RECENT CASES AND RULINGS.

RECENT CASES AND RULINGS

PROCEDURE & ADMINISTRATION

Plan Contributions by Salary Reductions of State Employees Were Subject to FICA 

Pursuant to Section 218 of the Social Security Act of 1950, New Mexico state employees are covered by the Social Security, system. In addition, New Mexico administers two qualified pension plans: one under the state Public Employees Retirement Act (PERA) and educational employees under the state Educational Retirement Act (ERA). Employee participation in these plans is mandatory.

Under Sec. 414(h)(2), contributions to state and local pension plans are treated as employer contributions, if the employer "picks up" the contribution; in this way, these contributions are not included in wages for FICA or income tax purposes. Effective July 1, 1983 (for contributions to the ERA plan) and May 21, 1986 (for the PERA plan), New Mexico picked up all designated employee contributions as employer contributions.

In 1983, Congress amended Sec. 3121 (v)(1)(B), stating that "picked up" amounts treated as employer contributions under Sec. 414(h)(2) would be considered FICA wages. In 1984, Congress again amended Sec. 3121(v)(1)(B) to reflect that any employee contributions picked up by the employer pursuant to a salary reduction agreement were FICA wages.

New Mexico challenged its FICA liability for 1983-86, arguing that, because the pickup and resulting salary reductions were mandated by state law, there was no salary reduction "agreement" and the state was not liable for FICA taxes on those contributions. After review by the Social Security Administration, New Mexico brought suit; the district court held for the government. The Court of Appeals (opinion Tacha, J.) affirms; even though the employer contributions were mandated by state law, they are made pursuant to a "salary reduction agreement."

Before discussing salary reduction agreements, we must first address what is meant by an employer "pickup" under Sec. 414(h) (2). The meaning of that term dictates understanding what a "salary reduction agreement" is under Sec. 3121(v)(1)(B). Congress did not define the phrase "pickup" and it is not readily apparent what Congress meant by use of the phrase. Accordingly, the IRS has interpreted this term in Rev. Ruls. 81-36, 81-35 and 77-462.

Contributions are deemed "picked up" by the employer under Sec. 414(h)(2) if two criteria are satisfied. First, the employer must specify that the contributions, although designated as employee contributions, are being paid by the employer in lieu of employee contributions. Second, the employee must not have the option of receiving the contributed amounts directly instead of having them paid by the employer to the pension plan.

In Rev. Rul. 81-35, the IRS provided the following examples to illustrate:

A is employed by a school district within a state whose statutes require that employees contribute 7 percent of gross salary to the state's pension plan....

A entered into an agreement with the school district in 1977 pursuant to which the school district contributed 7 percent of A's salary, on A's behalf, to the state's qualified pension plan. The agreement designated these amounts as employee contributions and provided that amounts paid by the school district were to satisfy A's obligation to contribute 7 percent of salary to the state's pension plan. The agreement in question was voluntary and was not entered into as a condition of A's employment....

The employer in the above example did specify that the contributions, designated as employee contributions, were paid by the employer in lieu of contributions by the employee. A, however, voluntarily entered into an agreement with A's employer to have these contributions made to the state's pension plan. Thus, A did exercise an option to have these contributions made to the pension plan rather than receiving the amounts directly and, therefore, such amounts are not considered "picked-up," within the meaning of section 414(h)(2), because they fail to satisfy the criteria stated above.

Accordingly, A may not, pursuant to section 414(h)(2) of the Code, exclude from gross income, for federal income tax purposes, contributions made by the employing governmental unit to its qualified pension plan. (Emphasis added.)

This situation as contrasted to the example presented in Rev. Rul. 81-36:

In 1977 the union representing A negotiated an agreement with the city under which the city was to contribute 10 percent of covered employees' salaries to the state's qualified pension plan.

Prior to the agreement, A's salary was $10,000, and A contributed $1,000 to the plan. As a result of the union agreement with A's employer, A's salary was reduced to $9,000, and the city contributed $1,000 to the plan; this $1,000 contribution was considered part of A's salary, for purposes of determining the required employee contribution.

The city's contributions were designated as employee contributions but, in addition, were specified by the city as being paid by the employer in lieu of employee contributions. Amounts paid by the city thus were to satisfy the employee's obligation to contribute 10 percent of the salary to the state's pension plan.

Rev. Rul. 81-35 ... deals with a situation where the employee entered into a voluntary agreement with the employing governmental unit to have certain contributions made to the state's qualified pension plan. Because the employee was given the option of having these contributions made to the plan rather than receiving these amounts directly, the amounts contributed were determined not to be "picked-up" within the meaning of section 414(h)(2) of the Code.

