Municipal retirement contributions qualify as employer pick-ups

Plain-English summary

A municipal employer adopted ordinances requiring specified employees to contribute to its governmental defined benefit and defined contribution plans. The ordinances provided that the employer would pick up the contributions, treat them as employer contributions, and give employees no right to receive the amounts in cash. The IRS ruled that the Plan X contributions for two employee classes and the Plan Y contributions for non-hybrid members qualified as employer pick-ups under section 414(h)(2). The amounts were excluded from current gross income and from wages for federal income tax withholding, although the IRS expressed no opinion on Federal Insurance Contributions Act taxes or the salary-reduction issue.

Ruling snapshot

• Question: Did the mandatory contributions to the two governmental retirement plans qualify as employer pick-ups for income-tax and withholding purposes?
• Outcome: Approved
• Key authorities: IRC §§ 414(h)(2), 3401(a)(12)(A); Rev. Rul. 81-35; Rev. Rul. 81-36; Rev. Rul. 2006-43

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201529009
Release Date: 7/17/2015
Index Number: 414.00-00, 414.09-00

Third Party Communication: None
Date of Communication: Not Applicable

Person To Contact:

, ID No.

Telephone Number:

Refer Reply To:
CC:TEGE:EB:QP4
PLR-T-103174-15

Date:
April 20, 2015

State S =
Employer A =
Plan X =
Plan Y =
Statute S =
Ordinance A =
Ordinance B =
Date 1 =
Date 2 =

Dear

This letter is in response to your request, dated July 16, 2014, and followed by
correspondence dated March 25, 2015, for a ruling on the proper federal income tax
treatment of certain contributions to two retirement plans under section 414(h) of the
Internal Revenue Code (the “Code”).

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

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Employer A is a municipal corporation and political subdivision of State S. Employer A
sponsors Plan X, a defined benefit plan intended to qualify under section 401(a) of the
Code as applicable to governmental plans as defined in section 414(d) of the Code.
Employer A also sponsors Plan Y, a defined contribution plan intended to qualify under
section 401(a) of the Code as applicable to governmental plans as defined in section
414(d) of the Code.

Other than public safety employees and elected officials, participation in Plan X is
mandatory for employees of Employer A hired before July 1, 2014, and is optional for
employees hired on or after July 1, 2014 (and certain employees rehired on or after that
date). Plan X membership consists of classes 1, 2, 3 and 4.

Class 1 consists of employees hired on or after July 1, 1979, and before July 1, 2014,
and employees hired before July 1, 1979, who elected to transfer from Class 3 or Class
4 membership to Class 1 membership. Class 2 members are those employees hired, or
in some cases rehired, on or after July 1, 2014. Class 3 and 4 members are employees
who are required to make employee contributions only on an after-tax basis. Class 1
and Class 2 members are the subject of this ruling request.

Other than public safety employees and elected officials, participation in Plan Y is
mandatory for employees of Employer A hired or rehired on or after July 1, 2014.
Employees hired, or in some cases rehired, on or after July 1, 2014, may elect to
participate in both in Plan X and Plan Y.

Ordinance A was passed on Date 1, amending Statute S to require Class 1 employees
to begin making contributions to Plan X. The amount of the mandatory employee
contributions is: 1% of compensation from July 1, 2013, through June 30, 2014; 2% of
compensation from July 1, 2014, through June 30, 2015; 3% of compensation from July
1, 2015, through June 30, 2016; 4% of compensation from July 1, 2016, through June
30, 2017; and 5% of compensation for fiscal years (July 1-June 30) beginning on and
after July 1, 2017.

Statute S, as amended by Ordinance A, provides that the scheduled increases for Class
1 employees apply only for fiscal years in which a minimum 2% salary raise has
become effective after negotiation with the appropriate employee organization or
professional organization. If a minimum 2% salary increase becomes effective after July
1 of a particular fiscal year, the contribution increase in effect for such fiscal year will be
suspended until the date the raise becomes effective and is applied pro rata from the
effective date of the raise through the end of the fiscal year. For the July 1, 2013 fiscal
year, the 2% salary increase was not effective until the pay period commencing October
12, 2013. Consequently, a pro-rata mandatory employee contribution of 1.37% became
effective as of the beginning of that pay period for Class 1 members.

PLR-T-103174-15 3

Ordinance B was passed on Date 2, amending Statute S to require employees, other
than public safety employees and elected officials, hired or in some cases rehired on or
after July 1, 2014, to make a one-time irrevocable election between two retirement plan
options. Employees electing Option 1 (“Hybrid Members”) become Class 2 participants
in Plan X and also participants in Plan Y. Employees who elect Option 2 (“Non-Hybrid
Members”) become participants in Plan Y but are not participants in Plan X.

Statute S, as amended by Ordinance B, requires Hybrid Members to begin making
employee contributions at 5% of compensation to Plan X as of the first full pay period
after Class 2 membership begins. Class 2 participation begins on the first anniversary of
the date of employment or reemployment. Hybrid Members are not required to make
employee contributions to Plan Y.

Statute S, as amended by Ordinance B, provides that Employer A intends to pick up the
employee contributions for Class 1 and Class 2 members and that the contributions,
although designated as employee contributions, will be treated as employer
contributions for federal income tax purposes. Statute S does not provide employees
the option of choosing to receive contributions directly instead of having such
contributions paid by Employer A into Plan X.

