deemed compensation paid in Illinois if the individual's service in
that year met the tests set forth in subsection (a) applicable to that
year. Compensation paid for past service includes amounts paid
under deferred compensation agreements where the amount of

compensation is unrelated to the amount of service being currently
rendered.
Under IITA section 203, in the case of an individual, Illinois begins with
federal adjusted gross income to compute the taxpayer’s Illinois base income.
The non-qualified stock option income is included in the Team Member’s federal
adjusted gross income when it is exercised and would, therefore, also be
included in Illinois base income. If the Team Member is no longer an Illinois
resident at the time the non-qualified stock option is exercised, the income is
deemed earned ratably over the last five years of employment and allocated to
Illinois accordingly. Even though the employee may have Illinois source income,
the employer would not be required to withhold income tax under 86 Ill. Admin.
Code 100.7010(c) if the deferred compensation was paid to the employee while a
nonresident.
We hope this information is helpful. As stated above, this is a GIL. A GIL
does not constitute a statement of policy that applies, interprets or prescribes the
tax laws, and it is not binding on the Department.

Very truly yours,

Brian E. Fliflet
Deputy General Counsel
Illinois Department of Revenue
100 W. Randolph St., 7-900
Chicago, IL 60601
Phone: (312) 814-1722
Email: [email protected]