The Connecticut Supreme Court (“Court”) recently determined that Connecticut properly taxed compensatory income derived from the exercise of nonqualified stock options (NQSO) that were exercised by a nonresident individual [Allen v. Connecticut Commissioner of Revenue Services, Conn. S. Ct., Dkt. No. 19567, December 28, 2016].
Corporate executives who are employed in Connecticut and are granted compensatory stock options (and other types of stock compensation) are often surprised to learn that upon their exercise all or a portion of the compensatory element (i.e., the ordinary income amount recognized for federal income tax purposes) can be taxed by Connecticut even if the executive abandons his or her Connecticut domicile and is considered a nonresident of Connecticut at the time the options are exercised[Conn Agencies Regulations §12-711(b)-18].
In this case, however, the taxpayer was aware of the rule and had reported the NQSO compensatory income attributed to Connecticut on his timely filed original Nonresident Connecticut personal income tax returns. The taxpayer, however, subsequently filed Connecticut amended tax returns claiming tax refunds with respect to the compensatory option income that was reported. The claims were denied by the Commissioner, resulting in appeal and judicial proceedings – ultimately finding its way to the Connecticut Supreme Court.
The Court disagreed with all of the taxpayer’s arguments for the income exclusion. At stake was over $53 million of compensatory stock option income (for the tax years 2002, 2006 and 2007).
The Court rejected the taxpayer’s argument that the Due Process Clause of the United States Constitution prohibits the taxation of income derived from the exercise of the stock options because the options had no readily ascertainable value when they were granted and there was an insufficient nexus between Connecticut, the taxpayer, and the value attributable to the options at the time of exercise. The Court held that the fact that the taxpayer was granted stock options as compensation for performing services in Connecticut constitutes a sufficient connection with the taxpayer and the compensatory income to satisfy the requirements of the due process clause.
The taxpayer next argued that Conn Agencies Regulations §12-711(b)-18, dealing with the taxation of NQSOs, requires that the taxpayer be performing services in Connecticut at the time the stock options were not only granted but also when they were exercised (i.e., throughout the period in which the options were granted and subsequently exercised).The Court rejected this and determined that the regulation only requires that the taxpayer performed services in Connecticut at the time the options were granted to be taxable and does not require the taxpayer to be also performing services in Connecticut at the time of exercising the options.
Lastly, the taxpayer contended that the income recognized from the exercise of the stock options was not a result of the performance of services in Connecticut; but rather that the income was a result of the appreciation in value of the underlying stock, which was not connected to the taxpayer’s services within Connecticut. Therefore, with respect to taxing a nonresident individual, this appreciation (which generated the income) should not be considered Connecticut sourced income and subject to Connecticut income taxation. The Court, however, rejected this characterization stating that for compensation in the form of stock options, the intended compensation for services performed within the state is measured and taxed at the time the options are exercised, and that income recognition is equal to the difference between the option price and the fair market value of the stock at the time of the exercise.
As this case reminds us, corporate executives who worked in Connecticut and abandoned their Connecticut residency taking along with them their unexercised stock options, restricted stock, deferred compensation and the like (other than pension or “retirement plan” income), will find the grey cloud of Connecticut income taxation following them to their sunnier (and perhaps no state tax) new residence.
If you would like to discuss how your stock based compensation, deferred compensation, or retirement plan income may be taxed, please contact Tony Switajewski at firstname.lastname@example.org.
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