Pennsylvania DOR Reverses Position Regarding Taxation of Deferred Compensation

On May 12, 2004, the Commonwealth Court of Pennsylvania held in the consolidated cases, Ignatz v. Commonwealth, and Peabody v. Commonwealth, that elective deferrals of compensation by employees under nonqualified deferred compensation plans are constructively received when the compensation is earned and vested, not when it is paid, for Pennsylvania personal income tax (PIT) purposes, and are subject to taxation and withholding on the same basis as elective contributions to qualified 401(k) plans. Those decisions are now pending en banc review by the Commonwealth Court, and will likely be appealed to the Supreme Court. The Peabody and Ignatz cases thereby held that the principles of income deferral and constructive receipt that apply for federal income tax purposes do not apply for Pennsylvania income tax purposes, in spite of the fact that the wording of the Commonwealth’s constructive receipt doctrine is virtually identical to the federal constructive receipt doctrine. Under federal tax law, as a general matter, if structured properly, deferred compensation under nonqualified deferred compensation plans is not subject to federal income tax until it is distributed to the participant. For discussions of recent federal law changes in this area, see Treasury Issues Guidance Implementing New Deferred Compensation Rules.

In response to the Ignatz and Peabody decisions, the Pennsylvania Department of Revenue (DOR) issued PIT Notice #112 on November 9, 2004 (revised on December 2, 2004), stating that withholding requirements for elective deferrals under nonqualified deferred compensation arrangements would become effective April 1, 2005, and that thereafter the DOR would begin auditing employer records to determine whether employers are withholding properly.

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