PLR 200631024: City's picked-up pension contributions excluded from current wages

Plain-English summary

A municipal employer adopted an ordinance to pay required employee pension contributions through reductions in cash salary. Employees could not choose to receive those amounts in cash. The IRS ruled that the contributions were treated as employer contributions under IRC § 414(h)(2), excluded from employees' current gross income and from wages for federal income tax withholding. The ruling applies only from the later of the ordinance's adoption or the date the pickup takes effect and assumes the pension plan qualifies under § 401(a). The IRS did not decide whether the amounts are subject to Social Security and Medicare taxes.

Ruling snapshot

• Question: Do the mandatory pension contributions picked up by the city count as employer contributions excluded from current income and withholding wages?
• Outcome: Approved, subject to the stated effective date and plan qualification conditions.
• Key authorities: IRC §§ 401(a), 414(h)(2), 3401(a)(12)(A); Rev. Ruls. 77-462, 81-35, 81-36, 87-10.

Full text (IRS public release)

200631024

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Uniform Issue List: 414.09-00

5/8/06
T:EP:RA:T 2

Attn: ***

Legend:

Employer M = *

State A = *

Plan X = *

Statute P = *

Statute Q = *

Statute R = *

Statute S = *

Group N Employees = *

Ordinance O = *

Dear ****:

This is in response to a letter dated April 21, 2006, as supplemented by a letter dated May 9, 2006, submitted on your behalf by your authorized representative, in which you request a ruling concerning the federal income tax treatment under Internal Revenue Code (Code) section 414(h)(2) of certain contributions to Plan X.

The following facts and representations have been submitted by your authorized representative:

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Employer M is a governmental employer in State A. Statute P provides that in each municipality, as defined in Statute Q, with a population of between 5,000 and 50,000 inhabitants, the city council or board of trustees shall establish and administer a pension plan for the benefit of its employees and their beneficiaries. Employer M is described as a municipality in State A and established Plan X for the benefit of its Group N Employees and their beneficiaries. You represent that Plan X is qualified under section 401 (a) of the Code and is a governmental plan as described in section 414(d) of the Code.

Statute R provides, in general, that each Group N Employee shall contribute a certain percentage of his or her salary to Plan X. You represent that the basic contribution rate is 9 percent of each Group N Employee’s salary, which amount is withheld from the Group N Employee’s salary and contributed to Plan X.

Statute S provides, in general, that a municipality, such as Employer M, may pick up the Group N Employees contributions’ required by Statute R. If a municipality decides not pick up the contributions, the required contributions shall continue to be deducted from salary. Statute S further provides that if contributions are picked up, they shall be treated as employer contributions in determining tax treatment under the Code; however, the municipality shall continue to withhold Federal and State income taxes based on these contributions until the Internal Revenue Service or the Federal courts rule that pursuant to section 414(h) of the Code, these contributions shall not be included as gross income of the Group N Employees until such time as they are distributed or made available. Statute S also states that the municipality shall pay these contributions from the same source of funds which is used to pay the salaries of the Group N Employees and that the municipality may pick up these contributions by a reduction in the cash salary of the Group N Employees or by an offset against a future salary increase or by a combination of a reduction in the salary and offset against a future salary increase. If contributions are picked up they shall be considered for all purposes of this statute as Group N Employee contributions made prior to the time that contributions were picked up.

To effectuate and implement the pickup as provided for in Statute S, Employer M adopted Ordinance O on April 4, 2006. Ordinance O provides that Employer M will pick up the contributions the Group N Employees are required to make to Plan X pursuant to Statute R, as permitted by Statute S. Ordinance O further provides that such contributions, although designated as employee contributions, shall be made by Employer M in lieu of employee contributions, and the cash salary of each Group N Employee shall be reduced by the amount so contributed. In addition, Ordinance O states that the Group N Employees shall not be given the option of receiving the contributions directly rather than having such contributions deposited in Plan X.

Based on the aforementioned facts, you request the following rulings:

1. That the contributions made by the Group N Employees to Plan X pursuant to
   Ordinance O will satisfy the requirements of Code section 414(h)(2) and are not includible in the employees’ gross income until such time as they are distributed from Plan X.

2. That such contributions made to Plan X by the Group N Employees will be

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treated as employer contributions for federal income tax purposes.

3. That such contributions will not constitute wages from which taxes must be
   withheld under Code section 3401(a)(12)(A) in the taxable year in which they are contributed to Plan X.

