Tax Executives Institute, Inc., Upstate New York Chapter ......based on 2017 financial reporting...

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EMPLOYEE BENEFITS AND EXECUTIVE COMPENSATION UPDATE

Rosina Barker & Jonathan Zimmerman

May 9, 2017

Tax Executives Institute, Inc., Upstate New York Chapter,

58th Annual Tax Conference

Table of Contents

I. Treatment of Clawbacks and Give-Backs for Newly Hired and Former Executives

II. Section 162(m) Update

III. New York State Payroll Tax Audits

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TREATMENT OF CLAWBACKS AND GIVE-BACKS FOR NEWLY HIRED AND FORMER EXECUTIVES

What is a Clawback?

• Traditionally: Recoupment of compensation after it is earned for violation

of company policy, agreement or law

• Sources of traditional clawbacks – Company policy or agreement (e.g., violation of non-compete)

– Federal agency enforcement policy

– Shareholder suits

• No-fault clawbacks under recent federal statutes

– Sarbanes-Oxley Act of 2002 §304

– Emergency Economic Stabilization Act of 2008 §111 (TARP Clawbacks)

– Dodd-Frank Wall Street Reform and Consumer Protection Act §954

– Recovery of “erroneously awarded incentive-based compensation” if issuer is

required to restate earnings due to “material noncompliance” with disclosure

obligations of federal securities law. SEC Proposed Rule 10D-1.

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The Future of Statutory No-Fault Clawbacks

• The Trump administration has signaled intent to repeal or amend Dodd-Frank, and could re-examine other financial regulatory regimes as well.

• But companies might voluntarily adopt no-fault clawback policies in connection with a financial restatement:

– As part of the company's standard corporate governance practices.

– Because not having a clawback policy is viewed negatively by proxy advisory firms such as Institutional Shareholder Services (ISS) and Glass Lewis & Co. (Glass Lewis) .

– Under an unjust enrichment theory.

– For other reasons.

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I. Company’s Deduction

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Deducting Bonuses: The General Rule

• Code Section 404(a)(5): Deferred compensation deductible in company’s fiscal year in or with which ends employee’s taxable year in which employee takes amount into income, rather than when accrued.

Generally:

– Compensation received more than 2 ½ months after company’ taxable year of related services: deductible in year employee takes amount into income

– Compensation received within 2 ½ months after taxable year of related services: deductible in company’s taxable year of accrual.

• Employee “receives” compensation for income tax purposes when paid or made available without substantial limitations or restrictions.

• Compare with proposed Rule 10D-1: Employee “receives” incentive-based compensation in employer’s fiscal year in which financial reporting measure specified in compensation award is attained.

• For accrual basis taxpayer, deduction accrues when all events have occurred to fix fact and amount of liability.

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Impact of Clawback Policy on Company Deduction

• Compensation subject to clawback is accrued under normal principles; clawback contingency is “remote” and should not defeat accrual. See United States v. General Dynamics Corp., 481 U.S. 239 (1987).

• But if incentive based compensation is deducted in one taxable year of company, and recouped in subsequent taxable year, company might

have to take amount back into income in year of recoupment, under the

“tax benefit rule,” which generally requires income inclusion of amount

previously deducted when events occur that are “fundamentally inconsistent” with the earlier deduction. See, e.g., Larchfield Corp. v. United States, 373 F.2d 159 (2d Cir.1966), Code section 111(a).

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Example

• Company with fiscal year ended 12/31:– December 2013: grants RSU to Executive Officer, to be settled only if target financial reporting

measure attained by end of three-year period ending 12/31/2016.

– December 31, 2016: specified financial reporting measures met.

– March 1, 2017: Company pays cash under RSU to Executive Officer, and accrues deduction for taxable year ended December 31, 2016.

– In 2017, board concludes 2016 financial statements contain a material error rendering entire RSU settlement “erroneously awarded incentive-based compensation”.

– In 2018, company files Form 8-K reporting restated financials.

– In 2018, Executive Officer repays RSU settlement amount to company.

• Tax consequences to company– RSU is incentive based compensation “received” for Rule 10D-1 three-year lookback rule in

company’s 2016 fiscal year.

– RSU “received” by Executive Officer for tax purposes on March 1, 2017: Company accrues and deducts for its 2016 taxable year, reports on Executive Officer’s 2017 W-2.

