NY State tax treatment of Accrued Market Discount for US Treasury Note

[Thank_You]

New York State

Here is the subject case:

1) A US Treasury Note is purchased on the secondary market at a discount.

2) The Note is held to maturity and then redeemed.

3) The amount of the "Accrued Market Discount" (Box 1f reported on 1099-B for TY23) is determined to be interest for income tax purposes.

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Here is the Question:
Is this interest from the accrued market discount exempt from NY State income tax?

Important note to avoid any misunderstanding:

This is not a question about the interest from the Note reported on Form 1099-INT which I am aware is NY State tax exempt. It is a question about the interest reported on form 1099-B as "Accrued Market Discount."
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Thank you for any definitive specific answer and if a citation can be provided that would also be appreciated.

 

[davew9128]

Accrued market discount is considered to be interest. Not providing citations because I don't research for free (even when I already know the answer).

 

[Taxing Matters]

Note that the accrued interest is not interest from the Treasury, so it won't be exempt from state tax even if the state otherwise exempts interest paid on federal obligations.

 

[Bali Hai Again]

Note that the accrued interest is not interest from the Treasury, so it won't be exempt from state tax even if the state otherwise exempts interest paid on federal obligations.

Sounds like a downside to buying treasuries on the secondary market, especially if you live in a high income tax state like New York. For me it’s go straight to the source and redeem or reinvest at maturity.

 

[Thank_You]

Accrued market discount is considered to be interest. Not providing citations because I don't research for free (even when I already know the answer).

Thank you for your reply, but whether or not the AMD is treated as interest was not the question. The question already stipulates that it is treated as interest. The question was whether it is also treated as exempt from New York state income tax.

Note that the accrued interest is not interest from the Treasury, so it won't be exempt from state tax even if the state otherwise exempts interest paid on federal obligations.

Thank you too for your reply. You may well be correct. Unfortunately, in several places where I posted this question, I have received conflicting responses from those who were confident they were correct. Some of them responded as you did, some responded that it is exempt from state income tax in all states and others responded that it is exempt in some states but not others. Each response, including yours seems to have logical support. But logical isn't always right especially when it comes to legislation. So I sincerely do appreciate your response but in light of the other responses I have received at this point I will need some additional supporting information in order to help me decide which response is correct. If you can provide anything to that end I would be grateful.

Sounds like a downside to buying treasuries on the secondary market, especially if you live in a high income tax state like New York. For me it’s go straight to the source and redeem or reinvest at maturity.

Yes, if correct, it should be factored into the calculation when making the buying decision and may give an advantage to other competitive bonds with higher coupons and smaller market discounts or those selling at a premium for some buyers.

 

[LdiJ]

Thank you for your reply, but whether or not the AMD is treated as interest was not the question. The question already stipulates that it is treated as interest. The question was whether it is also treated as exempt from New York state income tax.



Thank you too for your reply. You may well be correct. Unfortunately, in several places where I posted this question, I have received conflicting responses from those who were confident they were correct. Some of them responded as you did, some responded that it is exempt from state income tax in all states and others responded that it is exempt in some states but not others. Each response, including yours seems to have logical support. But logical isn't always right especially when it comes to legislation. So I sincerely do appreciate your response but in light of the other responses I have received at this point I will need some additional supporting information in order to help me decide which response is correct. If you can provide anything to that end I would be grateful.



Yes, if correct, it should be factored into the calculation when making the buying decision and may give an advantage to other competitive bonds with higher coupons and smaller market discounts or those selling at a premium for some buyers.

Taxing Matters is a tax attorney. What were the professional credentials of the people who gave you advice that contradicted his?

 

[Thank_You]

Taxing Matters is a tax attorney. What were the professional credentials of the people who gave you advice that contradicted his?

If true, and he has had first hand professional experience with this topic, it is the kind of additional information I had in mind with respect to deciding which responses I find most credible.