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 determined to be qualified under section 401(a) of the Code, established by a state government or a political subdivision thereof, or any agency or instrumentality of any one of the foregoing, and are picked up by the employing unit.

The federal income tax treatment to be accorded contributions which are picked up by the employer within the meaning of section 414(h)(2) of the Code is specified in Revenue Ruling 77-462, 1977-2 C.B. 358. In that revenue ruling, the employer school district agreed to assume and pay the amounts employees were required by state law to contribute to a state pension plan. Revenue Ruling 77-462 concluded that the school district's picked-up contributions to the plan are excluded from the employees’ gross income until such time as they are distributed to the employees. The revenue ruling held further that, under the provisions of section 3401(a)(12)(A) of the Code, the school district's contributions to the plan are excluded from wages for purposes of the Collection of Income Tax at Source on Wages; therefore, no withholding is required from the employees' salaries with respect to such picked-up contributions.

The issue of whether contributions have been picked up by an employer within the meaning of section 414(h)(2) of the Code is addressed in Revenue Ruling 81-35, 1981-1 C.B. 255, and Revenue Ruling 81-36, 1981-1 C.B. 255. These revenue rulings established that the following two criteria must be met: (1) the employer must specify that the 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 be given the option of choosing to receive the contributed amounts directly instead of having them paid by the employer to the pension plan. Furthermore, it is immaterial, for purposes of the applicability of section 414(h)(2), whether an employer picks up contributions through a reduction in salary, an offset against future salary increases, or a combination of both.

In order to in Revenue Ruling 81-35, and Revenue Ruling 81-36, with respect to particular contributions, Revenue Ruling 87-10, 1987-1 C.B. 136 provides that the required specification of designated employee contributions must be completed before the period to which such contributions relate. If not, the designated employee contributions being paid by the employer are actually employee contributions paid by the employee and recharacterized at a later date. The retroactive specification of designated employee contributions as paid

by the employing unit, i.e., the retroactive “pick up” of designated employee contributions by a governmental employer, is not permitted under section 414(h)(2) of the Code. Thus, employees may not exclude from current gross income designated employee contributions to a qualified plan that relate to compensation earned for services rendered prior to the date of the last governmental action necessary to effect the pick up.

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In this case, Ordinance O satisfies the criteria set forth in Revenue Ruling 81-35 and Revenue Ruling 81-36 by specifically providing that Employer M shall pick up the contributions the Group N Employees are required to make to Plan X; that such contributions, although designated as employee contributions, shall be made by Employer M in lieu of contributions by the Group N Employees; that the cash salary of each Group N Employee shall be reduced by the amount so contributed to Plan X; and that the Group N Employees will not be given the option of choosing to receive the contributed amounts directly instead of having them deposited in Plan X.

With respect to ruling requests one, two, and three, we conclude that the mandatory contributions made by the Group N Employees to Plan X and picked up by Employer M shall be treated as employer contributions within the meaning of Code section 414(h)(2), and will not be included in the current gross income of the Group N Employees for federal income tax purposes in the year in which contributions are made to Plan X, These amounts will be includible in the gross income of the Group N Employees or their beneficiaries only in the taxable year in which they are distributed, to the extent they represent contributions made by Employer M. Because we have determined that the picked-up amounts are to be treated as employer contributions, they are excepted from wages as defined in section 3401(a)(12)(A) of the Code for federal income tax withholding purposes. In addition, no part of the amounts picked up by Employer M will constitute wages for federal income tax withholding purposes in the taxable year in which they are contributed to Plan X.

This ruling applies only if the effective date for the commencement of the pick up is not earlier than the later of the date Ordinance O is signed and adopted by Employer M, or the date the pick-up is put into effect. This ruling is based on Ordinance O as submitted with your correspondence dated April 21, 2006.

This ruling is based on the assumption that Plan X meets the requirements of Code section 401(a) at all times relevant to this proposed transaction.

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 amounts in question are paid pursuant to a “salary reduction agreement” within the meaning of Code section 3121(v)(1)(B).

This ruling is directed only to the taxpayer who 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 letter has been sent to your authorized representative in accordance with a Power of Attorney on file with this office.

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If you have any questions, you may contact ****** SE:T:EP:RA:T:2.

Sincerely yours,

[illegible]
Joyce E. Floyd, Manager
Employee Plans Technical Group 2

Enclosures:
Deleted copy of this ruling letter
Notice of Intention to Disclose - Notice 437