Lawsuit Cites Contradictions in a Rare Retirement Benefit

For thousands of retired police officers, firefighters and correction officers in New York, the city's most oddly structured and awkwardly named retirement benefit — the Variable Supplement Funds — is a fruit of maturity more valued than early-bird specials or afternoon naps.

Since 1970, the funds have provided some retirees with annual lump sum payments in addition to their regular pension checks. The payments increase by $500 each year, and this year recipients are each getting $9,000, on which they do not pay state income taxes.

The benefit is so attractive that many of the vast majority of city employees who do not get it have lobbied and sued for years to gain the benefit for themselves. The city has successfully beaten back 29 lawsuits that challenged the funds.

But recently, a lawsuit was filed that again challenges the funds, not by asserting that they are distributed unfairly, but by maintaining that they violate the federal tax code.

If the lawsuit, filed by a group of retired correction officers, is successful, it could force the city to overhaul the way it has structured its pension system. But city lawyers said they were confident that this lawsuit would fail like the others.

"Now that they have been rejected on every other theory," said a lawyer for the city, James Dwyer, "they have glommed on to this new theory, which we believe will also be rejected."

In the new lawsuit, filed in April in State Supreme Court in Manhattan, the retirees say the variable supplement system threatens the tax-exempt status of their $39 billion pension fund because it is financed through excess earnings from pension investments.

Under federal law, municipal pension money must be spent for pension purposes. The suit contends that the city violated that law by funneling pension earnings into the Variable Supplement Funds, which are defined as nonpension benefits in the state statutes that created them.

"We're worried that, if this fund is not really a pension benefit, it may throw the entire pension system out of compliance and we may be subject to taxes on it," said Anthony Arfi, one of 400 plaintiffs in the suit.

The city says that for federal tax purposes, the funds function like part of the pension system, even though they are called nonpension benefits under state law. "We're not taking money out of the pension fund to paint the Brooklyn Bridge," Mr. Dwyer said in a hearing this year. "We're taking money out of the pension fund to pay service retirees." Kevin Fitzpatrick, the lawyer for the plaintiffs, said the city cannot have it both ways. "They can't say it is black under state law and white under federal law," he said.

The way these funds are set up is rare among municipal pension systems, and has led to some paradoxes. Like pension income, V.S.F. income is not taxed by the state. But unlike pension income, V.S.F. income is not distributed in divorce settlements because a state appeals court has ruled that the funds are not pension benefits.

Even the city seemed confused in 1988 when, with permission from the affected unions, it took $75 million from the Variable Supplement Funds to help balance its budget. Several pension law experts said that if the funds were part of the pension system, as the city has contended, removing money for nonpension purposes would seem to have violated the federal tax code. "Dipping in is not a good thing to do," said Harvey Katz, a Manhattan lawyer specializing in pension law.

A former city official, who spoke only on the condition of anonymity, said the city believed the money could be removed because it had not taken proper interest credits on earlier transfers into the funds.

The Variable Supplement Funds were given to retired police officers and firefighters 31 years ago when the city sought permission to invest their pension funds in the stock market. But state law forbids reductions in pension benefits, and the city was unsure it wanted provide the benefit forever, so the new funds were defined as nonpension benefits in the state laws that created them, officials said.More than 20,000 retirees now receive the benefit, which was extended to transit and housing police officers in 1988, and to correction officers in 2000. Retirees who left those jobs before the benefit was granted, like Mr. Arfi, are not eligible. The city has said it was too expensive to extend the benefit to those retirees or other unions.

The lawsuit contends that if the pension systems lose their tax-exempt status, active employees will have to pay taxes on pension contributions made on their behalf each year by the city even though they do not get the money until retirement. But city lawyers have said there is little chance that the Internal Revenue Service will make such a ruling.

"We have presented all of the details of the V.S.F. to the I.R.S. and answered all of their questions," Mr. Dwyer said, "and they have concluded that, for the purposes of the I.R.S. code, the V.S.F. and the pension are one unitary structure."

An Internal Revenue Service spokesman said that the agency, by law, did not discuss matters involving taxpayers.

"Regardless of what the I.R.S. ultimately holds," said Norman Stein, a professor and pension expert at the University of Alabama, "it does seem that the city acted with minimal regard to the tax consequences when it created this fund."

Those who are entitled to the V.S.F. benefit are not happy with Mr. Arfi and the other retirees.

"I think they are acting very irresponsibly and selfishly," said Norman Seabrook, the president of the Correction Officers Benevolent Association. He characterized the lawsuit as a frivolous attempt to "take away from present members something that we worked very hard for."

But Edward Ranieri, a retired transit police officer who helped organize the new challenge, said the suit was not an effort to hurt anyone. "If there is deceit here," he said, "they can thank the people who were supposed to make sure that the pension system was in full compliance with the law."