PLR 200127049: Governmental plan contributions qualify for employer pick-up treatment

Plain-English summary

A governmental retirement system asked how mandatory employee contributions and payments to buy service credit would be taxed under its defined contribution plan. The IRS ruled that mandatory contributions and irrevocable payroll deductions to buy past or additional service credit could be treated as employer contributions under IRC § 414(h)(2). For the system's employees, those amounts would be excluded from income until distribution and from current federal income tax withholding wages. The system also asked whether both after-tax and picked-up repayments of refunded contributions escaped the § 415(c) limit. The IRS gave that treatment only to after-tax repayments used to restore forfeited service credit. It did not rule on rollover funding, FICA treatment, or whether the payments arose from a salary reduction agreement.

Ruling snapshot

• Question: Do a governmental plan's mandatory contributions and irrevocable service-credit payroll deductions qualify as employer pick-ups, and which repayments avoid the § 415(c) limit?
• Outcome: Mixed; pick-up treatment approved, but the § 415(k)(3) exception applies only to after-tax repayments.
• Key authorities: IRC §§ 401(a), 414(h)(2), 415(c), 415(k)(3), 3401(a); Rev. Rul. 81-35 and 81-36.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Uniform Issue List: 414.09-00
Washington, DC 20224
415.00-00
Person to Contact:
Telephone Number:
Refer Reply to: T:EP:RA:T2
Date: APR 9 2001

Attn:

Legend:
State A =
System S =
Participating Employer/Employers =
Plan Y =
Resolution R =
Form P =
Statute T =

This letter is in reply to a request for a letter ruling dated February 5, 1999, as supplemented by submissions of September 17, 1999, November 9, 1999, March 14, 2000, November 2, 2000, February 8, 2001, and April 4, 2001, made on your behalf concerning the federal tax treatment of certain contributions made to Plan Y under section 414(h) (2) of the Internal Revenue Code ("Code").

The following facts and representations have been submitted:

System S is a retirement and benefit system created by the laws of State A for the purpose of providing retirement annuities and other benefits for employees of Participating Employers. Since 1941, System S has maintained a defined benefit plan qualified under section 401(a) of the Code. Plan Y received its recent determination letter on April 19,1999. Effective in 1998, as an alternative to participating in the defined benefit plan, eligible employees may elect to participate in Plan Y, a defined contribution plan, to be maintained by System S. System S is also an employer of employees who are participants in Plan Y. Plan Y is administered by the Board of Trustees of System S in accordance with the provisions of Statute T.

All participants in Plan Y are required to contribute a specified percentage of their compensation to Plan Y. Under the provisions of Statute T, required employee contributions under the defined benefit plan of System S or the defined contribution plan, Plan Y, shall be made as an "employer pick-up" under section 414(h) (2) of the Code. Statute T also provides that any employee participating in the defined benefit plan prior to electing to participate in Plan Y shall continue to have the employer pick up the required contributions. Because Plan Y was a spin-off from the defined benefit plan, the same pick-up procedures utilized under the defined benefit plan are now being used under Plan Y. With respect to the required employee contributions, Statute T provides that each employer is required to pick up the employee contributions of a Plan Y participant and those contributions are to be treated as employer contributions. The employer may pick up the contributions by a reduction in the participant's salary, by an offset of future salary increases or by a combination of both. Statute T further provides that in no event shall a Plan Y participant have an option of receiving the "picked-up" amounts in cash.

Under the provisions of Statute T, employees of Participating Employers may make contributions to Plan Y for the purpose of obtaining additional service credit under two circumstances: (1) for the purpose of restoring prior service with a Participating Employer that was forfeited due to a refund of contributions ("Past Service"); and (2) for the purpose of obtaining additional service credit for periods of service not previously credited by Plan Y, such as prior service before becoming a participant, service with other State A public agencies, military service, or service for leaves of absence ("Permissive Service").

Provisions of Statute T permit an employee leaving the service of a Participating Employer the opportunity to obtain a refund of contributions made during the course of that employee's employment. The refund shall include employee contributions and interest thereon, and shall also include employer contributions and interest thereon credited to the individual's account, if the employee is vested in employer contributions when he or she terminates employment. If a former employee returns to work for a Participating Employer that entitles the employee to again become a member of System S, then that employee has the option, after remaining in eligible service for a 2-year period, of reinstating the Past Service credit that was forfeited upon obtaining the refund. To reinstate the Past Service credit the employee must repay the full amount that was refunded without interest. The election to reinstate Past Service credits must be made at a time prior to the date of the employee's retirement. Under present procedures the contributions must be paid directly to System S and must be paid in a lump sum. As with the election to purchase Past Service credits, an employee who elects to purchase Permissive Service credits must currently make payment directly to System S on a lump sum basis. The service credit may be purchased in increments of one year, if more than one year of service is available to purchase.