In the above situation, A's union, on behalf of A and all other covered employees, negotiated an agreement with A's employer concerning the amounts to be picked up and contributed to the state's qualified pension plan. A thus was required to have the $1,000 contributed to the pension plan and was not given the option of instead receiving the contributed amounts directly. Thus $1,000 also was designated as being paid by the employer in lieu of required employee contributions.

Accordingly, A may, pursuant to section 414(h)(2) of the Code, exclude from current gross income, for federal income tax purposes, all of the contributions made by the employing governmental unit to its qualified pension plan. Such "picked-up" contributions are not includible in A's gross income until distributed or made available.

The distinction between the two examples is, in one sense, a fiction. In both examples, A takes the same amount home, and the employing governmental unit has paid out the same amount. Nevertheless, the distinction is significant because Congress has made it so, imposing a lesser tax burden on employees whose employers "pick up" their employee contributions than on those whose employers do not.

There is no question, given the Service's interpretation of Sec. 414(h)(2), that New Mexico picked up its employees' contributions from 1983 to 1986. The two necessary criteria for contributions to be considered picked up under Sec. 414(h)(2) existed in New Mexico during those years, and continue to exist today. First, the statutes under which the states' pension plans are administered require the State employer to specify that contributions, although designated as employee contributions, are to be paid by the employer in lieu of contributions by the employee. Second, under those same statutory sections, the employee does not have the option of receiving the contributed amounts directly.

Thus, it is clear that the contributions under consideration here were "picked up" by New Mexico during the relevant time period.

Sec. 3121(v)(1)(B) includes as FICA wages "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" Congress did not define "salary reduction agreement" in the statute. New Mexico argues that the meaning of the term is dear and that a salary reduction agreement excludes arrangements such as New Mexico's in which the employees' participation in the salary reduction plan is mandated by state statute. Rather, the state contends that a salary reduction agreement "requires an individually negotiated contract under which an employee agrees to a salary reduction and an employer agrees to contribute the amount of the reduction to a qualified trust for the employee's benefit." According to the state, although New Mexico's pickup plan is one described in Sec. 414(h)(2), it is not pursuant to a salary reduction agreement, and the contributions at issue here are not included within the FICA definition of wages.

Our understanding of the term "pickup" as used in Sec. 414(h)(2) is that a pickup under Sec. 414(h)(2), must be mandatory. The state argues that a salary reduction agreement must be voluntary. Under the state's definition of the latter term, however, Sec. 3i21(v)(1)(B) makes no sense. The two terms would be mutually exclusive; because a pickup is mandatory, it could never be pursuant to a salary reduction agreement. Yet, Sec. 3121(v)(1)(B) speaks directly to pickups that are pursuant to a salary reduction agreement.

For the provision to operate coherently, the term "salary reduction agreement" must refer to something broader than "an individually negotiated contract under which an employee agrees to a salary reduction and an employer agrees to contribute the amount of the reduction to a qualified trust for the employee's benefit." A salary reduction agreement necessarily includes any arrangement in which there is a reduction in an employee's salary in exchange for the employer's contribution of the amount of the reduction to a pension plan on the employee's behalf. An "agreement" is not limited to individually negotiated contracts, but may also refer generally to a manifestation of mutual assent on the part of two or more persons. Such manifestation of assent may be made by word, or any other conduct. Here, an employee's decision to go to work or continue to work as a state employee constitutes conduct manifesting assent to a salary reduction in exchange for the state's contribution to a pension plan on the employee's behalf. The employee has "agreed" to the salary reduction by continuing employment with the state.

The New Mexico State employee contributions to one of two pension plans from 1983 to 1986, mandatorily picked up by the state as employer contributions with a corresponding reduction in the employees' gross salaries, were contributions made pursuant to a salary reduction agreement. Accordingly, such contributions were subject to FICA tax under Sec. 3121(v)(1)(B).

Public Employees' Retirement Board V. Shalala, 10th Cir., 9/2/98, aff'g DC

RELATED ARTICLE: IN THIS DEPARTMENT

Procedure & Administration

* FICA taxes on plan contributions by salary reduction of state employees: Public Employees' Retirement Board, 10th Cir.; p. 873.

The reports of cases, rulings, etc., herein, except for the Reflections, are edited versions of the relevant court opinion, published ruling, etc.

* This development, concerning related matters, is covered in the Reflections to the report of the principal item.