Are an employer's nonqualified deferred-compensation payments to nonresidents protected from New York tax, including payments made before employment ends?
Plain-English summary
An employer maintains two unfunded nonqualified deferred compensation plans whose sole purpose is to provide benefits in excess of the IRC limits on its qualified 401(k) and pension plans. The plans generally pay out after a participant's termination of employment, but to comply with IRC § 409A, some payments can be triggered before termination (for example, on an 80%+ reduction in services or a leave of absence over six months). The employer asked whether payments to nonresident participants are New York source income subject to withholding.
The Office of Counsel split the answer:
- Post-termination payments: These excess-benefit payments to a nonresident after termination of employment are "retirement income" under the federal Pension Source Law (4 USC § 114(b)(1)(I)(ii)) - a plan maintained solely to provide benefits beyond the IRC § 401(a)(17)/415 (etc.) limits. They are not subject to New York income tax, withholding, or reporting (consistent with TSB-A-00(6)I, 01(2)I, 16(1)I).
- Pre-termination payments: Payments a participant receives before terminating employment are not "retirement income" under the Pension Source Law, are New York source income, and because they're treated as wages for federal withholding, are subject to New York withholding and reporting (Tax Law § 631(a), § 671(a), § 674(a); 20 NYCRR 171.3(a)).
What this means for you
Employers with excess-benefit (top-hat) deferred-comp plans
Track when each payment is made relative to termination. Post-termination excess-benefit payments to nonresidents escape New York tax/withholding; payments triggered before termination (e.g., under § 409A's reduced-services or leave rules) are taxable wages requiring New York withholding.
Nonresident participants
Your excess-benefit deferred comp is shielded from New York tax once it's paid after you've terminated employment. Distributions you receive while still employed are New York source wages and will be taxed/withheld.
Common questions
Q: Are all our nonqualified plan payments to nonresidents exempt?
A: No. Only those made after termination of employment qualify as protected retirement income. Pre-termination payments are taxable.
Q: Why are some payments made before termination?
A: IRC § 409A's "separation from service" rules can require payment on a major reduction in services or an extended leave, even before formal termination.
Q: Do we withhold New York tax on pre-termination payments?
A: Yes. They're New York source wages, so withholding and reporting apply.
Q: Can I rely on this opinion?
A: It binds the Department only as to the petitioner. Use it as guidance and confirm your own facts.
Citations and references
Statutes, regulations, and prior opinions:
- 4 USC § 114(b)(1)(I)
- Tax Law § 631(a); § 671(a); § 674(a); 20 NYCRR 171.3(a); 174.1
- IRC § 3121(v)(2)(C); § 409A; TSB-A-00(6)I; TSB-A-01(2)I; TSB-A-16(1)I
Source
- Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income-ao-2020.htm
- Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a20-8i.pdf
Original ruling text
New York State Department of Taxation and Finance
Office of Counsel
TSB-A-20(8)I
Income Tax
October 6, 2020
STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION
The Department of Taxation and Finance (“Department”) received a Petition for Advisory
Opinion from [ REDACTED ] (“Petitioner”). Petitioner asks whether payments from its nonqualified
deferred compensation plans to nonresidents at the time of distribution are New York source income
for personal income tax purposes and subject to income tax reporting and withholding.
We conclude that the payments made to nonresidents after termination of employment conform
to the definition of “retirement income” under 4 USC § 114(b)(1)(I)(ii), and are not subject to New
York State income tax withholding and reporting. Payments made to nonresidents prior to
termination of employment do not conform to the definition of “retirement income” under 4 USC §
114(b)(1)(I)(ii) and will be subject to personal income tax reporting and withholding.
Facts
Petitioner maintains offices and transacts business in various states including New York.
Petitioner maintains a 401(k) Plan and a Pension Plan, both of which are qualified plans that qualify
for favorable tax treatment under section 401(a) of the Internal Revenue Code (“IRC”). IRC §§
401(a)(17), 401(k), 401(m), 402(g) and 415 limit the contributions and benefits participants can
receive under the 401(k) Plan, and IRC §§ 401(a)(17) and 415 limit the benefits participants can
receive under the Pension Plan Petitioner also maintains two unfunded plans, [ REDACTED ] and the
[ REDACTED ], that are nonqualified deferred compensation plans as defined in IRC §
3121(v)(2)(C). The sole purpose of the nonqualified plans is to supplement participants’ qualified plan
benefits by providing benefits in excess of one or more of the statutory limits that apply to the
qualified plans.
