<DOC>
[109th Congress House Hearings]
[From the U.S. Government Printing Office via GPO Access]
[DOCID: f:24986.wais]
TO AMEND TITLE 4 OF THE UNITED STATES CODE TO CLARIFY THE TREATMENT OF
SELF-EMPLOYMENT FOR PURPOSES OF THE LIMITATION ON STATE TAXATION OF
RETIREMENT INCOME
=======================================================================
deg.HEARING
BEFORE THE
SUBCOMMITTEE ON
COMMERCIAL AND ADMINISTRATIVE LAW
OF THE
COMMITTEE ON THE JUDICIARY
HOUSE OF REPRESENTATIVES
ONE HUNDRED NINTH CONGRESS
FIRST SESSION
ON
H.R. 4019
__________
DECEMBER 13, 2005
__________
Serial No. 109-72
__________
Printed for the use of the Committee on the Judiciary
Available via the World Wide Web: http://judiciary.house.gov
______
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COMMITTEE ON THE JUDICIARY
F. JAMES SENSENBRENNER, Jr., Wisconsin, Chairman
HENRY J. HYDE, Illinois JOHN CONYERS, Jr., Michigan
HOWARD COBLE, North Carolina HOWARD L. BERMAN, California
LAMAR SMITH, Texas RICK BOUCHER, Virginia
ELTON GALLEGLY, California JERROLD NADLER, New York
BOB GOODLATTE, Virginia ROBERT C. SCOTT, Virginia
STEVE CHABOT, Ohio MELVIN L. WATT, North Carolina
DANIEL E. LUNGREN, California ZOE LOFGREN, California
WILLIAM L. JENKINS, Tennessee SHEILA JACKSON LEE, Texas
CHRIS CANNON, Utah MAXINE WATERS, California
SPENCER BACHUS, Alabama MARTIN T. MEEHAN, Massachusetts
BOB INGLIS, South Carolina WILLIAM D. DELAHUNT, Massachusetts
JOHN N. HOSTETTLER, Indiana ROBERT WEXLER, Florida
MARK GREEN, Wisconsin ANTHONY D. WEINER, New York
RIC KELLER, Florida ADAM B. SCHIFF, California
DARRELL ISSA, California LINDA T. SANCHEZ, California
JEFF FLAKE, Arizona CHRIS VAN HOLLEN, Maryland
MIKE PENCE, Indiana DEBBIE WASSERMAN SCHULTZ, Florida
J. RANDY FORBES, Virginia
STEVE KING, Iowa
TOM FEENEY, Florida
TRENT FRANKS, Arizona
LOUIE GOHMERT, Texas
Philip G. Kiko, Chief of Staff-General Counsel
Perry H. Apelbaum, Minority Chief Counsel
------
Subcommittee on Commercial and Administrative Law
CHRIS CANNON, Utah Chairman
HOWARD COBLE, North Carolina MELVIN L. WATT, North Carolina
TRENT FRANKS, Arizona WILLIAM D. DELAHUNT, Massachusetts
STEVE CHABOT, Ohio CHRIS VAN HOLLEN, Maryland
MARK GREEN, Wisconsin JERROLD NADLER, New York
RANDY J. FORBES, Virginia DEBBIE WASSERMAN SCHULTZ, Florida
LOUIE GOHMERT, Texas
Raymond V. Smietanka, Chief Counsel
Susan A. Jensen, Counsel
Mike Lenn, Full Committee Counsel
Brenda Hankins, Counsel
Stephanie Moore, Minority Counsel
C O N T E N T S
----------
DECEMBER 13, 2005
OPENING STATEMENT
Page
The Honorable Chris Cannon, a Representative in Congress from the
State of Utah, and Chairman, Subcommittee on Commercial and
Administrative Law............................................. 1
The Honorable Melvin L. Watt, a Representative in Congress from
the State of North Carolina, and Ranking Member, Subcommittee
on Commercial and Administrative Law........................... 2
WITNESSES
The Honorable George W. Gekas, former United States
Representative, former Chairman of the Subcommittee on
Commercial and Administrative Law, Committee on the Judiciary
Oral Testimony................................................. 3
Prepared Statement............................................. 4
Mr. Lawrence F. Portnoy, LLP, retired partner,
PricewaterhouseCoopers
Oral Testimony................................................. 6
Prepared Statement............................................. 8
Mr. Harley T. Duncan, Executive Director, Federation of Tax
Administrators
Oral Testimony................................................. 12
Prepared Statement............................................. 14
Mr. Stanley R. Arnold, CPA, former Commissioner of New
Hampshire's Department of Revenue Administration and former
President of the Federation of Tax Administrators
Oral Testimony................................................. 18
Prepared Statement............................................. 19
APPENDIX
Material Submitted for the Hearing Record
Biography of the Honorable George W. Gekas, former United States
Representative, former Chairman of the Subcommittee on
Commercial and Administrative Law, Committee on the Judiciary.. 25
Biography of Lawrence F. Portnoy, LLP, retired partner,
PricewaterhouseCoopers......................................... 26
Biography of Harley T. Duncan, Executive Director, Federation of
Tax Administrators............................................. 27
Biography of Stanley R. Arnold, CPA, former Commissioner of New
Hampshire's Department of Revenue Administration and former
President of the Federation of Tax Administrators.............. 29
TO AMEND TITLE 4 OF THE UNITED STATES CODE TO CLARIFY THE TREATMENT OF
SELF-EMPLOYMENT FOR PURPOSES OF THE LIMITATION ON STATE TAXATION OF
RETIREMENT INCOME
----------
TUESDAY, DECEMBER 13, 2005
House of Representatives,
Subcommittee on Commercial
and Administrative Law,
Committee on the Judiciary,
Washington, DC.
The Subcommittee met, pursuant to notice, at 4:04 p.m., in
Room 2141, Rayburn House Office Building, the Honorable Chris
Cannon [Chairman of the Subcommittee] presiding.
Mr. Cannon. This hearing of the Subcommittee on Commercial
and Administrative Law will now come to order.
Today we will consider H.R. 4019, a bill I introduced
earlier this year to clarify the treatment of self-employment
in regard to the taxation of retirement income and, to ensure
fairness across the board for all retirees. This bill is
intended to place all retirees on equal footing regarding the
taxation of their retirement benefits, whether they worked for
a company as an employee, were self-employed or were a partner
prior to retirement.
In the 104th Congress this Subcommittee passed the Senate
Taxation of Pension Income Act of 1995, which subsequently
became Public Law 104-95. The purpose of this act was to
prohibit the State taxation of certain retirement income of
nonresidents. The act did not allow all retirement income to be
removed from taxation by a State where the retirees were no
longer residents. It specifically set certain standards under
which a retiree's income could not be taxed by State where that
person was no longer living.
No matter how clear and precise Congress thought it was
when it originally passed the bill to prevent States from
taxing the retirement incomes of retirees who no longer live in
those States, it seems that the language and principle in
Public Law 104-95 is being circumvented, or at least an attempt
is being made.
Congress made it so very clear in 1995 in determining that
States should not tax the retirement income of people who are
not in the State. The determination was regarding all retirees.
This bill is not trying to change the intent of the original
law or increase the bounds. It is to make sure that, as it
should be, all retirees are treated the same, regardless of
whether they worked for someone else or themselves prior to
retirement.
The bill clarifies that Public Law 104-95 was intended to
cover all retirees with regard to the described plans,
specifically the non-qualified types of plans and the
restrictions in it.
I look forward to the testimony of the panel.
Without objection, the Chair will be authorized to declare
recesses of the hearing at any point.
Hearing none, so ordered.
I further ask unanimous consent that Members have 5
legislative days to submit written statements and statements by
interested parties for inclusion in today's record.
I now yield to Mr. Watt, the Ranking Member of the
Subcommittee, for an opening statement.
Mr. Watt. Thank you, Mr. Chairman. And thank you for
convening the hearing so that we can get some clarification
about what we may be doing subsequently in the markup.
This bill amends, as I understand it, Public Law 104-95, to
which some of us objected when it came before the Committee in
1996.
A review of the record from 1996 indicates that at that
time I, along with several of my colleagues, including Ranking
Member Conyers, had three principal concerns about the bill:
that it failed exclude non-qualified deferred compensation
plan; that it failed to impose a monetary cap on exempting
funds; and that it was not made subject to the Unfunded Mandate
Reform Act.
These concerns have really not gone away and were this a
new bill that presented the same issues that were presented by
Public Law 104-95 that we were marking up in 1996, no doubt
we'd probably be having the same debate with the same concerns
being raised.
As I understand H.R. 4019, however, we do not today revisit
the policy choices implemented by the underlying bill. Instead,
H.R. 4019 represents a technical correction designed to preempt
at least one State from implementing an interpretation that's
clearly at odds with the intent of the original bill, and one
which would create a situation under which a specific group of
retirees--that is partners and principals--would be treated
differently from all other groups of retirees.
I will be interested in hearing Mr. Duncan's testimony
since he suggests that bill may be more than simply a technical
correction. So I'll be listening carefully to what he has to
say about that.
However, if H.R. 4019 is truly only a technical correction,
I see no reason to oppose it. In addition, even if the bill
does not--does more than merely clarify the original intent of
the underlying law, there is nonetheless some basis upon which
to support it. And that is presumably most States have, over
the nearly 10 years since the law first passed, structured or
enforced their tax systems in accordance with the law and
they've made the necessary adjustments to this bill already.
