PLR 1138006: IRS confirms a public employer's pension plan can exclude participating services from FICA

Plain-English summary

A political subdivision maintained a defined benefit plan for certain employees and asked whether the plan qualified as a retirement system under IRC § 3121(b)(7)(F). It also asked whether services performed by plan participants were excluded from employment for FICA purposes. The IRS concluded that the plan met the applicable minimum-benefit requirements through the safe harbor formulas in Rev. Proc. 91-40. Services of qualified participants were therefore excluded from FICA employment, while wages paid to employees excluded from the plan remained subject to FICA.

Ruling snapshot

• Question: Whether a public employer's defined benefit plan qualifies as a retirement system and excludes qualified participants' services from FICA employment under IRC § 3121(b)(7)(F).
• Outcome: Approved, for qualified participants; nonparticipants' wages remain subject to FICA.
• Key authorities: IRC § 3121(b)(7)(F); Treas. Reg. § 31.3121(b)(7)-2; Rev. Proc. 91-40.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201138006 Third Party Communication: None
Release Date: 9/23/2011 Date of Communication: Not Applicable
Person To Contact:
3121.02-00 ------------------------,
------------------------------------------------------------- Telephone Number:
---------------------
------- Refer Reply To:
------------------------------------------- CC:TEGE:EOEG:ET2
---------------------------- PLR-108037-11
------------------------------- Date:
------------------------------ June 06, 2011

Legend

Employer A = -----------------------------------------------------------------
Plan X = ----------------------------------------------------------------------------------------------

State C = --------

Dear --------------:

This is in response to your letter of February 3, 2011, as supplemented by
correspondence dated April 18, 2011, requesting letter rulings on two issues involving
Employer A’s deferred compensation plan (Plan X). You requested rulings on the
following two questions:

1. Whether Plan X qualifies as a retirement system within the meaning of Internal
   Revenue Code (Code) § 3121(b)(7)(F); and

2. Whether service performed by a participant in Plan X is excluded from “employment”
   under Code § 3121(b)(7)(F) and the regulations thereunder.

Facts:

It is represented that Employer A is a political subdivision of State X. Employer A
maintains Plan X for certain of its employees. Plan X is a defined benefit retirement
plan that is intended to be qualified under Code § 401(a). Plan X is intended to be a
retirement system under Code § 3121(b)(7)(F).

Plan X section 5.1 provides that an eligible employee will become a plan participant on
the date the individual begins employment. Plan X section 2.1 defines employee in
pertinent part as a “full-time employee.” Employer A may, from time to time, employ
part time and temporary employees who are not eligible to participate in Plan X. Plan X
section 5.1 provides that employees who first become firefighters after the age of 36 are
PLR-108037-11 2

not eligible to participate in Plan X without the approval of the Board of Trustees and the
satisfaction of various listed conditions.

Plan X section 6.1(b) provides that the amount of normal retirement benefit under Plan
X is a monthly payment equal to the product of a member’s credited service multiplied
by the member’s highest average monthly pay multiplied by 1.67%. Plan X section
5.1(a) provides that credited service means service for which a member makes a
contribution, calculated in years and completed months.

Plan X section 2.1(a) provides that “highest average monthly pay” means the average
compensation of a member based on the sixty consecutive months of service with
Employer A which yields the highest monthly average. Plan X section 2.1(a) defines
“compensation” as all wages within the meaning of Code § 3401(a), and all other
compensation for which Employer A is required to furnish a Form W-2, Wage and Tax
Statement, but excluding (1) lump sum payments for unused sick and vacation pay
upon termination of employment and (2) payments in addition to an employee’s base
pay that are due to overtime, other than standard overtime pay, and “step-up service”
under which additional payments are made for a period of temporary service during
which the employee is performing duties of a higher classification. Compensation also
includes any amounts that were subject to a compensation reduction election under
Code §§ 125, 132(f), 401(k), 403(b), and 457(b).

Law

Code § 3121(b)(7)(F) generally includes in employment for Federal Insurance
Contributions Act (FICA) purposes the services of employees of states, political
subdivisions, and instrumentalities of the foregoing, if they are not members of a
retirement system within the meaning of Code § 3121(b)(7)(F).

Employment Tax Regulation (Regulation) section 31.3121(b)(7)-2(b) generally treats an
employee as a member of a retirement system if he or she participates in a system that
provides retirement benefits, or has an accrued benefit, or receives an allocation under
the system that is comparable to the benefits he or she would have received under
social security.

Regulation section 31.3121(b)(7)-2(e)(1) provides that for purposes of Code
§ 3121(b)(7)(F), a retirement system includes any pension, annuity, retirement or similar
fund or system within the meaning of section 218 of the Social Security Act that is
maintained by a State, political subdivision or instrumentality thereof to provide
retirement benefits to its employees who are participants.

Regulation section 31.3121(b)(7)-2(d)(1)(i) provides the general rule for determining
qualified participant status in a defined benefit retirement system. Qualified participant
status is determined as services are performed. An employee is a qualified participant
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in a defined benefit retirement system with respect to services performed on a given day
if under the plan he or she has a total accrued benefit that meets the minimum benefit
requirement.

