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- What is a pick-up?
- Employee contributions are never deductible or excludable from income; only employer contributions are. (For this reason, tax-deferred contributions to such plans are 401(k), 403(b), and 457 plans are technically considered employer contributions.)
- Federal civil service employee in the early 1970s nevertheless argued that he neither received nor had any right to receive mandatory employee contributions to the civil service retirement plan, and was therefore not taxable on them. Example: employee earns $200 a week, and has $10 taken out for mandatory contributions to civil service plan. Employee argued that only $190 was subject to income tax.
- Possible whiplash effect if employee did not pay taxes on contributions now, but the amounts attributable to the contributions were nevertheless treated at the time of distribution as being previously taxed (and therefore not again taxable) amounts.
- Pick-up rules (Code section 414(h)) added by ERISA
- Private plans and federal government plans: Internal Revenue Code (“Code”) section 414(h)(1) states that a contribution to a qualified plan shall not be treated as having been made by an employer if it is designated by the plan as an employee contribution.
- State and local government plans:
- Special problem: state agencies and localities often did not have control over the terms of a state plan document. A private employer could treat mandatory contributions as employer contributions simply by paying lower salaries (or not increasing employer salaries) and amending its plan to call for larger employer contributions. For example, suppose a private employer were currently paying an employee $190 a week and requiring the employee to make contributions of $10 a week to a plan, and would otherwise have raised the employee’s pay to $200 a week. The employer could get favorable tax treatment by instead keeping the employee’s salary at $190 but amending the plan to eliminate the $10 employee contribution and add a $10 employer contribution. However, this option was not open to a local government employer which had no option to amend a state plan to which it contributed.
- Resolution: Code section 414(h)(2) states that “where the contributions of employing units are designated [by the plan] as employee contributions but where any employing unit picks up the contributions, the contributions so picked up shall be treated as employer contributions.”
- The original legislative history described a pick-up plan as one under which “the governmental unit pays all or part of the employee’s contribution but does not withhold this amount from the employee’s salary.” H.R. Rep. No. 807, 93d Cong., 2d Sess., reprinted in 1974 U.S. Code Cong. & Admin. News at 4810.
- However, in GCM 38194, the Internal Revenue Service recognized that it was not practical to figure out whether a governmental unit was in effect picking up a contribution in lieu of salary. Thus, in Rev. Rul. 81-35, 1981-1 C.B. 255 and Rev. Rul. 81-36, 1981-1 C.B. 255, it set up an alternate test. For contributions to be treated as picked up,
(1) they must be designated by the employing governmental unit as being picked up, and
(2) the participant must have no right to receive the contributions in cash, in lieu of having them contributed to the plan.
- In the early 1980s, the City of Philadelphia recognized the tremendous tax advantage that its employees could recognize if it simply converted mandatory employee contributions into picked up contributions, by nominally reducing employees’ wages by the amount of the contributions and then having the employer make the contributions. Example: an employee who currently earned $200 a week would have his or her wages nominally reduced by $10 a week, but the employer would then begin paying $10 in picked up contributions. The net result was that the employee was now taxable only on the $190 in nominal wages left after the reduction. The City of Philadelphia instituted and obtained a favorable IRS ruling on such a pick-up plan, which became the model for other jurisdictions throughout the United States.
- Current Issues in Pickups
- FICA taxation
- Because 414(h)(2) deals only with income taxation, the IRS initially took the view that it did not affect FICA and FUTA taxation. Thus, it treated pickups made out of wages as subject to FICA and FUTA taxation, while pickups not out of wages were treated as exempt from such taxation.
- Rowan Cos. v. United States, 452 U.S. 247 (1981) – Supreme Court held that there could not be separate definitions of wages for income tax withholding and FICA and FUTA taxation. Thus, pickups would have had to be exempt from FICA.
- Social Security Amendments of 1983, P.L. 98-21, added Code section 3121(v)(1)(B), which provided that “any amount treated as an employer contribution under section 414(h)(2)” would be subject to FICA taxation. This went farther than the original IRS position, since it included even pickups which did not reduce wages in the amount subject to FICA taxation.
- Deficit Reduction Act of 1984, P.L. 98-369, modified Code section 3121(v)(1)(B) to impose FICA taxes only on “any amount treated as an employer contribution under section 414(h)(2) where the pickup referred to in such section is pursuant to a salary reduction agreement (whether evidenced by a written instrument or otherwise).”
