ALERT - Stock Options/Deferred Compensation: Minnesota Exclusion Repealed For 2008

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March 17, 2008

Minnesota's exclusion from state income taxes for compensation paid to non-residents who earned the compensation while they were residents in Minnesota has been repealed, effective January 1, 2008.

Prior to the recent law change (enacted on March 7, 2008), Minnesota law contained a more generous income-exclusion rule. Under the old rule, (1) wages earned by a former employee during any part of the year when the employee was a non-resident of Minnesota; and (2) wages for work performed while the employee was a resident of Minnesota were exempt. This has now been repealed, as indicated above, starting January 1, 2008.

There is no grandfather rule for this change in Minnesota tax law. Amounts paid anytime during 2008 or thereafter under pre-existing compensation arrangements will now be subject to Minnesota income tax. Even though those arrangements may not have been taxed in the past, payments will now be subject to taxation.

Examples of compensation formerly exempt and now subject to tax are:

  • individuals on contract whose contracts provide for them to continue to be paid for some time period after they complete the work required under the contract,
  • individuals who receive non-qualified deferred compensation, and
  • individuals who receive stock options while performing work as a Minnesota resident, but do not exercise the options until they have moved to another State.

This new Minnesota law would not apply to non-resident individuals participating in qualified plans (such as a regular defined benefit pension, 401(k), 403(b), IRAs, and 457 plans) and certain non-qualified plan payments (such as if the payment is part of a series of substantially equal periodic payments made not less frequently than annually for a period of not less than ten years). Federal law prohibits State taxation of withdrawals from these plans by non-residents of Minnesota even though they were received or earned when in Minnesota.

Although employers are now required to withhold Minnesota income taxes on the deferred compensation payments, they have been granted a transition exemption until April 1, 2008. This only means, however, that any payments received in 2008 by a non-resident former employee, are not subject to withholding taxes by the Company, but are subject to taxation in Minnesota for the non-resident. Any payments received by the non-resident former employee after April 1, 2008 will be withheld upon by the Company.

To the extent that the Company and the non-resident former employee have records to indicate services performed outside the State when the deferred compensation was earned, the amounts will be exempt. Income is assigned to Minnesota to the extent the individual performed services in Minnesota under the employment contract, which granted the stock option. See Revenue Notice 96-21 (issued by Minnesota DOR in 1996).

For example, in the case where a non-resident individual recognizes income when the option is granted or when the option is exercised, the Minnesota source income is the income recognized for Federal purposes multiplied by the ratio of days worked in Minnesota during the employment contract period granting the option over the total of days worked under the contract.

The requirement of records to indicate when the employment services were rendered and where and the unclear nature of where the compensation should be considered to be earned, are difficult administrative problems faced not only for the non-resident former employee, but also for the Company. Until further guidance is provided by the Minnesota Department of Revenue, these administrative difficulties will have to be dealt with as best they can.

In summary, beginning in tax year 2008, non-resident former employees receiving non-qualified deferred compensation payments will be subject to Minnesota taxation and to Company withholding. However, Company withholding does not apply to payments made before April 1, 2008 even though the non-resident employee is subject for Minnesota taxes.

If you have any questions please contact Jerry Geis at 651.808.6409 or by
e-mail.