Important Tax Information

New York State Tax Law Amended to Exempt

Most LOSAP Payments from New York State Income Tax

 

The New York State Tax Law was recently amended to exempt from New York State income tax payments made from a length of service award program (LOSAP) adopted in accordance with the New York State General Municipal Law, provided the following conditions are met:

 

1)    The payment is not made in the form of a lump-sum distribution.

2)    The taxpayer receiving the distribution is at least age 59 1/2;.

 

This new section of the Tax Law is §612(c)(41), and it essentially supersedes opinion TSB-M-03(5)I written by the New York State Department of Taxation and Finance on July 25, 2003. This opinion stated that a taxpayer who received a distribution from a LOSAP could exclude the distribution from New York State income tax by utilizing the $20,000 “other pension and annuity” provision found in §612(c)(3-a) of the Tax Law. Similar to the new statute, §612(c)(3-a) also requires the taxpayer to be at least age 59 1/2; and the distribution to not be paid as a lump sum.

While it is better to have this tax exemption stated in law, rather than in an opinion, the language used in the statute is not as clear as desired. Furthermore, it still does not exempt all LOSAP payments from New York State income tax. We have reviewed this new section of the Tax Law with our tax attorney and how it applies to common LOSAP administrative practice in New York State and will share our findings here.

 

Age Requirement

Despite the fact that the entitlement age can be as low as age 55 in volunteer firefighter and volunteer ambulance department defined contribution programs, only payments made after the taxpayer is age 59 1/2; or older are potentially eligible for the tax exclusion. If a program has an entitlement age younger than age 60 (using 59 1/2; as an entitlement age is just not administratively practical), the sponsor could allow a participant to defer payment to age 60. Allowing deferrals in a volunteer firefighter LOSAP (the State law for volunteer ambulance squad programs is slightly different and already allows payment deferrals) creates some complications because the program must not only comply with New York State law, but the Internal Revenue Code as well. The administration of the deferral option and the timing of the volunteer’s election to defer are critical in order to avoid adverse federal income tax consequences. It also increases the administrative burden on the sponsor and administrator. Although deferrals could be administered in both defined contribution (DC) and defined benefit (DB) programs, allowing a deferral option in a DB plan creates more administrative complications. For more details about payment deferrals, please contact our office.

 

Volunteer Firefighter / Ambulance Worker

The new statute begins, “The amount of any award paid to a volunteer firefighter or volunteer ambulance worker…” (emphasis added). Since service award programs are designed and administered like pension or retirement plans, many (if not the majority) of those collecting a LOSAP benefit are no longer volunteers. It seems that the intent of the statute was to provide this income tax exemption to all taxpayers, not just those who remain volunteers while receiving payment. This could also include death benefits paid to beneficiaries. We discussed this possible defect with an attorney very familiar with municipal law, and we concluded until the law is clarified or there is guidance provided by the State, it is reasonable to assume that all taxpayers can take advantage of this tax exemption, not just volunteers. In addition,the instructions for the new IT-225 (see NYS Tax Return section below) do not distinguish that the individual must be a volunteer to take the exemption.

 

Lump-Sum Distribution

The statute further stipulates that lump-sum distributions do not receive the favorable income tax treatment. A LOSAP can be designed to avoid the lump-sum designation on a distribution, but the solutions are different depending on the type of program.

With a DC program, each volunteer has an account balance. In most cases, the account balance is paid as a lump sum after the attainment of the entitlement age. However, if the account balance is paid over a period of at least two or more years (meaning each distribution is made in a different tax year), then each “installment” is not considered a lump sum and therefore, would not be included in taxable income for New York State purposes. If a two-installment option is made available, the volunteer would receive half of the account balance in year one, then the remaining portion of the account balance during the subsequent year. The unpaid portion would be subject to investment earnings, fees, and other transactions during the year.

Therefore, a DC program sponsor may wish to consider amending their program to allow a participant to be paid in installments over two or more years in order to enable the participant to avoid paying New York State income tax. The number of installments offered is subjective – a program could allow a participant to select the installment period (we would suggest no more than 5 years), or simply set a fixed period.

With a DB program, the normal form of payment is typically a lifetime monthly annuity. These payments are clearly not a lump-sum distribution, and therefore, monthly payments made to a taxpayer after age 59 and one half; would not be taxable. Some programs, however, allow a participant to elect to be paid a one-time actuarially equivalent lump sum in lieu of monthly payments. This lump-sum payment would have to be included in the participant’s New York State taxable income. Any other actuarially equivalent payment(s), provided that payments are made in at least two different tax years, would not be considered a lump sum and therefore not subject to New York State taxation.

 

Death & Disability Benefits

Death and disability benefits are provided in all service award programs. Assuming that LOSAP distributions paid to beneficiaries and individuals who are no longer volunteers are eligible for the income tax exclusion (see prior section of this article), a program sponsor may consider modifying its program so these payments qualify for the exemption. In most cases, the disabled participant or the beneficiary of a deceased participant will be under age 59 and one half;, making the payment taxable. Based on the nature of and circumstances of these benefits, we believe it is unlikely that such a payment recipient would want to defer payment in order to qualify for the tax exclusion, even if that option was available.

