Mandatory public-plan contributions qualify as employer pick-ups

Plain-English summary

A state created a governmental defined contribution plan requiring covered employees to contribute 8 percent of compensation through salary reduction, alongside a 6 percent employer contribution. State law required employers to pick up the employee-designated contributions, treated them as employer contributions, and gave employees no option to receive the amounts in cash. The IRS ruled that the mandatory contributions qualified as employer pick-ups under section 414(h)(2). They were excluded from employees' income and wages when contributed, then taxable under section 402 when distributed as a pension, lump sum, or other payment. The ruling assumed that the plan remained qualified under section 401(a) and governmental under section 414(d).

Ruling snapshot

• Question: Did the statutory pick-up arrangement make the mandatory employee-designated contributions employer contributions for income and withholding tax purposes?
• Outcome: Approved on the stated facts and assumptions
• Key authorities: IRC §§ 401(a), 402, 414(d), 414(h)(2), and 3401(a)(12)(A); Rev. Ruls. 77-462, 81-35, 81-36, 87-10, and 2006-43

Full text (IRS public release)

201509069
DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

DEC 04 2014
Uniform Issue List: 414.00-00, 414.09-00

XXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXX

T:EP:RA:T3

Legend:

State A = XXXXXXXXXXXXXXXXXX

System B: = XXXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXX

Plan C = XXXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXX

Statute D = XXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXX

Statute E = XXXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXX

Amendment F = XXXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXX

Category G Employees = XXXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXX

Dear XXXXXXXXXX:

This letter is in response to correspondence dated December 23, 2013, as supplemented
by correspondence dated November 24, 2014, submitted on behalf of System B by its
authorized representative, in which a request for a letter ruling was submitted with respect

-2- 201509069

to the federal income tax consequences of certain contributions to, and distributions from,
Plan C, as amended by Statute E and Amendment F.

The following facts and representations are submitted under penalties of perjury in support
of your request:

In 2013, the State A Legislature enacted Statute D, which established Plan C, a defined
contribution plan. Pursuant to Statute D, as amended by Statute E, all Category G
Employees elected or appointed on or after January 1, 2014 must participate in Plan C.
Plan C is a governmental plan described in section 414(d) of the Code, and is intended to
be a retirement plan qualified under section 401(a) of the Code. A favorable determination
letter was issued by the Internal Revenue Service with respect to Plan C on October 15,
2014.

Plan C requires a salary reduction contribution (hereinafter referred to as a “Mandatory
Employee Contribution”) on behalf of each participant equal to 8% of the participant’s
compensation (as defined under the Plan). In addition, Plan C mandates an employer
contribution equal to 6% of each participant’s compensation. Plan C limits such salary
reduction and employer contributions as required under section 415 of the Code.

Statute D, as amended by Statute E, provides that, although designated as participant
contributions, all participant contributions made to Plan C shall be picked up and paid by
the employer in lieu of contributions made by the participant. The Statute further provides
that all participant contributions that are picked up by the employer under Plan C shall be
treated as employer contributions under section 414(h) of the Code, shall be excluded
from the participants’ gross income for federal and state income tax purposes, and are
includable in the gross income of the participants or their beneficiaries only in the taxable
year in which they are distributed. The Statute also explicitly states that a Plan C
participant does not have the option of choosing to receive the contributed amounts
directly instead of the employer paying the amounts to Plan C.

• Based on the above facts and representations, you request the following rulings:

1. The Mandatory Employee Contributions made by Category G Employees’ to
   Plan C that are picked up by the employing units will be treated as employer
   contributions under section 414(h)(2) of the Internal Revenue Code (the “Code”).

2. A distribution of the amounts picked up on behalf of the affected employees,
   either through a retirement pension, lump sum payment or otherwise, will be
   considered a distribution of employer contributions taxable at time of receipt by
   the employees as prescribed by section 402 of the Code. .

3. Under section 3401(a)(12)(A) of the Code, the picked-up contributions will be
   treated as employer contributions to a plan qualified under section 401(a) and
   will be excluded from wages for purposes of collection of income tax at source

on wages. .