– Company takes 2016 RSU deduction into income in 2017 or 2018, depending on when it decides the “fundamentally inconsistent” event occurs.

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II. Tax Withholding and Reporting

for Employee

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Repaying Compensation in the Same Year - Easy

• Bonus repaid in same year paid – for income and FICA tax purposes, treated as if never paid.

– Principle of annual income tax accounting. Couch v. Commissioner, 1 B.T.A. 103 (1924), acq. 1925-1 C.B. 1 (1925), Russel v. Commissioner, 35 B.T.A. 602 (1937), acq. 1937-1 C.B. 22; Rev. Rul. 79-311, 1979-2 C.B. 25.

• EXAMPLE

– Executive Officer is paid $100K incentive-based bonus on March 30, 2018, based on 2017 financial reporting measures.

– Bonus is “received” for tax purposes in employee’s 2018 taxable year, even though “received” for Rule 10D-1 purposes in company’s 2017 fiscal year.

– Executive Officer repays $100K to company on December 1, 2018.

– Company does not report $100K on Executive Officer’s 2018 W-2. Company can generally reverse any resulting over-withholding (for example, if employee repays by writing a check) by reducing withholding taxes from remaining compensation payable in 2018.

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Repaying Compensation in Later Year – Hard

• EXAMPLE

– Executive Officer receives $100K bonus in 2017, pays tax on 2017

Form 1040.

– Executive Officer repays $100K bonus in 2018, by having amount withheld

from compensation otherwise payable in 2018.

– 2018 reporting and withholding: IRS says Company may not report or withhold

on employee’s 2018 wages net of the 2018 $100K bonus repayment

Rev. Rul. 79-311, 1979-2 C.B. 25.

– Executive Officer can deduct $100K on 2018 tax return under Code section

162 as miscellaneous itemized deduction.

– But miscellaneous itemized deduction is limited by 2% floor and is not

available against alternative minimum tax (AMT).

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Code Section 1341 Eliminates 2% Floor and AMT

• Section 1341 allows “make-whole” treatment of repaid amount.

• Taxpayer gets “better of” deduction or refundable credit:

– Deduction for year of repayment (without 2% floor or AMT) or

– Refundable credit equal to additional tax in year of payment

– Both deduction and credit approach eliminate 2% floor and AMT

• Statute

– Repayment over $3,000.

– Deductible under another Code section.

– It appeared that taxpayer had unrestricted right to payment in year of payment.

– Established after close of year that taxpayer did not have right to payment.

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Impact of Section 1341: Example

• In 2017, employee receives $400,000 performance-based bonus.

• Income tax on bonus = $158,400 (= 39.6% x $400,000).

• In 2018, entire bonus is clawed back upon accounting restatement.

Her 2018 AGI is $1 million.

• Section 1341 relief entitles her to income tax refund of $158,400.

• Absence of section 1341 relief:

– She deducts $380,000 (repayment in excess of 2% of $1 million AGI).

– Assume $380,000 deduction is added in full to her Alternative Minimum Taxable Income (AMTI).

– Assume AMT = $106,400 (= 28% x $380,000).

– She recovers $44,080 (= $158,400 - ($7,920 + $106,400)) of $158,400 income tax paid on bonus.

• She is $114,320 worse off than had she not received the bonus.

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Code Section 1341 –IRS Rulings Not Clear or Consistent

• Statute says Section 1341 available only if it “appeared” taxpayer had right to amount

when received.

• IRS thinks “apparent” right means only illusory rights and not “actual” rights.

• Example: Executive Officer receives performance based compensation in Year 1, and

repays it in Year 2 because accounting restatement shows it was “erroneously awarded”

under Rule 10D-1. Can she claim Section 1341 relief?

– NO. Her right to bonus was actual (non-illusory) under the original accounting statement “available”

to her in Year 1. See Rev. Rul. 68-153 situation 2.

– YES. Her right under the original accounting statement was illusory, as shown by accounting

restatement. See Rev. Rul. 68-153, situation 3

– NO. She had an actual (non-illusory) right under the original accounting statement. Her right was

defeated by subsequent event, namely, the restatement and clawback policy. See Rev. Rul. 68-153,

situation 4. The “subsequent event” analysis is arguably more likely to the extent board of directors

has discretion on whether to enforce clawback. See, e.g., 80 FR 41144, 11163 (July 14, 2015).