However, some DB programs provide additional lump-sum death benefits after entitlement age, which would be taxable if not structured differently. Because of the different variations that exist among programs, it is hard to give generic advice except to say that the same principles described for a participant attaining the entitlement age would apply to these payments as well.

 

Post-Entitlement Age Benefits

According to our attorney, any newly credited amount(s) paid in years after the tax year of the initial distribution from the LOSAP are not considered lump sum(s) and therefore, are not taxable. For DC programs, the additional contribution earned after entitlement age and paid as a single amount is not actually a “lump sum” for New York State income tax purposes. Some volunteer firefighter DB programs provide that if a volunteer earns service credit after the entitlement age, the volunteer is paid an actuarially equivalent “lump sum” instead of having the monthly payments increased (sometimes referred to as LOSAP II). Again, according to our attorney, since these are newly credited amounts paid in years after the year of the initial distribution, they are not considered lump-sum payments for New York State income tax purposes and therefore, they not subject to New York State income tax (provided the payment it made to a taxpayer over age 59 and one half;).

 

Changing Your Program

How does a program sponsor go about changing its program? First, the State of New York has already changed volunteer ambulance squad DC programs to allow for a two-installment payment option. The ambulance squad DB programs do not need any changes, as the entitlement age for these programs is 65 and there is no lump-sum payment option. So it will be sponsors of volunteer firefighter programs that will have to consider how to implement any changes.  General Municipal Law §217(h) allows for different forms of payment. GML §216(3)(e) states a program can be amended in the same manner as it was established and that the amendment is to be effective the January 1st following the adoption of the amendment. We would argue that since the form of payment is not one of the items required to be listed in the adopting governing board resolution or the associated voter proposition (the same manner as the program was created), this administrative change can be made simply by governing board resolution. However, we recognize that the wording of the statute seems to strongly suggest that any change to the program (with the exceptions provided in the statute) would require a referendum. We certainly invite (as we always have) our clients and their attorney(s) to communicate with us on the best way to proceed.

 

Federal Tax Forms

We feel that this discussion would not be complete without touching on the form used to report these federally-taxable LOSAP distributions to the IRS. LOSAP distributions are subject to ordinary federal income tax, but not FICA tax. The form used to report this income must be based on the federal tax treatment of LOSAP and not the state treatment (New York State or other state), or how the program is designed or administered. Unfortunately, we do not have any direct guidance or instructions from the IRS stating how to report payments from a LOSAP as described in §457(e)(11) of the Internal Revenue Code. For the 25 years that Penflex has been in business, we have reported LOSAP distributions on form 1099-MISC, in Box 3 (not Box 7), based on the over-arching principle that the participating individuals are volunteers, not employees. There is mounting evidence that perhaps LOSAP distributions should be reported on form W-2, and we continue to research and debate this possibility. We are aware that some vendors use the W-2 to report LOSAP distributions. We cannot disagree with this decision outright. For the time being, we are plan to continue to issue form 1099-MISC, but will also continue researching this matter further, and will certainly notify our clients if we believe a change is required.

We do know that reporting a distribution from a service award program on form 1099-R is not correct based on the federal tax status of LOSAP. A service award program is not a pension, annuity, retirement or profit-sharing plan, despite the fact that prior to this new New York State tax law, the State allowed individuals to treat it as such (as an “other” pension or annuity). Under the Internal Revenue Code, service awards are considered a form of deferred payment, with those payments having some properties similar to wages or compensation. Some vendors utilize annuity contracts to make LOSAP distributions, either through an individual annuity contract or a payment from a group annuity contract. In general, a distribution from an annuity contract should be reported on form 1099-R, but if the annuity contract is purchased to make LOSAP distributions, and LOSAP distributions should not be reported on form 1099-R, this creates an unresolved conflict.

It is absolutely not our intent in any way to discredit another vendor or create a controversy about this subject; we simply want to mention these facts for completeness in this article. Ultimately, a LOSAP distribution is subject to ordinary federal income tax, but not FICA tax, and the form used must be selected based on the instructions provided by the IRS. Furthermore, the form received has not in the past, and should not in the future, prevent the taxpayer from taking the New York State tax exemption. The IRS may have other reasons why it would prefer reporting LOSAP payments on a particular form; however, until formal guidance is given by the IRS, there will continue to be some variances in the forms being used.

 

NYS Tax Return

The State has released a new form in 2014, the IT-225. This form is used to report any NewYork additions and subtractions that do not have its own line in the IT-201. The LOSAP exemption is subtraction S-130. Since the State has created this new form, the federal tax form on which the LOSAP distribution is reported should not create any difficulty in taking this exemption.

If you have any specific questions, please email those questions to us at info@penflexinc.com. Depending on the number of questions we receive, we may provide a document with answers to frequently asked questions.

 

To print a convenient hand-out to post at your station or distribute to volunteers, please click

here