Update

Then there is this:

"Talked to my friend who is a CPA and has a Master's Degree in Taxation.
He said that you do not pay tax on the AMD in either state. He said that it really isn't up to the state as states are prevented from taxing US government interest under Article VI, Clause 2, of the US Constitution. See McCulloch v. Maryland, Osborn v. Bank of the United States, and Weston v. Charleston. In the Weston case the court explicitly held that states cannot tax interest on US bonds and other securities. He said that AMD is considered interest.”

 

[Taxing Matters]

Then there is this:

"Talked to my friend who is a CPA and has a Master's Degree in Taxation.
He said that you do not pay tax on the AMD in either state. He said that it really isn't up to the state as states are prevented from taxing US government interest under Article VI, Clause 2, of the US Constitution. See McCulloch v. Maryland, Osborn v. Bank of the United States, and Weston v. Charleston. In the Weston case the court explicitly held that states cannot tax interest on US bonds and other securities. He said that AMD is considered interest.”

My practical view is that if the state accepts it as interest paid to the Treasury and exempts it then that taxpayer favorable position is the one I would take. It only becomes a fight if the state looks at it as as not interest paid by the federal government. Unless the amount at issue was considerable, it wouldn't be worth paying the cost to fight that battle. If the state is happy, and the state's position is favorable to you, then that's what matters.

The position the state published 1996 on the treatment of interest from U.S. obligations makes no distinction between the AMD interest and the instrument's stated interest. As it is still on the website it may still reflect the thinking of the NY State Department of Taxation and Finance. That information is on memorandum TSB-M-95 (4) I. Hopefully that will be helpful in your search for the answer on the AMD portion of the proceeds.

 

[Thank_You]

My practical view is that if the state accepts it as interest paid to the Treasury and exempts it then that taxpayer favorable position is the one I would take. It only becomes a fight if the state looks at it as as not interest paid by the federal government. Unless the amount at issue was considerable, it wouldn't be worth paying the cost to fight that battle. If the state is happy, and the state's position is favorable to you, then that's what matters.

The position the state published 1996 on the treatment of interest from U.S. obligations makes no distinction between the AMD interest and the instrument's stated interest. As it is still on the website it may still reflect the thinking of the NY State Department of Taxation and Finance. That information is on memorandum TSB-M-95 (4) I. Hopefully that will be helpful in your search for the answer on the AMD portion of the proceeds.

Thank you, your posts are some of the most useful I have found and I appreciate your expertise. However, with this post you seem to be backing off from your original statement which seemed to emphatically state that the AMD is not exempt from state tax.

Am I wrong?

 

[davew9128]

If true, and he has had first hand professional experience with this topic, it is the kind of additional information I had in mind with respect to deciding which responses I find most credible.

Update

Then there is this:

"Talked to my friend who is a CPA and has a Master's Degree in Taxation.
He said that you do not pay tax on the AMD in either state. He said that it really isn't up to the state as states are prevented from taxing US government interest under Article VI, Clause 2, of the US Constitution. See McCulloch v. Maryland, Osborn v. Bank of the United States, and Weston v. Charleston. In the Weston case the court explicitly held that states cannot tax interest on US bonds and other securities. He said that AMD is considered interest.”

I don't like to get caught up in credential boasting and male sex organ wagging. The CPA is right but the prohibition is also codified in Title 31 of the US Code. The problem you run into in a situation like this is defining what is considered US Treasury bond interest. Some states (including NY) will not recognize US govt. interest from a mutual fund unless certain income and asset tests are met with regard to the fund's holdings.

Is that relevant to your situation? Only as an analogy as to the complexity of this. FWIW, I agree with the CPA absent something from NY that states otherwise. IRC 1278 considers this interest, and the source is from a treasury obligation, so unless the state adopts a different definition, I would consider it exempt.

Oh and for the record, Enrolled Agent, MST and admitted to the US Tax Court bar.

