State Taxation of Separation Payments Framework for State

Journal of Multistate Taxation and Incentives (Thomson Reuters/Tax & Accounting)

Volume 29, Number 8, November/December 2019

SALT @ WORK

State Taxation of Separation Payments

By CHARLIE KEARNS

CHARLIE KEARNS is a Partner in the Washington, D.C. office of Eversheds Sutherland (U.S.) LLP.

States use various methods to tax payments made under separation agreements to employees following termination of their employment. A recent Kentucky appellate court decision, Ridge v. Commw. of Kentucky Finance and Administration Cabinet, Dep't of Revenue, adds to the guidance that employers should consider when drafting separation agreements.1 In Ridge, the Kentucky Court of Appeals held that a Tennessee resident was subject to Kentucky tax on income derived from a separation agreement with his former Kentucky-based employer.

This article describes the framework that states use to tax payments made under separation agreements, addresses how the Ridge decision fits into that framework, and provides some suggestions as to how employers may draft their separation agreements to avoid unwanted results for nonresident former employees.

Framework for state taxation of separation payments

To better understand Ridge, a quick review of the states' authority to tax the income earned by resident employees and nonresident employees may be helpful.

Refresher—residence and source: States impose individual income taxes, and the correlative employer withholding obligations, based on the employee's residency and where the employee performs work for the employer.2 Generally, states tax residents on all of their income, wherever earned ("residence" taxation), but states limit taxation of nonresidents to income earned from sources in the state ("source" taxation).3

Examples of state approaches: The questions surrounding the state taxation of separation payments to nonresidents are typically more complex than determining the former employee's residency status. States frequently look to the underlying reason(s) the former employee received the payment. For instance, states consider whether the payment was made in consideration for: (i) prior employment and length of service; (ii) future services and forbearance; or (iii) foregoing a contractual right to future employment.4

Regardless of the characterization of separation payments, payees are subject to tax in their residence state at the time they receive the payments.5 For example, the Utah State Tax Commission found that taxpayers who moved to Utah after they terminated employment, but before the former employer made the separation payment, were subject to Utah tax because the taxpayers were Utah residents at the time they received the payment 6 The State Tax Commission's ruling is consistent with the general rule that taxpayers are subject to tax in their state of residence on all income, wherever earned.7

State tax authorities adopt various approaches when seeking to tax separation payments made to nonresidents. And like other nonresident issues that arise in multistate employer withholding,8 some states take a more sound approach than others do when taxing separation payments.

In one of the more reasoned approaches, the Virginia Department of Taxation issued a series of rulings that explain when it has authority to tax separation payments made by a Virginia employer to nonresidents. These rulings focus on the employer's reason(s) for making the payment to the nonresident former employee to determine if the payments are subject to employer withholding and personal income tax in Virginia.

Under the Virginia rulings, severance payments that relate to the nonresident's prior employment in the Commonwealth are subject to withholding and tax.9 Thus, for Virginia withholding and personal income tax purposes, severance payments relate to prior services of the payee for their former employer—and are sourced accordingly—because such a payment "is compensation for the termination of an employment relationship or is deemed to be remuneration for past services."10

As distinguished from severance payments, consideration for non-compete agreements paid to a nonresident is not Virginia-source income because that former employee performs the contract (i.e., by "not competing") where they are located after the employment relationship ended.11 In a 2010 ruling, the Department explained this distinction:

Under these rulings, any payments made to the [taxpayer] as severance pay are subject to Virginia income tax, while any payments made to the [taxpayer] after he moved out of

Virginia that were attributed to the noncompetition provision would not be subject to Virginia income tax.12

The Department of Taxation has taken a substance-over-form approach when reviewing separation agreements between a Virginia employer and nonresident, as to whether the payments made thereunder are severance payments or consideration for a non-compete agreement.13 However, the Department of Taxation also has explained that it is incumbent on the former employee and employer to provide specific evidence of the consideration paid for the non-compete agreement.14