- IRS is currently concerned about what it perceives as “massive noncompliance” with FICA rules for pickups, and is contemplating a field directive which would probably forgive the past, but set forth clear rules for the future as to what picked up amounts would be subject to FICA taxation. The proposal is now before the Chief Counsel’s office in the National Office of the IRS. Given the wide variety of positions taken by governmental entities on whether a pickup is “pursuant to a salary reduction agreement,” it can be expected that the field directive may prohibit certain arrangements now in place in state and local government.
- Trade-off: Avoidance of FICA taxation also eliminates picked up amounts from the wage base for Social Security.
- Pickups to allow for elective participation. An early issue arose from the fact that the two revenue rulings cited above stated that the participant must be given no option to receive the money in cash as opposed to having it contributed to the plan.
- The question was whether allowing participants a choice at the time of hire (or upon initial eligibility to participate) as to whether to participate in a plan (required by some state laws which prohibited reductions of an individual’s salary without the individual’s consent) would disqualify the arrangement.
- The IRS early on took the position that such an election would not disqualify the arrangement.
- Pickups to allow for elective contribution levels (“quasi-401(k) plans”)
- Some governmental employers have taken the above a step farther, and have permitted employees at the time of initial hire (or upon initially becoming eligible to participate) to elect among several available contribution levels, with higher benefits available at the higher contribution levels. This, too, has been approved in IRS private letter rulings.
- To the extent that this procedure is followed for a defined contribution plan, the plan may in many ways resemble a 401(k) plan, and may be a way to get around the prohibition on governmental employers (other than grandfathered ones) adopting 401(k) plans. However, the disadvantage is that the election of the contribution rate must be irrevocable for the employee’s entire employment, as opposed to being allowed to vary from year to year.
- Pickups for purchase of service credit
- In numerous private rulings, the IRS has permitted individuals to purchase service credit through “one-time elections” to have salary reduced by the amount necessary to fund the purchase.
- These one-time elections have not necessarily been made at the time of hire or first participation in the plan. Moreover, in some instances separate “irrevocable” elections have been made to purchase different service credit. These “irrevocable elections have typically not continued indefinitely, but have been for a period of time stated in the original election form.
- How far can this be taken? Could an individual make an “irrevocable election” to contribute X% of compensation for 2001, and then another irrevocable election to contribute Y% of compensation for 2002? If so, how would this differ from a 401(k) plan?
- The correctness of even the rulings which permit multiple elections in the context of purchasing service credit could be questioned. And private letter rulings are not binding except with respect to the taxpayer to whom they are issued. Thus, as a practical matter, an employer considering a nontraditional type of pick-up would probably want to get its own ruling.
- Avoidance of pickup rules by plan amendments. Section 414(h) applies, by its terms, only if contributions are stated to be employee contributions. Can its requirements be avoided if the contributions are stated in the plan to be employer contributions?
- Probably not a solution to the requirement that contributions be irrevocable, since employer contributions pursuant to a voluntary revocable arrangement may well not be tax-deferred due to the 401(k) rules.
- Answer to FICA issues?
- Can statewide plan permit different employers to choose whether contributions will be pickup contributions or straight employer contributions?
- Can employer contributions be included in compensation for benefits purposes (assuming no violation of the 415(b) limits)?
- Effect of pickups on other plans
- All plans: Compensation for purposes of all applicable statutory limits is reduced by the amount of salary reduction contributions under a pickup plan. This differs from salary reduction contributions to 401(k) or 403(b) plans, which can be treated as part of compensation.
- 401(a) plans: Picked up contributions to a 401(a) defined benefit plan are included in the 415(b) limit, unlike mandatory after-tax employee contributions which are included in the 415(c) limit.
- 403(b) plans: In calculating the prior contributions to annuity contracts for purposes of the maximum exclusion allowance, picked up contributions to defined benefit plans must be determined based on actuarial calculations, not based on the actual amounts contributed.
- 403(b) “pickups”
- Section 414(h)(2) by its terms is applicable only to qualified plans.
- Nevertheless, salary reduction contributions to a 403(b) plan pursuant to a one-time irrevocable election can avoid both the universal availability requirement of Code section 403(b)(12)(i) and the maximum limit on deferrals under 402(g). This may have particular advantages in structuring executive compensation arrangements.
- FICA taxation