Indiana Ruling Addresses Taxation of a Nonresident’s Deferred Compensation

By: Betsy Goldstein, SALT Senior Manager

At a glance

• The main takeaway: While certain types of deferred compensation may be taxable only by the recipient’s state of residence, other types may be taxable in the state(s) in which the individual previously worked.
• Assess the impact: If you are moving to another state, it is important to consider the tax implications of any deferred compensation that you may receive in the future, as you could owe taxes on income to states you previously worked in.   
• Take the next step: Aprio’s State and Local Tax (SALT) team can help you understand your income tax obligations and minimize any risks of incurring unexpected liabilities or penalties.  

Schedule a free consultation today to learn more!

The full story:

Almost all employees, during their working careers, will voluntarily defer a portion of their earnings to a later date and/or their employers may offer compensation that by its terms is deferred to a later date. This is commonly referred to as “deferred compensation.” An example of the former is contributions to a pre-tax 401(k), and an example of the latter is the receipt of certain stock options that may not be exercisable until a future date.

For federal income tax purposes, deferred compensation typically results in the deferral of income tax due on that compensation. For state income tax purposes, depending on the type of deferred compensation and where the employee resides, it is possible that the state in which such compensation would have been taxed at the time it was deferred may not be the same state in which it is taxed once it actually becomes taxable income.

For example, consider an individual that lives and works in Georgia for 40 years and consistently makes contributions to a pre-tax 401(k) plan. Those contributions reduce the worker’s taxable income, and as a result, Georgia does not tax those amounts. After that 40-year career, the individual moves to Florida and begins to withdraw amounts from that 401(k) plan, at which point the income constitutes taxable income for federal and state income tax purposes.

Which state gets to tax that income?

It seems reasonable for Georgia to claim a right to tax that income, since the deferral arose from compensation earned in Georgia. However, due to a federal law, the correct answer is Florida (which doesn’t tax personal income) since it is the individual’s state of residence. That federal law prohibits states (other than an individual’s state of residence) from taxing certain “retirement income.”¹

What happens when an individual receives income from deferred compensation that is not qualified “retirement income” under that federal law? 

In that case, it may be necessary to analyze the rules in each state in which the individual performed services that gave rise to the deferred compensation. A recent ruling from the Indiana Department of Revenue addressed this issue in the context of an employee that recognized income from non-qualified stock options.

The taxpayer resided and worked in Indiana until February 2018, at which point the taxpayer left his current job, sold his Indiana home, and relocated to another state where he started a job with a new employer. The taxpayer and his wife established residency in their new state. While employed with an Indiana employer, the taxpayer was granted non-qualified stock options in 2013, 2016, and 2017.² During 2021, the taxpayer exercised the non-qualified options and received payment for the increased value of the stock over the option price. The taxpayer received W-2 compensation in 2021 for this income and the Indiana employer withheld Indiana taxes on the compensation.

The taxpayer filed a nonresident Indiana return in 2021 and requested a refund for the income tax withheld by the Indiana employer, claiming that he was not an Indiana resident in 2021 and that he did not work in Indiana during 2021. Therefore, income should not have been subject to Indiana income tax.

The Department of Revenue (Department) disagreed and denied the refund request. The Department explained that nonresidents are subject to Indiana income tax on “compensation for labor or services rendered within the state.”³ The income received for exercising the non-qualified stock options is considered deferred revenue or compensation. Per Indiana’s regulation, “deferred compensation, other than that from [certain qualifying retirement income], is directly attributable to services performed, and is taxed by the state where the services were performed.”⁴

Even though the taxpayer was no longer employed or a resident of Indiana, the income received upon exercising the non-qualified stock options is deferred compensation which was granted based on services rendered in Indiana during 2013, 2016, and 2017. The non-qualified stock options would not have been granted but for those services provided.

The bottom line

If you are moving to another state, whether for retirement to a state with no income taxes or for a new job, it is important to consider the tax implications of any deferred compensation that you may receive in the future, as you may owe taxes on such income to states in which you previously worked. 

Aprio’s SALT team has experience with these issues, and we can assist you to ensure that you minimize any risks of incurring unexpected liabilities or penalties. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

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¹ See 4 U.S.C. § 114.  That law list 9 types of qualifying “retirement income” including income from 401(k) plans, IRAs, and certain pension plans.

² Non-qualified stock options are not considered qualifying “retirement income” under 4 U.S.C. § 114.

³ Ind. Code 6-3-2-2(a)(4)

⁴ 45 IAC 3.1-1-7(3).