• IRS rulings not always consistent and do not always follow “apparent but not actual right”

test.

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Code Section 1341 – Courts Reject IRS Apparent But Not Actual Right Test

• In Dominion Resources, 4th Circuit rejected IRS apparent-but-not-actual right test, applied “same circumstances” test. Tax Court, Court of Federal Claims, and the five Federal Courts of Appeal have adopted this test. None has adopted IRS position.

– Section 1341 applies if original repayment payment made because of specified “circumstances, terms and conditions,” and repayment made because those “circumstances, terms and conditions”were not satisfied

• Can our hypothetical executive claim Section 1341 relief under this test?

– Arguably YES. Bonus was paid because of specified circumstances, terms and conditions (original financial statement) and repaid because those circumstances, terms and conditions were not satisfied (financial restatement).

• Some IRS rulings follow the same-circumstances test: Rev. Rul. 72-78, 1972-1 CB 45; Rev. Rul. 2004-17, 2004-1 CB 51.

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Section 1341 - The Nacchio Subjective Belief Test

• Nacchio v. US, United States Court of Federal Claims, March 12, 2014.

• Former CEO convicted of insider trading; disgorged $45 million profit. In refund claim, sought $18 million credit under section 1341 for income taxes paid on profits received but subsequently forfeited.

• Government argued section 1341 not available because taxpayer had no “apparent right” to gains based on trades jury found illegal.

– Claims Court denied summary judgment. Whether taxpayer had apparent right under section 1341 depends on whether he “subjectively believed” he had right to funds, which is a question of fact. Criminal conviction via jury verdict not relevant to his subjective belief; taxpayer did not plead guilty.

• Appeals Court reversed on other grounds. Disgorgement was a “fine or similar penalty" barring tax deductibility under Code Sections 162 and 165.

• Did not touch subjective belief test: Was right apparent to taxpayer?

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Repaying Compensation In Later Year: What About Netting Repayment Against Other Pay?

• Assume company recoups $400,0000 bonus by withholding it from

$1 million compensation otherwise payable in recoupment year.

• Can company report $600,000 wages and income on W-2?

• Rev. Rul. 79-311, 1979-2 C.B. 25: NO

• There are some authorities for a YES position. See, e.g., Aramony v. United Way, 86 AFTR.2d 2000-5987 (S.D.N.Y. 2000).

• IRS might argue these are distinguishable.

• Good up-front paperwork will bolster company’s arguments.

• Company bears risk of interest and penalties for underwithheld

taxes.

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Some Code Section 409A Issues

• In requiring repayments of nonqualified deferred compensation subject to Code Section 409A, keep in mind the basic Section 409A rules:

– No accelerations (Code Sec. 409A(a)(3))

– No subsequent deferral elections (outside of 12-month/5-year rule, Treas. Reg. Sec. 1.409A-2)

– No substitutions (Treas. Reg. Sec. 1.409A-3(f))

• Repayment of compensation not yet paid and taken into income

– Simplest solution: Clawback policy provides for forfeiture

– Section 409A permits forfeiture if not accompanied by substitution of other amount payable at another time (Treas. Reg. Sec. 1.409A-3(f))

– For Rule 10D-1 clawbacks, permissibility of repayment via forfeiture will depend on final SEC rule.

See generally 80 Fed. Reg. 4114, 41163-4 (July 14, 2015)

• Repayment of compensation already paid and taken into income

– Under Section 409A, issuer should be able to offset against compensation payable in later year, unless it reports and withholds on net basis in contravention of IRS position under Rev. Rul. 79-311. Netting could arguably raise Section 409A issues under no-substitution rule.

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Recovering FICA taxes

• Claim of right doctrine does not apply to FICA taxes.

• Use procedures under Code section 6413 for erroneous overpayments.

• Employer recoups FICA taxes withheld by filing Form 941-X within

statute of limitations (3 years after filing original Form 941).

• Employer must repay employee’s share of withheld FICA taxes to

employee, by reducing FICA taxes withheld from other wages, or directly.

• Also Employee must repay compensation to Employer.

– Does employee have to repay gross payment, or payment net of FICA taxes already

withheld?

– Answer not entirely clear but recent IRS guidance suggests repayment of net amount

is sufficient (but note that proposed Rule 10D-1 requires that Executive Officer repay

entire pre-tax amount of erroneously awarded incentive-based compensation).

