Checklist of Federal Tax Law Rules Applicable to Public Retirement Systems (Posted on October 8, 2016 by )


Carol V. Calhoun, Counsel
Venable LLP
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Washington, DC 20001
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Carol V. Calhoun

Note: This outline is a basic summary of the principal Internal Revenue Code qualification requirements that apply to governmental plans, other than plans described in Code section 403(b) or 457(b). It also includes selected Code requirements that do not relate to qualification. It is very general in nature, and does not replace research on specific questions.

  1. 401(a)(1) Contributions made to a trust are for the purpose of distributing the trust’s principal and income to employees in accordance with the plan. Section 401(a)(1) is applicable to governmental plans. This provision provides the basis in the regulations for requiring a written plan.

  2. 401(a)(2) Exclusive Benefit Rule. Applicable to governmental plans. Code section 401(a)(2) requires that a qualified plan be maintained for the exclusive benefit of employees or their beneficiaries and that under the plan’s trust instrument, it be impossible, at any time prior to the satisfaction of plan liabilities, for any part of the principal or income of the trust to be diverted for any other purpose.

  3. 401(a)(3) Minimum Coverage Standards of section 410(b). Not applicable to governmental plans due to section 410(c)(2).

  4. 401(a)(4) Requirement that plan benefits not discriminate in favor of certain top employees. Under section 401(a)(5)(G), governmental plans are exempt from Code section 401(a)(4).

  5. 401(a)(5) Permissible exceptions to the general provisions of Code section 401(a)(4), and cross-reference to section 401(l). Not applicable to governmental plans due to section 401(a)(5)(G).

  6. 401(a)(6) Requirement that a plan satisfy the coverage provisions of section 401(a)(3) at least one day each quarter of the plan year. Not applicable to governmental plans, inasmuch as such plans are not subject to Code section 401(a)(3). See 3, above.

  7. 401(a)(7) Minimum Vesting Standards of section 411. The normal rules for private plans under Code section 411 are not applicable to governmental plans because of section 411(e)(1); however, governmental plans must satisfy Code Sections 401(a)(4) and (7) as in effect before the enactment of ERISA, because of section 411(e)(2). Before ERISA, Code section 401(a)(4) stated that

    either benefits or contributions must not discriminate in favor of employees who are officers, shareholders, persons whose principal duties consist in supervising the work of other employees, or highly compensated employees.

    Code Section 401(a)(7) read as follows:

    (7) A trust shall not constitute a qualified trust under this section unless the plan of which such trust is a part provides that, upon its termination or upon complete discontinuance of contributions, under the plan, the rights of all employees to benefits accrued to the date of such termination or discontinuance, to the extent then funded, or the amounts credited to the employees’ accounts are nonforfeitable. This paragraph shall not apply to benefits or contributions which, under provisions of the plan adopted pursuant to regulations prescribed by the Secretary or his delegate to preclude the discrimination prohibited by paragraph (4), may not be used for designated employees in the event of early termination of the plan.

    Under section 401(a)(5)(G), governmental plans are exempt from Code section 401(a)(4). However, the IRS still considers pre-ERISA Code section 401(a)(4) vesting standards to apply for vesting purposes. It has issued a Notice of Proposed Rulemaking, Applicability of Normal Retirement Age Regulations to Governmental Pension Plans, 81 FR 4599 (January 27, 2016), describing the vesting requirements for a governmental plan.

  8. 401(a)(8) Prohibition on using forfeitures under a defined benefit plan to increase benefits. Applicable to governmental plans.

  9. 401(a)(9) Required Distributions. Applicable to governmental plans for plan years beginning after December 31, 1986. A governmental plan must contain language setting forth the distribution requirements of section 401(a)(9), which apply beginning on (a) the later of the April 1 of the calendar year following the calendar year in which the employee attains age 70½ or the April 1 of the calendar following the calendar year in which the employee retires, or (b) the employee’s death. Governmental plans are exempt under 401(a)(9)(C)(iv) from the requirement to actuarially increase benefits that begin after age 70½.

  10. 401(a)(10) “Top-Heavy” Requirements of section 416. Not applicable to governmental plans. Section 401(a)(10)(B)(iii).

