Are multi-year installment payments from a nonqualified deferred compensation plan, paid to a former New York employee who has become a nonresident or nondomiciliary, exempt from New York personal income tax under the federal source-tax law at 4 U.S.C. § 114?

Plain-English summary

Merrill Lynch & Co., Inc. maintains a nonqualified deferred compensation plan for certain employees, including some who work in New York. Participants defer part of their compensation and choose "benchmark return options" that peg their unfunded account balance to the performance of employer-sponsored mutual funds. At retirement, a participant can take the balance as a single lump sum or in annual installments over up to 15 years. If installments are chosen, each year's payment equals the account balance as of the prior month-end divided by the number of installments still remaining - a "declining balance of years" formula. Because the account keeps being adjusted for investment performance each year, the dollar amounts of successive installments won't be exactly equal, even though the underlying formula is fixed.

The question was whether 4 U.S.C. § 114, a federal law barring states from taxing the "retirement income" of nonresidents and nondomiciliaries (for amounts received after December 31, 1995), exempts these installment payments from New York tax when paid to someone who was a New York employee at the time of deferral but is not a New York resident or domiciliary when the payments are received. Section 114(b)(1)(I) defines "retirement income" to include income from a plan described in IRC § 3121(v)(2)(C) - a broadly defined "nonqualified deferred compensation plan" - but only if the income is part of a series of "substantially equal periodic payments" made at least annually over a period of 10 years or more. Neither the statute nor federal guidance defines "substantially equal periodic payments" for this particular provision.

Faced with that gap, the Department reasoned by analogy to a related but distinct area of federal tax law: the rules under IRC § 402(c)(4)(A) for what counts as an "eligible rollover distribution" from a qualified retirement plan. Treas. Reg. § 1.402(c)-2 Q&A 5(d) specifically addresses defined contribution plans and treats a series of payments as "substantially equal" over a period if each year's payment equals the remaining account balance divided by the number of years remaining - exactly the declining-balance-of-years formula Merrill Lynch's plan used. Since the plan is a defined contribution plan under IRC § 414(i) (individual accounts tied to contributions and investment performance) and its installment formula matches the declining-balance test, the Department concluded that, assuming the stated facts, the installments qualify as "substantially equal periodic payments" over 10 or more years and thus as exempt "retirement income" under 4 U.S.C. § 114 - meaning New York could not tax them once paid to a nonresident or nondomiciliary, notwithstanding that the compensation had originally been earned and deferred while the employee worked in New York.

What this means for you

Employers designing nonqualified deferred compensation plans for a mobile workforce

If you sponsor a nonqualified deferred compensation plan and want installment payouts to retain their federal "retirement income" exemption for employees who later move out of state, structuring the payout as a declining-balance-of-years formula (balance divided by remaining installments each year) over a period of at least 10 years mirrors the test the Department applied here. A fixed-dollar installment schedule, or one that doesn't track a declining account balance, is not addressed by this opinion and could be analyzed differently.

Former New York employees now living elsewhere and receiving deferred compensation installments

If you deferred compensation while working in New York but now receive it in annual installments after becoming a nonresident or nondomiciliary, this opinion supports the position that New York cannot tax those installments (for amounts received after December 31, 1995) so long as the payments are made at least annually for 10 or more years and follow the declining-balance formula described here. The exemption turns on your residency status at the time of receipt, not on where the compensation was originally earned.

Common questions

Q: Why does the specific installment formula matter, rather than just the number of years the payments span?
A: 4 U.S.C. § 114(b)(1)(I)(i) exempts income only if it is part of a "series of substantially equal periodic payments," not merely any payments spread over 10-plus years. Because that phrase isn't defined for this statute, the Department needed a concrete test for what "substantially equal" means, and it adopted the declining-balance-of-years formula - each year's payment equals the remaining balance divided by the remaining number of installments - as that test. A payout schedule over the same number of years but calculated a different way wasn't evaluated in this opinion.

Q: Why did the Department borrow a rule from the rollover-distribution rules under IRC § 402(c)(4)(A) to interpret a different statute (4 U.S.C. § 114)?
A: There was no direct federal guidance interpreting "substantially equal periodic payments" under 4 U.S.C. § 114(b)(1)(I)(i). Treas. Reg. § 1.402(c)-2 Q&A 5(d), however, interprets the identical phrase in the context of determining whether defined contribution plan distributions are "eligible rollover distributions" under IRC § 402(c)(4)(A). Absent contrary guidance, the Department applied that existing interpretation by analogy to the undefined phrase in the federal source-tax statute.

Q: Does the declining-balance test apply to any deferred compensation plan, or only to defined contribution plans?
A: The Treasury regulation's declining-balance-of-years rule specifically applies to defined contribution plans - plans with individual accounts based on contributions plus allocated income, expenses, gains, losses, and forfeitures, as defined in IRC § 414(i). Merrill Lynch's plan qualified because each participant's deferred amounts were credited to an individual account balance that was adjusted for the performance of the chosen benchmark return options.