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SECTION 162(M) UPDATE

Section 162(m)

• $1 million annual limit on a corporation’s deduction for compensation to certain executives

• Applies only to “publicly held” corporations:

• Any corporation issuing any class of common equity securities required to be registered under Section 12 of the Securities Exchange Act

• Status determined as of the last day of the corporation’s tax year.

• Not considered a publicly held corporation:

• Privately held corporations

• Corporations voluntarily registering their equity securities

• Corporations with only publicly held debt

• Partnerships not taxed as corporations

Applies only to “covered employees”: • CEO, three highest compensated individuals (other than the CEO and CFO) whose compensation is required to be reported under the Securities Exchange Act

• Status is determined as of the last day of the corporation’s tax year

• No covered employees if disclosure of a summary compensation table is not required

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Section 162(m) Exception for Performance-Based Compensation

– Qualified performance-based compensation is exempt from the $1,000,000 compensation deduction limit

– Overview of the basic requirements:

– Performance goal

– Compensation committee composed only of “outside directors”

– Shareholder approval

– Certification by compensation committee of performance

– Requirements apply to compensation paid in forms other than stock options or SARs

– Requirements are modified for stock options and SARs (where discounts are prohibited)

– Special transition rules apply to post-IPO grants

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Commonly Seen Section 162(m) Audit Issues

– Failure to timely obtain publicly-traded shareholder approval of the “material terms” of the performance goal

– Also note some agents’ objections to “too many” performance measures

– Compensation committee outside director requirement

– Lack of documentation regarding shareholder approval, performance goals, certification of results

– Impermissible discretion increasing performance compensation

– Exceeding approved plan share limit

– Failure to specify a per-person limit on the number of shares to be issued

– On acquisitions, IRS examination assertions that “no action” letter by SEC (thus, no more summary compensation table) does not absolve a corporation of its prior-year liability under 162(m) (but these disputes should be limited to acquisitions after the 45th day of the year).

– Five year reapproval of goals only versus entire plan: Company practice v. IRS inquiry – in one audit, an agent proposed to disqualify a plan because shareholders had approved the plan without “separate approval” of the performance measures

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Section 162(m) Claim and Litigation Activity

• Section 162(m) is often basis for a “220 request”

– Demand by shareholder to inspect books and records of corporation under 8 Del. C. Section 220

– Shareholder needs a “credible basis” to make the request – e.g. some evidence of possibly mismanagement

– Mere curiosity or a desire for a fishing expedition will not suffice

– Request must be limited to documents that are “necessary and essential” to the inquiry

• Failure of corporation to obtain separate five-year reapproval of “laundry list” of performance criteria:

– Claim that proxy was misleading lead shareholders to believe that the compensation committee had the ability to grant tax-deductible awards under the equity plan

– Sometimes an unrelated plan amendment was approved by shareholders within the five year period, but without a specific “re-up” of the performance criteria list

• Failure of compensation committee member to qualify as “outside director” for purposes of Section 162(m) because they were officers or interim officers in prior years

• Overissuance of awards not provided for under plan

• Proxy statement that compensation committee could make non-deductible grants under plans other than those approved by shareholders “coerced” the shareholders into approving the plan (because bonuses would be paid anyway and would not be deductible)

– Seinfeld v. O'Connor (Del. 2012)

– But PLR 200617018 – IRS ruled that taxpayer's reservation of the right to pay discretionary bonuses outside of the Section 162(m) plan would not prevent the plan from qualifying as a qualified performance-based compensation plan

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Section 162(m) Claim and Litigation Activity

• Failure to minimize taxes:

– Seinfeld v. Slager (Del. 2012)

– Freedman v. Adams (Del. 2013) - derivative complaint challenging the board's decision to pay cash bonuses that were not tax-deductible did not state a claim for waste

• Misleading proxy disclosures:

– Freedman v. Mulva (Del. 2014) - derivative action alleged misleading proxy disclosure with respect to the tax deductibility of incentive compensation

– Kaufman v. Allemang (Del. 2014) - derivative action alleging that board and its named executive officers made false and misleading proxy disclosures with respect to the tax deductibility of stock compensation

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Protecting Against Section 162(m) Claims

• Keep a close eye on the five year period, and include a specific and separate shareholder approval of the performance criteria in the proxy

