Twists in Determining New York State Taxable Income

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Complexities of Interest on 17.5. Government Obligations and SUNY Pension Contributions

Few things are more disconcerting to an individual taxpayer than receiving a letter from the tax authorities, be it the IRS or the New York State Department of Taxation and Finance, indicating an error in one's tax return. Most individuals, including those who use a tax preparer, spend an inordinate amount of time making certain their tax information is correct. Any tax preparer knows that it is difficult to stay abreast of every nuance in the tax law. Two fairly new twists, related to interest income and retirement income, must be handled properly on an individual's New York State tax return in order to prevent big headaches later on.

Tax-Free Interest Income

When is tax-free interest income not taxfree? 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. …

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