Absent a persuasive objection from the States, therefore I
see no reason to deviate from that policy because one State
revenue department has found a potential loophole in the
original language.
I'll listen intently to the testimony, particularly Mr.
Duncan's testimony, and look forward to the hearing and perhaps
look forward to the subsequent markup.
Mr. Cannon. The gentleman yields back.
Mr. Watt. I yield back.
Mr. Cannon. Thank you.
I'm going to dispense, just to meet the needs of a couple
of our Members, I'm going to dispense with introductions if you
don't mind. We'll include those for the record and we'll just
go right directly to your testimony.
[The information referred to is available in the Appendix.]
So Mr. Gekas, would you honor us with your testimony?
Welcome back before--I feel really awkward sitting up here with
the chairman sitting at the table.
Mr. Watt. Mr. Chairman, I'm almost constraint to introduce
the Honorable George Gekas myself, just to give him an adequate
introduction. But I'll restrain myself.
Mr. Cannon. A man who otherwise needs no introduction and
who used to chair this Committee. We appreciate your coming
back Mr. Gekas, and look forward to your testimony.
STATEMENT OF THE HONORABLE GEORGE W. GEKAS, FORMER UNITED
STATES REPRESENTATIVE, FORMER CHAIRMAN OF THE SUBCOMMITTEE ON
COMMERCIAL AND ADMINISTRATIVE LAW, COMMITTEE ON THE JUDICIARY
Mr. Gekas. Thank you, Mr. Chairman, Mr. Watt----
Mr. Cannon. Your microphone, please. First time on that
side of the table.
Mr. Gekas. I'm so nervous.
In conjunction with the Chair's first offering, I'm going
to offer this historic document as my written statement in this
hearing for the record and proceed to outline some of the
issues that already have been touched upon by both the Chair
and Mr. Watt.
My sole purpose in being here today is to testify to the
legislative intent upon which you've both touched. And that
legislative intent was so clear from the beginning that I was
astounded when, very recently, I was called and asked if I
would testify here as to that very same intent because the
State of New York, I had learned, was eager to jump on what
they considered to be a loophole for the purpose of reaching
beyond its borders to attach a taxation vehicle.
This first came to light, as some of you will remember--I
remembered it very well--when Barbara Vucanovich, then
Congresswoman Vucanovich, came to my office to explain that
she, as a representative of our Congressional District in
Nevada, was concerned, very concerned, about the great number
of retirees who came to Nevada from the State of California,
came to Nevada to establish permanent residence and then were
affronted by the fact that California was reaching across the
borders to tax their retirement income.
Well, that one thing led to another. I, too, was mortified
at that because what it had done was to rear the ugly head of
double taxation, which was one of the first fears that I
uncovered as a legislator, both in the Pennsylvania Legislature
and in Congress.
And indeed, this is a subject matter that arose in the
context of double taxation, and therefore, Barbara's persuasion
led to eventually the enactment of the--of the law which we're
discussing here today.
The pure legislative intent was to honor all retirees in
all States and to keep them safe from the taxation of a
neighboring or any State in the Union in reaching to their
retirement income, now in their new retired residential status
in another State. That is clear to me. I don't see how it can
be argued any other way.
Something that Mr. Watt mentioned also brings to mind that
one of the chief proofs that we have about the intent to--not
to exclude partners but to include partners in the whole
context of retirees, was the fact that the opponents, those who
voted against it back then, somewhere along the line in their
documents, perhaps in the minority report, referred to the
ugliness that would occur if that bill--if our bill would be
passed, because you could see partners doing bailout contracts
with their employers or their former bosses or colleagues. The
very fact that they mentioned as a possibility means that
they--that partners fit into the type of retiree that should be
free from this taxation.
And so I'm eager to have your record indicate that when we
enacted this legislation there was no doubt about the inclusion
of partners.
As a matter of fact, we never dreamed at that time, except
for that one reference in the minority report which came about
after the hearings and after the deliberations and after the
final vote, et cetera, that partners would be excluded. You'd
have to search deeply--not search, but rather embed some kind
of thoughts into the general language to bring about an
exclusion for partners.
So with all of that, I am gratified that we have, joining
me on this panel, experts in this whole field on all sides of
the issue and I'm urging them not to contradict me at all. And
if they do, they will find that I will not be here. I have to
leave immediately.
With that, I yield the balance of my non-time and wish you
all well. And as I'm wafting out of here, I hope to hear some
lingering--shall I say--endorsement of my statement.
Thank you very much.
[The prepared statement of Mr. Gekas follows:]
Prepared Statement of the Honorable George Gekas
Mr. Chairman, Congressman Watt and distinguished Members of the
Subcommittee:
Thank you for the opportunity to testify on H.R. 4019, a bill that
would make it clear that existing federal law prohibits States from
taxing the retirement income of any non-residents retirees. Congress
needs to take action quickly to prevent States from undermining the
common-sense legislation that was enacted in 1996 to prevent unfair and
burdensome taxation. I commend you, Mr. Chairman, for introducing H.R.
4019 and for holding this hearing.
I understand that at least one large State is attempting to exploit
an ambiguity in the 1996 law to argue that some non-resident retirees,
namely non-resident retired partners, are not covered by the current-
law prohibition on State taxation of non-resident retirees. As Chairman
of the Subcommittee on Commercial and Administrative Law when Congress
originally considered this issue, I can tell you this is simply not the
case. The purpose of my testimony today is to provide some legislative
background and history that will make this abundantly clear.
This issue first arose in the 1990s because some States, such
California and New York, were imposing an income tax on retirement
income of retired, non-resident individuals who worked in those States
for part or all of their careers. At the time, several other States
were discussing so-called ``State source'' taxes. There was no question
that States had the Constitutional authority to impose such taxes, but
Congress intervened because of the risks of double taxation and the
complexity of multi-state compliance.
Largely due to the efforts of Congresswoman Barbara Vucanovich of
Nevada, Congress ultimately passed the State Taxation of Pension Income
Act of 1995 (Public Law 104-95). Public Law 104-95 is very
straightforward. It provides that a State may not tax the retirement
income of non-residents. The definition of retirement income includes
income from a qualified retirement or annuity plan, such as an IRA or
401(k) plan, and income from a nonqualified deferred compensation plan.
As Congresswoman Vucanovich noted when she introduced the legislation,
it was purposefully designed to apply to all retirement income in order
to be fair and treat all retirees equally.\1\
---------------------------------------------------------------------------
\1\ Congressional Record, Extension of Remarks, January 5, 1995, p.
E42.
---------------------------------------------------------------------------
Although I believe that current law prohibits any State taxation of
non-resident retirement income, I also understand that at least one
State is arguing that there is a ``loophole'' in the statute that
allows them to tax some non-resident retirees and not others, simply
because they are non-resident retired partners rather than non-resident
retired employees. I disagree. Therefore, it is important that Congress
remove any doubt by enacting H.R. 4019. Otherwise, certain non-resident
retirees could face costly litigation to fight aggressive taxation by
some States--a fight retirees would clearly win in court. In addition,
if Congress does not act now, this issue could develop into a
significant problem with other States.
The issue we are considering today stems from the definition of
nonqualified deferred compensation plan contained in Public Law 104-95.
When the decision was made during the legislative process to include
nonqualified retirement plans, we referred to the definition of
``nonqualified deferred compensation plan'' found in the employment
tax. At least one State has used this reference to argue that Public
Law 104-95 only applies to nonqualified deferred compensation received
by retired, non-resident employees and does not protect retired, non-
resident partners. In reality, we used the reference to employment tax
because, unlike qualified retirement plans, there is no reference to
nonqualified retirement plans in the income tax code. The employment
tax reference was meant to serve as a general, non-technical
description of nonqualified deferred compensation plans. Had we fully
understood the potential tax implications of including a FICA tax
reference, we most certainly would have drafted the legislation
differently.
Congress never intended to arbitrarily carve out certain groups of
individuals from the protection of Public Law 104-95 even though the
retirement income that they receive is in all other respects identical
to the retirement income received by individuals enjoying the
protection of Public Law 104-95. For example, Congress never intended
to prohibit source State taxation of nonqualified retirement income of
all employees, including highly compensated executives, but not of
self-employed individuals, such as partners. Moreover, Congress never
intended for self-employed retirees to receive protection from source
State taxation on their qualified retirement income (which Public Law
104-95 clearly covers) but not their nonqualified retirement income,
while highly compensated executive retirees enjoy protection under
Public Law 104-95 with regard to both types of retirement income. It is
also difficult to see any policy reason for such a distinction.
In fact, Members of Congress who opposed Public Law 104-95 clearly
believed the statute would apply to partners. The Dissenting Views
section of the Committee report complains that ``[b]y including
nonqualified plans in the legislation, Congress will open broad new
loopholes for lucrative compensation arrangements, such as golden
parachutes, partnership buy-outs, and large severance packages.'' \2\
---------------------------------------------------------------------------
\2\ H. Rep. No. 104-389 at 16.
