State taxation: the source tax law

• Author: Marla J. Aspinwall - Michael G. Goldstein
• Pages: 291-300

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CHAPTER XI

STATE TAXATION: THE SOURCE TAX LAW

I. INTRODUCTION

Most states impose an income tax and some do not. When employees move between

states with an income tax and states without an income tax, issues arise. A federal statute often

referred to as the “Source Tax Law” can prohibit a state from taxing its former resident on

NQDC benefits if he or she moves to a state with no income tax. The federal statute only applies

if the NQDC benefits meet certain requirements. Thus, the federal statute will create planning

opportunities for some, and will be a trap for the unwary for others.

A.

States Imposing an Income Tax. Forty-one states and the District of Columbia

impose a broad-based personal income tax.1 Most of those states calculate taxable income based

on the federal income tax system, with adjustments. Thus, in many cases, the same general tax

treatment of NQDC for federal income tax purposes will apply for state income tax purposes;

namely, the employee will not include the NQDC benefit in taxable income until it is actually or

constructively received, usually after retirement.2

EXAMPLE: Employer establishes a very generous NQDC plan

for Employee’s benefit. Employee lives and works in Missouri

and remains in Missouri throughout retirement. The Missouri

income tax is based on federal adjusted gross income with some

modifications.3 If the NQDC plan is properly structured,

Employee’s NQDC benefits will not be subject to federal or

Missouri income tax until the amounts are actually paid to

Employee, during retirement. When the NQDC benefits are paid

to Employee, the benefit payments will be subject to both federal

and Missouri income tax.4

EXAMPLE: Although Employee worked in Missouri, he retires to

Massachusetts. Massachusetts will impose an income tax on

1 H.R. Rep. No. 104-389, at 4 n. 6 (1995) (Report of Judiciary Committee on Public Law 104-95, State

Taxation of Pension Income Act of 1995.) The States that do not impose an income tax are Alaska,

Florida, Nevada, South Dakota, Texas, Washington and Wyoming, and New Hampshire and Tennessee

impose an income tax on only limited types of income (such as interest, dividends, and capital gains).

2 See Rev. Rul. 60-31, 1960-1 C.B. 174 (general tax treatment of NQDC for federal income tax purposes),

modified by Rev. Rul. 64-279, 1964-2 C.B. 121, and Rev. Rul. 70-435, 1970-2 C.B. 100.

3 See Mo. Rev. Stat. § 143.121.1 (1994) (none of the Missouri “modifications” would cause the NQDC

payments to be taxed differently under Missouri law than under federal law).

4 For 2011, the maximum federal income tax rate on individuals is 35%, IRC § 1(c), and the maximum

Missouri income tax rate on individuals is 6%. See Mo. Rev. Stat. § 143.011. In calculating Missouri

income tax, only the first $10,000 of federal income tax paid is deductible on a joint return. Id. at

§ 143.171.1. Thus, the maximum combined income tax rate would be approximately 41%.