 

[Taxing Matters]

Thank you, your posts are some of the most useful I have found and I appreciate your expertise. However, with this post you seem to be backing off from your original statement which seemed to emphatically state that the AMD is not exempt from state tax.

Am I wrong?

It is my conclusion that when analyzed financially the AMD is not interest paid by the Treasury. (I also have a background in finance.) But the tax law and sound financial analysis is not always the same. NY hasn't stated anything more specifically on it than what I pointed out before, as far as I've been able to find. And that seems to suggest NY would treat it all as exempt interest. My general rule when advising clients is that when the government's position is favorable to the client, go with that even if the government's position doesn't really make sense or isn't logical. There are plenty of provisions in the tax statutes and regulations of the federal and state governments that don't really make sense logically or follows some other financial convention than would be used by anyone else. It's when the agency determination is not favorable to my client and there is no case law yet on it that I'll recommend taking the more favorable position I've arrived at and go from there unless the amount at issue is just to small to make it worth anyone's time and money to contest it. In this case the position I arrive at just from logic isn't favorable, and I don't see any reason to take that on a return if there's a chance the state's position is different or the state just isn't willing to contest it. It may just fly through the system without any human eyeball ever seeing it.

 

[Thank_You]

Note that the accrued interest is not interest from the Treasury, so it won't be exempt from state tax even if the state otherwise exempts interest paid on federal obligations.

It is my conclusion that when analyzed financially the AMD is not interest paid by the Treasury. (I also have a background in finance.) But the tax law and sound financial analysis is not always the same. NY hasn't stated anything more specifically on it than what I pointed out before, as far as I've been able to find. And that seems to suggest NY would treat it all as exempt interest.

I had been hoping that your first response was an indication that your familiarity with this issue was based on your personal professional experience with it as a tax attorney and that your response was so emphatic and conclusive because you have had enough experience to know with confidence what the outcome would be if the exemption is taken.

But you seem to have now taken the opposite position in the course of this online discussion, so it seems like that is not the case.

I also have a background in finance and I understand the point about the AMD not being interest but only treated as interest for federal tax purposes. Unlike the coupon interest paid on the bond, the AMD is not income related to an obligation of the US Treasury, or paid by the federal government to the bondholder, it is income related to the price of the bond in the private marketplace. In fact that was the understanding that prompted me to raise this question in the first place.

I am leaning towards a conclusion that the AMD is tax exempt at the state level based on a seeming lack of any indication to the contrary. But I still have (apparently) not found a convincing conclusive answer from someone who works professionally with this and has firsthand knowledge of how the states handle it. With surely at least hundreds of thousands or more of these bonds traded on the secondary market every year, surely there are tax professionals who deal with it regularly. But it appears my search for such a source is still unfruitful.

Taxing Matters is a tax attorney. What were the professional credentials of the people who gave you advice that contradicted his?

I think this is a good example of why credentials are not the best predictor of accuracy in most cases but rather experience with the issue at hand.

 

[Taxing Matters]

I had been hoping that your first response was an indication that your familiarity with this issue was based on your personal professional experience with it as a tax attorney and that your response was so emphatic and conclusive because you have had enough experience to know with confidence what the outcome would be if the exemption is taken.

I don't practice in NY and even if I did, the state of the law in NY is not much, from what I can see. But what there is available seems to support the notion that NY treats it all as Treasury interest. The only way you'll get a definitive answer to that is if NY issues a tax ruling on the issue, the matter is decided by a court, or the NY legislature passes a law clarifying the treatment.

But you seem to have now taken the opposite position in the course of this online discussion, so it seems like that is not the case.

The initial answer I gave is what I would give a client if there was no guidance anywhere on the issue and one had to rely on logic to complete the return rather than something from the state or the courts that indicates the answer is different. I found the NY ruling after my initial post. With a ruling like that, I would be more comfortable recommending a client take the more favorable position that it's all exempt, even if the state's conclusion isn't all that logical.