Statute T was amended in 1997 to permit Participating Employers to pick up the contributions required to be made by employees who wish to purchase service credit. Under Statute T an employee may elect to have a Participating Employer pick up the contributions required to purchase service credits and the election to have these contributions picked up is irrevocable.

System S proposes to implement a program under which an employee who participates in Plan Y will have several options concerning the method under which contributions could be made when the employee elects to purchase service credits, whether by repaying the amount of a prior refund, without interest, in order to reinstate Past Service credits, or by making the contributions required to purchase Permissive Service credits.

Under the proposed program, an employee will have the option to elect: (1) to make the contributions on a lump sum after-tax basis, (2) to make the contributions as a lump sum pre-tax contribution from an eligible rollover contribution, or (3) to irrevocably make the contributions on an installment basis by pre-tax payroll deductions. If the employee elects to make the contributions by payroll deduction, the repayment period must be for a period of one, two, three, four, or five years,and the payments will also have to be scheduled so that the contributions for purchase of service credits will be completed prior to the employee's retirement. If the employee elects to make the contributions for the purchase of service credits by irrevocable pre-tax payroll deduction, the contributions will be withheld by the employer and forwarded to Plan Y as picked-up contributions under section 414(h) (2) of the Code.

By your authorized representative's letter of March 14, 2000, it was clarified that in an effort to provide a full description of the program for purchasing service credit, System S has described the three methods above (including rollover contributions) that may be used for such purposes. However, it has been represented that System S is not requesting a ruling that a rollover contribution

is eligible for "pick up" treatment under section 414 (h) (2) of the Code when used to reinstate Past Service credit or purchase Permissive Service credit.

If the employee elects the irrevocable payroll deduction program, then Plan Y will refuse any direct payments from the employee for the purchase of the service credits that were being paid for by irrevocable payroll deduction. Also, the employee could not change the amount or length of time over which the irrevocable payroll deduction will occur. However, if the employer changes the employee's payroll frequency, the number and amount of each payroll deduction will automatically be adjusted, without any action on the employee's part, for the balance of the elected repayment period.

In the case of the death of an employee, payments for the purchase of service credits will stop and partial service credit will be granted, rounded down to the next quarter-year increment, based upon the contributions made to the date of death. Contributions in excess of the amount needed to provide a quarter-year of service credit will be paid to the employee's beneficiary or estate.

If irrevocable payroll deductions cease due to termination of employment or the disability of the employee, the employee will have a 60-day period in which to make an after- tax lump sum payment to pay for the balance of the contributions required to obtain the service credits which the employee intended to purchase or, if no after-tax lump sum payment is made by the employee, then partial service credit will be granted, rounded down to the next quarter-year increment, based upon the contributions made to the date payments ceased, with any excess contributions refunded to the employee.

Employees will be permitted to make separate payroll deduction authorizations to purchase service credit relating to different types of service or different periods of time. However, any subsequent irrevocable payroll deduction authorizations will not alter, amend or revoke the amount of picked up contributions to be made to Plan Y under any irrevocable elections then in effect.

A Participating Employer will be required to adopt

Resolution R authorizing the employer to participate in the pick-up program. This resolution shall designate such payroll deductions (as are made pursuant to a binding irrevocable payroll deduction authorization between an employee and respective employer to have such amounts picked up) as being picked up by such employer and paid by such employer with the employee having no option of receiving such picked up amounts contributed to Plan Y.

The payroll deduction authorization form (Form P) will state the type of service and the period of service which the employee intends to purchase, the dollar amount and the period of time over which payroll deductions will take place, that the employee understands that the payroll deduction authorization is binding and irrevocable, that the employee has no option to subsequently choose to receive those amounts directly instead of having them paid to Plan Y, that payments are to be made by the employer only and that Plan Y will not accept payments from the employee with respect to the purchase of the service credit to which the election relates, and that the agreement shall remain in effect until either the payroll deductions are completed or the payroll deductions can no longer be made due to the employee's death, disability, or termination of employment.

Based on the above facts and representations, your authorized representative has requested the following rulings:

1. That mandatory employee contribution amounts
   picked up by Participating Employers, even though designated as employee contributions for state law purposes, will be treated as employer contributions, pursuant to section 414(h) (2) of the Code.

2. That such mandatory amounts picked up by System S
   on behalf of employees of System S and contributed to Plan Y will be excluded from the gross income of the employees and will not be included in their gross income until distributed to such employees.

3. That the mandatory amounts so picked up by System
   S on behalf of employees of System S and contributed to Plan Y will not constitute wages under section 3401(a) of the Code from which federal income tax must be withheld in the tax year in which such amounts are contributed.