---------------------------------------------------------------------------
I believe it is clear from the statutory language, legislative
history and purpose of the statute that Public Law 104-95 protects all
non-resident retirees, regardless of whether they are a retired
employee or a retired partner. However, because at least one large
State is unwilling to recognize this, I strongly support enactment of
H.R. 4019, which would shut down any possibility that States might be
able to unfairly tax the retirement income of certain non-resident
retirees, effective as of the date of enactment of Public Law 104-95
because it is consistent with Congressional intent.
Thank you again for the opportunity to testify today. I would be
happy to answer any questions you may have.
Mr. Cannon. If you leave quickly, I think Mr. Portnoy is
probably going to be very supportive of your statement.
Thank you for being here. And just for everyone's
recollection, you were the Chairman at the time this bill was
passed.
Mr. Gekas. That's correct.
Mr. Cannon. You chaired this Committee. And so we
appreciate your expertise and your knowledge on the subject.
I recognize----
Mr. Watt. Mr. Chairman, can I just thank the gentleman for
being here?
Mr. Cannon. Certainly.
Mr. Watt. George was always one of my favorite people to
get into debates with. But he's a great guy and no doubt when
he leaves we're going to hear sleigh bells ring. That's what
we're likely to hear.
Mr. Gekas. Bill, glad to see you.
Mr. Delahunt. Good to see you, George, and welcome back. I
would echo all of the kudos and sentiments that were expressed
by Mr. Watt.
I haven't read the bill yet, but I am sure I'll support it
with vigor, if you leave now.
Mr. Gekas. Thank you very much.
Mr. Cannon. Thank you, George.
Mr. Portnoy, I will recognize you for 5 minutes and feel
free to summarize your testimony because we do have your
written record in the record. Thank you very much.
STATEMENT OF LAWRENCE F. PORTNOY, LLP, RETIRED PARTNER,
PRICEWATERHOUSECOOPERS
Mr. Portnoy. Thank you, Mr. Chairman.
I'm Lawrence Portnoy, a retired partner of
PricewaterhouseCoopers, LLP. From 1992 until my retirement in
2001, I served as the tax matters partner for my firm. During
this period, among other things, I supervised the firm's
implementation of the procedure to account for income earned by
staff working in nonresident States, withholding and reporting
procedures, preparation of the resident tax returns for staff
claiming credit for tax paid to the nonresident States, and
calculating any amounts to be paid by the firm to those staff
to assure that their total tax cost was no greater than if they
did not work temporarily in a nonresident State.
For example, if you send someone out of town to work on a
job for 6 months, and because of that he's got an incremental
tax cost, this was a process to take care of all of that and to
make that person whole.
As a result of my work in this area, I'm very familiar with
the laws regarding the taxation, both federally and at the
State level, of individuals and other taxable entities. In this
regard, I wish to express my concerns with the States'
misinterpretation in the State Taxation and Pension Act of
1995, P.L. 104-95, often referred to as H.R. 394.
The purpose behind passage of the act was simple, to
prohibit State taxation of certain pension income by States in
which the recipient was neither resident nor domiciled at the
time of receipt.
According to the December 7, 1995 report of the Committee
on the Judiciary of the House of Representatives, the bill was
needed because the system permitting both the individual State
of residence and the States in which the individual had
previously earned income to tax that retirement income would
produce a burden on retirees that would ``be, all too often,
simply unreasonable.''
The act defines retirement income broadly. The reason for
exempting income from both qualified and nonqualified plans was
best expressed by Representative Vucanovich during the hearing
before the Subcommittee on Commercial and Administrative Law of
the Committee on the Judiciary in June 1995. She stated that
``it is a question of fairness to make the law apply equally to
all retirees.''
I would particularly like to point out that after the
enactment of P.L. 104-95, all of the States respected the
exemption of nonqualified deferred compensation, as defined in
the act, from nonresident taxation to all retirees,
irrespective of whether he or she was formerly an employee or a
self-employed individual.
This was the case until the past year or so. Now the
question of whether the law applies equally to all retirees is
being questioned by one State. And there's no doubt that other
States will follow. This State is asserting that the exemption
does not apply to retired partners, only to retired employees.
Any disparity in the treatment of retired partners would raise
a major issue with regard to fairness in that, unlike
employees, partners of large accounting and law firms pay tax
in as many as 30 or more States because that's where the
partnerships did business rather than where the individual
partner performed services. These partners did not reside in
these States where they paid tax and, in many instances,
performed no services in the vast majority of these States.
They were taxed under State partnership rules and received no
benefits from the State either as a resident or as an income
earner.
Congress clearly understood the issue of burden, which is
one of the major reasons for the original legislation. And the
same burden applies to retired partners as well. And, in fact,
the burden is even greater on retired partners than it is on
retired employees. As a result of the original legislation,
retired partners correctly concluded that they were covered by
P.L. 104-95 and thus, did not file any returns outside their
State of residence.
It's been 10 years since P.L. 104-95 has been enacted and,
up until last year, the States agreed with that position. If
the States were now to adopt a different position, the States
could require nonresident returns to be filed for all prior
years with the payment of tax and interest.
Let me emphasize that the burden on retired partners also
involves determining how much of their income is taxable by a
particular nonresident State. We could easily be looking at 30
or more States for which data would have to be gathered and the
proper formula applied. This is precisely the type of burden--
--
Mr. Cannon. Mr. Portnoy, could I just ask how much more do
you have left in your testimony?
Mr. Portnoy. Quarter of a page.
Mr. Cannon. Go ahead.
Mr. Portnoy. Sorry.
This is precisely the type of burden the act was designed
to avoid. This bill clarifies P.L. 104-95 by specifically
stating that retired partners are included. The bill further
clarifies the type of income Congress intended to cover because
one State is trying to tax certain types of nonqualified
retirement income. These changes are intended to provide
clarity and precision to the types of income intended to be
covered.
Most importantly, since it is a clarification of existing
law rather than a change in the law, H.R. 4019 will be
effective as of the date that P.L. 104-95 was effective. With
the passage of H.R. 4019, Congress will have assured that the
problems that necessitated the enactment of P.L. 104-95 are
solved for all retirees.
Thank you for your time and consideration of this important
issue.
[The prepared statement of Mr. Portnoy follows:]
Prepared Statement of Lawrence F. Portnoy
Mr. Chairman, Congressman Watt and distinguished Members of the
Subcommittee: Thank you for the opportunity to testify on H.R. 4019.
I am Lawrence Portnoy, a retired partner of PricewaterhouseCoopers,
LLP. I joined the tax department of Price Waterhouse (now
PricewaterhouseCoopers) in 1964 and was admitted to the partnership in
1975.
During my years with the firm I served as a tax consultant for many
large multinational clients and later was responsible for representing
clients before the National Office of the Internal Revenue Service on
accounting method change requests, accounting period change requests,
ruling requests and requests for technical advice. I represented the
firm when making comments to IRS and Treasury Department on proposed
regulations.
From 1992 until my retirement in 2001 I served as Tax Matters
Partner and Senior Tax Technical Partner. This involved setting policy
for the firm on major client tax matters and having responsibility for
planning and compliance (the filing of all required tax returns) for
the firm's federal, state, local, and international tax matters. During
this period I supervised the firm's implementation of the procedure to
account for income earned by staff in nonresident states, withholding
and reporting procedures, preparation of resident tax returns for staff
claiming credit for tax paid to nonresident states, and calculating any
amounts to be paid by the firm to staff to assure that their tax cost
is no greater than if they did not work temporarily in nonresident
states.
As a result of my work in this area, I am very familiar with the
laws regarding the taxation, both federally and at the state level, of
individuals and other taxable entities. In this regard, I wish to
express my concerns with the misunderstanding in the State Taxation of
Pension Income Act of 1995, (P.L. 104-95), often referred to as HR 394.
The purpose behind passage of the Act was simple: to prohibit state
taxation of certain pension income by states in which the recipient was
neither resident nor domiciled at the time of receipt. According to the
December 7, 1995 Report of the Committee on the Judiciary of the House
of Representatives, the bill was needed because a system permitting
both the individual's state of residence and the states in which the
individual had previously earned income to tax retirement income, would
produce a burden on retirees that would be ``all too often simply
unreasonable.''
The Act defines retirement income broadly and exempts all income
from ``qualified'' pension plans as defined in the Internal Revenue
Code, as well as income received under deferred compensation plans that
are ``non-qualified'' retirement plans under the Code, but that meet
additional requirements. While HR 394 as originally proposed did not
exempt income from non-qualified plans, it was amended prior to passage
to add the exemption (with certain caveats) to distributions from such
non-qualified plans. The reason for including income from non-qualified
plans was best expressed by Representative Vucanovich during the
Hearing before the Subcommittee on Commercial and Administrative Law of
the Committee on the Judiciary in June of 1995. She stated that ``it is
a question of fairness to make the law apply equally to all retirees.''
After the enactment of HR 394, all of the states respected the
exemption of non-qualified deferred compensation (as defined under the
Act) from nonresident taxation to all retirees, irrespective of whether
he/she was formerly an employee or a self-employed individual-until the
past year or so. Now, the question of whether the law applies equally
to all retirees is being questioned by the states, ``unreasonable''
burdens are surfacing, and double taxation of such income is again
likely. The major factor accounting for the lack of equal application
is that some states are asserting that the exemption does not apply to
retired partners, only to retired employees. These states are also
asserting that, even if retired partners are eligible for the exemption
from nonresident taxation, an additional requirement applies to non-
qualified deferred compensation received by them. Specifically, they
assert that, if a partnership plan has a formulary cap or a provision
for a cost of living adjustment, it does not qualify for the exemption,
since the payments do not meet the Act's definition of ``substantially
equal periodic payments.''
Why do we now have a problem? While the law was intended to apply
to all retirees, due to what I believe is a misreading of the section
of HR 394 exempting non-qualified plan benefits only where such
benefits are paid pursuant to Section 3121 (v)(2)(C) of the Internal
Revenue Code, some state taxing authorities maintain that the exemption
is only available to employees. This section is a part of the Code
relating to the Social Security and Medicare tax payments that
employers and employees make under FICA. Partners, as self-employed
individuals, make their payments of Social Security and Medicare taxes
under a different section of the Code. However, nowhere does HR 394 use
the word ``employee.'' All references are to individuals and a
reasonable interpretation would be that the reference to Section 3121
(v)(2)(C) was meant only to generally describe the type of non-
qualified plan subject to the exemption - not to restrict the exemption
to employees and allow the taxation of those who were self-employed.
This disparity in the treatment of retired partners raises a major
issue with regard to ``fairness'' in that, unlike employees, partners
of large accounting and law firms paid tax in as many as thirty or more
states because that is where the partnership did business rather than
where the individual performed services. These partners did not reside
in these states and, in many instances, performed no services in the
vast majority of these states. They were taxed under state partnership
rules and received no benefits from the states either as residents or
as income earners. In most cases, the partnership filed both a
partnership return and a composite return that included all partners
who elected to be part of the return. The firm determined the income
allocable to the state based on the firm's federal taxable income and
the specific state apportionment formula. That total was then allocated
to each partner. The composite return was filed for non-resident
partners in lieu of individual returns filed by each nonresident
partner and was based on the partner's distributive share of the firm's
income earned in the state - whether the individual partner had worked
in the state or had never stepped foot in it. In contrast, employees
generally worked in only a few states during their active careers and
actually earned income in such states and enjoyed the benefits as
income earners in the states.
With regard to the issue of burden, it is clear that a system that
would require retired partners, particularly those who were members of
large partnerships, to determine how much of their income was taxable
in every state in which the partnership earned income is difficult at
best, impossible at worst. Add to this the fact that most retired
partners reasonably believed that they were covered by HR 394 and never
filed returns outside of their state of residence. These retired
partners have no statute of limitations protection. It is ten years
since HR 394 was enacted, and states could require nonresident returns
to be filed for all prior years, creating a substantial compliance
burden in terms of tax and interest, and the cost of preparing
nonresident tax returns. The statute of limitations trap is exacerbated
by the fact that retired partners who reside in a state that imposes an
income tax can only claim a refund for nonresident taxes paid within
the resident state's statute of limitations, generally three years.
Nonresident taxes that are assessed outside of this period will provide
no resident state tax relief, resulting in double taxation for the
entire amount of nonresident tax assessed. This is a burden that had
not even been contemplated when the law was passed.
Another burden involves determining how much of the retired
partner's pension income is allocable to a particular state. One state
is presently considering employing two alternative methods, depending
on whether the retired partner's interest in the partnership is totally
liquidated. If the interest is not totally liquidated, then the state
intends to allocate the retirement income by the allocation percentage
of the partnership itself for the current year. If the interest is
liquidated, then the amount allocated to the state is based on where
the partner performed his or her services prior to retirement, using
the ratio derived from dividing the number of days services were
performed in the state during the portion of the retirement year plus
the prior three years, by the total number of days services were
performed everywhere during the same period.
Neither of these methods is reasonable. In the first instance,
since the retired partner performed no work for the partnership during
the taxable year, how can the partnership's allocation percentage be
relevant? Under the second method the problem of finding and defending
the number of days worked years in the past is virtually an
insurmountable burden. Worst of all, each state that determines that
partners are not exempt individuals may devise its own allocation
formula. We could easily be looking at 30 or more states for which data
would have to be gathered and the proper formula applied. This is
precisely the type of burden the Act was designed to avoid.
As to double taxation, it is clear that retired partners who may
have earned income in as many as thirty states during their active
tenure could be responsible for taxes in all of these states. This
raises the possibility they will pay state taxes on more than one
hundred percent of their retirement income.
State administrators point to the fact that the states generally
allow a credit for taxes paid to non-domiciliary states. They must also
agree, however, that this does not eliminate the problem. Most states,
if not all, allow the credit only up the amount that would be subject
to tax under their laws. For example, if I am a resident of a state
that imposes its tax at the rate of five percent, and a state that
imposes its tax at the rate of ten percent also taxes my retirement
income, I will pay ten percent to that non-resident state, but only
receive a credit by my resident state equal to five percent of that
amount. Also, some states will not allow a credit to its residents for
a tax that they do not impose on its nonresidents, or do not believe is
valid. And, of course, retirees who live in states that do not impose
an income tax will receive no relief from paying tax to other states
when there is no offset to be had. Finally, there may be little or no
concomitant federal tax relief for these multiple payments due to the
Alternative Minimum Tax.
. An example of the difficulties of calculating the amounts owed is
attached to this testimony. It would be necessary to estimate the
amount a state could assess on audit for each open year and the maximum
credit available to be claimed against the tax in the resident state.
Further, the schedule would need to be updated periodically as the
states assess and collect the tax. In the attached schedule, a retired
partner resident in New Jersey had, in the 2001 tax year, a total of
$18,826.06 of state taxable income attributable to 34 different states.
His state tax would total $1,192.49 but based on state rules, only
$1,040.58 would be creditable. It is clear that the credit mechanism
does not solve the problem of double taxation. Further, retired
partners who, in 2001 were residents of Pennsylvania, Illinois,
Mississippi or Hawaii would receive no credit since those states did
not tax pension income.
How can these problems be solved? The answer is to enact HR 4019.
This bill clarifies HR 394 by specifically stating that retired
partners are included. Further, it makes it clear that the language
requiring that payments from non-qualified plans must be ``part of a
series of substantially equal periodic payments (not less frequently
than annually)'' does not preclude such plans from the exemption based
merely upon caps or limits based on a predetermined formula or on
adjustments such as cost of living increases. Most importantly, since
it is a clarification of existing law, rather than a change in the law,
HR 4019 is applied retroactively to the December 31, 1995 date that HR
394 was enacted. With the passage of HR 4019, Congress will have
assured that the problems that necessitated the enactment of HR 394 are
solved for all retirees.
Thank you for your time and consideration of this important issue.
ATTACHMENT
<GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT>
Mr. Cannon. Thank you, Mr. Portnoy.
Mr. Duncan, we look forward to your testimony now.
STATEMENT OF HARLEY T. DUNCAN, HARLEY T. DUNCAN, EXECUTIVE
DIRECTOR, FEDERATION OF TAX ADMINISTRATORS
Mr. Duncan. Thank you, Mr. Chairman. My name is Harley
Duncan. I'm the Executive Director of the Federation of Tax
Administrators, which is an association of the principal tax
administration agencies in the 50 States, D.C., and New York
City. We appreciate the opportunity to present our position on
H.R. 4019.
That position can be summarized, I think, as follows, that
if the Subcommittee determines that it is appropriate to move
forward with the bill, we would encourage you to take steps to
improve the clarity and precision of the bill in order that we
can avoid conflict in interpretations and confusion for
taxpayers, make the act administrable by the States, and
prevent the bill from creating opportunities for substantial
tax avoidance.
The Federation was an active participant in the discussion
surrounding the passage of Public Law 104-95, and we worked
closely with Mr. Gekas and the Members of this Subcommittee to
define--develop the final legislation.
Then, as now, we recognize that the source principle of
taxation must be balanced with the administrative difficulties
and burdens that might be imposed on taxpayers and their
employers in maintaining sufficient records over a lifetime of
earning to ensure an appropriate allocation of the deferred
income among all States in which it might be taxed.
At the same time, the proponents of 104-95 and this
Subcommittee recognized that limitations that were going to be
imposed on State and local taxing authority needed to be
narrowly and clearly drawn so that they accomplished their
intended purposes, did not create unintended consequences and
open up the States to substantial taxable avoidance. We think
the same considerations are appropriate for 4019.
Public Law 104-95 substantially achieved those principles
and goals because every item of income that's subject to the
act is defined with reference to the Internal Revenue Code so
that the taxpayer knows and the tax agency knows what type of
income we're talking about.
In the one area where that's not possible, with the
nonqualified deferred comp plans, there were two provisions
inserted by the Subcommittee to make sure that distributions
from those nonqualified plans looked like the rest of the
retirement income that was being--that was covered by the bill,
namely that it was paid out over a substantial period of years
or the length of life of the individual, and that it came out
in substantially equal installments to take then the
differential nonqualified deferred comp and make it look like
the rest of the retirement income, but again with specific
reference to the Internal Revenue Code so that it both defined
it specifically and prevented abuses.
Those two things do not occur in H.R. 4019. First of all,
the term retirement benefits, which are then to be subject to
the limitation, is fully undefined in the bill. There's no
reference to the Code, there's no reference to anything that we
could find that we would then be able to say this constitutes
the retirement benefit that's subject to the limitation.
Second, the term retired partner is defined by a
parenthetical that says defined as such in appropriate tax
laws. But that's not a meaningful statement. It doesn't help
you determine who is eligible for the limitation and when
they're eligible for the limitation.
Finally, there are some qualifications then added to the
two limitations that this Subcommittee put in in 1995, about
the length of the pay out and the substantially equal
installments. And those are accompanied by undefined terms such
as a predetermined formula that might be used to deviate from
those limits, similar alterations or similar formula to alter
those pay outs again, without respect to any definition that we
could find.
The end result then is that you've got an ability to
recharacterize virtually any income as a retirement benefit and
try to qualify for the limitation. We don't know who it applies
to. And the predetermined formula and qualifications on the
length of pay out and substantially equal payments can be used
to effectively negate those limitations.
If you move forward, we would make several suggestions.
First, tie the income to some part of the Code. We'd throw out
1402(a)(10) as a starter for working away from it. At least it
talks about the types of income that makes for non--for retired
partners.
Specifically include an exclusion for retirement--from the
definition of retirement benefits for gains on the sale of a
partnership interest in a trade or business so that we don't
have that converted into retirement benefits.
Delete the modifications on the length of the pay out and
the substantially equal test or put them in some form so that
they are meaningful limits and can't be used to negate those
two principles.
If those don't work for you, consider tying the amount of
income that's exempt to some prior level so that we know what
we're looking at. Those are the types of things that we think
need to be done so that A, the taxpayer knows what he or she
can do; B, the State can administer it and we don't open
ourselves up to avoidance.
One minute, 15 seconds on the effective date, if I may.
We would argue that it ought to be January 2006. It may be
that this is retirement income that is similar to that in 104-
95. I think it is fair to say that retired partners were not
excluded by choice from 104-95. Equally, I think it's an
overstatement to say that they are included in 104-95. The
language tying to all those references in the Code doesn't deal
with partners. They simply aren't addressed in the bill as it
was passed.
So I think it's an overstatement to say clarification.
That, if you extend it, if you take the effective date back to
1995, that implies a misapplication in some fashion by the
States. I don't think that's the case. If a taxpayer feels
that's the case, he or she should contest that in a State tax
administration appeals system.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Duncan follows:]
Prepared Statement of Harley T. Duncan
Chairman Cannon, Congressman Watt and Members of the Subcommittee:
Thank you for the opportunity to appear before the Subcommittee on
H.R. 4019 relating to state and local taxation of certain payments to
retired members of partnerships. My name is Harley Duncan, and I am the
Executive Director of the Federation of Tax Administrators. The
Federation is an association of the principal tax administration
agencies in the 50 states, the District of Columbia and New York City.
My purpose today is twofold: (1) to request that the Subcommittee
require the proponents of the bill to demonstrate with clear and
convincing evidence that the source principle of taxation should be
overridden because of concerns regarding the administrative and
recordkeeping burden associated with taxing retirement income paid to
retired partners in the source state; and (2) to request that, if the
Subcommittee determines it is appropriate to move forward with this
bill, that it take steps to improve the clarity and precision of the
bill in order to prevent the bill from creating opportunities for
substantial avoidance.
H.R. 4019 would amend P.L. 104-95 by including in the list of
specific distributions from specific types of retirement plans that may
be taxed only by the state in which an individual resides or is a
domiciliary a new category of income characterized as ``any plan,
program or arrangement providing for retirement benefits to a retired
partner (treated as such under applicable tax laws). . . .'' It would
also liberalize the requirement that distributions from nonqualified
deferred compensation plans (and the newly included partnership
retirement benefits) be made not less frequently than annually and that
the distributions be made in substantially equal amounts.
INTRODUCTION
As a preliminary matter, it should be stated that to this point,
there has been no discussion with the Federation or its staff as to the
need for H.R. 4019. We understand there is a desire to bring parity to
the tax treatment of various streams of income that some consider
``identical,'' and that there are issues of administrative burden that
have been raised. These, however, have not been explained to or
discussed with us. We believe that the Subcommittee as a first order of
business should require the proponents of the bill to demonstrate
clearly that the administrative and recordkeeping burden associated
with taxing the retirement income in question is so onerous as to
require a modification of the source principle of taxation, which would
hold that the income in question should be taxed where the services
giving rise to the income were performed even if the taxation is
deferred until the income is actually received. Simply saying that the
income in question is the ``same as that covered by an earlier act of
Congress'' (P.L. 104-95) is insufficient without further evidence.
The Federation was an active participant in the discussions
surrounding the passage of P.L. 104-95 and worked closely with this
Subcommittee in developing the final shape of the legislation. Then, as
now, we recognize that the source principle of taxation must be
balanced with administrative difficulties and burdens that might be
imposed on taxpayers and their employers in maintaining sufficient
records over a lifetime of income to ensure an appropriate allocation
of the deferred income among all states in which it might have been
earned. At the same time, proponents of P.L. 104-95 and Members of this
Subcommittee recognized that any limitations imposed on state and local
taxing authority should be narrowly and clearly drawn so as to
accomplish their intended purpose, but not to create unintended
consequences and open up opportunities for substantial tax avoidance.
We think the same considerations are appropriate in deliberations
regarding H.R. 4019.
During testimony before this Subcommittee on legislation that
ultimately became P.L. 104-95, FTA offered the following statement:
As a general matter, the Federation urges the Congress to move
cautiously in considering legislation to restrict the ability
of states to tax retirement income paid to former residents.
Any such legislation should: (1) preserve to the maximum extent
possible the source taxation principle under-girding state
income tax systems; (2) not create opportunities for
substantial tax avoidance; (3) be designed carefully to address
the issues present in today's environment and not a series of
hypothetical situations which someone might conjure; and (4) be
capable of being administered by being precisely drawn and
based upon references to current laws or understood concepts
where possible.\1\
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\1\ Testimony of Harley T. Duncan before the Commercial and
Administrative Law Subcommittee of the House Committee on the
Judiciary, ``State Taxation of Nonresident Pension Income,'' June 28,
1995.
P.L. 104-95 substantially follows these principles in that it
specifically identifies the types of retirement income that are taxable
only in the state of residence by defining them with respect to
specific sections of the Internal Revenue Code. As to non-qualified
deferred compensation plans, which are by definition variegated
arrangements, the legislation imposed standards for the length and
amount of distributions so as to avoid potentially abusive situations
where an individual could defer substantial amounts in the latter part
of a career, move to a non-tax state and avoid substantial taxes to the
state in which the income was earned. P.L. 104-95 provides a good model
to follow should the Subcommittee determine that the administrative
burdens associated with continuing to tax the income in question at the
source are too onerous. Any limitation should be clear and unambiguous.
SOURCE TAX PRINCIPLE
There should be no question regarding the legal authority of states
to tax the retirement income of nonresident partners where the services
giving rise to the income were performed in the state.\2\ The basis of
current state income tax systems is that a state may tax income that is
derived from sources within the state, regardless of whether it is
earned by a resident of the state or a nonresident engaging in income-
producing activities within the state. In-state sources are generally
defined to include the performance of services in the state, the
conduct of a trade, business or occupation in the state, or the receipt
of income from property owned within the state.
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\2\ Throughout the testimony, references to nonresident pension or
retirement income should be read to refer to that portion of any
deferred compensation arrangement that is attributable to services
performed in the state at an earlier point in time. A state would not
have authority to tax pension income of a nonresident if it did not
arise from services or other activities performed in the state.
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State authority to tax nonresident income from in-state sources was
validated by the U.S. Supreme Court over 70 years ago in Shaffer v.
Carter 252 U.S. 37 (1920) when it wrote:
. . .we deem it clear, upon principle as well as authority,
that just as a State may impose general income taxes upon its
own citizens and residents . . . , it may, as a necessary
consequence, levy a duty of like character, and not more
onerous in its effect, upon incomes accruing to non-residents
from their property or business within the State, or their
occupations carried on therein. . . .
As the Shaffer court noted, and as has been developed in subsequent
cases, the essential constraint on the states in the taxation of
nonresident income is that the nonresident may not be taxed to a
greater degree than a similarly situated resident of the state and may
not be discriminated against by virtue of the nonresident status.\3\ It
is also clear that states have authority to tax all income received by
a resident, regardless of the source of that income.\4\ To avoid double
taxation, however, all states with a broad-based income tax \5\ provide
a tax credit to residents for income taxes paid to another state on
income which is also included in the tax base of the state of
residence.\6\ This system of reciprocal credits generally prevents
retirement (and other) income from being taxed in both the state in
which it is earned and in the state of residence.\7\
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\3\ With respect to nonresident pension income in particular,
states take the position that the pension income is simply deferred
income or compensation for services performed at an earlier point in
time. This issue has not been addressed directly by the Supreme Court.
The Court's ruling in Davis v. Michigan Department of Treasury 109
S.Ct. 1500 (1989) (intergovernmental tax immunity and 4 U.S.C. 111
prevent a state from taxing federal pensions to a greater degree than
they do state and local pensions), however, certainly supports the
state interpretation that pensions are deferred income paid for
services performed previously.
\4\ New York ex. rel. Cohn v. Graves, 300 U.S. 308 (1937) and
Lawrence v. State Tax Commission, 286 U.S. 276 (1932).
\5\ Forty-one states and the District of Columbia levy a broad-
based personal income tax. New Hampshire and Tennessee levy an income
tax on limited types of interest, dividend and capital gains income.
Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming do
not levy a personal income tax.
\6\ Maine and Virginia do not grant such a credit on retirement
income. Neither state, however, includes retirement income from non-
state sources in the tax base of the resident.
\7\ Certain groups of states do not use such a system of credits.
Instead, they have reciprocal agreements under which all income is
taxed by the state of residence rather than the state in which it is
earned. (This also avoids taxation by two states.) These agreements are
most prevalent in the Virginia-D.C.-Maryland, Pennsylvania-New Jersey,
and Ohio-Indiana-Illinois areas.
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As noted, the principle of source taxation must be balanced with
issues concerning the administrative and compliance burden that may be
imposed on individual taxpayers and their employers in maintaining the
records necessary to appropriately allocate income among states and
filing the requisite returns. For example, Congress has limited the
taxation of individuals engaged in most interstate transportation
industries to the state of residence or where the taxpayer spends a
majority of his/her time in recognition of this type of burden. It was
these sorts of concerns that also were the genesis for P.L. 104-95. As
Congress has recognized in its earlier deliberations, if limits are to
be imposed on state taxation, care must be taken to ensure that the
limits are clear and precise and that they do not create opportunities
for unwarranted tax avoidance.
ISSUES RELATIVE TO H.R. 4019
The Federation believes that H.R. 4019, as drafted, falls short of
this goal and the criteria outlined earlier in this testimony.
Specifically, we have three concerns with H.R. 4019: (1) Certain terms
and phrases used in H.R. 4019 are unclear and require further specific
definitions; (2) Without greater clarification and precision, H.R. 4019
creates opportunities for substantial, unwarranted tax avoidance; and
(3) The effective date in H.R. 4019 should be changed.
Lack of precision. In subsection 1(a)(1) of H.R. 4019, the term
``retirement benefits'' is used, but not defined in any way.\8\ By
contrast, P.L. 104-95 goes to great length to define the term
``retirement income'' with specific reference to sections of the
Internal Revenue Code. This not only provides specificity for
administrative purposes, but ensures that the income is actually
retirement income in the normal sense of the term, where income has
been systematically set aside in a trust arrangement to be paid out
when one ceases work. Without any definition, H.R. 4019 would
potentially allow nearly any stream of post-employment income to be
characterized as ``retirement income'' and made free of tax if one
resided in a non-tax state. We would suggest that the Subcommittee
consider IRC section 1402(a) as a potential definition for ``retirement
benefits.'' The section defines income of former partners that are not
subject to self-employment tax and may be a model for H.R. 4019.\9\
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\8\ Other than, we presume, by the current law's limits regarding
the length of payouts and the ``substantially equal'' requirement that
govern distributions from nonqualified deferred compensation
arrangements.
\9\ This reference is provided as a possibility for further
analysis. It has not been reviewed widely by states to determine if it
would be suitable. It is an example, however, of the benefits of tying
the definition in H.R. 4019 to other sections of the Internal Revenue
Code.
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The phrase ``retired partner (treated as such under applicable tax
laws)'' [Section 1(a)(1)] is presumably designed to define the types of
individuals that qualify for the limitation. Without further
specificity, however, it is simply a phrase without meaning. It will
become a point of contention and litigation and creates opportunities
for recipients to try to avoid tax by characterizing themselves as
``retired partners.'' The phrase must be defined with reference to the
specific tax laws that help define ``retired partner'' or otherwise
provide a statement of the qualifications that define one as a retired
partner if it is to be administrable and enable taxpayers and states
alike to determine who qualifies for the special treatment.
The meaning and intent of Section 1(a)(2) is unclear and requires
explanation. On its face, it modifies the ``substantially equal
periodic payments'' test imposed on distributions from nonqualified
deferred compensation plans to enable what are being touted as
``retirement benefits'' to be paid under some non-normal schedule. This
would seem to open up the bill to gaming by allowing the partnership
benefits to be paid on some other basis. If the purpose of H.R. 4019 is
to replicate P.L. 104-95, this modification should be deleted. The
effort in P.L. 104-95 was to place a limit on what all considered to be
``normal'' retirement plans. The ``substantially equal'' requirement
was designed to ensure that nonqualified plans could not easily be used
to avoid tax liabilities.\10\
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\10\ Note also that the term ``period'' in page 2, lines 13 and 14
of the bill should be changed to ``periodic.''
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The phrases ``predetermined formula'' and ``similar adjustments''
in Section 1(a)(3) also need to be defined, if indeed the terms are
even necessary. If those terms remains undefined, they become points of
potential conflict and litigation. Also, such adjustments could be
structured so as to effectively negate the ten-year/life-expectancy
requirement and the ``substantially equal'' requirement, both of which
are critical to limiting the use of nonqualified deferred compensation
programs as tax avoidance techniques. While it is unclear why the
language is necessary, such adjustments should be limited in some
fashion, e.g., as a proportion of the total amount, not more than some
percentage annually or the like.
Tax Avoidance. As noted, without precise and specific definitions
of such terms as ``retirement benefits'' and ``retired partner,'' there
is a significant potential that income that is simply deferred
(regardless of the reason) could be characterized as retirement income
and thus be subject to the limitation in the bill. Depending on the
state in which the individual lives at the time the income is received,
it could turn a tax deferral into a tax exemption.
The greatest concern is that, given the lack of precision in the
language, an individual that was a partner in a trade or business could
sell the partnership interest and structure the pay-out so that it met
the time period and ``substantially equal'' tests and argue that the
income is retirement income subject to the limitation. In actuality,
the income is gain on the sale of assets associated with the trade or
business and is subject to tax in the state(s) in which the trade or
business operated. However, without specific definitions of
``retirement benefits'' in the bill, there is a potential for the gain
to be characterized as retirement income.
In addition to precisely defining what constitutes ``retirement
benefits,'' we would offer several additional suggestions of ways to
avoid potential abuse of the limitation contained in H.R. 4019.
<bullet> The bill should be amended to state that proceeds
from the sale of a partnership interest in a trade or business
shall not be considered a retirement benefit subject to the
limitation.
<bullet> The amount of retirement income subject to the
limitation could be defined with reference to a particular
level of income earned by the partner prior to retirement,
e.g., income in excess of 110 percent of the average annual
wages subject to wage withholding paid to the recipient by the
partnership in the three years prior to retirement of the
partner would not be considered retirement income.
<bullet> The limitation could be limited to income paid from
plans or programs that existed for some time period (e.g.,
three years) prior to the time the partner retired.
<bullet> The term ``retirement benefit'' could be left to
determination under state law, thus allowing the states to
distinguish between retirement payments and proceeds from the
sale of partnership interests.
EFFECTIVE DATE
As introduced, H.R. 4019 provides that the amendments shall be
applied to income received after December 31, 1995. The effect is to
retroactively apply the law change against the states. It would
arguably allow those taxpayers that have voluntarily complied with
those laws currently imposing tax on the affected income to file claims
for refund. It would also negate any assessments states may have made.
The change should be applied only to tax year 2006 and forward.
The implication of the retroactive date is that the states have in
some fashion misapplied P.L. 104-95 and that P.L. 104-95 was intended
to cover the types of income that is the subject of H.R. 4019. That is
simply not true in my estimation. As an active participant in the
discussion surrounding P.L. 104-95, it is true that retirement payments
to retired partners were not considered when P.L. 104-95 was approved.
It is incorrect to say that such income would be included within the
terms of P.L. 104-95. If a taxpayer was assessed on tax that is
considered to be within the terms of P.L. 104-95, she/he should contest
the assessment through administrative appeals processes as opposed to
pursuing federal legislation.
CONCLUSION
In conclusion, Mr. Chairman and Members of the Subcommittee, the
Federation is committed to working with you further on this legislation
if the proponents demonstrate to you the need for the legislation. We
believe that H.R. 4019 as drafted is ambiguous and imprecise. It is
likely to result in conflict and litigation regarding its
interpretation and application Further work to clearly define what
constitutes ``retirement benefits,'' who is a ``retired partner,'' and
to avoid situations in which income could be re-characterized to take
advantage of the limitations is necessary and we are willing to assist
in this effort.
Mr. Cannon. Thank you, Mr. Duncan.
As always, your comments are very constructive. We
appreciate them and we'll take them into account and hopefully
you'll be available to work with us as we refine this bill
before it goes to the floor.
Mr. Duncan. We would be more than glad to work with you,
and the Committee and the proponents of the bill.
Mr. Cannon. Thank you, very much.
Mr. Arnold, you may have noticed by now that we have a
little clock up there that goes red--or from green to yellow to
red. Thank you. Obviously, we're not pounding on the red, but
if you could draw your comments to a close when we get there,
we'd appreciate that.
Thank you.
STATEMENT OF STANLEY R. ARNOLD, CPA, FORMER COMMISSIONER OF NEW
HAMPSHIRE'S DEPARTMENT OF REVENUE ADMINISTRATION AND FORMER
PRESIDENT OF THE FEDERATION OF TAX ADMINISTRATORS
Mr. Arnold. Thank you, Mr. Chairman, Members of the
Committee.
My name is Stan Arnold and I served as the Commissioner of
the New Hampshire Department of Revenue Administration for 14
years, spanning the administration of four governors, both
Republican and Democrat, from 1988 to 2002. I also was
President of the Federation of Tax Administrators and served on
a number of joint business and Government task forces
attempting to resolve tax administration issues.
In fact, Harvey became Executive Director of the FTA the
same year that I was appointed, first appointed, commissioner.
Several years later, I became President of FTA and had the
pleasure of working closely with Harley during that time.
Currently, I'm the Senior Tax Policy Adviser at the law
firm of Rath, Young & Pignatelli on Concord, New Hampshire. I
have a total of 30 years of experience in State and Federal
taxes, both in the private sector and in Government. I have
prepared tax returns for individuals and businesses, I've
audited business tax returns as a State auditor, I developed
audit policies as an assistant director of an audit division,
and I developed new tax laws as commissioner.
I appear before the Committee in support of H.R. 4019 and
to present the viewpoint of a former State tax administrator as
why it's appropriate for Congress to take action on this issue.
In the United States, both of the Federal and State tax
systems are voluntary compliance systems built on an unwritten
agreement between the citizens being taxed and the taxing
authorities. Citizens are willing to put up with some
administrative burden because they understand the need for
compliance. But at the same time they expect administrators and
their elected officials to keep that administrative burden to a
minimum.
Administrative burden is reduced when there is stability
and predictability in the law. It's my experience that citizens
and businesses value that stability in tax law above all else.
They want to be able to plan their affairs. They want to be
able to comply with the law. Most of all, they don't want the
rules to be changed after they believe that they have honestly
complied with the law.
H.R. 4019 is not a State's rights issue. Congress decided,
back in 1995, that it was appropriate for it to assert its
Commerce Clause authority. We're now asking that Congress
clarify its intention to prevent States from taxing all
nonresidents, including partners, on their retirement income.
This is an issue of whether or not citizens should be able
to rely the actions of Congress once it decides to resolve a
State tax issue. This is about stability of the tax system and
the unwritten agreement between citizens and Government to
minimize compliance burden. This is a matter of all retirees
being treated equally and fairly.
Congress has only rarely involved itself in State tax
matters. And because Congressional action to resolve the State
tax issue is extraordinary, the rule of law created by
Congressional action must be respected.
For 10 years following the passage of Public Law 104-95,
the taxation of nonresident income has been settled law. In
fact, until recently the law as passed in 1995 has guided and
been respected by taxpayers and individual States alike.
In passing the original law, Congress took an important and
difficult action to resolve what was becoming a possible
impediment to interstate commerce. Public Law 104-95's purpose
was to make sure that States could not reach and tax the
retirement income of nonresidents.
Today you are being asked to clarify that retirement
benefits to a retired partner are included for the purposes of
that previous limitation on State taxation.
Once Congress entered the field in '95 and asserted its
authority under the Commerce Clause, States have not attempted
to tax these retirement payments. Congress broadly restricted
the source taxation of retirement income whether from qualified
or nonqualified plans.
However, one State at least has issued a technical bulletin
deciding retirement benefits paid to nonresident partners are
not included in the Congressional limitation. There is no
rational distinction to treat nonqualified plans for employees
different from nonqualified plans for partners. Therefore,
Congress should adopt H.R. 4019 to clarify its intent to ensure
consistent application of those principles established in 1995.
Thank you for the opportunity to testify. I'm prepared to
answer any questions you may have.
[The prepared statement of Mr. Arnold follows:]
Prepared Statement of Stanley R. Arnold
I. INTRODUCTION
A. Personal Information.
My name is Stanley R. Arnold, CPA, MBA and I served as the
Commissioner of the New Hampshire Department of Revenue Administration
for 14 years spanning the administration of four governors both
Republican and Democrat from 1988 to 2002. I also served as President
of the Federation of Tax Administrators and served on a number of joint
business and government task forces attempting to resolve tax
administration issues. Currently, I am the Senior Tax Policy Advisor at
the law firm of Rath, Young & Pignatelli, P.A. in Concord, NH. I have a
total of 30 years of experience in state and federal taxes. My 30 years
of experience has included work in both the private sector and in
government. I have prepared tax returns for individuals and businesses;
audited business tax returns as a state auditor; developed audit
policies as an assistant director of an audit division; developed new
tax laws as Commissioner and now represent clients on tax matters. I
also advise clients and teach classes on the how and why the state tax
system works the way it does work--or doesn't work.
B. Overview of Testimony.
I appear before the committee to support H.R. 4019 and to present
the viewpoint of a former state tax administrator as to why it is
appropriate for Congress to take action on this issue. In the United
States both the federal and state tax systems are voluntary compliance
systems built on an unwritten agreement between the citizens being
taxed and the taxing authorities. Citizens are willing to put up with
some administrative burden to increase compliance, but at the same
time, expect administrators and their elected officials to keep that
administrative burden to a minimum. One way to minimize the
administrative burden is stability and predictability in tax law. It is
my experience that citizens and businesses value stability in tax law
above all else. They want to be able to plan their affairs and they
want to be able to comply with the law. Most of all, they don't want
the rules to be changed after they believe they have honestly complied
with the law.
Congress has only rarely involved itself in State Tax matters.
Because Congressional action to resolve a state tax issue is an
extraordinary step, the rule of law created by Congressional action
must be respected. For ten years following the passage of Public Law
104-95, codified at 4 U.S.C. 114, the taxation of non-resident
retirement income has been settled law. In fact, until recently, the
law as passed in 1995 has guided and been respected by taxpayers and
the individual States alike.
In passing the original law, Congress took an important and
difficult action to resolve what was becoming a possible impediment to
interstate commerce. Public Law 104-95's purpose was to make sure that
states could not reach out and tax the retirement income of
nonresidents. Today you are being asked to clarify that retirement
benefits to a retired partner are included for the purposes of the
previous limitation on state taxation of retirement income. Once
Congress entered the field in 1995 and asserted its authority under the
Commerce Clause, States have not attempted to tax these retirement
payments. Congress broadly restricted the source taxation of retirement
income whether from qualified or non-qualified retirement plans.
However, at least one state recently issued a draft Technical Services
Division Bulletin deciding that retirement benefits paid to nonresident
and part-year resident partners was not included in the congressional
limitation. There is no rational distinction to treat non-qualified
plans for ``employees'' different from non-qualified plans for
``partners.'' Therefore, Congress should adopt H.R. 4019 to clarify
their intent to insure consistent application of the principles
established in 1995.
At the time of previous Congressional action, expert testimony
before this committee discussed two courses of probable action that a
state could take if it wished to continue to tax retirement income
after the passage of P.L.104-95. First, an individual state could tax
deferred retirement income on a current basis by decoupling from the
federal deferral provisions. While various states, including New
Hampshire, have decoupled from recent federal tax law changes, no state
has chosen to decouple on this issue. Second, a state could seek to tax
the deferred income in the year a resident changed residence to another
state. To the best of my knowledge, no state has passed this type of
``exit toll'' provision either. In my opinion, State Legislatures have
not taken action to enact such provisions because they are keeping
faith with the underlying principle established by Congress that States
should not tax the retirement income of nonresidents.
II. 1995 CONGRESSIONAL ACTION (P.L. 104-95)
When I was the New Hampshire Commissioner, I supported annual
resolutions adopted by the Federation of Tax Administrators (FTA)
asking Congress not to pass legislation restricting a state's authority
to design its own tax system. I continue to believe that Congress'
power to restrict States taxing power should be used with restraint. At
the same time, the States are not always right when they develop their
tax policy and Congress has stepped in several times in the past when
Congress believed it was necessary to prevent inappropriate actions
which would affect individual and business taxapayers. The most well
known example of Congressional action was the passage of Public Law 86-
272 (15.U.S.C. 381) which permits companies to engage in certain sales
solicitation activities in states without being subject to state
corporate income tax. While not popular with tax administrators, the
core of that law has been respected by the states. Tax administrators
have tested it around the edges, but the core principle embodied in
that law continues to be observed.
In 1995, this Committee and Congress enacted P.L. 104-95 to limit
state taxation of retirement income when a resident retired and moved
from one state to retire in another state. Congress understood that
when individuals retire to a different state they no longer vote in
that state, they no longer receive benefits from that state, and
therefore, they should not be taxed in their former state. Congress
acknowledged that the States had a right to tax non-resident retirement
income under the so called ``source rule.'' Congress also made clear
that it wished to restrict that right because of the (1) administrative
burden imposed on a citizen in complying with such a demand and (2) the
unfairness, whether perceived or actual, of a state continuing to tax
retirement income once a citizen had moved from the state.
There are several elements included in the testimony presented on
H.R. 394 that are relevant to the need for H.R. 4019. In testimony to
this committee on H.R. 394, several members of Congress expressed
concern that H.R. 394 could lead to abusive tax planning by wealthy
individuals using tax planning to defer income while in a high tax
state and then receive that income after retiring to a non-income tax
state. An amendment to the original bill addressed that concern by
requiring that payments from non-qualified plans be in the form of
periodic payments under federal rules. It appears to me that the debate
on the original legislation and subsequent amendment clearly shows
Congress was broadly defining retirement benefits from non-qualified
plans in the protected category.
III. DYNAMICS OF A TAX SYSTEM
Questions from individuals, businesses, tax professionals and
internal staff of the agency may always be raised about how to apply
tax laws after they are passed. Many questions are answered on an ad
hoc basis or through letters, Technical Information Releases and
Declaratory Rulings. There are two ``waves'' of questions; those raised
during the implementation phase of a law and those raised several years
later when taxpayers are audited.