-3- 201509069

Section 401(a) of the Code provides that a trust created or organized in the United States
and forming a part of a qualified stock bonus, pension, or profit sharing plan of an
employer constitutes a qualified trust only if the various requirements set out in section
401(a) of the Code are met.

Section 1.401(k)-1(a)(3) of the Income Tax Regulations (the “Regulations”) generally
defines a cash or deferred election as any direct or indirect election (or modification of an
earlier election) by an employee to have the employer either: (1) provide an amount to the
employee in the form of cash (or some other taxable benefit) that is not currently available,
or (2) contribute an amount to a trust, or provide an accrual or other benefit under, a plan
deferring the receipt of compensation.

Section 402(a) of the Code generally provides that any amount actually distributed to any
recipient by any employees’ trust described in section 401(a) of the Code, which is exempt
from tax under section 501(a) of the Code, shall be taxable to the recipient, in the taxable
year of the distribution, under section 72 of the Code (relating to annuities).

Section 1.402(a)-1(a)(1)(i) of the Regulations provides that if an employer makes a
contribution for the benefit of an employee to a trust described in section 401(a) of the
Code for the taxable year of the employer which ends within or with a taxable year of the
trust for which the trust is exempt under section 501(a) of the Code, the employee is not
required to include such contribution in his or her income except for the year or years in
which such contribution is distributed or made available to him or her.

Section 414(h)(1) of the Code provides that any amount contributed to an employees’ trust
described in section 401(a) of the Code shall not be treated as having been made by the
employer if it is designated as an employee contribution.

Section 414(h)(2) of the Code provides that, for purposes of section 414(h)(1), in the case
of any plan established by the government of any State or political subdivision thereof, or
by any agency or instrumentality of any of the foregoing, or a governmental plan described
in the last sentence of section 414(d) (relating to plans of Indian tribal governments),
where the contributions of employing units are designated as employee contributions but
where any employing unit picks up the contributions, the contributions so picked up shall
be treated as employer contributions.

The federal income tax treatment to be afforded contributions that are picked up by the
employer within the meaning of section 414(h)(2) of the Code has been developed in a
series of revenue rulings. In Revenue Ruling 77-462, 1977-2 C.B. 358, 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 were excluded from the employees’
gross income until such time as they were distributed to the employees. The revenue
ruling further held that, under the provisions of section 3401(a)(12)(A) of the Code, the
school district’s contributions to the plan were excluded from wages for purposes of the
collection of income tax at the source on wages. Therefore, no withholding was required
for federal income tax purposes from the employees’ salaries with respect to such picked-
up contributions.

-4-

201509069

Revenue Ruling 81-35, 1981-1 C.B. 255, and Revenue Ruling 81-36, 1981-1 C.B. 255,
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.

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 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.

Revenue Ruling 2006-43, 2006-35 I.R.B. 329, amplifying and modifying Revenue Ruling
81-35, Revenue Ruling 81-36, and Revenue Ruling 87-10, describes the actions required
for a state or political subdivision of a state, or an agency or instrumentality of either, to
pick-up employee contributions to a plan qualified under section 401(a) of the Code so that
the contributions are treated as employer contributions pursuant to section 414(h)(2).
Specifically, Revenue Ruling 2006-43 provides that a contribution to a qualified plan
established by an eligible employer (i.e., a governmental employer) will be treated as
picked-up by the employing unit under section 414(h)(2) of the Code if two conditions are
satisfied:

1. First, the employing unit must specify that the contributions, although designated as
   employee contributions, are being paid by the employer. For this purpose, the
   employing unit must take formal action to provide that the contributions on behalf of
   a specific class of employees of the employing unit, although designated as
   employee contributions, will be paid by the employing unit in lieu of employee

contributions. A person duly authorized to take such action with respect to the
employing unit must take such action. The action must apply only prospectively and
be evidenced by a contemporaneous written document (e.g., minutes of a meeting,
a resolution, or ordinance).