Statute S as amended requires members of Plan Y who are Non-Hybrid members to
begin making employee contributions at 5% of compensation to Plan Y as of the first full
payroll period on or after Plan Y participation begins. Plan Y membership begins on the
180th day after the date of employment. Statute S provides that mandatory contributions
to Plan Y, although designated as employee contributions, are paid by Employer A in
lieu of contributions by members. In addition, members may not receive the
contributions directly. The mandatory contributions are intended to be treated as
employer contributions for federal income tax purposes.

Employer A treats all mandatory employee contributions into Plan X and Plan Y as
being made pursuant to a salary reduction agreement under section 3121(v)(1)(B) and
as wages subject to tax under the Federal Insurance Contributions Act.

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

1. That the mandatory contributions made by Class 1 and 2 members of Plan X and
   picked up by Employer A will not be included in the current gross income of
   Class 1 or Class 2 members on whose behalf the pick-up is made for federal
   income tax purposes.

2. That the mandatory contributions made by Class 1 and 2 members of Plan X and
   picked up by Employer A will be treated as employer contributions for federal
   income tax purposes; and will not constitute wages subject to federal income tax
   withholding.

PLR-T-103174-15 4

3. That the mandatory contributions made by Non-Hybrid members of Plan Y and
   picked up by Employer A will not be included in the current gross income of Plan
   Y members on whose behalf the pick-up is made for federal income tax
   purposes.

4. That the mandatory contributions made by Non-Hybrid members of Plan Y and
   picked up by Employer A will be treated as employer contributions for federal
   income tax purposes; and will not constitute wages subject to federal income tax
   withholding.

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 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 Income Tax Regulations (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

PLR-T-103174-15 5

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 or made available to
the employees. The revenue ruling also 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.

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 pickup.

Revenue Ruling 2006-43, 2006-35 I.R.B. 329, amplifying and modifying Rev. Rul. 81-
35, Rev. Rul. 81-36, and Rev. Rul. 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, Rev. Rul. 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

PLR-T-103174-15 6

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 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.

Rev. Rul. 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.

With respect to your first ruling requested, Plan X satisfies the criteria set forth in Rev.
Rul. 81-35, Rev. Rul. 81-36, and Rev. Rul. 2006-43. Section 8 of Statute S, as amended
by Ordinance A, provides that Employer A shall pick up the mandatory contributions
deducted from Class 1 and 2 employees' salaries and contributed by Employer A to
Plan X. Employer A took formal action by enacting Ordinance A on Date 1, before
October 25, 2013, the first pay period during which mandatory employee contributions
were made for Class 1 members. Class 2 employees will make mandatory
contributions no earlier than July 1, 2015.

In addition, no provision of Statute S permits Class 1 or Class 2 employees the option to
choose to receive the contributed amounts directly instead of having them paid by
Employer A to Plan X. Therefore, employees are not permitted to make a cash or
deferred election with respect to the contributions.

We conclude that the mandatory contributions made by the employees to Plan X and
picked up by Employer A shall be treated as employer contributions and will not be
included in the current gross income of the employees for federal income tax purposes
in the year in which contributions are made to Plan X. These amounts will be includible
in the employees' (or their beneficiaries’) gross income only in the taxable year in which
they are distributed, to the extent they represent contributions made by the employer.

With respect to your second ruling requested, because we have determined that the
picked-up amounts are to be treated as employer contributions, they are excluded from
wages as defined in section 3401(a)(12)(A) of the Code for federal income tax
withholding purposes.

With respect to your third ruling requested, Plan Y satisfies the criteria set forth in Rev.
Rul. 81-35, Rev. Rul. 81-36, and Rev. Rul. 2006-43. Ordinance B, amending Statute S,

PLR-T-103174-15 7

provides that Employer A shall pick up the contributions deducted from non-Hybrid
employees’ salaries and contributed by the Employer A to Plan Y and that such
contributions, although designated as employee contributions, will be paid by Employer
A in lieu of contributions by participants. Employer A took formal action by enacting
Ordinance B on Date 2 and employees will begin to make mandatory contributions
prospectively starting no earlier than January 1, 2015.

In addition, Ordinance B provides that employee contributions are mandatory and that
participants may not receive the contributed amounts directly instead of having them
paid by Employer A to Plan Y. The amount of the contribution is 5% of compensation
regardless of whether the employee is a Hybrid member and the contribution is to Plan
X or the employee is a non-Hybrid member and the contribution is to Plan Y. Therefore,
we find that the employees are not permitted to make a cash or deferred election with
respect to the contributions.

We conclude that the mandatory contributions made by the employees to the Plan Y
and picked up by Employer A shall be treated as employer contributions and will not be
included in the current gross income of the employees for federal income tax purposes
in the year in which contributions are made to Plan Y. These amounts will be includible
in the employees’ (or their beneficiaries') gross income only in the taxable year in which
they are distributed, to the extent they represent contributions made by Employer A.

With respect to your fourth ruling request, because we have determined that the picked-
up amounts are to be treated as employer contributions, they are excluded from wages
as defined in section 3401(a)(12)(A) of the Code for federal income tax withholding
purposes.

No opinion is expressed as to whether the amounts picked up by Employer A 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 based on the assumption that Plan X and Plan Y satisfy the qualification
requirements set forth in section 401(a) of the Code, and constitute governmental plans
within the meaning of section 414(d) of the Code, at all relevant times.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

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

PLR-T-103174-15 8

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,

Laura B. Warshawsky

Senior Tax Law Specialist

Qualified Plans Branch 2

(Tax Exempt and Government Entities)