State Taxation of Deferred Compensation and Income from Stock Options: Issues for Employers and Nonresident Recipients

This article expands upon that earlier material by exploring ways in which the amount of income subject to tax under the new law may be determined.

Minnesota non-residents who receive certain types of deferred compensation (such as deferred compensation paid in a lump sum payment or in short-term installments) or income from nonqualified stock options in connection with their employment in Minnesota may be subject to state tax on those payments. This change in law is effective for payments made on or after January 1, 2008. Therefore, former Minnesota residents who were previously protected from Minnesota tax may be required to file Minnesota personal income tax returns for 2008 and the years that follow.

Although this new legislation clearly requires affected non-residents to pay Minnesota income tax on certain deferred wage income, it does not explicitly address how to determine the amount of that income that is subject to Minnesota tax. Current law provides only that the income is assigned to the state "if, and to the extent that, the work of the employee is performed within it."

This standard is easily applied where the income recipient performed services only in Minnesota. However, many income recipients will have performed services for their employers in a number of jurisdictions. In these cases, current law may not adequately address how to treat this income.

The Minnesota Department of Revenue has indicated that it will reissue Revenue Notice 96-21 to provide guidance on this issue. This revenue notice, prior to its repeal in 2001, specifically addressed the assignment of income that was recognized with respect to employer-provided stock options—both nonqualified and qualified.

Revenue Notice 96-21 provides that the Minnesota source income recognized on the exercise of a nonqualified option is determined by looking at the ratio of the days that the former resident worked in Minnesota during the employment contract period in which the option was granted to the total days worked under the contract. With respect to incentive stock options, the same rule is applied to the lesser of the gain recognized on the sale of the stock or the amount which would have been recognized upon the exercise of the option. ¹

While this notice did not address other deferred-compensation arrangements, personnel at the Revenue Department have indicated the same method will be applied for these arrangements.

The position taken by the Revenue Department in Revenue Notice 96-21 may not reflect an appropriate method of allocation in every situation. For example, the deferred compensation may not be easily attributable to a certain "contract period" or may be properly attributable to only certain services provided in a "contract period."

This approach may be particularly ill suited for certain performance pay arrangements, restricted stock grant programs and similar arrangements where the compensation might not be deemed earned or vested until certain contingencies occur. This raises the question of whether residency status on the date of those events is more significant than the proportion of time worked in Minnesota during some "contract period."

Issues may also arise relating to the length of the contract period and the proportion of time worked in Minnesota under the contract. Given these uncertainties, the Revenue Department's method could overstate or understate the Minnesota share of taxable deferred compensation, and it may be reasonable for taxpayers to use a different method on their returns.

Nonresidents may have to file Minnesota estimated tax returns for 2008 with respect to their Minnesota source income from deferred compensation and specified stock options. Employers will have to begin withholding on such income with respect to income paid after April 1, 2008.

While the Revenue Department has indicated it may support legislation that would delay an employer's obligation to withhold until January 1, 2009, there is no certainty that such legislation will be passed. Thus, both employers and employees may need to report these payments during 2008.

Whenever withholding begins, it will generally be treated as supplemental wage withholding under Minnesota law. Therefore, the withholding rate on these payments will ordinarily be 6.25 percent and will be in addition to any federal withholding that is required.

For more information

For questions about the impact of this Minnesota tax rule on your personal income tax returns—or its impact on your deferred compensation arrangements—please contact any attorney in our tax or employee benefits groups.

¹ Under current Minnesota law, income that is classified as "wages" is the only income of a non-resident that is subject to allocation to the state. Therefore, income recognized by a non-resident with respect to an ISO should not be subject to Minnesota tax unless the income is recognized on a disqualifying disposition.