If you want to cash in equity-compensation awards and are thinking about moving or retiring to a state with no personal income tax, such as Florida, better hurry: your window of opportunity to pull off the great escape may be closing.
State tax authorities generally have a clear right to tax deferred compensation earned in-state, regardless of a taxpayer’s current domicile. Historically, though, some states did not enforce that right as aggressively as they could have, says AmyLynn Flood, a partner in the human resource services practice at PricewaterhouseCoopers.
That has been changing over the past couple of years, with economic hard times having spurred states to redouble their revenue-generation efforts. In addition, more states continue to enact legislation specifying formulas for calculating the tax on equity-based compensation due them, which makes it easier to collect the tax. Such laws are new or pending in Arizona, Georgia, Illinois, Minnesota, Rhode Island, and Virginia. “The legislation is a testament to those states’ knowledge that they’ve been missing out on revenue,” says Flood.
There is longer-lived legislation in a number of other states, including California, Connecticut, Michigan, New Jersey, New York, Ohio, and Pennsylvania, that collectively comprises a large percentage of equity rewards earned by executives. But even in those states, some potential revenue was historically left on the table, says Flood.
For their part, state tax authorities generally decline to acknowledge as much. “The way the department audits, investigates, and collects taxes from individuals and businesses relating to treatment of stock options, restricted stock, and stock appreciation rights received by nonresidents and part-year residents has not changed,” says Susan Burns, a spokesperson for the New York State Department of Taxation and Finance.
Arthur Rosen, a tax partner at law firm McDermott Will & Emery and a former deputy counsel of New York’s tax department, characterizes the current level of enforcement activity as somewhere between the levels suggested by Flood and Burns. That there is a significant recent increase in states’ efforts to collect the equity-based revenue “is what everybody is saying,” he notes. “But while states are being a little tougher, it’s not at a whole new level.” He also says the incidence of executives moving to lower-taxed states in a bid to cash in awards at lower or no tax is “slightly increasing.”
Rosen adds, though, that states generally are becoming more open to hiring independent contractors to collect tax revenue from those who have moved out of state. That can increase the pressure on the executives.
For companies, the heightened scrutiny places more urgency on making sure to withhold from executives’ payouts at the applicable rate for any state that’s entitled to collect tax. An executive could simply pay taxes on the income, of course, but that might not save the company from having to pay interest and penalties if it does not fulfill a withholding obligation. “Our clients are having to go through a lot of state audit activity lately,” says Flood. Many third-party stock-plan administrators have pitched in by updating their systems to show the residential history of equity award winners.
But having to pay money to tax authorities is not the crux of the issue for employers, according to Rosen. “Even for a big company, those potential costs are not that great,” he says. “The problem with complying with the laws is the administrative burden.”
A large part of that burden derives from the fact that each state has its own formula for assessing revenue. In New York, for example, tax is assessed on an equity award’s change in value between the date of grant and the date of full vesting, while California compares the grant value with the value upon exercise of the award.
And regardless of whether they assess tax upon vesting or exercise, some states, such as Connecticut, arrive at the final tax bill by dividing days worked in the state from the time of grant to the taxable event by total workdays for that period. “For a person who has been with a company and is awarded deferred compensation over 20 or 30 years, figuring out exactly where that person was every day during that period is an almost impossible task,” says Rosen.
There is another type of cost for an employer as well: a reputational one. “It’s embarrassing to have to say you’re having an audit, or didn’t report correctly, and must get back into compliance,” says Flood.