2. Second, the pick-up arrangement must not permit a participating employee from
   and after the effective date of the pick-up to have a cash or deferred election right
   within the meaning of section 1.401(k)-1(a)(3) of the Regulations with respect to
   designated employee contributions. Thus, for example, no participating employee
   may be given the right to opt out of the pick-up arrangement described in section
   414(h)(2) of the Code, or to receive the contributed amounts directly instead of

having them paid by the employing unit to the plan.

5 201509069

Revenue Ruling 2006-43 states that the pick-up rules expressed in Revenue Ruling 81-35
and Revenue Ruling 81-36 apply even if the employer picks up contributions through a
reduction in salary or through an offset against future salary increases.

In the present case, consistent with the requirements stated in Revenue Ruling 81-35,
Revenue Ruling 81-36, and Revenue Ruling 2006-43, with respect to a valid pick-up
arrangement under section 414(h)(2) of the Code, Statute D, as amended by Statute E, as
enacted by the State A Legislature, explicitly states that the Mandatory Employee
Contributions made on behalf of each Category G Employee under Plan C, although
designated as participant contributions, shall be picked up and paid by an employer into
Plan C. The Statute further provides that all participant contributions that are picked up by
the employer under Plan C shall be treated as employer contributions under section 414(h)
of the Code,

In further satisfaction of the requirements of Revenue Ruling 81-35, Revenue Ruling 81-
36, and Revenue Ruling 2006-43, Statute D, as amended by Statute E provides that a
participant does not have the option of choosing to receive the Mandatory Employee
Contribution amounts directly instead of having the employer pay such amounts into Plan
C. Accordingly, as required under the Revenue Rulings, Plan C does not permit a
participating employee from on and after the effective date of the pick-up to have a cash or
deferred election right within the meaning of section 1.401(k)-1(a)(3) of the Regulations
with respect to any designated employee contributions.

Moreover, each participating employer's obligation to pick up the Mandatory Employee
Contributions on behalf of each Plan C participant exists before the participant earns any
compensation for Plan C purposes. Therefore, there can be no retroactive pick-up of
designated employee contributions by the employer under Plan C in contravention of
Revenue Ruling 87-10.

Based on the foregoing, we conclude as follows:

1. With respect to ruling request one, the Mandatory Employee Contributions made to
   Plan C on behalf of Category G Employees that are picked up by the employing
   units will be treated as employer contributions under section 414(h)(2) of the Code.

2. With respect to ruling request two, and in accordance with the holding in Revenue
   Ruling 77-462, a distribution of the amounts picked up on behalf of the affected
   employees, either through a retirement pension, lump sum payment or otherwise,
   will be considered a distribution of employer contributions taxable at the time of
   receipt by the employees as prescribed by section 402 of the Code.

3. With respect to ruling request three, because we determined that the Mandatory
   Employee Contributions picked up by the employer under Plan C are excluded from
   the employees’ gross income until such time as such amounts are distributed,
   pursuant to Revenue Ruling 77-462, under section 3401(a)(12)(A) of the Code; the
   picked-up contributions will be treated as employer contributions to a plan qualified
   under section 401(a) and will be excluded from wages for purposes of collection of
   income tax at source on wages.

-6-

No opinion is expressed as to the federal tax consequences of the transactions described
above under any other provisions of the Code.

This ruling is based on the assumption that Plan C satisfies the qualification requirements
set forth in section 401(a) of the Code, and constitutes a governmental plan within the
meaning of section 414(d) of the Code, at all relevant times.

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

Pursuant to a power of attorney on file with this office, a copy of this letter ruling is being
sent to your authorized representative.

Should you have any questions or concerns regarding this ruling, please contact XXXXXXXX
(I.D. Number XXXXXXXXX), at (XXX) XXX-XXXX. Please address all correspondence to
SE:T:EP:RA:T3.

Sincerely yours,

Laura B. Warshawsky, Manager
Employee Plans Technical Group 3

Enclosures:
Deleted copy of this letter
Notice of Intention to Disclose

CC: XXXXXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXXXXXX