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IN RE: ACE AMERICAN INSURANCE COMPANY, INC.: A CHALLENGE TO PHILADELPHIA’S TREATMENT OF NONQUALIFIED DEFERRED COMPENSATION

In general, Pennsylvania does not follow the Internal Revenue Code for Pennsylvania Personal Income Tax (“PIT”) purposes. During the late 1990s, the Pennsylvania Department of Revenue (“Department”) reversed its long standing position and diverged from federal income tax rules, becoming the only state to determine that elective nonqualified deferred compensation was taxable during the year it was earned, not when it was actually received. During 2005, the Pennsylvania legislature amended the PIT statute, thereby reversing the Department’s position. In addition to overruling the Department’s policy, the PIT amendment statutorily reversed a highly publicized Commonwealth Court decision holding that contributions to a nonqualified deferred compensation plan were subject to PIT at the time of deferral and not subject to PIT at the time of distribution. Contrary to the case law and the Department’s policy, the PIT amendment provided that contributions to nonqualified deferred compensation plans were subject to PIT at the time of distribution not at the time of deferral, thus conforming Pennsylvania’s PIT treatment of nonqualified deferred compensation to the federal standard.

However, different rules may apply for purposes of Philadelphia taxation. Currently, the City of Philadelphia is asserting the position that nonqualified deferred compensation is subject to Philadelphia Wage Tax at the date of deferral, not at the date of distribution – thus contrary to the PIT and federal law. The City of Philadelphia imposes a wage upon “salaries, wages, commissions and other compensation due,” which it further defines as, “[w]ages, commissions, bonuses, incentive payments, fees and tips that may accrue or be received…for services rendered.” Philadelphia Code, §19-1501(10). The City imposes the wage tax upon City residents, regardless of their place of employment, as well as non-City residents to the extent they work within the City.

In the case of In Re: Ace American Insurance Company, Inc., Docket No. 36WMMERZZ9625, Ace sought to challenge the validity of Philadelphia’s determination that non qualified deferred compensation was subject to wage tax at the time of deferral not the time of distribution. The Tax Review Board ruled against Ace, holding that contributions to nonqualified plans are subject to wage tax at the time of deferral. The Court of Common Pleas affirmed the decision of the Tax Review Board and the case is currently pending on appeal before the Commonwealth Court.

All businesses with nonqualified deferred compensation plans should be concerned with the outcome of Ace. Depending upon how a business has treated the withholding of Philadelphia wage tax from nonqualified deferred compensation plans will dictate how the decision will affect the particular employer. If the court ultimately holds that wage tax should have been withheld at the time nonqualified deferred compensation was earned, businesses which withheld wage tax at the time of distribution from nonqualified deferred compensation plans are subject to audit and assessment by the City. However, if the courts ultimately hold that wage tax should have been withheld at the time the nonqualified deferred compensation was distributed, businesses which withheld wage tax at the time of contributions to nonqualified deferred compensation plans would have a basis to file refund claims for the wage tax improperly withheld and remitted. Thus, it is important that employers and employees alike who are subject to the Philadelphia wage tax keep a watchful eye on the outcome of this case before the Commonwealth Court.

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    Mr. Weintraub’s practice has centered on taxation for more than 40 years. He helps clients plan and structure transactions so that all state and local tax obligations are minimized. He represents clients in all aspects of state ...