MINNESOTA ISSUES GUIDANCE ON TAXATION OF SEVERANCE, EQUITY BASED INCOME AND OTHER DEFERRED COMPENSATION PAID TO NONRESIDENTS
On October 20, 2008, the Minnesota Department of Revenue published Revenue Notice #08-10 entitled “Individual Income Tax and Withholding – Wages of Nonresident Individuals Assigned to Minnesota for Work Performed in Minnesota” and Withholding Tax Fact Sheet #19 entitled “Nonresident Wage Income Assigned to Minnesota.” This guidance has been anticipated since the Minnesota legislature eliminated the income tax exemption for non-qualified deferred compensation earned in Minnesota and received by a nonresident. The exemption was eliminated for compensation received on or after January 1, 2008, and employers must withhold tax from such payments after April 1, 2008.
The new guidance includes separate allocation rules for severance, equity based awards and other nonqualified deferred compensation, as follows:
Severance is allocated to Minnesota “to the extent that work connected with the employment from which the payment is received was performed in Minnesota.” The Fact Sheet offers two examples. The first example is a downsizing severance award for a lifetime Minnesota employee. Since all work was performed in Minnesota, it is not clear what “work” must be considered. The second example involves a severance benefit paid pursuant to the terms of an employment contract and indicates that the “work” taken into account is limited to the term of the employment contract. Neither example addresses the potential impact of non-competition covenants or other post termination contractual terms that could be included in severance agreements, or other complexities that are likely to arise in the severance context.
Equity Based Awards
Equity based awards, such as options, stock appreciation rights and restricted property, are allocated to Minnesota based on the number of days worked in Minnesota over the period from the date of grant to “substantial” vesting (or earlier sale). The Fact Sheet’s examples involve options that are vested upon grant (when the employee works the entire grant year in Minnesota), options issued to non-residents who work in Minnesota for some days during the grant to vest period, and options granted with staggered vesting dates.
Other Deferred Compensation
Other deferred compensation is allocated to Minnesota based on the number of days worked in Minnesota over “the period of time during which the employee accrued the right to the deferred compensation.” The Fact Sheet gives examples of allocation of income from a nonqualified SERP, elective deferred compensation, and incentive bonuses.
Challenges for Employers
At least two of the three allocation tests require a comparison of employee days in the state to days out of the state so employers have record-keeping responsibilities not likely compatible with their existing systems. It is unclear what the Department of Revenue will accept as allocation documentation for periods prior to the enactment of the new law. The current guidance provides no administrative relief.
Deferred compensation payments may be exempt from Minnesota Tax if payable to a non-resident over the individual’s life or life expectancy or in substantially equal periodic payments over a period of not less than 10 years. Extreme caution must be taken to ensure that any non-qualified deferred compensation plan amendments or distribution elections modifying the time or form of distribution do not violate the requirements of Internal Revenue Code section 409A.
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