Employees today are increasingly mobile and companies that grant equity or have deferred compensation programs are faced with complex withholding and reporting requirements in the various states. Employees who move between states before a taxable event occurs with respect to their equity or deferred compensation are often subject to tax in both their state of residence and states where they provided services, but no longer reside (i.e., states where they are considered a nonresident).
States have differing rules with respect to the taxation of nonresidents and as a result, mobile employees are often subjected to tax (and the employer has a withholding/reporting obligation) in more than one state. States also have different rules governing the ability of a resident to claim a tax credit for taxes paid in another state, which can result in mobile employees having additional tax liability.
In recent years, states have focused more energy on enforcing these rules and have increasingly been willing to litigate. These cases often arise on account of an employee moving to a state with lower or no income tax with the expectation of more favorable tax treatment.
While the decision in Allen (discussed below) focused on Connecticut’s ability to tax a former executive’s option income when he was a nonresident, it serves as a reminder to employers with mobile employees that they should closely consider the state tax and withholding issues related to deferred compensation and equity, including implementing procedures for withholding and reporting with respect to terminated employees who may subsequently relocate.
The Case Study
On June 5, 2017, the U.S. Supreme Court denied the petition of a former oil company executive (Executive) challenging the Connecticut Supreme Court’s decision that Connecticut may tax income from a nonresident’s exercise of stock options that were earned while performing services in Connecticut. See Allen v. Comm’r of Revenue Services, 324 Conn. 292 (Dec. 28, 2016), petition for review denied (June 5, 2017)).
In December 2016, the Connecticut Supreme Court held that the state had the power to tax all of the income derived from Executive’s exercise of nonqualified stock options earned while performing services in Connecticut. In summary, Executive received grants of nonqualified options for performing services solely in Connecticut for his employer. Executive moved out of Connecticut and exercised certain of the options he earned while performing services in Connecticut. Executive timely filed a state income tax return and paid applicable Connecticut taxes on the option income. Subsequently, Executive filed amended returns for the taxable years in question, claiming refunds for the Connecticut income tax that he had paid. Executive claimed that since he exercised the options after leaving Connecticut, no taxes were due to Connecticut and he was entitled to a refund for the taxes he paid.
The Executive’s argument for a refund was based, in part, on a perceived ambiguity in the statutory language that governed Connecticut’s tax treatment of nonqualified stock options. The applicable Connecticut statutory authority provides that option income is taxable by Connecticut if the optionee was performing services within Connecticut “during the period beginning with the first day of the taxable year of the optionee during which such option was granted and ending with the last day of the taxable year of the optionee during which such option was exercised”. The Executive claimed that the regulation requires a taxpayer to be performing services in Connecticut at the time of exercising the option as well as at the time the options were granted in order for the option income to be subject to Connecticut taxation.
The Court did not agree with Executive’s interpretation, concluding that the regulation was unambiguous as the reasonable construction of the word “during” meant “at some point in the course of” versus “throughout the continuance or course of”. Accordingly, the Court determined that, “if at any point during the taxable year in which the options were granted and the taxable year in which the options were exercised the taxpayer was performing services in Connecticut, the income derived from the exercise of the options would be includable in Connecticut adjusted gross income.” The Court also disagreed with Executive’s arguments that Connecticut’s taxation of his option income violated his due process rights under the federal constitution and that such income was not attributable to services performed in Connecticut, but rather to the appreciation of the stock underlying the options.
There have been recent pushes for a uniform multistate approach to withholding and reporting for mobile employees. However, until such an approach is actually implemented, in light of the various complex state rules, employers should continue to maintain comprehensive mobile employee guidelines to ensure compliance with applicable reporting and withholding obligations. The guidelines should also make it clear (and it should be communicated to employees) that withholding and reporting will be based on the information the employer has in its files at the time of the taxable event and that it is the employee’s obligation to notify the employer of any subsequent changes.