[ REDACTED ] Plan provides for elective deferrals, company matching contributions, and
several types of non-elective company contributions. A participant is eligible to make elective
deferrals under the [ REDACTED ] Plan for a plan year only if the participant is eligible to make
elective deferrals under the 401(k) Plan for that plan year. Similarly, a participant is eligible to receive
a particular type of company contribution under the [ REDACTED ] Plan for a plan year only if the
participant is eligible to receive the same type of company contribution under the 401(k) Plan for that
plan year. In addition, a participant is eligible to receive company contributions under the
[ REDACTED ] Plan only with respect to compensation that is not taken into account for purposes of
calculating the participant’s company contributions under the 401(k) Plan. [ REDACTED ] Plan also
permits Petitioner to make additional, discretionary company contributions, although this provision is
rarely invoked in practice.
[ REDACTED ] Plan generally provides for payment following a participant’s termination of
employment. Payments may be made in the form of a single lump sum or between two and ten
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annual installments. If a participant dies before benefits have been paid in full, the remainder of the
participant’s benefit is paid to one or more designated beneficiaries in a single lump sum payment.
A participant is eligible for a benefit under the [ REDACTED ] Plan only if the participant
is eligible for a benefit under the Pension Plan. A participant’s [ REDACTED ] Plan benefit equals
the Pension Plan benefit the participant would have accrued under the Pension Plan without regard to
the IRC §§ 401(a)(17) and 415 limits, minus the Pension Plan benefit the participant actually accrued
under the Pension Plan. [ REDACTED ] Plan generally provides for payment following a
participant’s termination of employment. Payments may be made in the form of a single lump sum, a
single-life annuity, or a joint and survivor annuity. Different portions of a participant’s
[ REDACTED ] Plan benefit may be paid in different forms. If a participant dies before benefit
payments begin, the participant’s benefit is paid to one or more designated beneficiaries in a single
lump sum or a single-life annuity.
Effective January 1, 2005, the nonqualified plans became subject to the requirements of IRC §
409A and remain in compliance with that section. In order to comply with IRC § 409A, benefits
subject to IRC § 409A must be paid upon a participant’s “separation from service,” as that term is
defined for purposes of IRC § 409A. In limited circumstances, a participant’s “separation from
service” is not the same as the date the participant terminates employment with Petitioner for other
purposes. As a result, for example, payment would be required if a participant’s level of services
decreases by at least 80% (but less than 100%), or if a participant is on a leave of absence (including
disability leaves of absence) for longer than six months. These rules were designed in accordance with
IRS rules to prevent abusive arrangements in which participants could avoid “terminating” by working
very few hours or taking an extended leave, thereby delaying their payments. Any attempt by
Petitioner or the participant to postpone such payments until the participant terminates employment
would trigger substantial tax penalties under IRC § 409A.
In accordance with section 10.01 of the [ REDACTED ] Plan and section 8.01 of the
[ REDACTED ] Plan, all amounts payable under the unfunded nonqualified plans constitute general
unsecured obligations of Petitioner and are paid out of Petitioner’s general assets. Also, the
nonqualified plans are plans described in IRC § 3121(v)(2)(C). The sole purpose of the nonqualified
plans is to allow participants to make elective deferrals and/or receive company-provided benefits that
they are unable to make or receive under the qualified plans because of the limitations imposed under
IRC §§ 401(a)(17), 401(k), 401(m), 402(g) and 415.
Petitioner states that when distributions are made from the plan they are reported on Form W2, Box 1, are subject to federal income tax withholding and are considered supplemental wages for
federal income tax withholding purposes. Treas. Reg. § 31.3402(g)-1(a)(1)(i).
Analysis
Tax Law § 631(a) provides that the New York source income of a nonresident individual shall
be the sum of the net amount of items of income, gain, loss and deduction entering into his or her
federal adjusted gross income derived from or connected with New York sources, including those
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items attributable to a business, trade, profession or occupation carried on in the State. Tax Law §
671(a) and 20 NYCRR 171.1 require that every employer maintaining an office or transacting business
within New York State and making payment of any wages taxable under the personal income tax must
deduct and withhold from the employee’s wages an amount of tax substantially equivalent to the New
York State personal income tax reasonably estimated to be due resulting from the inclusion in the
employee’s New York adjusted gross income or New York source income of his or her wages
received during the calendar year. Tax Regulation 20 NYCRR 171.3(a) provides that payments that
are considered wages for Federal income tax withholding purposes also are considered wages for
payments of withholding for New York State personal income tax. Tax Law § 674(a) and 20 NYCRR
174.1 require that every employer required to deduct and withhold taxes from wages under the
personal income tax must file a New York State withholding tax return and pay over the taxes required
to be deducted and withheld.