Like Virginia, the Oregon Department of Revenue takes a practical approach to taxing separation payments. By regulation, the Department of Revenue explains that a nonresident who enters into a termination agreement with their Oregon employer is not subject to Oregon income tax on a lump-sum payment for release of wrongful termination claims and a covenant not to compete "because it is not based on services performed in Oregon."15 The Department of Revenue distinguishes those types of payments from a lump-sum payment based on one month's salary per years worked for an Oregon employer. That type of lump-sum payment is entirely sourced to Oregon because such "payment based on [taxpayer's] salary and years of service associates the payment with the employer-employee relationship...and the facts and circumstances indicate that it is paid because of prior performance of services and no other reason."16

Unlike Virginia and Oregon, but like Kentucky in Ridge, several other states tax non-compete agreements based on the location where the taxpayer worked for their former in-state employer.17

The Ridge v. Dep't of Revenue decision

In Ridge, the Kentucky Court of Appeals held that payments made by an in-state employer to a nonresident former employee, in consideration of the former employee's compliance with a non-compete and non-solicitation clause in a separation agreement, were subject to Kentucky income tax.18 The taxpayer was a Tennessee resident who worked for a Kentucky employer from 2005 through his last day of employment on December 31, 2015. Rather than being involuntarily terminated, the nonresident "ended his employment with [the former Kentucky employer]."19 The nonresident and the Kentucky employer entered into a separation agreement, which had the following pertinent terms:

• the nonresident agreed to a non-compete and non-solicitation clause in the agreement (though it is unclear from the facts of the case if the clause contained geographical limits, such as compliance within 30 miles of the employer)20 ;

• in exchange for the nonresident's compliance with those clauses, the former employer agreed to pay the taxpayer an amount equal to 26 weeks of his "regular salary less applicable payroll deductions" ($84,919.00); and • the former employer made those payments to the nonresident in the following year (2016) over biweekly installments.21

The former employer withheld Kentucky tax from the nonresident's biweekly payments under the separation agreement.22 The nonresident sought a refund for those withheld amounts because the payments were made for "post-retirement activity" and were not made for any "activity" in Kentucky.23 The Department of Revenue rejected the nonresident taxpayer's refund claim.24 Appeals to an administrative tribunal, and then a trial court, followed.25 Both the tribunal and trial court agreed with the Department.26 The trial court determined that "severance pay" was "taxable wages" and, therefore, the nonresident "did business" in the state during the tax year at issue.27

Like other states, Kentucky imposes tax on "the amount of income received by the [nonresident] individual from labor performed, business done, or other activities in this state[.]"28 However, "[t]he remainder of the income received by such nonresident shall be deemed nontaxable by this state."29 Based on this provision, the nonresident argued that Kentucky's imposition of income tax on nonresidents is limited to "positive activity" performed in the state during the tax year.30 Moreover, the nonresident argued that his forbearance under the non-compete and non-solicitation clause was not an "activity" encompassed by Kentucky's tax imposition statute.31

The court disagreed with the taxpayer's arguments:

At its most basic, and by its express terms, the statute [Ky. Rev. Stat. Ann. §141.020(4)] requires simply that an annual tax be paid for each taxable year. The statute does not, as a threshold matter, necessarily require any affirmative act. As noted by the appellee, "activities" within this Commonwealth are but one purpose upon which income may be taxed. The statute clearly delineates two other purposes for which income may be taxed—"labor performed" and "business done."32

To support its conclusion, the court relied on U.S. v. Quality Stores to determine that the nonresident's payments were taxable wages subject to Kentucky tax. In Quality Stores, the U.S. Supreme Court held that severance payments (supplemental unemployment compensation benefits) are "wages" subject to FICA tax.33 As quoted by the Ridge court, the Supreme Court in Quality Stores said:

Severance payments are made to employees only. It would be contrary to common usage to describe as a severance payment remuneration provided to someone who has not worked for the employer. Severance payments are made in consideration for employment—for a "service . . . performed" by "an employee for the person employing him, per FICA's definition of the term 'employment'."34

