Pa. Court OKs Tax on NQ Contribution

June 2, 2004 ( - An employee who defers money into an unfunded, non-qualified deferred compensation plan is subject to personal state income tax on the deferrals in the year earned.

The Commonwealth Court of Pennsylvania made the determination based on the Court’s reading of Section 302(a) of the Pennsylvania Code.   The Code “imposes a personal income tax on every dollar of income received by a resident during the taxable year.” Thus the court determined in Ignatz v. Commonwealth of Pennsylvania , a taxpayer must recognize for the purposes of state taxes the income in the year it is credited to the account, even if the taxpayer does not take “possession” of the income, according to an analysis by Dechert LLP.

The battle originated between the plaintiff and the Pennsylvania Department of Revenue.   The plaintiff had argued that the elected deferral should not be subject to the state income tax provisions based on a reading of federal law that does not subject income deferred into such plans to tax in the year of deferral.   In fact, the Revenue Department conceded that under applicable federal statues the deferred compensation would not be taxable as constructively received.  

However, the Department of Revenue went on to further reason that the taxpayer’s ability to elect whether to take the full amount in cash or take part in cash and have part contributed to the plan established a “requisite control” over the compensation.   In the Revenue Department’s ruling, this “requisite control” is enough to establish constructive receipt of the compensation, a determination the court agreed with.

In what the firm refers to as a “surprising and troubling decision,” Dechert calls into question the Court’s judgment based on federal law.   ” The Court seemed to ignore that facts that the taxpayer’s election was made before the amounts were even earned; there were no funds set aside on which the taxpayer might draw; and, should the taxpayer’s employer file for bankruptcy, there would be a high likelihood that the taxpayer could never receive the deferred amounts,” Dechert says in its analysis.

As such, Dechert says employers with Pennsylvania-based employees in nonqualified deferred compensation plans must now face the decision on whether or not to withhold Pennsylvania income tax on the income contributed to such plans.   For the moment though, Dechert said most companies will wait such a move pending the appeal of the Court’s decision.

It won’t be the first time that Pennsylvania tax law and federal law are out of sync.  Pennsylvania has never recognized a pre-state tax deferral for 401(k) plans, either.