Under a bill signed into law by Governor Pawlenty on Friday, March 7, Minnesota has altered its method of taxing former residents of the state who receive various types of deferred compensation for services that were rendered as employees in Minnesota. The amendment will cause nonresidents to be subject to Minnesota tax in circumstances where they were not subject to tax previously, and will also require Minnesota employers to withhold Minnesota taxes on former employees who are now nonresidents of the state.
The amendment relates to amounts that constitute “wages” for Minnesota (and federal) income tax purposes. The most common categories of compensation in question include nonqualified deferred compensation, severance or salary continuation payments, and income that arises on exercise of nonqualified stock options. For convenience these categories of income will be referred to as “deferred compensation.”
Under prior law, if an individual performed services as an employee in Minnesota and later changed residency to another state, the employee was not taxable in Minnesota on deferred compensation attributable to services performed in Minnesota received after the change in residence, provided that the employee (1) was a resident of Minnesota while performing the services, and (2) was not a resident of Minnesota for any portion of the year in which he or she received the deferred compensation. Under the new law, which is effective for the 2008 taxable year of individuals, this exemption is eliminated. Instead, a nonresident of Minnesota will remain subject to tax in Minnesota on amounts that are attributable to services performed in Minnesota. Therefore, if an individual performed all of the services under an employment contract in Minnesota and later becomes a resident of another state and receives deferred compensation, all of the deferred compensation will be taxable in Minnesota.
The new law also provides that employers are required to withhold Minnesota income taxes on payments that will be subject to Minnesota tax under the new rule, but only with respect payments made after April 1, 2008.
The new law does not apply to payments that Minnesota is prohibited from taxing under the federal State Income Taxation of Pension Income Act (P.L. 104-95). The amounts covered by this federal law include any payment received under a qualified retirement plan and also a payment received under a nonqualified plan if the payment is part of a series of substantially equal periodic payments made not less frequently than annually for a period of not less than ten years, and a payment received under an “excess” plan that is maintained to provide employees benefits in excess of the limitations imposed by Internal Revenue Code Sections 401(a)17, 402(g) and 415 and certain other limitations. Thus, the change in Minnesota law will not affect deferred compensation paid to a former resident in equal payments over a ten-year period or the payment of “excess” plan benefits.
The fact that the new Minnesota law will generally tax nonqualified deferred compensation received by former residents that is earned for services performed in Minnesota may make the federal law protection for ten-year payouts of deferred compensation and “excess” plan benefits a more significant planning strategy for Minnesota tax purposes.
This amendment was only recently enacted and the Minnesota Department of Revenue has not yet provided guidance on the law. Nevertheless, given the effective date of the withholding requirement, employers should review existing payments to former residents and determine if they may now be subject to Minnesota tax and withholding. In addition, employers revising deferred compensation plans to comply with section 409A of the Internal Revenue Code or adopting new plans will want to consider this change in Minnesota law in designing their plans. If you have questions regarding the guidance, please contact the attorney with whom you work.
The law change is contained in Article 3, section 7 of Minnesota Laws, 2008, chapter 154.