4. That after a Participating Employer has adopted
   Resolution R and the employee has executed the irrevocable payroll deduction authorization (Form P), contributions made to Plan Y for the purpose of an employee's purchase of service credit (regardless of whether such service credit is for Past Service or Permissive Service) will be treated as contributions picked up by the Participating Employer within the meaning of section 414(h) (2) of the Code and will be treated as employer contributions for federal income tax purposes.

5. That changes to the amount or number of payments
   under an irrevocable payroll deduction authorization, due to changes in the employer's payroll frequency, will not cause the contributions to cease to qualify as contributions picked up by a Participating Employer within the meaning of section 414(h) (2) of the Code nor cease to qualify as employer contributions for federal income tax purposes.

6. That for purposes of the application of section
   414(h) (2) of the Code, death, disability, or termination of employment are permissible reasons for the termination of the irrevocable election to make the contributions by payroll deduction.

7. That for purposes of employees of System S, who
   are participants in Plan Y, the picked-up contributions, pursuant to irrevocable payroll deduction elections, will not constitute wages under section 3401(a) of the Code from which federal income tax must be withheld in the tax year in which they are contributed.

8. That the contributions relating to the
   reinstatement of Past Service (whether after-tax or picked- up) are not subject to Code section 415(c) when made to Plan Y pursuant to section 415(k) (3) of the Code.

Section 414(h) (2) of the Code provides that contributions, otherwise designated as employee contributions, shall be treated as employer contributions if such contributions are made to a plan described in section 401(a) or 403(a) of the Code, established by a state government or political subdivision thereof, or by any agency or instrumentality of any of the foregoing, where the contributions of employing units are designated as employee contributions, the contributions so picked up shall be treated as employer contributions.

Revenue Ruling 77-462, 1977-2 C.B. 358, addresses the federal income tax treatment of contributions picked up by the employer within the meaning of section 414(h) (2) of the Code. In Rev. Rul. 77-462, the employer school district agreed to pick up the required contributions of the eligible employees under the plan. The revenue ruling held that under the provisions of section 3401(a) (12) (A) of the Code, the school district's picked-up contributions to the plan are excluded from wages for purposes of the Collection of Income Tax at Source on Wages, and no federal income tax withholding is required from employees' salaries with respect to the said picked-up contributions. The revenue ruling further held that the school district's picked-up contributions are excluded from the gross income of employees until such time as they are distributed to the employees.

Revenue Ruling 81-35, 1981-1 C.B. 255, and Revenue Ruling 81-36, 1981-1 C.B. 255,provide guidance as to whether contributions will be considered as "picked up" by the employer. Both revenue rulings establish that the following two criteria must be satisfied: (1) the employer must specify that contributions, although designated as employee contributions, are being paid by the employer in lieu of contributions by the employee; and (2) the employee must not have an option of choosing to receive the contributed amounts directly or to have them paid by the employer to the plan.

In Revenue Ruling 87-10, 1987-1 C.B. 136, the Service considered whether contributions designated as employee contributions to a governmental plan are excludable from the gross income of the employee. The Service concluded that to satisfy the criteria set forth in Revenue Rulings 81-35 and 81-36 with respect to particular contributions, the required specification must be completed before the period to which such contributions relate.

In this case, Plan Y is a governmental plan as described in section 414(d) of the Code. Under Statute T, each Participating Employer is required to "pick up" within the meaning of section 414 (h) (2) of the Code the mandatory employee contributions of employees who participate in Plan Y, and the contributions so picked up shall be treated as employer contributions for federal income tax purposes. The employer may pick up these contributions by a reduction in the participant's salary, by an offset against a future salary increase, or by a combination of both.

In accordance with the provisions of Statute T and Resolution R, a Participating Employer will pick up certain employee contributions and pay them to Plan Y. If an employee of a Participating Employer elects to reinstate Past Service credit or purchase Permissive Service credit and agrees to do so by payroll deduction, the Participating Employer will pick up (i.e., assume and pay) the contributions that the employee is required to pay for the purchase of service credit. Further, in accordance with the provisions of Form P, the election of the employee to purchase service credit by payroll deduction under the pick-up arrangement with such Participating Employer is irrevocable and cannot be changed by the employee prior to termination of employment, disability, or purchase of all of the service credit set forth on Form P.

The provisions of Resolution R in conjunction with Statute T meet the requirements of Rev. Rul. 81-35 and Rev. Rul. 81-36. Thus, the amounts deducted by a Participating Employer from employees' compensation and contributed to Plan Y for the purchase of service credit will qualify as picked-up contributions within the meaning of section 414 (h) (2) of the Code.