• Monitor independence of compensation committee directors

• Monitor availability of shares under plan

• Proxy should state only a general policy of taking Section 162(m) deductibility into account when making awards to covered employees, and expressly reserve the right to grant non-deductible awards

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NEW YORK PAYROLL TAX AUDITS

Topics Covered

I. Current State Payroll Tax Requirements and Audit Issues

II. Mobile Workforce State Income Tax Simplification Act

III. NY Payroll Audits

IV. Federal Protections

V. Practical Approaches for Managing Exposures

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I. Current State Payroll Tax Requirements and Audit Issues

• Companies with peripatetic workforces—employees and contractors working in, and moving among, many different states, either in a single year or over the course of the vesting period for bonuses, stock options, restricted stock, or other equity compensation—have special problems due to myriad state laws governing the taxation of residents and non-residents.

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State Taxation of Workers in Multiple States: Impediments/Opposition

• Form W-2 includes spaces in Boxes 15-20 at the bottom of the Form for reporting income to two different states (separated by a broken line).

• The IRS instructions to Form W-2 say, “If you need to report information for more than two states or localities, prepare a second Form W-2.”

• Payroll systems may not accommodate (or capture) multiple work locations.

• But employees almost invariably complain if employers report wages in more than one state.

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State Taxation of Workers in Multiple States: Employer Withholding

• The “employer nexus” to trigger withholding, for most states is:

– Employer office in state, or some other nexus to trigger state income tax; and

– Payments of any wages subject to income tax in the state (or subject to contribution under the state’s unemployment compensation laws).

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State Taxation of Workers in Multiple States: Employer Withholding

• Some states provide thresholds before withholding is triggered, based on days worked, dollars earned, or some combination of the two. (See map on following slide.)

• Examples:

– NY – reasonable expectation that employee will work 14 days or less in NY

– GA – 23 days a quarter, or GA-allocated wages exceeding 5% of total compensation

– CT – 14 working days a year

– ND – 20 working days a year

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Overview of State Taxation Thresholds

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State Taxation of Workers in Multiple States: Risks of Employer Audits

• As with any payroll audits, it is simpler for state/local tax officials to audit employers, holding them liable for non-withheld income taxes where allocated wages exceed the state’s personal exemption, because that is more efficient than finding and auditing individual employees.

• If employers have neither reported nor withheld on the income, it is extremely unlikely that any non-resident of a state would have voluntarily paid income taxes (thereby enabling the employers to abate their liability for nonwithheld income taxes).

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State Taxation of Workers in Multiple States: Risks of Employer Audits

• However, it is nearly impossible for employers to keep track of day-counting income allocation rules (or with 183+ days residency tests).

• Some states have poorly explained rules on income allocations.

• Historically, many states were not aggressive in auditing non-residents or conducting payroll audits.

• Some states (e.g., NY) have been operating “amnesty programs” or “Voluntary Disclosure Agreements” to encourage employers to voluntarily confess their withholding/reporting errors.

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State Taxation of Employers Due to Telecommuting Employees

• Telebright – New Jersey Appellate Division found company subject to income tax based solely on presence of one telecommuting computer programmer.

• Company did not care where employee worked.

– Employee was originally based outside NJ, but asked to continue employment after moving there.

• No solicitation/marketing activities in NJ.

• Employee’s daily presence in NJ for the purpose of carrying out her responsibilities as an employee was sufficient to satisfy the substantial nexus requirement of the Commerce Clause.

• See Warwick McKinley, Inc., Cal. SBE 489090.

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State Taxation of Workers in Multiple States: Stock Option/SAR Allocation Methods

• The state rules governing the taxation of stock options (or SARs) and the income allocation withholding rules for option income received by non-residents vary greatly depending on the state (and some states have never adopted any option-sourcing rules):– Grant-to-Vest Method: Taxes option exercise income based on the percentage of time

in the state between the date of grant and the date the options vest;

– Grant-to-Exercise Method: Taxes option exercise income based on the percentage of time between the date of grant and the date the options are exercised;

– Year-of-Exercise Method: Option spread from exercise is taxable only if services were performed during the year of exercise and not over a multiyear period;

– Degree of Appreciation Method: Allocates the income based on the amount of appreciation of the underlying option that occurred while the taxpayer was a resident of the state.