Because Kentucky incorporates the federal definition of gross income and wages, the Ridge court determined that, for Kentucky tax purposes, "the severance pay at issue was clearly taxable income as wages."35

The Ridge court next assumed that even if the severance pay was not taxable wages, the payments would be subject to the tax on nonresidents as "labor performed" or "business done," which includes "[d]eriving income from or attributable to sources within this state[.]"36 The court said that the source of the payments was Kentucky because: (i) the payments originated from an in-state employer, and (ii) the separation agreement was executed in the state. The court next found that these facts brought the payments within the statutory definition of "doing business in the state."37

Finally, the court had no problem concluding that the payments were for service performed in Kentucky. The court said the severance payment "was in recognition of the [taxpayer's] past 'labor performed'—that is, the [taxpayer's] previous ten years' of service."38 The court continued: "[a]lthough [the taxpayer] emphasizes that the monies supplied to [taxpayer] per the separation agreement were not for past work performed, but, rather, in exchange for appellant's forfeiture of certain rights, it is hard to imagine that [the employer] would have agreed to pay the appellant nearly $85,000 had it not been for the appellant's lengthy record of service to the company."39

Per the rationale of Ridge, a separation payment from a Kentucky employer may be subject to withholding and personal income tax if the employer is located in the state and the agreement was executed there, irrespective of where the former employee performed their obligations under non- compete or non-solicitation clauses. The court disregarded the place where the nonresident performed the services (the forbearance in Tennessee) that entitled him to the separation payments. But, while not a fact stressed by the court, the separation payments were tied to length of prior service even though the compliance with the non-compete and non-solicitation clause was forward-looking.

Conclusion

Given the conflicting rules for taxing separation payments, employers and employees should be aware of the state tax implications before entering into separation agreements. This preparation is particularly important if, at the time of receipt of the payment(s), the employee may be a nonresident of the state where they were employed. For example, some states will attribute payments from a non-compete clause to the state where the nonresident's forbearance occurs; whereas other states will attribute those payments to the nonresident's state of prior employment that gave rise to the agreement. Accordingly, separation agreements ought to allocate specific compensation to those performance obligations that relate to future services (such as non-compete, non-solication, or consulting clauses) and those that directly relate to prior employment (such as compensation for involuntary termination). Moreover, parties may consider: (i) making non-compete or non-solicitation lump-sum payments in lieu of tying payments to years of prior service or other length of employment, and (ii) expanding the geographical scope of a non- compete or non-solicitation clause beyond the state of prior employment.40

1 No. 18-CI-00719, 2019 WL 3850790 (Aug. 19, 2019).

2 See Hellerstein & Hellerstein, State Taxation (Thomson Reuters/Tax & Accounting, 3rd ed. 2001, with updates through April 2015) (online version accessed on Checkpoint (www.checkpoint.riag.com) July 18, 2015) at Part IV, ¶ 6.04.

3 Id.

4 See New York Ad. Op. No. TSB-A-05(2)(I), Apr. 4, 2005 (distinguishing payments made for termination of future rights under an employment contract from payments made in consideration for prior services).

5 If the payee worked in another state that imposes an income tax, the taxes owed by the payee in their residence state (at the time of receipt) may be subject to a credit for taxes paid on the separation payments to a nonresident state where the payee worked for their former employer.

6 Taxpayers v. Taxpayer Svcs. Div. of the Utah State Tax Comm'n, Dkt. 17-738, July 23, 2018.

7 E.g., Utah Admin. Code r. R865-91-3(A) (explaining, "[a] Utah resident taxpayer is required to report his entire state taxable income ... even though part of the income may be from sources outside this state"); see also Utah Code Ann. §59-10-104(1).

