Twists in Determining New York State Taxable Income
Complexities of Interest on U.S. Government Obligations and SUNY Pension Contributions

By Gary P. Briggs

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Tax-Free Interest Income

When is tax-free interest income not tax-free? When it is part of a regulated investment company’s portfolio.

As a general rule, interest accruing to individuals on U.S. government bonds and obligations is taxable at the federal level and exempt at the state level. And while this statement is true in most jurisdictions, tax preparers in New York (as well as California and Connecticut) must be aware of the special tax rules in these states.
While interest accruing to individuals on most U.S. government obligations received directly by New York taxpayers was always exempt from New York State taxes, such interest received indirectly through regulated investment companies was not. Prior to 1986, individuals filing personal income tax returns in New York were required to pay tax on all income accruing from a regulated investment company, regardless of its source. To remedy this inequity between those who invest directly in U.S. government obligations and those who invest indirectly in the same obligations through a regulated investment company, the New York legislature amended section 612(c) of the New York State Tax Law in 1986. The law does contain some significant limitations, however.

The 50% rule. Since 1986, individuals filing personal tax returns in New York State have been able to exclude the interest earned on U.S. obligations that
accrued through regulated investment companies from their taxable income, but only if the regulated investment company (or, as is usually the case, a designated fund of the company) meets the 50% U.S. obligations asset requirement stated in section 612(c)(1) of the New York State Tax Law. For a particular fund of a regulated investment company to meet this 50% rule, at least 50% of the total dollar value of all investments held by the fund at the close of each quarter must be in U.S. obligations deemed exempt from state and local tax. Regulated investment companies must meet the 50% rule at the end of each quarter for any of the interest earned for the fund to be exempt from New York taxation.

Interest received from the fund of a regulated investment company that meets the 50% rule is exempt from New York State taxation to the extent that the interest is a percentage of the total distribution of the regulated investment company fund. For example, if interest from U.S. obligations represents 45% of the total interest income earned by a regulated investment company fund during the year, then 45% of the income received from that regulated investment company’s fund is exempt from taxation. The remaining 55% will be taxable on the individual’s state tax return. The 50% rule is based on the total asset value of the fund, not the total interest income earned by the fund.

While New York made a serious effort to correct the inequity within its tax laws, the 1986 amendment of section 612(c)(1) does not completely eliminate the problem. Funds of regulated investment companies holding less than 50% of their value in U.S. obligations receive no benefit under the current law. It is imperative that interest income received from any fund of a regulated investment company meet the 50% rule at the end of each quarter for any of the interest in the regulated investment company’s fund to be exempt from New York State taxation.

Retirement Income

When is a pension, received by a New York resident from a State University of New York (SUNY) institution, not completely excludable from New York State taxation? When that “SUNY institution” is a private corporation.

New York State residents who receive pension benefits from the federal government, or from any New York state or local government, may exclude 100% of that income from New York State taxation. The Department of Taxation and Finance includes both SUNY and CUNY colleges within their definition of New York State government institutions. It is a little-known fact, however, that, for example, one prominent “SUNY institution” isn’t a state institution at all. The Research Foundation of the State University of New York is “a private, nonprofit educational corporation that administers externally funded contracts and grants for and on behalf of the State University of New York” (www.rfsuny.org). Retirees from the SUNY Research Foundation are, thus, limited to the traditional $20,000 exclusion relative to such pension benefits. Tax preparers working with “SUNY retirees” should inquire as to exactly which SUNY institution the individual has retired from.

While this particular scenario may be limited, it is symptomatic of a more pervasive twist: While pension contributions made by SUNY or CUNY colleges are not taxable to New York State residents, pension contributions received from any other college are limited to the $20,000 exclusion.

Many college faculty are, or were, enrolled in the Teacher’s Insurance Annuity Association–College Retirement Equities Fund (TIAA-CREF); unlike most retirement plans, TIAA-CREF is transferable from college to college. So while individuals may have retired from a SUNY/CUNY institution, not all of their pension contributions were necessarily made by a SUNY/CUNY institution. It is up to the tax preparer to determine exactly which institutions contributed to the individual’s TIAA-CREF retirement fund and what percentage of the total retirement distributions received is related to SUNY/CUNY institutions. A tax preparer can contact TIAA-CREF for this information. The author knows from personal experience that the New York State Division of Taxation and Finance is looking very closely at taxpayers who deduct 100% of their TIAA-CREF distributions as coming from a New York State institution.

While all of this SUNY/CUNY confusion may be a bit of a nuisance at tax time, a little extra investigation then will save a lot of headaches later. Tax preparers should also remember that TIAA-CREF distributions received from institutions other than SUNY/CUNY are still excludable from New York state taxation up to a maximum of $20,000.