PLR 1122034: IRS explains the taxable and nontaxable portions of pension annuity and lump-sum payments

Plain-English summary

An individual living outside the United States asked how pension annuity payments and a related lump-sum transfer to an IRA would be treated if the individual were a U.S. resident. The IRS treated the individual's previously taxed employee contributions as investment in the contract and determined that part of the lump sum was a nontaxable return of that investment. It also applied the simplified rule under Notice 88-118 to determine the nontaxable portion of each monthly annuity payment. The ruling addressed the treatment under section 72 for purposes of the individual's tax treatment under the applicable treaty.

Ruling snapshot

• Question: How should the individual's pension lump sum and annuity payments be divided between taxable income and a nontaxable return of investment?
• Outcome: Approved, with the stated tax treatment and limitations.
• Key authorities: IRC § 72; Notice 88-118 (1988-2 C.B. 450); IRC § 6110.

Full text (IRS public release)

Significant Index Number 0072.00-00

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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION MAR 08 2011

A=

B=

Country C =

Date D1 =

Date D2 =

Date D3 =

Pension Plan and Fund F =
Organization O =

Dear

This is in reply to your request for a ruling concerning the income tax treatment of
annuity benefits receivable by you from Pension Plan and Fund F, the retirement
plan for Organization O.

According to the information submitted, you became eligible for pension annuity
benefits for life commencing on Date D1, in the amount of $ per month,
and adjusted annually for cost of living. If B survives you, she will be entitled to

annuity payments of $ per month (also adjusted for cost of living). You
also elected to have the pension fund transfer to an IRA of the present value
of your contract, or $ in connection with the commencement of your
annuity. Your annuity benefit as stated above is the reduced amount to reflect

this distribution under your contract. You were born Date D2. B was born Date

D3. You are a resident of Country C.

You are a citizen of the U.S., and were a citizen of the U.S. while employed by
Organization O. Before you retired, you contributed $ to the Pension
Fund F. These employee contributions were includible in your gross income
under U.S. tax law. Over the same period your employer contributed an amount
to the fund on your account. These employer contributions were not included in
your income for U.S. tax purposes. The Pension Fund F is organized within the
U.S., and distributions under the Plan to you are considered to arise within the

U.S. According to your representation, Pension Plan and Fund F is a U.S.
qualified pension plan. Based on the above facts and representations, you
requested a ruling as to the correct income tax treatment of the annuity payments
as if you were a U.S. resident. The tax treatment that would apply if you were a
resident of the U.S. affects your tax treatment under the tax laws of Country C.

I. INTERNATIONAL CONSIDERATIONS

Under the United States – Country C Income Tax Treaty (the Treaty), Article
XVIII(1), Country C may tax its residents on pensions arising in the U.S. only to
the extent such payments would be included in U.S. gross income if they had
been received by a resident of the U.S. The determination of whether these
payments arise within the U.S. must be made under Country C law. It is your
representation that Country C considers the above pension payments to arise
within the U.S. in their entirety. Therefore, Article XVIII(1) applies to such
payments.

Generally, pension payments arising within the U.S. paid to a U.S. resident are
included in gross income under section 72 of the Internal Revenue Code of 1986
(the Code), but subsection 72(b) excludes from income that portion of each
payment which represents a return of the investment in the contract. The
employee's own contributions which were includible in his gross income at the
time contributed generally constitute his investment in the contract.

II. RULES APPLICABLE TO PAYMENTS UNDER ANNUITY CONTRACT

Section 72(b) of the Code provides that gross income does not include that
portion of each payment which represents a return of your investment in the
contract. For any annuity starting before November 16, 1996, the General Rule
of section 72(b) would be applicable for determining the excludible amount.
However, Notice 88-118 (1988-2 C.B. 450) allowed retirees to elect to apply the
simplified rule contained therein rather than the General Rule for determining the
excludible amount. You have elected to use the simplified rule. The computation
under this rule requires first determining the investment in the contract as of the
annuity starting date.

III. LUMP SUM PAYMENT RETURN OF INVESTMENT

Section 72(e) of the Code provides for the treatment of payments received under
an annuity contract but received not as an annuity, such as lump sum
distributions. Section 72(e)(2) distinguishes different treatments for a lump sum
paid before or after the start of an annuity. In this case, the lump sum was paid
on the same day as the annuity starting date. However, the election to receive
the lump sum was made before the annuity starting date, and the annuity rate,
from the first day of the annuity obligation, reflected the reduced account balance
resulting from the payment of the lump sum. Section 72(d)(1)(D) provides that if

a lump sum is paid from a qualified plan in connection with the commencement
of an annuity, it is to be treated as being paid before the annuity starting date,
even if the actual date of its transfer is not before the annuity starting date. For
these purposes, your lump sum payment is treated as paid before the start of the
annuity.

Section 72(e)(8) of the Code determines the tax treatment of a lump sum
payment that is paid under a qualified plan before the start of the annuity. The
ratio of the investment in the contract to the account balance establishes the
portion of the entire lump sum payment that is excludible from income as a return
of your investment in the contract. With a defined benefit plan an account
balance is often not available, but we will accept the present value of your
contract as representative of the account balance. Since your lump sum
payment was 1/3 of the present value of the contract, the total present value of
the contract was $ Your employee contribution amount of

$ is your investment in the contract. The ratio of the investment in the
contract to the account balance is 15.9 percent. Therefore 15.9 percent of the
lump sum payment, or $ represents a return of your investment and is
non-taxable. After this, your remaining investment in the contract is

IV. ANNUITY PAYMENTS

Under the simplified Safe Harbor Rule of Notice 88-118, the monthly exclusion
amount is found by dividing your investment in the contract by a divisor based on
your age. Since your age at the annuity starting date was at least age 55 and
below age 60, the divisor is 260. Your contributions to the plan, reduced by the
tax-free part of the lump sum payment, constitute the remaining investment in the
contract for purposes of the simplified rule. Therefore, considering your situation
as if you were a U.S. resident, your monthly exclusion amount would be

$. / 260 or $ This amount would be excludible from gross
income for each annuity payment received under the contract, until the total
amount under the contract so excluded equals the total investment in the
contract.

This ruling is limited to the issues expressly stated herein. We are expressing no

opinion as to the taxability or non-taxability of any payments for a nonresident
alien.

You may need to attach a copy of this ruling to the initial tax return in which you

apply the above exclusion rule. We are enclosing a copy for your Country C tax
return.

If you have any question concerning this matter, please contact

Sincerely,

David M. Ziegler

Manager, Actuarial Group 2
Employee Plans Technical

Enclosures
Copy of this ruling
Notice 437
Deleted Copy