December 12, 2011
Beware of New York's "Special Accrual" Trap
If you are an executive who receives incentive compensation and expect to move to or from New York State, beware of the "special accrual" trap. New York's special accrual rule (under NY Tax Law §639) has been on the books for over 15 years, yet many individuals are caught off guard by the rule and the increase in their New York tax bill that goes along with it. The majority of taxpayers report their income using the cash basis method of accounting, which means income is reported when cash exchanges hands. New York's special accrual rule turns the cash basis method of accounting concept upside down and states certain income items, most commonly incentive compensation, are required to be recognized as New York income even if cash was not received as a New York resident. The law prevents individuals from avoiding New York tax by arranging to receive incentive compensation when the individual is no longer a resident. New York determines incentive compensation as a special accrual by following the Internal Revenue Service's accrual method of accounting rules which states that incentive compensation must be both "fixed" and "determinable". "Fixed" means there is no obstacle, other than not having received the cash, standing in the way to prevent receipt of the incentive compensation. "Determinable" refers to the concept that the amount of the incentive compensation can be quantified with reasonable accuracy.
The New York Department of Taxation is stringent when it comes to determining whether the income is both fixed and determinable. Therefore, it is critical that executives plan for New York's accrual rules. New York will engage in their due diligence and look at hard evidence, including the structure of the incentive compensation plan, to establish if the incentive compensation is a New York special accrual as illustrated in the Matter of Alain J. and Haydee L. Belda. In that case, New York denied three executives from treating two different incentive compensation plans from Alcoa Inc. as non New York income in 2000, a period when they were nonresidents of NY, as opposed to the year 2001 when the compensation was paid and they were residents of New York.
Alain P. Belda, George Pizzey and Lawrence Purtell, the executives, were paid by Alcoa in the year 2001 two different types of incentive compensation plans. Alcoa reported the amount paid on each of the petitioner's 2001 Form W-2 Wage and Tax Statement. The petitioners were nonresidents of New York during the year 2000 and moved to New York as full time residents in 2001 when Alcoa moved their headquarters from Pittsburgh, Pennsylvania to New York City. The petitioners argued the compensation should be taxable in the year 2000 since Alcoa accrued the compensation as of December 31, 2000 on their financial statements. Also, the petitioners argued that the income was fixed since the only item pending receipt of the compensation was the approval from the compensation committee which did not occur until 2001. The petitioners viewed the compensation committee's approval process as a mere formality. In addition, the petitioners took the position the income was determinable, because the amount was based on the outlines of the compensation plans which were determined based on past performance.
The Division argued that the incentive compensation was not fixed and determinable as of December 31, 2000. Further findings revealed the compensation committee approval of the compensation awards was not a ministerial act. In fact, the role of the compensation committee was to determine the amount of compensation to pay and whether or not the compensation would be ultimately paid based on the structure of the compensation plans, overall economic climate, and the performance of the aluminum industry. Since the ultimate decision rested with the compensation committee and the decision was not made until 2001, New York concluded that the incentive compensation was not fixed and determinable under the accrual method in 2000. The court concluded the incentive compensation was taxable in 2001 when the income became fixed and determinable. The petitioners were required to pay the deficiencies New York assessed.
The primary issue in this case is the executives did not properly plan and coordinate with the employer. If the executives intended the incentive compensation to become fixed and determinable in 2000, prior to becoming residents of New York, they should have coordinated with their tax advisors and employer. A W-2 dated 2000 would have ensured the reporting in the desired year end and the structure of the compensation plans and any other critical factors would have been in line with their original intention.
Should you find yourself in such a situation, see below for a few items to consider:
- Will I receive incentive compensation that could be considered a New York special accrual?
- How could I structure the incentive compensation to ensure the income is not a New York special accrual?
- Is the incentive compensation fixed and determinable? Is there a contract? Is this discretionary?
- If the incentive compensation is a special accrual, how will I pay for the special accrual? Will I report the income today or in later years?
Before you move, consult with your tax advisor about how your incentive compensation will be taxed by New York in different scenarios. Planning ahead is the most important aspect of the New York special accrual rules. This is especially critical today in a time when New York is working to close their budget deficit.