A taxpayer we will call John worked for a savings bank in New York that was acquired by Washington Mutual Bank. John participated in the New York bank’s supplemental executive retirement plan (SERP) and its deferred compensation plan, both of which were nonqualified deferred compensation plans. When Washington Mutual Bank acquired the New York bank, the taxpayer retired and began receiving monthly payments for life under the SERP and a year later over a period of 12 years under the deferred compensation plan. John resided in both New Jersey and Virginia but was never a resident of New York. Presumably, however, John worked in New York while he was employed by the bank.
In 2008 Washington Mutual Bank filed for bankruptcy and its assets were sold to JPMorgan Chase (“Chase”). Under a global settlement agreement, Chase did not assume the SERP or deferred compensation plan, but was required to satisfy the obligations under the plans. To that end, in May of 2012, Chase paid John a lump sum distribution representing the present value of the annuity payment under the SERP and the balance in the deferred compensation plan. Chase withheld from the distribution New York state and local estimated taxes. John asked the State of New York for an advisory opinion regarding whether New York state and local taxes should have been withheld from the payments.
Based on federal law, the New York Commission of Taxation and Finance concluded that the amounts would not be subject to New York taxes. Under federal law, states are not allowed to tax retirement income of nonresidents if the payments meet certain criteria. If the payments are from a nonqualified deferred compensation plan, the payments must be made over a period of at least ten years or for life. John’s payments had met those requirements at the time that they began. Of course, those payments quit being lifetime or ten year installments when they were paid in a lump sum after the bankruptcy. The New York Commissioner concluded that the unforeseeable act of Washington Mutual’s filing for bankruptcy should not change the tax treatment of the payments for John. Therefore, John’s payments would not be subject to New York tax and he would be able to get a refund of the amounts withheld.
New York is known as a state that aggressively pursues and taxes nonqualified deferred compensation earned by nonresidents while working in New York. This advisory opinion favors the taxpayer by not asserting New York taxation in a situation in which unforeseeable circumstances resulted in a change in the method of payment. Because the decision is an advisory opinion, only the taxpayer who requested it can rely upon it. Nevertheless, it is helpful authority for taxpayers who structure payments from their deferred compensation plan in order to avoid taxation by a state in which they are not a resident at the time of payment. Other states sometimes look to New York or California for guidance on these issues since those states, with their larger populations, have a more developed body of law on these issues. Taxpayers may have greater confidence that they can move after retirement to a state with low or no income taxes, receive their nonqualified deferred compensation payments over ten years or for life, and avoid taxation by the state where they earned the income even if their chosen payment arrangement changes for reasons beyond their control.
Because this is a state tax advisory opinion, it does not address federal tax issues, such as Internal Revenue Code Section 409A, the tax code section that limits the ability of employers and employees to change the time and form of deferred compensation payments. The payments in this case began in 2002 and 2003 and 409A does not apply to deferred compensation amounts that were fully vested by December 31, 2004. Therefore, it is likely that Section 409A did not apply to this acceleration of benefits. However, employees with deferred compensation subject to Section 409A would also have to consider the impact of that statute on any change in the payment schedule of their deferred compensation. An employee may be able to avoid the imposition of state taxes from the state in which the deferred compensation was earned, but might still be subject to penalty taxes under Section 409A for having accelerated payment of the benefit. Employees would want to work closely with their advisers in situations in which deferred compensation payments are proposed to be changed as a result of the employer’s bankruptcy or other financial restructuring.
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