8 See Kearns, "State Withholding Considerations for Special Payments to Traveling Employees," 25 JMT 7 (Oct. 2015).

9 Virginia Dep't of Tax'n P.D. Rul. 97-123, Mar. 10, 1997. In this ruling, the Department of Taxation explained, "supplemental compensation, such as severance or incentive payments, paid to an employee after involuntary separation from his employer constitutes wage income." Id. The Department determined,

"a nonresident individual receiving such payments from a Virginia source would generally be required to file and report such income on a Virginia nonresident return; and (ii) the [former employer] would be required to withhold Virginia taxes from severance or incentive payments made to an employee who resides outside of Virginia." Id.

10 Virginia Dep't of Tax'n P.D. Rul. 05-36, Mar. 16, 2005.

11 Virginia Dep't of Tax'n P.D. Rul. 02-151, Dec. 10, 2002.

12 Virginia Dep't of Tax'n P.D. Rul. 10-37, Apr. 8, 2010.

13 Virginia Dep't of Tax'n P.D. Rul. 05-36, Mar. 16, 2005. Here, the Department determined that the period payments at issue made to a nonresident by an in-state former employer were not severance payments, even though labeled as such in the separation agreement, because they were not made on termination of employment. Rather, the so-called severance payments were made as consideration for the nonresident's compliance with the separation agreement, which included non-compete and non- solicitation clauses. Id.

14 Virginia Dep't of Tax'n P.D. Rul. 10-37, Apr. 8, 2010. According to the Department, it is not enough to assign a value to a non-compete clause in a separation agreement. Hence, at least for Virginia tax purposes, any separation agreement with a nonresident former employee that includes non-compete or non-solicitation clauses should specifically state the portion of the payment(s) attributable to those future services, or risk that those payment(s) may be treated as severance payments that relate to the employee's prior service in Virginia.

15 Or. Admin. R. 150-316-0165(f), ex. 8.

16 Id. at ex. 9.

17 See, e.g., N.Y. Tax Law §631(b)(1)(F) ("Items of income, gain, loss and deduction derived from or connected with New York sources shall be those items attributable to: ... income received by nonresidents related to a business, trade, profession or occupation previously carried on in this state, whether or not as an employee, including but not limited to, covenants not to compete and termination agreements"); Cal. Code Regs. tit. 18, §18662-5(2)(B) ("[p]ayments received for a covenant not to compete in California" are subject to California income tax); Brown v. Missouri Director of Revenue, Mo. Admin. Hearing Comm'n, Docket 97-1109 RI, June 22, 1999.

18 No. 18-CI-00719, 2019 WL 3850790 (Aug. 19, 2019).

19 Ridge, 2019 WL 3850790 at *1.

20 Compare Lackey v. Alabama Dep't of Revenue, Ala. Dep't of Rev., Admin. Law Div. Docket: INC 06- 962, Apr. 15, 2008 (ruling a non-compete agreement, which following the sale of a business prohibited the taxpayer from competing with the purchaser within 30 miles of any of the business locations, was taxable in Alabama because 17 of the 18 business locations were at least 30 miles from the state line and, thus, "the non-compete agreement required her not to take certain actions in Alabama").

21 Id.

22 Id.

23 Id.

24 Id.

25 Id.

26 Id.

27 Id.

28 Ky. Rev. Stat. Ann. §141.020(4).

29 Id.

30 Ridge, 2019 WL 3850790 at *1.

31 Id.

32 Id. at *2.

33 U.S. v. Quality Stores, Inc., 134 S. Ct. 1395 (2014).

34 Ridge, 2019 WL 3850790 at *3, citing Quality Stores at 146, 134 S. Ct. at 1399-1400.

35 Ridge, 2019 WL 3850790 at *3.

36 Id. at *3 (internal citations omitted).

37 Id. at *3.

38 Id. at *3 (emphasis in original).

39 Id. at *3.

40 Of course, any allocations of compensation or adjustments to the non-compete or non-solicitation clauses should take into account the impact from an employment law and other compliance perspectives. For example, expanding the geographic scope of the non-compete could affect its enforceability.