  11. 401(a)(11) Requirement of Joint and Survivor Annuity. Not applicable to governmental plans, due to the last sentence of section 401(a) (following 401(a)(37)).

  12. 401(a)(12) Merger and Consolidation Rules of section 414(l). Not applicable to governmental plans, due to the last sentence of section 401(a) (following 401(a)(37)).

  13. 401(a)(13) Assignment and Alienation. Not applicable to governmental plans, due to the last sentence of section 401(a) (following 401(a)(37)). (But see 43, below, regarding qualified domestic relations orders).

  14. 401(a)(14) Commencement of Benefits. Not applicable to governmental plans, due to the last sentence of section 401(a) (following 401(a)(37)).

  15. 401(a)(15) Requirement that plan not decrease plan benefits on account of certain Social Security increases. Not applicable to governmental plans, due to the last sentence of section 401(a) (following 401(a)(37)).

  16. 401(a)(16) Limitations on contributions and benefits of section 415. Applicable in modified form to governmental plans.

    Also, for a private employer, employee contributions to a defined benefit plan are treated as annual additions under section 415(c), but the benefit generated by them is excluded in applying the maximum benefit limitations of section 415(b). In the context of a governmental plan, this is true only for after-tax employee contributions. Picked-up contributions under section 414(h)(2) are treated as if they were not part of the employee’s compensation for purposes of the section 415 limits, and picked-up contributions to a defined benefit plan are not part of the annual addition. However, benefits generated by picked-up contributions to a defined benefit plan are subject to the limits of section 415(b).

    These rules may be a source of problems for governmental plans, e.g., Rhode Island, where a court held that an attempt to roll back benefits to comply with the section 415 limits violated state constitutional provisions. Since courts in approximately two-thirds of the states have held that federal or state constitutions impose some sort of prohibition on rolling back even future benefit accruals for existing employees, a problem in this area can be hard to correct.

    Excess benefit plans may provide one way of getting around section 415 problems. However, they contain a number of pitfalls, and raise a variety of legal issues.

  17. 401(a)(17) $200,000 (as indexed) limitation on compensation taken into account for purposes of contributions or benefit accruals. Became applicable to governmental plans, effective for the first plan year beginning on or after January 1, 1996, or 90 days after the opening of the first legislative session beginning on or after January 1, 1996 of the governing body with authority to amend the plan, if that body did not meet continuously. A transitional rule permits a governmental plan to apply section 401(a)(17) only to persons who become plan participants after the effective date, if certain conditions are met. One of those conditions is that the plan must have been amended before the beginning of the first plan year beginning on or after January 1, 1996.

  18. 401(a)(18) Repealed.

  19. 401(a)(19) Requirement that certain benefits not be forfeited on account of participant withdrawals. Not applicable to governmental plans, due to the last sentence of section 401(a) (following 401(a)(37)).

  20. 401(a)(20) Requirements with respect to PBGC notices on qualified total distributions. Not applicable to governmental plans, due to the last sentence of section 401(a) (following 401(a)(37)).

  21. 401(a)(21) Repealed.

  22. 401(a)(22) Requirements of section 409(e) imposed on plans which invest in certain employer securities. Not applicable to governmental plans because it concerns employer stock.

  23. 401(a)(23) Requirements of section 409(h) and (o) imposed on stock bonus plans. Not applicable to governmental plans, because it concerns employer stock.

  24. 401(a)(24) Group trusts will not be disqualified by holding moneys of any plan or governmental unit described in section 818(a)(6). Applicable to governmental plans.

  25. 401(a)(25) Requirement that actuarial assumptions be specified. Applicable to governmental plans for plan amendments after July 30, 1984. Note, however, that this rule has a limited effect on governmental plans, since such plans can change their actuarial assumptions without regard to the limitations in section 411.

  26. 401(a)(26) Under 401(a)(26)(G), governmental plans are exempt from Code section 401(a)(26).

  27. 401(a)(27) Special rules for profit-sharing plans. Applicable to governmental profit-sharing plans, which are technically permissible, but rare.

  28. 401(a)(28) Additional requirements relating to employee stock ownership plans. Not applicable to governmental plans, since governmental entities do not have stock.

  29. 401(a)(29) Security required upon adoption of amendment resulting in significant underfunding. Although unclear, probably not applicable to governmental plans, since governmental plans are not subject to the funding requirements of section 412.

