While recent federal tax reform initiatives and commentary have garnered most tax-related headlines, including in the area of taxation of executive compensation, the Supreme Court of Connecticut in Allen v. Comm’r of Revenue Services, 324 Conn. 292 (December 28, 2016), has just reminded us that executives must still be cognizant of state tax laws, particularly in the context of mobile executives holding non-qualified stock options.
In Allen, an executive received stock options while performing services in Connecticut as the CEO of his employer, but exercised such options while residing in a state outside of Connecticut. The executive argued that since he exercised after leaving Connecticut, no taxes were due to Connecticut and he was owed a refund of the Connecticut taxes he had paid on $53,000,000 of income.
The executive’s argument was based, in part, on what appeared to be an ambiguity in the relevant tax regulation. The regulation provided that option income was taxable by Connecticut if the optionee performed services in Connecticut “during the period beginning with the first day of the taxable year of the optionee during which such option was granted and ending with the last day of the taxable year of the optionee during which such option was exercised.’’ Regulations of Connecticut State Agencies § 12-711(b)-18. The executive argued that this regulation taxed option income only if the optionee continuously performed services in Connecticut during the period from grant through exercise. The Court disagreed, holding that the regulation was “unambiguous” because the only reasonable interpretation of the word “during” was "at some point in the course of" rather than “throughout the continuance or course of.” The court concluded that the regulation imposed Connecticut income tax on employee options granted as compensation for services performed while a Connecticut resident, irrespective of state of residence at exercise. The court also rejected the executive’s contention that Connecticut’s method of taxing option income violated his federal constitutional due process rights, as well as the executive’s contention that the option exercise income was not attributable to services performed in Connecticut but rather to appreciation in the underlying stock, which was not connected to the Connecticut services.
Allen is a paradigmatic lesson for executives intending to move to a new state to retire, to change jobs, or simply to relocate to a new office. Such executives may be thinking, among other things, of the tax consequences or advantages of when and whether to exercise outstanding stock options. For example, an executive holding unexercised options may be motivated to relocate to a state without a state income tax based on the assumption that the gain on exercise could escape state level taxation as a result of a new non-taxing state of residence. Allen illustrates that for options granted to an executive as compensation for services performed in a state with an income tax, the more likely result is that at least some portion of the option gain will be taxed by the state of residence where the option was granted.
Further complicating matters, how much tax will be owed to the service-performance state and/or the option exercise state will be entirely driven by the interplay of the two states’ rules applicable to stock option income; they are far from uniform and must be carefully understood. Depending on each state’s rules granting and limiting credits against residents’ income taxes for income taxes that are paid to other states, it is even possible that the collective amount of tax payable could exceed the tax that would be payable if the option income were simply taxed in full by the highest rate state.
The Allen decision, in which the Connecticut Supreme Court upheld the Department of Revenue and a lower court’s decision that no refunds of income taxes were due in respect of options exercised after an executive had moved from Connecticut, highlights not only the ostensible ambiguity of the Connecticut Regulation governing stock option taxation, but also reminds us that each state may have a different methodology for option income for mobile executives, whether taxing in full or allocating based on some measure of the executive’s in-state and out-of-state residency during the period from grant through exercise.
The key point is that each state is different, and at least in Connecticut where the affirmed approach per the Supreme Court is taxation based on residency during service performance, there may be a risk that the holder of options does not realize the intended tax benefits of relocating prior to exercise of stock options, or even worse ends up paying more than one state on the same income.
For more information on the matters discussed in this Locke Lord QuickStudy, please contact the authors.