Q: Does the exemption depend on the individual's residency status when the compensation was earned, or when it is paid?
A: On payment. 4 U.S.C. § 114(a) bars a state from taxing "retirement income" of an individual who is not a resident or domiciliary of that state at the time the income is received. The opinion applies this to a person who was employed (and presumably a resident) in New York at the time of deferral but is a nonresident or nondomiciliary by the time the installments are paid - the earlier New York employment does not prevent the exemption from applying once the person is no longer a New York resident or domiciliary.

Q: Would a lump-sum payment, instead of installments, qualify for this exemption?
A: This opinion does not address that scenario. It relies specifically on the "series of substantially equal periodic payments...for a period of not less than 10 years" language in 4 U.S.C. § 114(b)(1)(I)(i)(II), which by its terms concerns a multi-year series of payments rather than a single lump-sum distribution.

Q: Is this opinion binding on deferred compensation plans generally?
A: No. Like all New York advisory opinions, it is limited to the facts presented by Merrill Lynch and binds the Department only as to that petitioner. Other plans would need their own facts - particularly whether the plan is a defined contribution plan and whether the installment formula matches the declining-balance test - evaluated against this same framework.

Citations and references

• 4 U.S.C. § 114(a) - bars a state from imposing income tax on the retirement income of an individual who is not a resident or domiciliary of that state, for amounts received after December 31, 1995
• 4 U.S.C. § 114(b)(1)(I) - defines "retirement income" to include income from a plan described in IRC § 3121(v)(2)(C) if paid as part of a series of substantially equal periodic payments (at least annually) over a period of not less than 10 years
• IRC § 3121(v)(2)(C) - defines a "nonqualified deferred compensation plan" as any deferral arrangement other than an ERISA/qualified plan under IRC § 3121(a)(5)
• IRC § 402(c)(4)(A) - excludes a series of substantially equal periodic payments made over a specified period of 10 years or more from "eligible rollover distribution" treatment
• Treas. Reg. § 1.402(c)-2 Q&A 5(d) - for defined contribution plans, treats payments as "substantially equal" over a period if each year's payment equals the account balance divided by the number of years remaining (declining balance of years)
• IRC § 414(i) - defines a "defined contribution plan" as a plan providing an individual account for each participant, with benefits based on amounts contributed plus allocated income, expenses, gains, losses, and forfeitures

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1996.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a96_7i.pdf

Original ruling text

New York State Department of Taxation and Finance

TSB-A-96 (7) I
Income Tax
December 24, 1996

Taxpayer Services Division
Technical Services Bureau
STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. I960828A

On August 28, 1996, a Petition for Advisory Opinion was received from
Merrill Lynch & Co., Inc., World Financial Center, South Tower, 7th Floor, New
York, New York 10080-6107.
The issue raised by Petitioner, Merrill Lynch & Co., Inc., is whether the
payment of deferred compensation to a nonresident or nondomiciliary of New York,
who was employed in New York at the time of deferral, will be exempt from
personal income tax under Article 22 of the Tax Law pursuant to section
ll4(b)(1)(I)(i)(II) of Title 4 of the US Code if the payment is one of a series
of installments as described below over a period of 10 or more years.
Petitioner submits the following facts as the basis for this Advisory
Opinion.
Petitioner maintains a deferred compensation plan which provides for
payment of deferred cash compensation to certain employees who have elected to
participate in the plan. Some of the employees who have elected to participate
in the plan are employed in New York. At the time of deferral, the participant
designates the amount that will be deferred as well as certain "benchmark return
options." By electing one or more benchmark return options, the employee elects
to key his or her deferred compensation account balance to the performance of
certain employer-sponsored mutual funds. The amount of compensation deferred is
credited to the participant's account as a vested but unfunded liability of
Petitioner to the participant. The account is adjusted (either positively or
negatively) to reflect the investment experience of the selected benchmark return
options in the same manner as if such investments had actually been made.
The participant's account balance will generally be paid, at the election
of the participant, at or after retirement, either in a single payment or in a
number of annual installments (not to exceed 15) selected by the participant.
If the annual installment payout is selected, the amount of each annual
installment is determined by multiplying the account balance as of the last day
of the month immediately preceding the month in which the payment is to be made
by a fraction, the numerator of which is one and the denominator of which is the
remaining installment payments (including the installment payment to be made).
Consequently, the account balance is adjusted by the performance of the benchmark
return options each year until the final installment payment is made to the
participant. Thus, the amount of the installment payments made over the course
of the payout period will not be exactly equal.
Petitioner states that its deferred compensation plan constitutes a plan,
program, or arrangement described in section 3121(v)(2)(C) of the Internal
Revenue Code ("IRC"). The installment payments will be made to a participant
annually for a period of 10 or more (but not to exceed 15) years.

