Could a Virginia resident subtract an entire IRC § 457 plan distribution because Pennsylvania had taxed his employee contributions to the plan?

Subject

Deferred compensation plan distributions contributions subject to out of state taxation

Plain-English summary

A Virginia resident could subtract only the pro rata share of an IRC § 457 deferred-compensation distribution attributable to contributions Pennsylvania had already taxed—not the entire distribution. The taxpayer worked for Pennsylvania from 1991 through 2006, contributed to a government deferred-compensation plan, moved to Virginia, and received a distribution in 2009.

Pennsylvania had included the employee contributions in taxable compensation even though federal adjusted gross income excluded them. That brought the contributions within Virginia's subtraction for certain retirement distributions whose contributions were taxed by another state.

The subtraction did not extend to investment earnings. Virginia rejected the taxpayer's proposed Pennsylvania cost-recovery method, which would treat distributions as a tax-free return of contributions until all contributions were recovered. Instead, the Department chose a pro rata method similar to federal basis recovery.

For each year, the eligible subtraction was the year's total distributions multiplied by this ratio:

remaining previously taxed contributions / (year-end account value + annual distributions)

In the ruling's first example, $50,000 of previously taxed contributions, a $100,000 year-end balance, and a $20,000 distribution produced an $8,333 Virginia subtraction. The remaining contribution balance then carried into the next year's calculation.

What this means for you

• Virginia residents may qualify for a subtraction when another state taxed employee contributions that federal law excluded.
• The full retirement distribution is not automatically exempt; earnings remain taxable.
• Records of previously taxed contributions, annual distributions, and year-end account value are necessary for the pro rata calculation described in the ruling.

Common questions

Why did the contributions qualify for a Virginia subtraction?

Pennsylvania taxed them as employee compensation, even though they were excluded from federal adjusted gross income when contributed.

Why was the entire 2009 distribution not subtracted?

The account included both previously taxed contributions and investment income. Virginia treated each distribution as containing a proportional share of both.

Did Virginia adopt Pennsylvania's cost-recovery method?

No. The Department concluded that a pro rata approach more accurately reflected the distribution.

Citations and references

• Va. Code §§ 58.1-301 and 58.1-322(C)(19).
• I.R.C. §§ 72 and 457.
• 61 Pa. Code § 101.6(c)(8).
• IRS Notice 87-16, 1987-1 C.B. 446.
• Pennsylvania Personal Income Tax Bulletin No. 2005-04 (October 12, 2005).
• People of State of New York ex rel. Cohn v. Graves, 300 U.S. 308 (1937).
• Howell's Motor Freight, Inc. v. Virginia Department of Taxation, Law No. 82-0846 (Roanoke City Cir. Ct. Oct. 27, 1983).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 10-214

Original ruling text

September 15, 2010

Re: Ruling Request: Individual Income Tax

Dear *:

This is in response to your letter in which you request a ruling on the application of Virginia's subtraction for deferred compensation plan distributions to the extent that contributions to such plan were subject to taxation in another state. I apologize for the delay in the Department's response.

FACTS

* (the "Taxpayer") was employed by the Commonwealth of Pennsylvania from 1991 through 2006. During his employment, the Taxpayer made contributions to a deferred compensation plan established pursuant to Internal Revenue Code (IRC) § 457(b). After moving to Virginia, the Taxpayer took a distribution from the deferred compensation plan in 2009.

Although the contributions were excluded from federal adjusted gross income (FAGI), they were included in the Taxpayer's compensation subject to Pennsylvania income tax. The Taxpayer requests that he be permitted to exclude the entire amount of the distribution from the computation of Virginia taxable income for the 2009 taxable year.

RULING

It is well established that a state may tax all the income of its residents, even income earned outside the taxing jurisdiction. In People of State of New York ex rel. Cohn v. Graves , 300 U.S. 308 (1937), the United States Supreme Court explained "[t]hat the receipt of income by a resident of the territory of a taxing sovereignty is a taxable event is universally recognized." Accordingly, Virginia is well within its authority to impose its income tax on all of the income of a resident of the Commonwealth of Virginia.

Virginia Code § 58.1-301 provides that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the IRC unless a different meaning is clearly required. For individual income tax purposes, Virginia "conforms" to federal law, in that it starts the computation of Virginia taxable income with FAGI. Income included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Va. Code § 58.1-322. Virginia Code § 58.1-322 C 19 provides a subtraction for:

any income received during the taxable year derived from a qualified pension, profit-sharing, or stock bonus plan as described by § 401 of the Internal Revenue Code, an individual retirement account or annuity established under § 408 of the Internal Revenue Code, a deferred compensation plan as defined by § 457 of the Internal Revenue Code, or any federal government retirement program, the contributions to which were deductible from the taxpayer's federal adjusted gross income, but only to the extent the contributions to such plan or program were subject to taxation under the income tax in another state.

