Could a Virginia widow subtract monthly FERS survivor-annuity death benefits from taxable income?

Plain-English summary

Virginia denied the widow's refund claim because her FERS survivor benefits did not qualify for the death-benefit annuity subtraction. Her federal-employee husband died in 2006, and she chose 36 equal monthly payments instead of a lump sum. She subtracted those payments on her 2007 through 2009 Virginia returns.

The Department said the subtraction required three things: the payment had to come from an annuity contract between a customer and an insurance company, it had to be awarded as a lump sum, and it had to be subject to federal income tax. The FERS payments failed the source requirement because they came from a retirement plan, not an insurance-company contract. They also were paid monthly rather than as a lump sum.

The taxpayer argued that annuities are inherently periodic. Virginia responded that an insurance-company annuity can still offer a lump-sum cash settlement. But even a lump-sum election would not have saved this claim because the FERS retirement-plan source independently disqualified it.

What this means for you

• Do not assume every payment labeled an annuity qualifies for Virginia's death-benefit subtraction.
• Identify the issuing arrangement: an employer or government retirement plan is not the insurance-company annuity contract described in this ruling.
• Payment form matters as well as source; the Department required a lump-sum award under the law discussed here.
• Keep plan documents and tax reporting that establish who issued the benefit, whether it was federally taxable, and whether a lump-sum option existed.

Common questions

Q: Why were the FERS payments disqualified?
A: They came from a federal retirement plan rather than an annuity contract between a customer and an insurance company.

Q: Did monthly payment matter?
A: Yes. The Department also required the death benefit to have been awarded as a lump sum.

Q: Would choosing a FERS lump sum have qualified?
A: No according to the determination. The retirement-plan source would still fail the insurance-company-contract requirement.

Q: What was the result?
A: The refund request for tax paid on the 2007 through 2009 benefits was denied.

Citations and references

• Va. Code §§ 58.1-1821, 58.1-301, 58.1-322 C 32, 58.1-203, and 38.2-106.
• IRC §§ 101 and 72.
• 5 U.S.C. § 8341, cited as the authority for the FERS survivor payment.
• Chapters 617 (2006) and 305 (2012), Acts of Assembly, discussed in the determination.
• Virginia Public Documents 09-36, 13-149, 97-497, 10-63, and 11-14, discussed in the determination.

Subject

Annuity payment made pursuant to a retirement plan, not qualified for subtraction

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 13-210

Original ruling text

November 12, 2013

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will reply to your letter in which you seek a refund of individual income tax paid by * (the "Taxpayer") for taxable years ended December 31, 2007 through 2009. I apologize for the delay in responding to your letter.

FACTS

The Taxpayer's husband, a federal government employee, died in August 2006. The Taxpayer elected to receive the husband's death benefit from a survivor's annuity provided by the Federal Employees Retirement System (FERS) in 36 monthly equal payments in lieu of a lump-sum payment. The Taxpayer subtracted the death benefit payments on her Virginia income tax returns for the 2007 through 2009 taxable years.

Under audit, the Department disallowed the subtractions and issued assessments because the annuity benefits were paid to her on a monthly basis rather than a lump sum, and the source of the annuity payments was a federal retirement plan and not a contract with an insurance company. The Taxpayer paid the assessments in full and filed an appeal, contending annuity distributions are made as a series of equal payment rather than in a lump-sum, and the payments she received qualify for subtraction under Va. Code § 58.1-322 C 32.

DETERMINATION

Virginia Code § 58.1-301 provides that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. For individual income tax purposes, Virginia conforms to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI). Income included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Va. Code § 58.1-322.

Pursuant to Va. Code § 58.1-322 C 32, a taxpayer is allowed a subtraction of "the death benefit payments from an annuity contract that are received by a beneficiary of such contract and are subject to federal income taxation." In order to qualify for the subtraction, a death benefit payment must meet three requirements. First, the source of the payment must be an annuity contract between a customer and an insurance company. Second, the annuity payment must have been awarded to the beneficiary in a lump-sum. Finally, the payment must be subject to taxation at the federal level. See Public Document (P.D.) 09-36 (3/31/2009).