• The variance between the states, and from year to year within certain states, clearly suggests there is no set rule, and the most appropriate method is to allocate the income based on a reasonable facts and circumstances analysis.

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II. Mobile Workforce State Income Tax Simplification Act

• This bill would address the taxation of non-resident employees (excluding professional athletes, professional entertainers, and some public figures) and would set a threshold of days below which a state could not subject the non-resident to state income tax.

• H.R. 2315 passed the U.S. House of Representatives on September 21, 2016.

• S. 386, the corresponding Senate bill, was introduced on February 5, 2015, and has been referred to the Senate Committee on Finance.

• For information about the 300+ member coalition of supporters, contact Doug Lindholm at [email protected].

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mailto:[email protected]

Mobile Workforce State Income Tax Simplification Act

• Establishes a 30-day threshold that non-residents would have to work in a state before becoming subject to out-of-state taxes

– Strong state opposition

• The initial bills had proposed a 60-day threshold, but because of state clamor a compromise was reached between employers and states, and in the most recent version of the bill a 30-day threshold was proposed.

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• A “day” is attributed to the state where an employee performs more of his employment duties compared to another state, UNLESS, the employee performs employment duties in a resident state and ONLY one non-resident state during one day. In this case the employee will be considered to have performed more of the duties in the non-resident state.

– Incentive to visit two states in a travel day

– Recordkeeping issues

– Unclear whether it simplifies anything

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• In testimony before the House Committee on the Judiciary on May 25, 2011, the President of the Federation of Tax Administrators (FTA) opposed H.R. 1864, arguing that:

– The 30-day rule should count work for any part of a day

– A dollar threshold should be added so that highly paid employees might be subjected to withholding for less than 30 days of work

– Stock options and multiyear compensation should be exempted

• The House Committee on the Judiciary approved H.R. 1864 on November 17, 2011 after rejecting changes proposed by Rep. Nadler (NY), but recognizing that changes may be required to respond to the FTA’s concerns.

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MTC Model Statute

• The Multistate Tax Commission (MTC) has proposed a mobile workforce withholding and individual income tax model statute that would decrease the threshold to 20 days. The MTC’s model statute provides that MOST non-residents’ income from work performed in states of non-residence would be exempt from withholding if the non-residents:

– have no income derived from the non-resident states;

– worked fewer than 20 days in such states (days in transit would be exempt from the day count); and

– reside in states that have reciprocal exemptions or do not impose personal income taxes.

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MTC Model Statute

• Certain workers would be excluded from the withholding protections provided by the MTC’s model statute:

– professional athletes;

– persons of prominence who perform services on a per-event basis;

– professional entertainers;

– construction laborers; and

– key employees.

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MTC Model Statute

• Under the MTC’s model statute, qualifying employees would not have a filing requirement in the state of nonresidence; and employers would not have a withholding requirement regarding qualifying employees.

• However, the model act does not explicitly address nexus issues for employers with no nexus to the state.

• Also, states with “income thresholds” instead of day-counting thresholds (e.g., Montana) have criticized the MTC's model statute and its “days of working presence” test for creating problems for states that have an income threshold for taxability. They also note that high-earner non-residents working less than 20 days would be exempt from filing returns, while lower-paid non-residents working more than 20 days in a state would have to file.

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Multi-State Worker Tax Fairness Act

• First introduced in 2004, and most recently introduced in April 2016 (S. 2813, 114th Cong.) – Would bar states from adopting a “convenience of the employer rule,” and require that an employee be physically present in the state as a precondition to imposition of tax on that worker.

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III. NY Payroll Audits

• Part-Day Counting: Any portion of a day in NY can trigger allocation of income to NY. See Matter of Holt, DTA No. 821018 (2007) (“petitioner [a Florida resident] finds it incredible that an individual's presence in New York for a portion of a day constitutes a day for New York tax purposes”).

• No Minimum Number of Days: Many states have some minimum number of days of work in a particular state before state income-allocation rules apply. NY does not.

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State Taxation of Workers in Multiple States: Some NY Horror Stories

• Meeting Burden of Proof to Show Non-Resident Status: In Inthe Matter of Julian H. and Josephine Robertson, NY DTA 822004 (2009 and 2010), NY auditors had maintained that a couple had been in NY for 183 days and that the taxpayers’ records showing time outside NY were inadequate for 4 days, and thus the taxpayers, as NY residents for more than 183 days, would owe additional NY City taxes totaling $26,702,341 for 2000.

