On September 26, 2017, the Ohio Supreme Court (Court) issued its decision in MacDonald v. Cleveland Income Tax Bd. of Rev.,¹ ruling that a Supplemental Executive Retirement Plan (SERP) is an exempt pension for City of Cleveland (city) income tax purposes. This decision concludes a controversy that had been making its way through Ohio courts for almost a decade.

Facts

The taxpayer retired in 2006 and was entitled to participate in a SERP offered by his employer. The SERP, although a nonqualified deferred compensation plan under federal law, did not involve a deferral of compensation owed to the taxpayer nor was it funded by the employer. The taxpayer had to pay federal Medicare tax on the present value of the payments to be made pursuant to the SERP in 2006 and such amounts were reported in box 5 of his Form W-2. The employer did not withhold tax and the city assessed the taxpayer on the amount reported in box 5 of his Form W-2. The taxpayer protested the assessment on the ground that the SERP was an exempt pension under the Cleveland city income tax ordinance (Cleveland Ordinance). The Cleveland Income Tax Board of Review upheld the assessment and the taxpayer appealed to the Ohio Board of Tax Appeals (BTA).

The taxpayer had previously prevailed at the BTA on the issue in litigation involving his city of residence, Shaker Heights. The BTA held that the SERP was a pension and exempt under a similarly-worded local ordinance (see Tax Alert 2013-414). The BTA's decision in that case was upheld by the Ohio 10th District Court of Appeals (court of appeals) in MacDonald v. Shaker Heights Income Tax Bd. of Rev.² At that time, the Court accepted discretionary review of the court of appeals' decision, but only as to the scope of the BTA's review of the local income tax review board's decision. The Court declined jurisdiction over the substantive issue of the taxability of the SERP. Relying on its prior decision that had been upheld by the court of appeals, the BTA again held that the SERP was a pension and exempt under the Cleveland Ordinance (see Tax Alert 2016-0790). Unlike Shaker Heights, Cleveland exercised its right, under law existing at that time,³ of direct (non-discretionary) appeal to the Court.

The Court's decision

In upholding the BTA's decision, the Court reviewed Cleveland Ordinance 191.0901(d), which excluded from tax " … pensions … not in the nature of compensation for services rendered … ." Although the term "pension" was not defined in the local ordinance, the Court, under commonly accepted definitions of the term, concluded that the SERP was a sum of money paid to the taxpayer as a retirement benefit — a pension.

The Court then addressed several arguments raised by Cleveland that the "pension exemption" did not apply. Cleveland argued that local regulations further defined pensions as limited to amounts reported on a Federal Form 1099R. The Court noted that the Cleveland Ordinance limited the tax administrator's authority to the administration, enforcement and collection of the tax. Accordingly, the regulation at issue was held to be an impermissible attempt to expand the scope of what the Cleveland Ordinance specified as being taxable.

The Court also rejected Cleveland's argument that the SERP was nonqualified deferred compensation, which was expressly made taxable elsewhere in its ordinance. The gist of this argument is that the reporting of the amount in box 5 of the Form W-2 is controlling because box 5 wages are "qualifying wages" under the Cleveland Ordinance. The Court reconciled this apparent conflict in the Cleveland Ordinance by turning to the rule of statutory construction that provides a more specific provision controls over a more general provision. The Court then noted that if the SERP involved deferred wages, then the "pension exemption" would not apply. In this case, there was no deferral of wages or other set-aside of amounts by the employer. Because the SERP in this case was a "pension" under the Cleveland Ordinance, the "pension exemption" applied.

Cleveland also argued that former Ohio Rev. Code Section 718.03(A) required it to tax the SERP as that provision defined "qualifying wages" to include nonqualified deferred compensation plans unless excluded by local ordinance. The Court noted that Cleveland had exempted pensions. Moreover, the Court noted that its prior decision in Gesler v. Worthington Income Tax Bd. of Appeals,⁴ held that the Ohio General Assembly can restrict a city's power to tax, but cannot impose tax on income the city has chosen to exempt.

Implications

The Court's decision brings some certainty to the treatment of certain SERPs that may otherwise meet the definition of nonqualified deferred compensation plans under federal law. If the local ordinance exempts a pension and the SERP does not involve a deferral of wages or some other funded promise to pay by the employer, the SERP should not be taxable. There is an emerging issue involving retired partners who are receiving similar pension benefits under their former firms' retirement plans. Those amounts are typically reported as guaranteed payments on a Schedule K-1. Some Ohio cities have been asserting tax on such payments under theories similar to those expounded in the MacDonald litigation. The Court's decision seems to indicate that the fact that retired partner benefits are not reported on a Form 1099-R should not be determinative if they are otherwise an exempt pension under local ordinance.

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ENDNOTES

¹ MacDonald v. Cleveland Income Tax Bd. of Rev., Slip Opinion No. 2017-Ohio7798.

² MacDonald v. Shaker Heights Income Tax Bd. of Rev., 10th Dist. Franklin No. 13AP-71, 2014-Ohio-708 (Tax Alert 2014-442).

³ Under the law in place at that time, taxpayers receiving an adverse decision from the BTA had a right to a direct appeal to the Court. Am. Sub. HB 49, the Ohio biennial budget bill, eliminated this right and now requires BTA decisions to be appealed to the appropriate county Court of Appeals with those decisions subject to the Court's discretionary exercise of appellate jurisdiction (Tax Alert 2017-1042).

⁴ Gesler v. Worthington Income Tax Bd. of Appeals, 138 Ohio St.3d 76, 2013-Ohio 4986.