Pennsylvania To Address Taxation of Nonqualified Deferred Compensation

Pennsylvania Positions Itself For Legislative Fix

In an interesting turn of events, the Pennsylvania Department of Revenue has recently withdrawn PIT Policy No. 112 from its website. While no formal announcement has been made, Governor Rendell has apparently asked the Pennsylvania Department of Revenue to suspend collection efforts as he has agreed to work with the Pennsylvania General Assembly toward a legislative solution aimed at adopting an approach based on the federal income tax scheme. We have also heard that the governor's office will join the parties to the Ignatz decision to ask the Commonwealth Court to suspend further proceedings until such time as a legislative solution is reached. 

Overview of Nonqualified Deferred Compensation in Pennsylvania

In 2004, the Commonwealth Court of Pennsylvania ruled, in a question of first impression, that voluntary employee contributions to an unfunded, nonqualified deferred compensation plan were constructively received for purposes of Pennsylvania personal income tax in the year earned (i.e., the year in which the services are performed, not the year in which the amounts are ultimately paid).  See Ignatz v. Commonwealth of Pennsylvania, 2004 WL 1057453 (Pa. Commw. May 12, 2004) (No. 136 F.R. 2003, 397 F.R. 2003).  The Ignatz decision caught the attention of many employers due to its potential application to a broad range of nonqualified elective deferral arrangements. Currently, the parties to the Ignatz decision have filed exceptions with the court regarding its decision and oral arguments are scheduled for February 2005.

In response to the Ignatz decision, the Pennsylvania General Assembly passed legislation (House Bill No. 176) that would have substantially undermined the Ignatz decision by adopting the federal constructive receipt rule for purposes of applying Pennsylvania's personal income tax.  On November 30, 2004, however, Governor Rendell vetoed House Bill No. 176, citing uncertainties regarding its application and the potential for a significant loss of revenue to the Commonwealth. 

Three days after the governor's veto of House Bill No. 176, the Pennsylvania Department of Revenue issued PIT Policy No. 112 ("Policy"). The Policy informed employers that Pennsylvania would begin enforcing withholding requirements on nonqualified deferred compensation deferrals, effective April 1, 2005. This Notice was recently withdrawn by the Pennsylvania Department of Revenue.

It is anticipated that any new legislation covering nonqualified deferred compensation will clarify that Pennsylvania's constructive receipt rule, as applied to nonqualified deferred compensation arrangements, will be construed in accordance with federal tax law. As a condition to signing such legislation, however, it is anticipated that Governor Rendell will require that distributions made from nonqualified deferred compensation plans not be eligible for Pennsylvania's income exclusion applicable to distributions from retirement plans.