• After an extensive trial, in a 100+ page opinion, the judge believed the taxpayers’ testimony; after an exception was filed, the case was argued again, another opinion was issued, and the taxpayers won again.

• But see Puccio, NY DTA 822476 (2011).

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• “Convenience of Employer” Rule: NY counts even services performed by any NY non-resident at the taxpayer's out-of-state home that could have been undertaken at the employer's office in NY, unless the services were performed out of state for the employer’s necessity, not the employee's convenience. (20 NYCRR section 132.18(a). See, e.g., Matter of Phillips v. New York State Department of Taxation and Finance, 267 AD2d 927, 700 NYS2d 566, lv denied, 94 NY2d 763, 708 NYS2d 52, Matter of Page v. State Tax Commission, 46 AD2d 341, 362 NYS2d 599; Matter of Simms v. Procaccino, 47 AD2d 149, 365 NYS2d 73), Matter of Zelinsky v. Tax Appeals Tribunal of State of New York, 1 NY3d 85, 769 NYS2d 464, cert denied 541 US 1009, 158 L Ed 2d 619), In the Matter of the Petition of Manohar and Asha Kakar, DTA No. 820440 (Feb. 16, 2006), and Matter of Huckaby v. New York State Division of Tax Appeals, 4 NY3d 427, 796 NYS2d 312, cert denied 546 US 976, 126 S Ct 546, 163 L Ed 2d 459).

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• See Edward A. Zelinsky, “New York’s ‘Convenience of the Employer’ Rule Is Unconstitutional,” State Tax Notes Doc. 2008-9044 (“New York’s ‘convenience of the employer’ doctrine has not fared well in the court of professional opinion.”).

• These harsh results are one of the drivers behind efforts to enact federal blockers on states’ abilities to tax non-residents. (See discussion below.)

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IV. Federal Protections: Federal Blocker of State Taxation of Certain Retirement Income of Former State Residents

• Since 1996, 4. U.S.C. § 114 has prohibited states from imposing an

income tax on “qualified retirement plan income” and certain other types of non-qualified deferred compensation benefits paid to any individual who had earned the income while working in one state (either as a resident, domiciliary, or part-time worker) but had retired and moved out of the source state before the income was paid.

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Federal Blocker of State Taxation of Certain Retirement Income of Former State Residents

• These rules were lobbied into the “interstate commerce” section of the Federal Code in 1996 by RESIST (Retirees Eliminating State Income Source Taxation), the American Payroll Association, and other affected mobile workforce employees.

• The rules were later extended to certain retired partners (as described in Code § 7701(a)(2)) who have “retired” under their partnership

agreements.

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• There will never be federal regulations because no federal agency would undertake such a project.

• There are some states that have issued regulatory guidance, and some that have issued private rulings on the rules’ application.

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• The definition of “retirement income” that cannot be taxed when earned by non-residents generally includes the following items:

– Qualified retirement plans;

– Excess benefit plans or wrap-around plans; and

– Certain other forms of nonqualified deferred compensation described in Code § 3121(v)(2) paid out in equal periodic installments over at least a 10-

year period or for a recipient’s life or life expectancy.

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• The excepted payments from “Qualified Retirement Plans” include:

– § 401(k) plans;

– § 408(k) simplified employee pensions;

– § 403(a) annuity plans;

– § 403(b) annuity contracts;

– § 7701(a)(37) individual retirement accounts;

– § 457(a) eligible deferred compensation plans;

– § 414(d) governmental plans;

– Military retired or retainer pay plans; and

– § 501(c)(18) employee contribution trusts.

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• “Excess benefit plans or wrap-around plans” are defined as:

– Plans solely for the purpose of providing retirement benefits for employees in excess of the limitations imposed by one or more of Sections 401(a)(17), 401(k), 401(m), 402(g), 403(b), 408(k), or 415 of such Code or any other limitation on contributions or benefits in such Code on plans to which any of such sections apply.

• The description of these plans in the legislative history references a statute before it was amended in conference, which confuses interpretation of this provision.

• New York issued one ruling concluding that even a salary-bonus plan combined with a SERP was an “excess plan” – so the 10-year or annuity distribution schedule did not apply.

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• The final exception encompasses other forms of nonqualified deferred compensation described in Code § 3121(v)(2) paid out in

equal periodic installments over at least a 10-year period or for the recipient’s life or life expectancy.