  30. 401(a)(30) Limitations on deferrals. Not applicable to governmental plans (except 403(b) annuities, 457(b) plans, and certain grandfathered section 401(k) plans) since other governmental plans cannot provide for elective deferrals.

  31. 401(a)(31) Direct rollovers. Applicable to governmental plans.

  32. 401(a)(32) Treatment of failure to make certain payments if plan has liquidity shortfall. Not applicable to governmental plans, because it applies only to “a defined benefit plan (other than a multiemployer plan) covered under section 4021 of the Employee Retirement Income Security Act of 1974…” Section 430(k)(2), as incorporated by reference in section 401(a)(32)(A).

  33. 401(a)(33) Prohibition on benefit increases while sponsor is in bankruptcy. Not applicable to governmental plans, because it applies “only to plans (other than multiemployer plans) covered under section 4021 of the Employee Retirement Income Security Act of 1974.” Section 401(a)(33)(C).

  34. 401(a)(34) Benefits of missing participants on plan termination. Not applicable to governmental plans, because it applies only to “a plan covered by title IV of the Employee Retirement Income Security Act of 1974.”

  35. 401(a)(35) Diversification requirements for certain defined contribution plans. Not applicable to governmental plans, because it relates to diversification requirements for plans that invest in employer securities.

  36. 401(a)(36) Distributions during working retirement. Applicable to governmental plans. Permits a pension plan to allow distributions to individuals over the age of 62 even if they continue working.

  37. 401(a)(37) Death benefits under USERRA-qualified active military service. Applicable to governmental plans.

  38. 401(b) Time for amending a plan to comply with qualification requirements. For governmental plans, this time normally expires on the last day of the seventh month following the end of the plan year. Notice 89-8, 1989-1 C. B. 628. Extensions are possible if the plan requests an IRS determination letter in a timely manner.

  39. 401(h) Limitation on provision of retiree health benefits through a qualified plan. Applicable to governmental plans.

  40. 401(k) Governmental employers cannot set up new 401(k) plans. Grandfathered governmental 401(k) plans are exempt from actual deferral percentage (ADP) testing due to section 401(k)(3)(G).

  41. 401(l) Integration rules. Not applicable to governmental plans due to the exemption of such plans from section 401(a)(4), as discussed in 4, above.

  42. 401(m) Nondiscrimination rules for employee contributions and matching employer contributions. Not applicable to governmental plans because it is an exception to 401(a)(4), which is inapplicable to governmental plans due to section 401(a)(5)(G).

  43. 401(n) Qualified domestic relations orders. If a distribution is made from a governmental plan pursuant to a domestic relations order, it will be treated for tax purposes as if it were made pursuant to a qualified domestic relations order. However, governmental plans cannot claim ERISA preemption of domestic relations orders, so they may have to comply with a wider variety of domestic relations orders than could apply to a private plan. Conversely, plan provisions or provisions of applicable state or local law that require compliance with domestic relations orders relating to same-sex partners (much more common in governmental plans than in private plans) may generate federal tax issues, inasmuch as domestic partners are not considered spouses, and will often not be considered dependents, under federal law.

  44. 402 Tax consequences to participants in disqualified plan. Governmental plans are not exempt from section 402(b), which taxes vested participants currently on each year’s accruals if a plan is disqualified for reasons other than discrimination. This would apply both to accruals based on employer contributions and to those based on contributions intended to be “picked up” under section 414(h)(2). There is a split of authority as to whether all of the favorable tax provisions in section 402 for recipients of lump sum distributions from qualified plans (e.g., rollovers and forward averaging) are unavailable if the plan is disqualified, or whether such favorable tax provisions might still be available as to that portion of the benefit accrued in years in which the plan was qualified.

    Moreover, even if IRS would likely be reluctant to penalize rank and file employees for being participants in a disqualified plan, it has another avenue of potential attack: collecting additional withholding taxes from the employer. Under section 3401(a)(12), contributions to qualified plans are exempt from withholding, but this rule does not exempt contributions to disqualified plans. Under section 3403, the employer is liable for the amount of the tax which should have been withheld, whether or not such amount has been withheld from the employee.