I also have a background in finance and I understand the point about the AMD not being interest but only treated as interest for federal tax purposes. Unlike the coupon interest paid on the bond, the AMD is not income related to an obligation of the US Treasury, or paid by the federal government to the bondholder, it is income related to the price of the bond in the private marketplace. In fact that was the understanding that prompted me to raise this question in the first place.

Those of use who tend to focus on logic and want to see that in the tax law sometimes end up being disappointed. Early in my career I stopped the frustating effort of trying to find logic in some of the tax rules. It turns out some just have no logic other than it appealed to some constituency of some member(s) of Congress or the state legislature. I've accepted that even though the tax law is one place where logic should prevail, it sometimes suffers at the hands of political expediency. So I understand why it bothers you that the answer, such as it is, seems to depart from logic. I also understand why you might be mystified that after all these years the issue has never been resolved, either by the state or by the courts. You'd think that somewhere along the way someone at the tax agency might have asked the question about the AMD portion. But if no one is making a big deal out of it, no one may pay attention to it. While I was at IRS I encountered some old rulings of the Service that any tax professional knowledgable about knew was no longer good. But despite decades of time passing, the IRS hadn't gotten around to pulling the ruling. That basically left everyone unclear about what position the IRS would take, much like the situation you have here. There just isn't the guidance out there on some issued that you'd like to have. That's one of the downsides of the complex income tax system we use in this country.

I am leaning towards a conclusion that the AMD is tax exempt at the state level based on a seeming lack of any indication to the contrary. But I still have (apparently) not found a convincing conclusive answer from someone who works professionally with this and has firsthand knowledge of how the states handle it. With surely at least hundreds of thousands or more of these bonds traded on the secondary market every year, surely there are tax professionals who deal with it regularly. But it appears my search for such a source is still unfruitful.

That depends on what kind of tax professional is working the issue and what their background is. What typically happens in situations where there is little to no official guidance is that people start filing taking the position that best favors them and hope that they don't end up being challenged on it. The idea is that if they are audited on the issue they can at least offer some logical reason for the position they took. While that would not prevent the state from increasing the tax and adding interest, they may at least avoid penalties. Whereas if there was guidance out there against them, the likelihood of escaping a penalty goes down significantly.

Ultimately when it comes to taking positions on returns where there is little guidance out there to give you comfort on which is the right one to take, you have to apply logic and apply a measure of practicality to it. How much money is at stake? What are the consequences if you take the more favorable position and lose? What is the best route for reducing risk? And what is your (or your client's) tolerance for risk?

I understand wanting a definitive answer on this question. But as matters stand today, there isn't one. At some point you have say you've done a sufficient search for the answer, haven't found, and proceed to make the decision based on the kinds of factors I've discussed above. Think about what possible different logical answers migh be given and how strong each is, and think about the practical effect of each position.

I think this is a good example of why credentials are not the best predictor of accuracy in most cases but rather experience with the issue at hand.

You want someone with both an understanding of the law and experience with how it's been applied by the particular tax agency involved. Keep in mind that someone with experience may still be wrong and just never was challenged on it in the past. I've seen some of that with some tax prep firms. The people are experienced in that they've done it the same way year after year and haven't had any problems. That's helpful experience, but it only goes so far. It doesn't guarantee that the agency won't start looking at that issue more closely and come out to a different conclusion. If the experience is not also supported by a defendable legal position, when the agency finally gets around to looking at, those people don't come out very well. You ideally want both the knowledge and experience. The best shot you have at that is consulting a NY tax professional (tax attorney, tax CPA, enrolled agent) and paying the fee for their expertise. Looking for free answers on any internet forum at best just points you in the right direction to pursue the answer.

 

[Thank_You]

@Taxing Matters

Thank you. Very insightful comments.

I have a CPA who is preparing several tax returns for me this year and plan to be guided by his advice. But since this is something I had no familiarity with, I was seeking a second opinion in advance of discussing it with him so I could be better informed when we discuss it, but I think I have now obtained all the information available to me.