Federal Taxation of LOSAP

Benefits paid from a LOSAP are subject to federal income tax as of the date this blog post is being written.

In general, any form of compensation is taxable in the year in which it is earned, unless the the Internal Revenue Code specifically exempts it. One of those exemptions are contributions into  401(k) - the Code allows an individual to defer taxation of compensation by depositing that compensation into a qualified 401(k) plan. Similarly, an individual can make contributions into an IRA and subtract those contributions (up to a certain limit) from the individual's taxable gross income.

Benefits accrued in a LOSAP are a form of compensation, and the Code does not contain any provision to exempt it from federal tax. NY State law stipulates, in summary, that the LOSAP benefits should not be taxable to the participants until it is paid. 

In order to prevent a participating volunteer from paying federal income tax on the LOSAP benefits as they are accrued rather than when they are paid, two stipulations are made on the Trust assets:

1) Trust assets are assets of the municipal sponsor.
2) Trust assets are subject to the creditors of the sponsor in the case of insolvency.

Stipulation #2 in particular means that it is possible that a participating volunteer will not be paid the accrued benefit, because the sponsor could, in theory, become insolvent and the Trust assets would be accessed by the sponsor's creditors. This is enough of a stipulation that the benefit is not taxable until it is made available to be paid to the participant. In New York, once it is made available to be paid, it is paid.

Note: this post is not meant to be an exhaustive explanation of all of the nuance of the federal taxability of LOSAP benefits. Please contact your own IRS tax specialist or contact our office for additional details.