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Section l14(a) of Title 4 of the US Code, as added by Public Law 104-95,
January 10, 1996, and applicable to amounts received after December 31, 1995,
provides that "[n]o State may impose an income tax on any retirement income of
an individual who is not a resident or domiciliary of such State (as determined
under the laws of such State)." Section l14(b)(1) of Title 4 of the US Code
defines the term "retirement income" as any income from, among other things:
(I) any plan, program, or arrangement described
3121(v)(2)(C) of [the IRC)], if such income -­

in

section

(i) is part of a series of substantially equal periodic
payments (not less frequently than annually) made for -­
(I) ...
(II) a period of not less than 10 years ....
Section 3121(v)(2)(C) of the IRC defines a "nonqualified deferred
compensation plan" as any plan or other arrangement for deferral of compensation
other than a plan described in section 3121(a)(5) of the IRC (generally, ERISA
or "qualified" plans).
Accordingly, pursuant to section 114 of Title 4 of the US Code, New York
State may not impose personal income tax under Article 22 of the Tax Law on the
retirement income of an individual who is not a resident or domiciliary of New
York. An individual's retirement income includes income from a nonqualified
deferred compensation plan that is described in section 3121(v)(2)(C) of the IRC
if the income is part of a series of substantially equal periodic payments (not
less frequently than annually) made for a period of not less than 10 years.
However, the phrase "substantially equal periodic payments" is not defined
for purposes of section ll4(b)(1)(I)(i) of Title 4 of the US Code and no federal
guidance has been issued with respect to this section. However, an analogous
provision of the IRC has defined "substantially equal periodic payments" with
regard to similar types of installment payments from qualified defined
contribution plans.
Under section 402(c) of the IRC, any portion of a
distribution from a qualified plan that is an eligible rollover distribution
described in section 402(c)(4) of the IRC may be rolled over to an eligible
retirement plan described in section 402(c)(8)(B) of the IRC.Section 402(c)(4)
of the IRC defines an "eligible rollover distribution" as:
any distribution to an employee of all or any portion of the balance
to the credit of the employee in a qualified trust; except that such
term shall not include -­
(A) any distribution which is one of a series of substantially
equal periodic payments (not less frequently than annually) made -­
(i) ...
(ii) for a specified period of 10 years or more ..."

Section 1.402(c)-2 Q&A 5 of the Treasury Regulations provides that for
purposes of determining whether a distribution is an eligible rollover
distribution, the determination of whether a series of payments is a series of

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substantially equal periodic payments over a period specified in section
402(c)(4)(A) of the IRC, is generally determined at the time payments begin, and
by following the principles of section 72(t)(2)(A)(iv) of the IRC, without regard
to contingencies or modifications that have not yet occurred. However, with
respect to a defined contribution plan, Q&A 5(d) provides that the following
rules apply in determining whether a series of payments from a defined
contribution plan constitute substantially equal periodic payments for a period
described in section 402(c)(4)(A) of the IRC:
(1) Declining balance of years.
A series of payments from an
account balance under a defined contribution plan will be considered
substantially equal payments over a period if, for each year, the
amount of the distribution is calculated by dividing the account
balance by the number of years remaining in the period.
For
example, a series of payments will be considered substantially equal
payments over 10 years if the series is determined as follows. In
year 1, the annual payment is the account balance divided by 10; in
year 2, the annual payment is the remaining account balance divided
by 9; and so on until year 10 when the entire remaining balance is
distributed ....
Accordingly, the IRC has interpreted the phrase "substantially equal
periodic payments" with respect to a qualified defined contribution plan to mean
a series of payments from an account balance over a period if, for each year, the
amount of the distribution is calculated by dividing the account balance by the
number of years remaining in the period.
Without guidance to the contrary, it would appear that the Internal Revenue
Service's interpretation of "substantially equal periodic payments" for purposes
a qualified defined contribution plan under section 402(c)(4)(A) of the IRC would
also apply to the same phrase in section ll4(b)(1)(I)(i) of Title 4 of the US
Code with respect to a defined contribution plan that is a non-qualified deferred
compensation plan that is described in section 3121(v)(2)(C) of the IRC. Under
section 414(i) of the IRC a "defined contribution plan" means "a plan which
provides for an individual account for each participant and for benefits based
solely on the amount contributed to the participant's account, and any income,
expenses, gains and losses, and any forfeitures of accounts of other participants
which may be allocated to such participant's account."
In this case, Petitioner states that the deferred compensation plan at
issue is a plan described in section 3121(v)(2)(C) of the IRC. Petitioner also
states that installment payments will be made to a participant annually for a
period of 10 or more (but not to exceed 15) years, and that the annual
installments will be determined by multiplying the account balance as of the last
day of the month immediately preceding the month in which the payment is to be
made by a fraction, the numerator of which is one and the denominator of which
is the remaining installment payments (including the installment payment to be
made). Assuming those facts, and the fact that it is a defined contribution
plan, it appears that, pursuant to section l14(a) of Title 4 of the US Code, the

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income from the deferred compensation plan received by an individual who is not
a resident or domiciliary of New York State would be exempt from New York State's
personal income tax under Article 22 of the Tax Law for amounts received from the
plan after December 31, 1995.

DATED: December 24, 1996

s/John W. Bartlett
Deputy Director
Technical Services Bureau

NOTE: The opinions expressed in Advisory Opinions
are limited to the facts set forth therein.