Federal legislation on state taxation of nonresident pension income.

• Position: Tax Executives Institute State and Local Tax Committee

On November 30, 1995, Tax Executives Institute filed the following comments concerning pending legislation with the Subcommittee on Commercial and Administrative Law of the House Committee on the Judiciary concerning proposed legislation to restrict the States' imposition of source-based taxes levied against the retirement income of nonresidents. TEI's comments were prepared under the aegis of its State and Local Tax Committee, whose chair is Christopher W. Baldwin of Gannett Co., Inc. Legislation restricting the States' right to tax nonresident pension income was signed into law by President Clinton on January 10, 1996.

Description of Source Tax Issue

Many States have enacted statutes to impose an income tax on pensions and nonqualified deferred compensation that was earned and deferred while an individual was a resident of a State but paid after that individual retired and moved to another State.(1) Under the "source principle," a State may tax that portion of the deferred compensation or pension benefit attributable to the value of the services performed while the individual was resident within the State. In some cases, the States have augmented enforcement of source taxation of nonresident pensioners by imposing reporting or withholding requirements upon the individual's former employer.

Several proposals have been introduced in this and preceding sessions of Congress to circumscribe the States' authority to tax nonresident pension income. In particular, H.R. 394 and its Senate companion, S. 44, would prevent the States from imposing an income tax on the retirement income of an individual who is not a resident or domiciliary of the State.(2) Another bill, H.R. 371, would similarly preclude the States from imposing an income tax on "pension income" of any individual who is not a resident or domiciliary of the State. H.R. 371, however, does not define "pension income" so its scope is unclear. H.R. 744, in contrast to both H.R. 394 and 371, provides relief from source taxation only for annuity payments from qualified plans and only to a maximum of $25,000 per year in retirement benefits.

Tax Executives Institute acknowledges that the source tax principle allows the States to achieve legitimate state tax policy goals. Nonetheless, permitting the States to layer a patchwork of regulations on top of the substantial recordkeeping burdens already imposed by the Department of Labor and Internal Revenue Service upon qualified pensions would be inimical to interstate commerce and the national pension policy evinced by ERISA. As a result, TEI recommends that Congress enact legislation to clarify that, at a minimum, distributions from qualified plans, trusts, or similar arrangements, may not be subjected to state or local taxation except in the retiree's state of domicile or residence. In addition, Congress should consider enacting legislation that circumscribes state source taxation of all forms of retirement income.

Background

Tax Executives Institute is a volunteer, professional association of approximately 5,000 accountants, lawyers, and other professionals who are responsible for managing the tax affairs of their companies. TEI members must contend daily with business tax laws, including those affecting the taxation of pensions, from tax planning, recordkeeping, and tax compliance perspectives. TEI represents a cross-section of the business community (including companies with diverse and mobile workforces). We are dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike.

The Institute is firmly committed to maintaining a tax system that works -- both for taxpayers and tax administrators. We believe the diversity and training of our members enable us to bring a uniquely balanced and practical perspective to your attention.

Constitutional Authority

The two primary bases of state taxing authority are residence and source.(3) In the absence of congressional action preventing the States from taxing the pension income of nonresidents attributable to employment in a State where the individual once worked or resided, many States claim the right to tax that income. The Due Process requirements of the Constitution are likely satisfied as long as the States tax only the portion of the income earned while the individual enjoyed the benefits, rights, and privileges of residence.

Nearly all States, however, link their income tax policy to the federal policy, thus permitting deferral of taxation on pension income. In doing so, the States grant an additional benefit of residence because they could, if they wish, tax the pension income at the time the benefit accrues or an amount is contributed to the plan. Hence, in the case of nonresident pensioners, when a State imposes a source tax on a pension payment of a former resident, it is merely "recovering" the previously deferred tax. Where that is so, the departure of a former resident has no bearing on the State's constitutional authority to tax the income derived from personal services rendered while resident in the taxing State.

On the other hand, Congress has broad authority under the Commerce Clause of the Constitution to regulate transactions within the stream of interstate commerce, including imposition of restrictions on the States' power to tax. Congress has exercised its authority to regulate the States' power to tax in instances where the burden of state taxation is deemed inimical to the free flow of goods and services in interstate commerce. Public Law No. 86-272's proscription against subjecting sellers of tangible personal property to state taxation for mere solicitation activities within a State is but one area where Congress has exercised its authority to restrict state taxation.(4) The nonresident pension income that States seek to tax under the source principle is clearly within the stream of interstate commerce because both the recipient and the pension payment cross (or have crossed) state lines. As a result, Congress may, if it deems it necessary to promote and protect interstate commerce, restrict the States' taxation of nonresident pension income.

Consequently, the focus of the debate over source taxation of nonresident pension income is properly shifted to whether the States should exercise their inherent authority to tax nonresident pensions and, if exercised...