I.R.S. Faults City Dealings on Pensions

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I.R.S. Faults City Dealings on Pensions

By KEVIN FLYNN, NY Times

January 20, 2003

The Internal Revenue Service has found that New York City violated federal tax laws by withdrawing $177 million over seven years from municipal pension systems and using it to pay its own operating expenses, according to a tentative settlement agreement reached this month between the city and the I.R.S.

The affected unions approved the withdrawals starting in 1988 in exchange for additional benefits for retired police officers, firefighters and other city workers. Nonetheless, the I.R.S. concluded that the transfers of money had violated the federal tax code, which says pension funds must be operated solely for the benefit of participants.

Any withdrawal of funds, other than to pay pensions or the pension system's operating expenses, is illegal and can cause a pension plan to lose its tax exemption or subject it to significant penalties.

But the I.R.S., citing the city's financial crisis since 9/11, has waived all sanctions against the city. The city also will not have to repay to the fund the $177 million that the I.R.S. contends it improperly received. Instead, past pension contributions that the city routinely made into the funds over the past decade to ensure they were fully funded will be credited as repayments of the $177 million, city officials said.

Several pension experts criticized the I.R.S.'s treatment of the city, saying it would undermine the agency's efforts to display consistent, evenhanded enforcement toward those who violate federal pension laws.

"This is an extremely serious matter," said Harvey Katz, a Manhattan lawyer who specializes in pension law. "Because it is the City of New York, they got a sweetheart deal. A private party would have been required to pay back the money immediately with interest and, under the I.R.S. guidelines, the sanctions would have been in the tens of millions of dollars."

The I.R.S., which drafted the agreement but has yet to sign it, declined to comment.

The city is also being required to seek state legislation to bring the pension plans into compliance with federal law.

The proposed settlement, which the city has already signed, grew out of more than three years of discussions between the I.R.S. and the city. The talks intensified in April 2001 when a group of New York City retirees filed a state lawsuit that maintained that several city pension systems violated the federal tax code. Their suit is still pending and they are challenging the settlement.

The $177 million was withdrawn in six payments between 1988 and 1995, from the police, fire and New York City Employees Retirement System pension plans, officials said. In exchange for the money, the city agreed, starting in 1988, to pay some retired police officers and firefighters an annual lump sum, above and beyond their traditional pensions. The payments come from what is known as the variable supplement funds. This year the retirees will receive $10,000.

Although they agreed to the terms of the settlement, city officials disputed the contention that the receipt of the $177 million was improper. They said the city was authorized to receive the funds, not only by the affected unions, but also by state law.

"We didn't remove it," said James J. Dwyer, a lawyer who directs the pension division for the city's Law Department. "The Legislature said we could take it."

City officials said the I.R.S. had also recognized that the money received by the city, unlike funds diverted by a private employer, had been spent for public purposes.

Yet if the city wanted to make similar deals with unions in the future, Mr. Dwyer said, "I don't believe that we would recommend that any similar agreements be structured along similar lines."

Financing arrangements like the ones that created the variable supplement funds are rare among municipal pension systems. They were first created by the city three decades ago. At the time, the city was seeking labor's permission to invest pension funds in the stock market, to take advantage of the potentially greater returns in the market compared with more conservative investments. In exchange for permitting the riskier investments, the police and fire unions were promised that their retirees would receive lump-sum payments each year, in addition to their pension checks.

The payments would be financed by the anticipated higher earnings of the stocks and would be based on how the investment portfolio had performed each year. To finance the payments, the city funneled the excess earnings of the pension plans into the variable supplement funds.

In 1988, the city changed the payment schedule. Instead of a variable amount each year, it promised a set amount that would be paid regardless of the stock market's performance. In exchange for such a guarantee, the city, which was in financial straits, got the police union to turn over $75 million from the union's variable supplement fund.

In later years, as unions representing firefighters and other workers sought the same guaranteed benefit, the city asked them to turn over similar amounts from their pension funds.

All told, the city received $177 million in this manner. That is the money that the I.R.S. contends should never have been withdrawn.

"All trustees authorized it," said Joseph Maccone, a pension consultant for the Patrolmen's Benevolent Association. "It wasn't as if the city did this without asking everybody's permission."

Today, more than 20,000 retired police officers, firefighters and others receive the lump-sum payments. Tens of thousands of other city retirees do not receive the benefit because the city says the cost would be too great. The disparity has led to long arguments. Retirees who do not receive the benefit, who include disabled firefighters and police officers who retired before it was created, have filed more than two dozen lawsuits challenging the benefit as discriminatory. All have failed.

Two years ago, however, a group of retired correction officers took an entirely different tack. They claimed in their suit that the original funneling of excess pension earnings into the separate variable supplement funds represented an illegal diversion of funds that, in itself, violated the federal tax code. In addition, the plaintiffs cited the city's withdrawal of money from the supplement funds over the years as improper.

The lawsuit led to a more rigorous I.R.S. review, city officials said, and, ultimately, the proposed agreement. During the review, the I.R.S. found that the withdrawal of money by the city was, indeed, a violation of the tax laws. At the same, it decided that the original diversion of excess pension earnings into the variable supplement funds was allowable.

City lawyers said the agreement resolved the basic question posed by the lawsuit in their favor: the supplement funds in themselves do not violate the federal tax code.

If the federal tax agency had stripped the pension plans of their tax-exempt status, the pension beneficiaries could have been required to pay immediate taxes on the current value of their holdings in the plans, experts said.

David Cohen, a lawyer who specializes in pension plans, said he found the I.R.S. position reasonable. "The I.R.S., instead of trying to break the city, is showing itself to be the kinder, gentler I.R.S., one that is more interested in compliance than punishment," he said.

But the lawyer for the retired correction officers said he would try to block the I.R.S. from finalizing the agreement. The lawyer, Kevin P. Fitzpatrick of Marschhausen & Fitzpatrick, said the I.R.S. had failed to enforce its own regulations.

"Is this the same I.R.S.," he asked in a Jan. 8 letter to the agency, "that routinely punishes private sector plans, corporations and even goes so far as to punish spouses who merely sign joint returns with a tax-evading spouse?"