Under IRC § 101 life insurance benefit payments paid by reason of the death of the insured are exempt from federal taxation, and thus exempt from Virginia taxation. IRC § 72, however, provides that a portion of the death benefits from an annuity, including life insurance contracts, is taxable. Because death benefits were treated dissimilarly for income tax purposes, the General Assembly sought to provide relief to individuals who are unable to obtain standard life insurance and utilize annuities to provide a similar benefit to their loved ones. As a result, the death benefits subtraction for certain annuity contract payments was enacted in 2006. See Chapter 617, Acts of Assembly . In 2012, the General Assembly enacted legislation (Chapter 305, Acts of Assembly ) codifying the Department's interpretation of the existing statute. See P.D. 13-149 (7/31/2013).

Virginia Code § 58.1-203 grants the Tax Commissioner the authority to issue rulings related to the interpretation and enforcement of the laws governing taxes administered by the Department. See P.D. 97-497 (12/10/1997). The Virginia Supreme Court has consistently held that the construction of a tax statute by a state official charged with its administration is entitled to great weight. See Webster v. Department of Taxation , 219 Va. 81, 84-85, 245 S. E.2d 252, 255 (1978) and Winchester TV Cable v. State Tax. Com . , 216 Va. 286, 290, 217 S.E.2d 885, 889 (1975).

Further, by reason of their character as legislative grants, statutes relating to deductions and subtractions allowable in computing income and credits against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See Howell's Motor Freight, Inc., et al. v. Virginia Department of Taxation, Circuit Court of the City of Roanoke , Law No. 82-0846 (10/27/1983).

The subtraction applies to death benefit payments subject to federal income tax. As indicated above, however, the intent of the death benefit subtraction was to equalize treatment of certain death benefit payments resulting from contracts with life insurance companies for Virginia income tax purposes. Under the Department's interpretation and subsequent clarifying legislation, the death benefit subtraction was never intended to be permitted for payments from a retirement plan.

The Taxpayer asserts that the Tax Commissioner's interpretation of the subtraction is erroneous because an annuity cannot be paid out as a lump-sum. The Taxpayer relied on a business dictionary that defines an annuity as "a series of payments at fixed intervals, for a fixed number of years." Typically, annuities are paid out as a series of equal payments over a set time period. However, the Virginia statute applicable to annuities provided by insurance companies allows annuity contracts to include a provision providing that a lump-sum cash settlement is an alternative to the option of periodic payments. See Va. Code § 38.2-106.

Further, IRC § 72 (c) provides rules for amounts received from annuity contracts that are not paid as annuities. As such, an annuity contract with an insurance company can issue a payment as a lump-sum and still be considered an annuity for purposes of the subtraction.

The Taxpayer also contends the Tax Commissioner's determinations in P.D. 10-­63 (5/7/2010) and P.D. 11-14 (1/25/2011) erroneously omit death benefit annuities paid to federal government employee survivors. As stated above, the source of the payment must be an annuity contract between a customer and an insurance company. The survivor annuity payment received by the Taxpayer was issued in accordance with FERS pursuant to 5 U.S.C. § 8341 (2000). As such, because the annuity payment was made pursuant to a retirement plan, the Taxpayer could not have qualified for the subtraction, even if she accepted a lump-sum in lieu of periodic payments.

Based on the foregoing, the Taxpayer did not qualify for the death benefit subtraction for any of the taxable years at issue. Accordingly, the Taxpayer's request for the refund of income tax paid pursuant to the assessments issued for the 2007 through 2009 taxable years is denied.

The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department's web site. If you have any questions regarding this determination, you may contact * in the Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-4809904940.B