• Directors and independent contractors are not eligible for this exception because SECA taxes have no corollary to 3121(v)(2). We are waiting to see if a petition is filed, or a settlement offer is proposed.

• Retired partners have special statutory protections added to the Federal statute in 1996.

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• Presumably the determination of whether distributions meet the “substantially equal periodic payment” rule would be determined by Reg. §1.402(c)-2, Q&A 5(a) and (c) (d) (providing that the determination is made at the annuity starting date, and is not affected by subsequent contingencies and modifications, such as death of a participant) and Q&A 5(d) (specifying that distributions over ten years can be paid under a “declining balance of years” method, which pays 1/10 in year 1, 1/9 of the remainder in year 2, etc.).

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• The Code § 3121(v)(2) regulations expressly exempt stock options, stock appreciation rights, restricted stock, severance, sick leave, compensatory time, and vacation pay.

• Stock options, SARs, and restricted stock could not be paid out over 10 years or as an annuity in any event.

• Code § 409A has significantly limited application of this exception by barring most changes in deferred compensation distribution schedules.

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• Since Code § 3121(v)(2) applies only to common law employees, it is

not clear whether this provision applies to corporate directors or other non-employees (excepting certain retired partners who are covered by a later statutory expansion of this federal source tax legislation).

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Additional Specialized Federal Blockers of State Taxation of Transient Non-Resident Workers

• Congress has enacted several industry-specific laws that fully or partially block states from mandating withholding on wages of certain non-resident employees of certain types of employers:

– Railroads – 49 USC §11502 (4-R Act);

– Airlines – 49 USC § 40116 (Anti-Head Tax Act);

– Motor Carriers – 49 USC §14503;

– Fishing vessels, or vessels engaged in “foreign, coastwise, intercoastal, interstate, or noncontiguous trade” – 49 USC §

11108.

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V. Practical Approaches for Managing Exposure

• From a practical perspective, 100% compliance is almost impossible.

• Establish policy for employees to report travel.

– Consider higher standard for highly compensated employees

– Consider requirements for specialty/temporary projects within a state

– Communication to employees

• Determine whether company threshold for withholding is appropriate.

– Help to limit exposure, but potential liability for noncompliance in some states.

• Ensure HR and marketing communicates with the tax and payroll departments when hiring employees or holding events in states where the company is not filing.

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Remediation of Historical Exposures

• Many states have voluntary disclosure agreements and/or temporary amnesty programs.

• Processes and requirements are not consistent.

– Limitation of look-back period and penalty relief

• Typically anonymous

• Formal agreement

• Correction programs have worked for executive groups and have eliminated the need to file individual returns.

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Voluntary Compliance Opportunities

• Given the heightened focus on audits and unreasonableness of the one-day rule in certain states, we are seeing many clients take advantage of these programs.

• New York has a streamlined program.

• California has both a voluntary compliance program and a filing compliance agreement program.

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Rosina B. Barker

Rosina B. Barker

Partner

Washington, DC

T +1.202.739.5210

F +1.202.739.3001

Rosina B. Barker counsels clients on the Employee Retirement Income Security Act (ERISA), tax, and securities law aspects of their employee benefits and executive compensation plans. Her practice ranges from sophisticated defined benefit pension plan matters to complex executive compensation issues. She regularly advises on compliance with Code Sections 409(A), 83, 162(m), 457A, and 280G; and frequently counsels on the benefits and executive compensation issues arising from mergers, divestitures, and other business reorganizations.

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Jonathan Zimmerman

Jonathan Zimmerman

Partner

Washington, DC

T +1.202.739.5212

F +1.202.739.3001

Jonathan Zimmerman helps clients design and maintain all types of employee benefit plans and programs. His practice focuses on Internal Revenue Code and Employee Retirement Income Security Act (ERISA) compliance for retirement, health and welfare, and executive compensation plans. He has particular experience with Code Sections 409A, 162(m), and 280G, and with taxes and fees arising under the Affordable Care Act (ACA). Jonathan also devotes a large part of his practice to payroll, withholding, and fringe benefits matters. He works with clients of all sizes and routinely handles matters ranging from large transactions to day-to-day administrative questions.

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Tax Executives Institute, Inc., Upstate New York Chapter ......based on 2017 financial reporting...

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