If a professional service corporation shareholder had to add back excess pension contributions to New York income before 1988, can later withdrawals from a rollover IRA be excluded from New York income until that add-back amount is recovered?

Plain-English summary

Petitioners Paul R. Comeau and James R. Maloney asked this question on behalf of a client ("Taxpayer") who was a shareholder and employee of a professional service corporation organized under Article 15 of the Business Corporation Law of New York State. During Taxpayer's employment, the corporation made pension plan contributions on his behalf. For each of those taxable years (all before 1988), Tax Law section 612(b)(7) required Taxpayer to "add back" to his federal adjusted gross income the portion of the corporation's pension contribution that exceeded the lesser of $15,000 or 15 percent of his earned income from the corporation - in effect, taxing that excess contribution as New York income even though it had not yet been paid out to him.

On March 31, 1986, the pension plan's proceeds were rolled over into an IRA with no required annuity-like or otherwise structured payment schedule; Taxpayer could withdraw as much or as little as he wanted, whenever he wanted (subject only to a mandatory commencement age of 70 1/2). When Taxpayer later began taking withdrawals, the IRA balance exceeded the total amount he had previously been required to add back under section 612(b)(7), and all of the money in the IRA came from the pension rollover (Taxpayer had made no separate contributions to the IRA).

The problem this creates is double taxation: the excess pension contributions were already taxed as New York income when added back under section 612(b)(7), so taxing the same dollars again as Taxpayer withdraws them from the IRA would tax that money twice. Tax Law section 612(c)(12) exists to prevent exactly this, by allowing a subtraction "for the amount necessary to prevent the taxation of amounts properly included in New York adjusted gross income in prior taxable years" under section 612(b)(7). The Department's own guidance, TSB-M-82(3)-I(Rev.) (December 21, 1983), explains how to compute that subtraction: if the entire aggregate add-back could be recovered within three years of withdrawals, the shareholder can simply subtract IRA payments from federal adjusted gross income each year until the whole previously-taxed add-back is recovered (a more complex formula applies instead if recovery would take longer than three years). TSB-M-89-(4)I (July 5, 1989) then explains how this section 612(c)(12) subtraction interacts with the separate $20,000 pension and annuity exclusion under section 612(c)(3-a): first compute and apply the section 612(c)(12) subtraction, and only once the entire add-back has been recovered does any remaining distribution become eligible for the section 612(c)(3-a) exclusion.

Because Taxpayer's IRA let him withdraw freely and without a fixed schedule, the Department found that the total add-back could be recovered within three years if he chose to withdraw it that fast, so the simpler "three-year rule" applied. The Department concluded that Taxpayer's IRA withdrawals each year can be subtracted from federal adjusted gross income under section 612(c)(12) until the entire aggregate add-back is recovered, after which any further withdrawals may qualify for the separate $20,000 pension and annuity exclusion under section 612(c)(3-a).

What this means for you

Retired shareholders of NY professional service corporations with pre-1988 pension contributions

If you were a shareholder-employee of a professional service corporation organized (or authorized to do business) under Article 15 or 15-a of the Business Corporation Law, and in taxable years before 1988 you had to add back excess pension contributions under Tax Law section 612(b)(7), you are not permanently taxed twice on that money. As you draw down an IRA (or other qualified plan) that the pension proceeds were rolled into, you can subtract those withdrawals from your federal adjusted gross income under section 612(c)(12) until you have recovered the full amount you previously added back. Only after that recovery is complete do further withdrawals fall outside section 612(c)(12) and instead potentially qualify for the ordinary $20,000 pension and annuity exclusion under section 612(c)(3-a).