Regulation section 31.3121(b)(7)-2(e)(2)(i) provides that the minimum benefit
requirement is not satisfied unless the retirement system provides a retirement benefit
to the employee that is comparable to the benefit provided under the Old-Age portion of
the Old-Age, Survivor, and Disability Insurance program of Social Security. A defined
benefit retirement system meets the minimum benefit requirement with respect to an
employee if the employee has an accrued benefit under the system that entitles the
employee to an annual benefit under the system commencing on or before his or her
Social Security retirement age that is at least equal to the annual Primary Insurance
Amount the employee would have under Social Security. See Regulation section
31.3121(b)(7)-2(e)(2)(ii).

Revenue Procedure 91-40, 1991-2 C.B. 694, outlines a set of safe harbor formulas for
defined benefit retirement systems. Benefits calculated pursuant to the rules of Rev.
Proc. 91-40 are deemed to meet the minimum retirement benefit requirement of the
regulations.

Section 3.01(2) of Rev. Proc. 91-40 provides that a defined benefit retirement system
that calculates benefits by reference to a participant’s average compensation over a
period of 60 months meets the minimum benefit requirement with respect to an
employee if it makes available to the employee a single life annuity payable beginning
no later than age 65 that is at least equal to 1.60 percent of average compensation for
each year of credited service.

Section 3.03(1)(a) of Rev. Proc. 91-40 requires that a defined benefit retirement system
must calculate benefits based on definition of compensation that satisfies the
requirements of Regulation section 31.3121(b)(7)-2(e)(2)(iii)(B). This section provides
that a definition of compensation used in determining whether a retirement system
meets the minimum benefit requirement must be no less inclusive than base pay as
designated by the employer or retirement system, provided such designation is
reasonable under all the facts and circumstances.

Revenue Procedure section 3.03(2)(a) provides that in order to meet the safe harbor
formula, a defined benefit retirement system must generally include in credited service
the employee’s entire period of service with the employer since commencing
participation in the retirement system, plus any past service credited under the
retirement system, except to the extent that service is treated as employment under
Code § 3121(b).
PLR-108037-11 4

Analysis

Issue 1: Whether Plan X qualifies as a retirement system within the meaning of Code
§ 3121(b)(7)(F).

Section 3.03(1)(a) of Revenue Procedure 91-40 provides that to meet the requirements
of any of the defined benefit safe harbor formulas, a retirement system must calculate
benefits based on a definition of compensation that complies with section
31.3121(b)(7)-2(e)(2)(iii)(B) of the regulations, which provides that compensation must
be no less inclusive than the definition of the employee’s base pay as designated by the
employer or the retirement system, provided that such designation is reasonable under
all the facts and circumstances. Plan X satisfies this requirement by providing a
definition of “compensation” that is no less inclusive than base pay. Plan X section
2.1(a) defines “compensation” as “all wages within the meaning of Code § 3401(a), and
all other compensation” for which Employer A is required to furnish a Form W-2, Wage
and Tax Statement.

Plan X section 2.1(a) provides that benefits will be calculated by reference to a
member’s highest average monthly pay, which is defined as the member’s average
monthly compensation based on the sixty consecutive months of service with Employer
A which yields the highest monthly average. Section 3.01(2) of Revenue Procedure 91-
40 provides that a defined benefit retirement system that calculates benefits by
reference to a participant’s average compensation over a period of 60 months meets
the minimum benefit requirement with respect to an employee if it makes available to
the employee a single life annuity beginning no later than age 65 that is at least 1.60
percent of average compensation for each year of service. Plan X section 6.1(b)
satisfies the above criteria by making available in the form of a single life annuity at age
65 a monthly payment equal to the product of a member’s credited service multiplied by
the member’s highest average monthly pay multiplied by 1.67%.

Plan X satisfies the minimum benefit requirements of Regulation section
31.3121(b)(7)-2 using the safe harbor formulas set forth in Revenue Procedure 91-40.
Thus, Plan X qualifies as a retirement system within the meaning of Code
§ 3121(b)(7)(F).

2. Whether service performed by a Plan X participant is excluded from employment
   under Code § 3121(b)(7)(F) and the regulations thereunder.

Plan X provides that eligible employees participate in Plan X as of the day their
employment commences. An eligible employee participates in the Plan as long as
employed by employer A.

We conclude that the services participants in Plan X perform for Employer A are
excepted from employment for FICA purposes under Code § 3121(b)7)(F) as long as
PLR-108037-11 5

the participants are qualified participants in Plan X within the meaning of Regulation
section 31.3121(b)(7)-2(d).

However, wages paid to employees excluded from participation in Plan X are subject to
FICA taxation pursuant to Code § 3121(b)(7)(F), as the services of such employees are
includible in employment for purposes of FICA taxes.

The above analysis is based on the assumption that Employer A is not covered by an
agreement entered into pursuant to section 218 of the Social Security Act within the
meaning of Code § 3121(b)(7)(E).

This ruling is directed only to the taxpayer requesting it. Code § 6110(k)(3) provides
that it may not be used or cited as precedent.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                  Sincerely,



                                  Lynne Camillo
                                  Branch Chief, Employment Tax Branch 2 (Exempt
                                  Organizations/Employment Tax/Government
                                  Entities)
                                  (Tax Exempt & Government Entities)