By reason of their character as legislative grants, statutes relating to deductions and subtractions allowable in computing income and credits allowed against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See Howell's Motor Freight, Inc., et al. v. Virginia Department of Taxation , Circuit Court of the City of Roanoke, Law No. 82-0846 (10/27/1983).

61 Pa. Code § 101.6(c)(8) provides that contributions made by an employee to a retirement benefits plan, including a deferred compensation plan under IRC § 457, may not be excluded from a taxpayers income. As such, because the contributions to the Taxpayer's retirement system were included in his income to taxation in Pennsylvania, the Taxpayer would be eligible to subtract the distribution from the Pennsylvania deferred compensation plan to the extent contributions were subject to tax in Pennsylvania.

While the contributions made to the deferred compensation plan would be eligible for the subtraction, income generated by those contributions would be subject to Virginia income tax when distributed to the Taxpayer. Because deferred compensation plan accounts can include multiple investment vehicles in which income is usually reinvested and to and from which funds can be moved depending on the objectives of the owner of the account, it is generally difficult, if not impossible, to determine what portion of a distribution would be a return of a contribution or income generated from the investments. Thus, the issue becomes what portion of a distribution would be considered contributions and what amount would be considered income.

The Taxpayer proposes that the Department should adopt the "cost-recovery" method used by Pennsylvania to account for contributions previously included in income. Under the cost-recovery rule, no income is recognized from a retirement benefits plan until the taxpayer has fully recovered his contributions. See Pennsylvania Personal Income Tax Bulletin No. 2005-04 (10/12/2005). Based on the information presented, the Taxpayer believes it should be able to subtract the entire 2009 distribution on his Virginia return.

Because Virginia "conforms" to federal law and starts the computation of Virginia taxable income with FAGI, the Department will generally look to Internal Revenue Service (IRS) treatment of like or similar items of income. Under IRC § 72, a pro-rata basis recovery rule generally applies to distributions from annuities, endowments, and life insurance contracts. Under this method, the portion of an annuity payment that represents the nontaxable return of basis is determined by applying a ratio equal to a taxpayer's total investment in the contract divided by the total expected payments over the term of such contract. The IRS applies a similar rule to distributions from an individual retirement account (IRA). See IRS Notice 87-16, 1987-1 CB 446.

After considering the issue, the Department believes that a pro-rata approach more accurately reflects the nature of a distribution from a retirement plan. Accordingly, a taxpayer who receives a distribution from a retirement plan as described in Va. Code § 58.1-322 C 19 and whose contributions to such plan were subject to income taxation in another state would determine the portion of the annual distribution(s) eligible for the subtraction by multiplying the total amount of the annual distribution(s) by a ratio equal to the total balance of previously taxed contributions divided by the sum of the value of the retirement account at the end of the taxable year plus the total amount of the annual distribution(s).

For example, taxpayer (T) lived and worked in State A. T made $50,000 of contributions to a retirement plan while working in State A. T moved to Virginia when he retired and started taking distributions from his retirement plan. In year one, T received $20,000 in distributions from the retirement plan. At the end of year one, the value of the retirement plan was $100,000. T's Virginia subtraction would be computed by multiplying the $20,000 total annual distributions by the $50,000 previously taxed contributions divided by the sum of the $100,000 value of the retirement account plus the $20,000 total distributions or:

$20,000 x $50,000/($100,000 + $20,000) = $8,333

For year 1, T would be permitted to subtract $8,333 under Va. Code § 58.1-322 C 19 on his Virginia income tax return.

In year 2, T again received $20,000 in distributions while the value of the retirement account at the end of the year was $85,000. T's Virginia subtraction would be computed by multiplying the $20,000 total annual distributions by the $41,667 ($50,000 - $8,333) balance of previously taxed contributions divided by the sum of the $85,000 value of the retirement account plus the $20,000 total distributions or:

$20,000 x $41,667/($85,000 + $20,000) = $7,937

For year 2, T would be permitted to subtract $7,937 under Va. Code § 58.1-322 C 19 on his Virginia income tax return.

The Code of Virginia sections cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this ruling, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Linda D. Foster

Deputy Tax Commissioner

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