Accordingly, based on the above facts and representations, we conclude that:

1. Mandatory employee contribution amounts picked up
   by Participating Employers, even though designated as employee contributions for state law purposes, will be treated as employer contributions within the meaning of section 414(h) (2) of the Code.

2. Such mandatory amounts picked up by System S on
   behalf of employees of System S and contributed to Plan Y will be excluded from the gross income of the employees and will not be included in their gross income until distributed to such employees.

3. The mandatory amounts so picked up by System S on
   behalf of employees of System S and contributed to Plan Y will not constitute wages under section 3401(a) of the Code from which federal income tax must be withheld in the tax year in which such amounts are contributed.

4. That after a Participating Employer has adopted
   Resolution R and the employee has executed the irrevocable payroll deduction authorization form (Form P), contributions made to Plan Y for the purpose of an employee's purchase of service credit (regardless of whether such service credit is for Past Service or Permissive Service) will be treated as contributions picked up by the Participating Employer within the meaning of section 414 (h) (2). of the Code and will be treated as employer contributions for federal income tax purposes. ,

5. Changes to the amount or number of payments under
   an irrevocable payroll deduction authorization, due to changes in the employer's payroll frequency, will not cause the contributions to cease to qualify as contributions picked up by a Participating Employer within the meaning of section 414 (h) (2) of the Code nor cease to qualify as employer contributions for federal income tax purposes.

6. For purposes of the application of section
   414 (h) (2) of the Code, death, disability, or termination of employment are permissible reasons for the termination of the irrevocable election to make the contributions by payroll deduction.

7. For purposes of employees of System S, who are
   participants in Plan Y, the picked-up contributions, pursuant to irrevocable payroll deduction elections, will not constitute wages under section 3401(a) of the Code from which federal income tax must be withheld in the tax year in which they are contributed.

With respect to Ruling Request #8, we notified your authorized representative in our letter dated October 13, 2000, that the Service was proposing to issue an adverse ruling. Your authorized representative, in his letter dated November 2, 2000, requested that Ruling Request #8 be issued as we had proposed.

Section 415(k) (3) of the Code provides that in the case of any repayment of contributions ( including interest thereon) to the governmental plan with respect to an amount previously refunded upon a forfeiture of service credit under the plan or under another governmental plan maintained by a State or a local government employer within the same State, any such repayment shall not be taken into account for purposes of this section

Section 415(k) (3) was added to the Code by section 1526(b) of the Taxpayer Relief Act of 1997 (TRA '97), Pub.L. 105-34, effective with respect to contributions made in plan years beginning after December 31, 1997. The legislative history to section 1526 of TRA '97 states that in the case of any repayment of contributions and earnings to a governmental plan with respect to an amount previously refunded upon a forfeiture of service credit under a plan (or another plan maintained by a State or local government employer within the same State), any such repayment shall not be taken into account for purposes of Code section 415 and service credit obtained as a result of the repayment shall not be considered permissive service credit. (H.R. Rep. No. 105-220, 105th Cong., 1st Sess. 742 (1997)). Thus, we conclude that the special rule under section 415 (k) (3) of the Code only applies to after-tax employee contributions that are paid into a state or local governmental plan to reinstate previously forfeited service credit.

Accordingly, with respect to Ruling Request # 8, we conclude that the after-tax employee contributions made to reinstate Past Service (not "picked-up" contributions) are not subject to Code section 415(c) when made to Plan Y within the meaning of Code section 415(k) (3).

Under the irrevocable payroll deduction program to reinstate Past Service credit or to purchase Permissive Service credit, the effective date for the commencement of any proposed pick up cannot be any earlier than the later of (i) the adoption date of Resolution R, (ii) the effective date of Resolution R, or (iii) the date the irrevocable payroll authorization form (Form P) is signed by both parties.

These rulings are based on the assumption that Plan Y meets the requirements for qualification under section 401(a) of the Code at the time of the proposed contributions and distributions. These rulings do not address the option under the proposed pick-up program that allows a participant to reinstate Past Service credit or purchase Permissive Service credit by using the funds from an eligible rollover contribution.

No opinion is expressed as to whether the amounts in question are subject to tax under the Federal Insurance Contributions Act. No opinion is expressed as to whether the contributions in question are paid pursuant to a "salary reduction agreement" within the meaning of section 3121(v) (1) (B) of the Code.

This letter ruling is directed only to the taxpayer that requested it. Section 6110(k) (3) of the Code provides that it may not be used or cited by others as precedent.

A copy of this ruling has been sent to your authorized representative in accordance with a power of attorney on file in this office.

Sincerely yours,

Joyce E. Floyd
Manager, Employee Plans
Technical Group 2
Tax Exempt and Government
Entities Division

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