4 USC § 114 (“the Pension Source Law”) provides that no state may impose an income tax on
any retirement income of an individual who is not a resident or domiciliary of such state. The term
“retirement income” means any income from qualified plans, including IRC §§ 401(a) & 401(k) plans.
See 4 USC § 114(b)(1)(A)-(H). It also includes income from any plan, program, or arrangement
described in IRC § 3121(v)(2)(C) if such income (i) is part of a series of substantially equal periodic
payments, not less frequently than annually, made for the life or life expectancy of the recipient or the
joint lives or joint life expectancies of the recipient and the designated beneficiary of the recipient, or a
period of not less than 10 years, or (ii) is a payment received after termination of employment and
under a plan, program, or arrangement (to which such employment relates) maintained solely for the
purpose of providing retirement benefits for employees in excess of the limitations imposed by one or
more of IRC §§ 401(a)(17), 401(k), 401(m), 402(g), 403(b), 408(k), or 415 or any other limitation on
contributions or benefits in the IRC on plans to which any of such sections apply. See 4 USC §
114(b)(I).
In Advisory Opinions TSB-A-00(6)I and TSB-A-01(2)I, the Department determined that under
the Pension Source Law, lump sum payments to nonresident employees from a nonqualified deferred
compensation plan maintained by their employer were not New York source income for New York
State personal income tax purposes. Like Petitioner’s nonqualified plans, the nonqualified plan
referenced in those opinions provided a benefit in excess of the benefit the employee was entitled to
receive from a tax-qualified profit-sharing plan, due to the application of various IRC limits, and
provided for payment following the employee’s termination of employment. Also, in Advisory
Opinion TSB-A-16(1)I, the Department determined that, under the Pension Source Law, a lump sum
payment to a nonresident employee after termination of employment from a nonqualified deferred
compensation plan maintained by the retiree’s former employer was not New York source income for
New York State personal income tax purposes. The nonqualified plan referenced in that opinion
provided a benefit in excess of the benefit the employee was entitled to receive from a tax-qualified
plan due to the application of the IRC § 401(a)(17) limit.
In some respects, the facts in this matter are substantially similar to the facts set forth in
Advisory Opinions TSB-A-00(6)I, TSB-A-01(2)I and TSB-A-16(1)I. The nonqualified plans are plans
described in IRC § 3121(v)(2)(C) and the purpose of the nonqualified plans is to allow participants to
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make elective deferrals and/or receive company-provided benefits that they are unable to make or
receive under the qualified plans because of the limitations imposed under IRC §§ 401(a)(17), 401(k),
401(m), 402(g) and 415. However, the plans here differ from the plans considered in those advisory
opinions because, in order to comply with IRC § 409A, the plan benefits in this matter may in certain
situations be received by participants prior to termination of their employment.
We conclude that the payments made by Petitioner to nonresident former employees after
termination of employment from Petitioner’s [ REDACTED ] plans that are maintained for the sole
purpose of providing employees benefits in excess of the compensation limitations under the
limitations imposed under IRC §§ 401(a)(17), 401(k), 401(m), 402(g) and 415 conform to the
definition of “retirement income” under 4 USC § 114(b)(1)(I)(ii). Therefore, those payments will not
be subject to New York State income tax, income tax withholding or reporting. However, payments
made by Petitioner to nonresident employees prior to termination of employment do not come within
the definition of “retirement income” under 4 USC § 114(b)(1)(I)(ii) and are not protected by the
Pension Source Law. Therefore, any income, gain, loss or deduction derived from New York sources
with respect to the distributions to the nonresident individuals from these plans will be subject to New
York personal income tax. Moreover, since the payments received by the nonresident from the
nonqualified deferred compensation plans are considered wages for Federal income tax withholding
purposes, the payments also will be considered wages for New York State withholding tax purposes
and Petitioner must deduct and withhold from these payments an amount of tax substantially
equivalent to the New York State personal income tax reasonably estimated to be due and file a New
York State withholding tax return and pay over the taxes required to be deducted and withheld.
DATED: October 6, 2020
/S/
DEBORAH R. LIEBMAN
Deputy Counsel
NOTE:
An Advisory Opinion is issued at the request of a person or entity. It is limited to the facts
set forth therein and is binding on the Department only with respect to the person or entity
to whom it is issued and only if the person or entity fully and accurately describes all
relevant facts. An Advisory Opinion is based on the law, regulations, and Department
policies in effect as of the date the Opinion is issued or for the specific time period at issue
in the Opinion. The information provided in this document does not cover every situation
and is not intended to replace the law or change its meaning.