Accountants computing the §612(c)(12)/§612(c)(3-a) subtraction sequence on IRA withdrawals

When advising a retired professional-service-corporation shareholder on a rollover IRA, first determine whether the client's total aggregate section 612(b)(7) add-back can be recovered within three years of withdrawals (as it was here, because the IRA imposed no annuity-like or fixed payment structure). If so, apply the simpler three-year rule from TSB-M-82(3)-I(Rev.): subtract the full withdrawal each year under section 612(c)(12) until the entire add-back is recovered. If recovery would take longer than three years, use the alternative formula in that same memorandum instead. Either way, per TSB-M-89-(4)I, compute the section 612(c)(12) subtraction first, reduce the federally reported distribution by that amount, and only then apply any remaining balance (up to $20,000) toward the section 612(c)(3-a) pension and annuity exclusion.

Common questions

Q: Why did Taxpayer have to add anything back to his New York income in the first place?
A: Because he was a shareholder-employee of a professional service corporation under Article 15 of the Business Corporation Law, Tax Law section 612(b)(7) required him, for taxable years before 1988, to add back the portion of the corporation's pension contributions on his behalf that exceeded the lesser of $15,000 or 15 percent of his earned income from the corporation.

Q: What does the section 612(c)(12) subtraction actually do?
A: It lets the taxpayer subtract from federal adjusted gross income the amount necessary to prevent the same dollars from being taxed twice - once when added back under section 612(b)(7), and again when eventually withdrawn from the pension or its IRA rollover.

Q: How do you know whether the "three-year rule" or the alternative formula applies?
A: Under TSB-M-82(3)-I(Rev.), if the total aggregate section 612(b)(7) add-back could be recovered within three years of withdrawals, the shareholder simply subtracts each year's payments until the whole add-back is recovered. If recovery would take longer than three years, a different formula in the same memorandum is used instead. Here, because Taxpayer's IRA had no annuity-like or structured payment requirement and he could withdraw freely, the add-back could be recovered within three years, so the simpler rule applied.

Q: Does it matter that the pension proceeds were rolled into an IRA rather than paid out directly?
A: No. TSB-M-89-(4)I confirms that a retired shareholder who receives distributions from an IRA, Keogh, or other qualified plan whose principal is fully or partially composed of rolled-over professional-service-corporation pension money remains eligible for the section 612(c)(12) subtraction.

Q: What happens once the entire add-back has been recovered?
A: At that point, section 612(c)(12) no longer applies to further withdrawals. Per TSB-M-89-(4)I, any further IRA withdrawals may then qualify, under section 612(c)(3-a), for the pension and annuity exclusion of up to $20,000 per taxable year.

Q: Can a taxpayer claim both the section 612(c)(12) subtraction and the section 612(c)(3-a) exclusion on the same distribution?
A: The two are computed in sequence, not simultaneously stacked on the same dollars: first the distribution is reduced by whatever section 612(c)(12) subtraction applies, and only the remaining portion of the distribution (if any), up to $20,000, can be subtracted as the section 612(c)(3-a) pension and annuity exclusion.

Citations and references

• Tax Law § 612(a) - defines New York adjusted gross income of a resident individual as federal adjusted gross income with specified modifications
• Tax Law § 612(b)(7) - requires a shareholder of an Article 15/15-a professional service corporation, for pre-1988 taxable years, to add back to federal adjusted gross income the corporation's pension contributions on the shareholder's behalf that exceed the lesser of $15,000 or 15 percent of earned income from the corporation
• Tax Law § 612(c)(12) - subtraction modification for the amount necessary to prevent taxation of amounts previously included in New York adjusted gross income under § 612(b)(7)
• Tax Law § 612(c)(3-a) - separate $20,000-per-year pension and annuity exclusion
• TSB-M-82(3)-I(Rev.), December 21, 1983 - explains the three-year recovery rule (and the alternative formula for longer recovery periods) for computing the § 612(c)(12) subtraction
• TSB-M-89-(4)I, July 5, 1989 - explains the method for computing the § 612(c)(12) subtraction and the § 612(c)(3-a) exclusion, in sequence, for a retired professional-service-corporation shareholder receiving IRA/Keogh/qualified-plan distributions

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/income_ao_1999.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/income/a99_2i.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-99(2)I
Income Tax
June 25, 1999