    Some of the harsh results set forth above could be mitigated under the IRS Voluntary Compliance Resolution (“VCR”) and Coordinated Appeals Procedure (“CAP”) programs. However, IRS representatives have informally stated that they will be seeking monetary sanctions, not just future compliance, from governmental plans which seek to remedy their qualification problems under these programs.

  45. 410 Minimum coverage requirements. Not applicable to governmental plans due to section 410(c)(2).

  46. 411 Vesting requirements. The normal rules for private plans under Code section 411 are not applicable to governmental plans because of section 411(e)(1); however, governmental plans must satisfy Code Section 401(a)(7) as in effect before the enactment of ERISA, because of section 411(e)(2). See 7, above.

  47. 412 ERISA funding requirements do not apply to governmental plans, although such plans remain subject to funding requirements of pre-ERISA section 401(a)(7). Section 412(e)(2)(C).

  48. 413 Special rules for multiemployer (collectively bargained) and multiple employer plans. Theoretically applicable to governmental plans, although their application is limited by the fact that governmental plans are exempt from section 401(a)(4) and 410. It can be difficult in the context of a governmental plan to determine whether the contributing entities are to be treated as one employer or more than one employer under the Code rules. See discussion of section 414(a), (b), (c), (m), (n), and (o) at 49, below, and the August 20, 1991 IRS general information letter concerning section 415. Also, it can be difficult to determine whether a governmental plan is collectively bargained, since (a) it is common for collectively bargained and noncollectively bargained employees to participate in the same plan, which is set up by statute rather than by collective bargaining, and (b) some states do not permit collective bargaining by public employees, but have “meet and confer” or similar processes by which employees are involved in benefits decisions on a more informal basis.

  49. 414(a), (b), (c), (m), (n) and (o), aggregation of various employers for purposes of various qualified plan. Although technically applicable to governmental plans, these rules rely on definitions of control which are based on equity ownership and may be hard to apply in a governmental context. Taxpayers would be entitled to rely, pending further guidance, on the definition of employer and aggregation rules set forth in an August 20, 1991 IRS general information letter concerning section 415 and in Notice 89-23, 1989-1 C.B. 654, as modified by Notice 90-73, 1990-2 C.B. 353, concerning nondiscrimination rules for section 403(b) annuities. Announcement 95-48, 1995-23 I.R.B. 13.

  50. 414(h) Tax treatment of certain contributions. Governmental plans have a special exception in 414(h)(2) (the “pick-up rules”) to the normal 414(h) rules.

  51. 414(l) See 401(a)(12) at 12, above.

  52. 414(p) Qualified domestic relations orders. See section 401(n) at 43, above.

  53. 414(q), (r), and (s) Definition of highly compensated employee, and special rules for separate line of business, and definition of compensation. Although governmental plans are not explicitly exempted from these rules, they are used primarily to apply certain nondiscrimination tests, and therefore are of limited applicability to the extent the plan itself is exempt from nondiscrimination rules. See 4 and 45, above.

  54. 415 Limitations on contributions and benefits. Applicable in modified form to governmental plans. See 401(a)(16) at 16, above.

  55. 416 Top heavy requirements. Not applicable to governmental plans. Section 401(a)(10)(B)(iii).

  56. 417 Joint and survivor annuities. The joint and survivor annuity rules are not applicable to governmental plans; see 401(a)(11) at 11, above. However, the actuarial assumptions of section 417 are used in calculations under section 415(b), to which governmental plans are subject in modified form. See 401(a)(16) at 16, above.

  57. 501(a) Tax exemption of trust. Theoretically applicable to governmental plans. However, under IRS News Release IR-1869 (August 10, 1977), the IRS will not treat a trust under a governmental plan as taxable even if the plan is disqualified. It is unclear whether a trust under a disqualified governmental trust would be taxable if IR-1869 were revoked; Private Letter Ruling 8936028 (June 9, 1989) treated a governmental health benefits trust as a governmental instrumentality exempt from tax under section 115, and GCM 34639 (October 12, 1971) suggested that a nonqualified governmental retirement plan might be eligible to obtain tax exemption under section 501(c)(3). There apparently remains the possibility that participants would be taxable on trust income under the grantor trust rules if a plan were disqualified and if the after-tax contributions of a participant exceeded the contributions of the employer on such participant’s behalf. Treas. Reg. § 1.402(b)-1(b)(6). This could occur, for example, if a plan were disqualified for such a long time that vested employer and “picked up” contributions after the disqualification (which are treated as employee contributions under Treas. Reg. § 1.72-8(a)(1)) plus after tax contributions of the employee both before and after disqualification exceeded employer and “picked up” contributions before the disqualification.