Auditors are always looking backwards. They are often auditing
returns that report transactions conducted two or three years
previously. Conflicts sometimes arise between taxpayers and auditors
because the law has changed and the interpretations of that law were
developed after the returns were filed. Good administrators will make
these adjustments prospective to maintain the stability and
predictability principles, but sometimes that does not occur.
Once the state auditors join in the fray, they will raise questions
based on their audit experience. Auditors are generally not concerned
with the policy behind the law; they simply want 100 percent compliance
regardless of any administrative burden. Administrative burden is the
responsibility of the policy makers. In the immediate issue at hand,
the draft technical bulletin addresses retirement payments to
nonresident partners. It is important to note, that the dynamics of the
system will cause the expansion of the enforcement beyond the initial
group. At some point, an administrator will point out that ``everyone
needs to be treated the same.'' So it is likely that the current audit
interpretation will expand to anyone the audit division can classify as
non-employees, such as proprietorships and self-employed individuals.
H.R. 4019 addresses this issue directly by clearly including the
retirement payments to partners and self-employed individuals.
States struggle every budget cycle on how best to finance the
services they provide fueled in part by balanced budget requirements.
In 2005, I served as a co-chair of Governor Lynch's transition team
with responsibility for developing the biennial budget. I have also
worked closely with four governors, both Republican and Democrat in
developing budgets and have never experienced an ``easy'' budget. The
state budget process is difficult and requires both financial and
political skills to achieve a balance between required services and
available revenue.
The ``no new taxes'' position has become a standard of American
politics and made it even more difficult for any eventual winner of an
election to develop a budget. The result is politicians have had to
become very imaginative in how to pay for state services. Aggressive
tax policy administration frequently raises revenue. And, all too often
states look to nonvoters to raise revenue without regard to the
administrative burdens imposed.
Audit division interpretations and informal rule making can raise
revenue directly or indirectly. Unfortunately, each of these methods
increases administrative costs to companies and individuals paying
lawyers and accountants to defend their rights. Often, aggressive audit
actions are reinforced by administrations trumpeting the ``success'' of
some audit initiative. By embracing the principles established in 1995,
H.R. 4019 will reduce administrative costs borne directly by taxpayers.
IV. CONCLUSION
H.R. 4019 is not a ``states' rights'' issue. Congress decided back
in 1995 that it was appropriate for it to assert its Commerce Clause
authority. We are now asking that Congress clarify its intention to
prevent states from taxing all nonresidents on their retirement income.
This clarification would of course have the same effective date as the
original legislation. This is an issue of whether or not citizens
should be able to rely on the actions of Congress when it decides to
resolve a state tax issue. This is about the stability of the tax
system and the unwritten agreement between citizens and government to
minimize compliance burdens.
Litigation might eventually resolve this controversy, but
litigation will take a number of years. Citizens should not have to
comply with the tremendous administrative burden identified in 1995,
nor pay expensive legal fees while waiting for the issue to work its
way through the judicial system. It is also possible that Congressional
inaction would encourage other states to adopt the same interpretation
to raise additional revenue.
Mr. Cannon. Thank you, Mr. Arnold.
I appreciate the panel's very concise testimony and we may
want to get to you as we move forward. I think we're going to
mark this bill up today. That means we have still many places
or several places where we can make adjustments to it. So we
appreciate your input.
Are there any Members of the panel that would like to ask
some questions?
Mr. Watt is recognized for 5 minutes.
Mr. Watt. I won't take 5 minutes, Mr. Chairman. I want to
do two things.
Number one, I think I misstated in my opening statement
that we acted on this bill in 1996. It was actually December of
'95. I think the bill was actually signed by the President in
'96. So I didn't want the record to be incorrect in that
respect.
I did want to ask Mr. Portnoy and Mr. Arnold whether they
share the concerns that have been expressed by Mr. Duncan, and
whether, in light of those concerns, we would be well advised
between now and the time the full Committee acts on this bill,
to address those concerns or what is your opinion on that?
Mr. Arnold. Mr. Watt, I think in many ways that some of the
issues that were brought up by Mr. Duncan were--resolved, at
least the initial one, and I'm not speaking for him, but he
makes an emphasis on the issue where--he used the term
retirement benefit rather than retirement income, which had
been the term that had been used in the original law. We agree
that that could be easily changed to retirement income and
would help in the clarity. It was not intended to establish a
new category of income.
Mr. Portnoy. May I add something, Mr. Watt?
Mr. Watt. Yes, sir.
Mr. Portnoy. The 4019 bill is not intended to make any of
the changes that were being described. Many of the issues that
he is articulating were issues when the original bill was
enacted. You dealt with them or didn't deal with them as you
saw fit. And our language does not change any of those issues.
Mr. Watt. But at the same time, we don't want to open
additional areas of dispute, whether they address concerns that
were addressed before or not. If we're going to open another
set of issues to be quibbled about or litigated about or vexed
about by accountants or State revenue authorities, we need to
clarify that, I would take it. Or would you disagree with that?
Mr. Portnoy. I think that's an appropriate concept, Mr.
Watt, but I don't think that any of that has occurred. For
example, the 10-year rule of substantially equal payments was
in the original legislation. But substantially equal was
undefined.
So there has always been a degree of question about what
that meant.
What our bill does is narrow that to a certain extent,
possibly in a way Mr. Duncan is not in favor of, but
nonetheless is just a clarification of the original bill with
these issues that you dealt with previously.
Mr. Watt. I appreciate it, Mr. Chairman. I yield back.
Mr. Cannon. The gentleman yields back.
The Chair hopes no one else is interested in asking
questions. That being the case, we want to thank the panel for
being here today.
Mr. Delahunt. Can I just ask one question?
Mr. Cannon. Absolutely, Mr. Delahunt. The gentleman is
recognized for 5 minutes.
Mr. Delahunt. Do you want your quorum? I figured you'd
recognize, Mr. Chairman.
I'm really confused and I wasn't here when the original
bill came out. But let me just pursue what Mr. Watt was
addressing.
Is this a language problem, Mr. Duncan?
Mr. Duncan. I thought perhaps it was. But now, after Mr.
Portnoy's answer, I'm not so sure that it is.
I guess we believe that the limits that are in the current
law of 10 years on the pay out and substantially equal are
important to avoid abusive situations with nonqualified
deferred comp plans.
The language that's being inserted here, we think can
effectively negate those. And the answer of Mr. Portnoy was--
implies that they'd like to at least alter the substantially
equal.
We are fine with the current language, in terms of length
of pay out and substantially equal.
Mr. Delahunt. Mr. Portnoy?
Mr. Portnoy. We have no changes to that language. It's
still 10 years substantially equal.
What we are saying is there are some standard provisions in
these type of plans, such as COLA adjustments annually, that
one State at the moment and others shortly are saying
disqualifies that from meeting the 10 years substantially equal
test.
We're suggesting that this legislation doesn't change that
definition of the 10 years substantially equal.
Mr. Delahunt. If I'm incorrect, I think that there's a
consensus that the issue should be addressed, but that there's
a real disagreement among Members of the panel here as to
whether, as Mr. Watt says, it opens up new areas of
uncertainty, as opposed to clarification.
Mr. Arnold. Mr. Delahunt, if I could, I think number one,
one of the main issues was the definition of whether or not we
were talking about retirement income or a new thing called
retirement benefit. We agree with Mr. Duncan that should be
changed.
And again, as far as working with the language, the
sponsors when this bill was drafted who were working on the
drafting of this bill, there was no intent to change what
Congress had done back in 1995.
Now from the standpoint of the language and where it is, I
think it's just a matter of maybe working with Mr. Duncan to
ensure that he understands how it does not change that.
Mr. Delahunt. That was going to be my recommendation
because I don't think that we want to make something that is
arcane and esoteric, really complicated because we don't like
to deal with things that are any of those.
So if you really have a desire to resolve this, I daresay
that the three of you gentleman sit down and have discussions
that prove to resolve that so you can reassure the Chairman and
Members of the Committee and the Ranking Member that we're all
on the same page.
I yield back.
Mr. Cannon. The gentleman yields back. Thank you.
Let me just say that we're learning as we go. I think some
very good ideas have come up here. We will be talking with
particularly Mr. Duncan and others and will involve certainly
the minority staff in this process so we can come up with a
bill that is actually clarificatory and not one that creates
more difficulty in the future.
Other questions from the panel?
If not, we thank you all for being here.
This hearing is adjourned and now we're going to go into a
markup, so gentleman, thanks for being here.
[Whereupon, at 4:43 p.m., the subcommittee was adjourned.]
A P P E N D I X
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Material Submitted for the Hearing Record
Biography of the Honorable George W. Gekas, former United States
Representative, former Chairman of the Subcommittee on Commercial and
Administrative Law, Committee on the Judiciary
<GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT>
Biography of Lawrence F. Portnoy, LLP, retired partner,
PricewaterhouseCoopers
<GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT>
Biography of Harley T. Duncan, Executive Director,
Federation of Tax Administrators
<GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT>
Biography of Stanley R. Arnold, CPA, former Commissioner of New
Hampshire's Department of Revenue Administration and former President
of the Federation of Tax Administrators
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<all>