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. I990407A

On April 7, 1999, a Petition for Advisory Opinion was received from Paul R. Comeau and
James R. Maloney, Hodgson, Russ, Andrews, Woods & Goodyear, LLP, 1800 One M&T Plaza,
Buffalo, New York 14203-2391.
The issue raised by Petitioners, Paul R. Comeau and James R. Maloney, is whether a
taxpayer is entitled to exclude from his New York adjusted gross income, under section 612(c)(12)
of the Tax Law, all withdrawals from an IRA, received during each taxable year, until such time as
the sum of such withdrawals exceeds the sum of all of the section 612(b)(7) of the Tax Law add-back
modifications the taxpayer made with respect to the professional service corporation's contributions
to the pension plan attributable to the taxpayer.
Petitioner submits the following facts as the basis for this Advisory Opinion.
Taxpayer, Petitioners' client, was a shareholder and employee of a professional service
corporation ("Corporation") organized under Article 15 of the Business Corporation Law of New
York State. During his employment, Corporation maintained a pension plan for the benefit of its
employees, including Taxpayer. Contributions were made to the pension plan on behalf of Taxpayer
until March 31, 1986, at which time the proceeds of the plan were rolled over into an Individual
Retirement Account ("IRA"). The IRA was not required to make annuity-like payments or to make
payments in any other fixed or structured manner. Taxpayer had unrestricted access to the IRA, and
could withdraw as much or as little as he saw fit at such times as he saw fit.
During the years Corporation made contributions to the pension plan on behalf of Taxpayer,
Taxpayer was required by section 612(b)(7) of the Tax Law (for purposes of computing New York
adjusted gross income under Article 22 of the Tax Law) to add back to his federal adjusted gross
income a portion of Corporation's contributions to the pension plan attributable to Taxpayer. The
portion Taxpayer was required to add back was the amount by which actual contributions exceeded
a statutory maximum. Taxpayer made all such add-back modifications required by section 612(b)(7)
of the Tax Law. At the time Taxpayer initiated withdrawals from the IRA, the funds in the IRA
exceeded the total of the addback modifications which Taxpayer had been required to make under
section 612(b)(7) of the Tax Law. Furthermore, all of the funds in the IRA at the time Taxpayer
began his withdrawals were from the pension rollover (i.e. Taxpayer had not contributed any funds
to the IRA in addition to the funds rolled over from the pension plan.).

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Income Tax
June 25, 1999
Discussion
Section 612(a) of the Tax Law defines New York adjusted gross income of a resident
individual as the individual's federal adjusted gross income with certain modifications. Section
612(b)(7) of the Tax Law requires an addition modification for a taxpayer who is a shareholder of
a corporation organized under Article 15 or authorized to do business in New York State under
Article 15-a of the Business Corporation Law, for the taxpayer's taxable years beginning before
1988, for the amount which is deductible by such corporation under section 404(a)(1), (2) or (3) of
the Internal Revenue Code ("IRC") for its taxable year ending in or with such taxpayer's taxable year
for contributions paid on behalf of such taxpayer minus the lesser of $15,000 or 15 percent of the
earned income derived by such taxpayer from such corporation during such taxpayer's taxable year.
Section 612(c)(12) of the Tax Law provides for a subtraction modification for the amount
necessary to prevent the taxation of amounts properly included in New York adjusted gross income
in prior taxable years in accordance with section 612(b)(7) of the Tax Law.
The computation of the subtraction modification under section 612(c)(12) of the Tax Law
was addressed in the Department of Taxation and Finance Technical Services Bureau Memorandum,
TSB-M-82(3)-I(Rev.), dated December 21, 1983 ("TSB-M-82(3)-I(Rev.)"). Such memorandum
provides that when the shareholder of professional service corporation begins receiving retirement
benefits, the subtraction modification is made in the following manner:
If the total aggregate amount of the addback modification under section
612(b)(7) can be recovered in 3 years, the payments received by the shareholder can
be subtracted from federal adjusted gross income until the entire aggregate amount
of addback previously taxed is recovered.
If the total aggregate amount of the addback modification under section 612(b)(7) cannot be
recovered within 3 years, TSB-M-82(3)-I(Rev.) provides that a formula is applied to determine the
amount of the subtraction modification.
Technical Services Memorandum TSB-M-89-(4)I, dated July 5, 1989, ("TSB-M-89-(4)I")
explains the proper method of computing the pension and annuity exclusion under section 612(c)(3­
a) of the Tax Law for a retired shareholder of a professional service corporation who is also eligible
for the subtraction modification under section 612(c)(12) of the Tax Law. Such memorandum
provides that a retired shareholder who receives a distribution from an IRA, Keogh or other qualified
plan, the principal of which is fully or partially composed of moneys rolled over from a professional
service corporation pension plan, remains eligible for the section 612(c)(12) subtraction
modification. In this instance, the subtraction and, if the shareholder qualifies, the pension and
annuity exclusion under section 612(c)(3-a), are computed as follows:

