Pennsylvania Adopts Federal Treatment of Nonqualified Deferred Compensation Plans

As reported in a prior LawFlash, the Commonwealth Court of Pennsylvania, in Ignatz v. Commonwealth of Pennsylvania, 849 A.2d 308 (Pa. Commw. Ct. May 12, 2004), upheld assessments of Pennsylvania personal income tax on compensation deferred by employees to unfunded, nonqualified deferred compensation plans. According to the court, for Pennsylvania personal income tax purposes, elective deferrals of compensation by employees under nonqualified deferred compensation plans are currently taxable under the constructive receipt doctrine when such compensation is earned and vested, not when it is paid. The court’s decision was inconsistent with federal treatment of nonqualified deferred compensation.

However, on July 7, 2005, Governor Edward G. Rendell signed into law House Bill 176, which effectively reverses the court’s decision in Ignatz by adopting the federal constructive receipt rule for purposes of computing taxable income in Pennsylvania. Specifically, House Bill 176 revises the definition of “constructive receipt” to provide that compensation will be deemed received when such compensation is actually or constructively received for federal income tax purposes as determined by the rules and regulations under the Internal Revenue Code of 1986, as amended (the “Code”). House Bill 176 also incorporates sections 83, 451, 409A and 457 of the Code, as well as any subsequent revisions to these sections of the Code, in determining when deferred compensation is required to be included in an employee’s income. With respect to the treatment of elective deferrals of compensation into nonqualified deferred compensation plans, Pennsylvania law is now consistent with federal law. The transition to the new rules has the potential to pose problematic systems issues. For example, a Pennsylvania employer administering a nonqualified deferred compensation plan may have at least two “buckets” of benefits under the plan: untaxed amounts (either pre-Ignatz or post-House Bill 176) and taxed amounts (post-Ignatz but pre-House Bill 176).

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