  58. 503 Prohibited transaction rules specifically for governmental plans.

  59. 3405 Withholding from plan distributions. Applicable to governmental plans.

  60. 4974 Excise tax on failure to make required distributions under section 401(a)(9). Theoretically applicable to governmental plans, although there may be Constitutional issues with imposing a tax on such plans.

  61. 4972 Excise tax on nondeductible contributions. Not applicable to governmental plans. Section 4972(d)(1)(B).

  62. 4975 Prohibited transaction rules. The rules of section 4975 do not apply to governmental plans, due to section 4975(g). Governmental plans are, however, subject to a separate set of prohibited transaction rules under section 503, as discussed at 58, above.

  63. 4980 Excise tax on reversion of plan assets. Not applicable to governmental plans. Section 4980(c)(1)(B).

  64. 6057 Requirement to file Schedule SSA. Not applicable to governmental plans, since they are not subject to the vesting standards of section 203 of ERISA. Section 6057(a)(1).

  65. 6058(a) Requirement to file Form 5500. Not applicable to governmental pension plans. Announcement 82-146, 1982-47 I.R.B. 53. However, this requirement may be an issue for certain other types of governmental plans, e.g., flexible benefits plans or plans providing for employees to make pretax premium payments on health or life insurance.

  66. 6058(b) Requirement to file Form 5310-A in case of merger, consolidation, or transfer of assets or liabilities. Should not be applicable to governmental plans, since the sole function of the statement is for the purpose of “evidencing compliance with the requirements of section 401(a)(12),” to which governmental plans are not subject. However, instructions to Form 5310-A provide a code with which to report the fact that the plan filing is a governmental plan, implying that such plans are subject to the Form 5310-A requirement.

  67. 6059 Requirement to file actuarial report. Not applicable to governmental plans, because it applies only to plans subject to section 412. Section 6059(a).

  68. 6652(i) Rollover notices required with respect to lump sum distributions. Applicable to governmental plans.

* * *

Other considerations

Under the Age Discrimination in Employment Act, a governmental plan cannot limit or reduce benefit accruals on account of age and may not prohibit plan participation on account of age. Under Title VII of the Civil Rights Act of 1964, governmental plans cannot discriminate in contributions or benefits on the basis of sex. The EEOC also takes the position that Title VII prohibits discrimination based on sexual orientation or transgender status. Other federal, state, and local civil rights statutes may also apply.

Most non-Code ERISA requirements are inapplicable to governmental plans. However, ERISA preemption also does not apply to governmental plans, so state law issues must be considered. For example, about two-thirds of state constitutions prohibit cutbacks in a governmental plan’s benefit formula for existing employees, and some courts have suggested that such a requirement applies under the federal constitution even in the absence of a state constitutional requirement. In addition, some courts have held that imprudent investments may be a violation of such constitutional provisions, even if the nominal benefit formula is not changed. State laws and state constitutional requirements also provide the basis for most funding requirements applicable to governmental plans.

Footnotes:
1. The preamble to the section 415 regulations, T.D. 9319 (April 30, 2007), states as follows:

One commentator asked whether the rules regarding adjustments for forms of benefit that are subject to the minimum present value standards of section 417(e)(3) apply to plans that are not subject to the requirements of section 417. Section 415(b)(2)(E) applies based on the form of the benefit, and not the status of the plan, and therefore the final regulations provide that these rules also apply to plans that are not subject to the requirements of section 417.

The preamble to the section 415 regulations, T.D. 9319 (April 30, 2007), states as follows:

One commentator asked whether the rules regarding adjustments for forms of benefit that are subject to the minimum present value standards of section 417(e)(3) apply to plans that are not subject to the requirements of section 417. Section 415(b)(2)(E) applies based on the form of the benefit, and not the status of the plan, and therefore the final regulations provide that these rules also apply to plans that are not subject to the requirements of section 417.