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TSB-A-99(2)I
Income Tax
June 25, 1999

1. Compute the amount of the qualified plan (or IRA) distribution attributable
   to the amount rolled over from the professional service corporation pension plan.
   The amount is determined using the rules for determining the previously taxed
   portion of distributions under section 72 of the IRC. This step is required only for
   the initial year of payment under the contract to determine whether the total amount
   previously taxed will be recovered in three years.
2. Then compute the section 612(c)(12) subtraction. Where the three-year
   rule applies, or where the payments constitute an annuity, the subtraction is to be
   computed using the guidelines in TSB-M-82-(3)I(Rev.).
3. The total distribution reported for federal purposes is then reduced by the
   section 612(c)(12) modification.
4. The portion of the distribution remaining, if any, up to a maximum of
   $20,000, is to be subtracted as the pension and annuity exclusion under section
   612(c)(3-a).
   In this case, pursuant to section 612(b)(7) of the Tax Law, Taxpayer was required to add­
   back to his federal adjusted gross income a portion of Corporation's contributions to the pension plan
   attributable to Taxpayer. On March 31, 1986, Taxpayer's proceeds of his pension plan were rolled
   over into an IRA. These proceeds were the only contribution Taxpayer made into the IRA. At the
   time that Taxpayer initiated withdrawals from the IRA, the funds in the IRA exceeded the total of
   the modifications Taxpayer made previously pursuant to section 612(b)(7) of the Tax Law.
   Taxpayer's IRA does not require that annuity-like payments be made nor that payments must
   be made in any other fixed or structured manner. Once Taxpayer is eligible to make withdrawals
   from the IRA, Taxpayer can withdraw as much as Taxpayer wants whenever Taxpayer wants, with
   a mandatory commencement upon reaching age 70 ½. Accordingly, the total aggregate amount of
   the addback modification under section 612(b)(7) of the Tax Law could be recovered by Taxpayer
   in three years, if such amount were withdrawn within that three year period.
   Therefore, pursuant to TSB-M-82(3)-I(Rev.), when Taxpayer begins receiving retirement
   benefits from the IRA, the amounts received by Taxpayer during each taxable year can be subtracted
   from federal adjusted gross income pursuant to section 612(c)(12) of the Tax Law, until the entire
   aggregate amount of addback previously taxed is recovered.
   Further, pursuant to TSB-M-89-(4)I, after the entire aggregate amount of the addback
   modification under section 612(b)(7) of the Tax Law has been recovered, Taxpayer's withdrawals

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TSB-A-99(2)I
Income Tax
June 25, 1999

from the IRA may qualify, under section 612(c)(3-a) of the Tax Law, for the pension and annuity
exclusion of up to $20,000 a taxable year.

DATED: June 25, 1999

NOTE:

/s/
John W. Bartlett
Deputy Director
Technical Services Bureau

The opinions expressed in Advisory Opinions are
limited to the facts set forth therein.