SERVICE HOLDS THAT RETROACTIVELY 'PICKED-UP' EMPLOYEE QUALIFIED PLAN CONTRIBUTIONS ARE CURRENTLY TAXABLE TO EMPLOYEES.

Rev. Rul. 87-10

ISSUE

May government employees exclude from current gross income required contributions designated as employee contributions to a qualified plan that relate to the period prior to the date of the last governmental action necessary to effect the employer pick up of such designated employee contributions under section 414(h)(2)?

FACTS

In 1978, State M established Plan X, a governmental plan qualified under section 401(a) of the Internal Revenue Code. Participants in Plan X have been required to contribute five percent of their earnings to the plan. Employees of A, a political subdivision of M, are participants in Plan X. State M enacted legislation on October 30, 1983, enabling A to pick up designated employee contributions as employer contributions on behalf of its employees. On November 30, 1983, A executed a resolution electing to pick up all of its employees' contributions retroactive to January 1, 1983.

LAW AND ANALYSIS

Section 414(h)(1) of the Code provides that amounts contributed to a plan qualified under section 401(a) shall not be treated as having been made by the employer if they are designated as employee contributions. However, section 414(h)(2) provides an exception in the case of any plan established by the government of a State, or political subdivision thereof, where the contributions of employees of an employing unit are picked up by the employing unit. The contributions so picked up shall be treated as employer contributions.

Rev. Rul. 77-462, 1977-2 C.B. 358, provides that contributions "picked up," within the meaning of section 414(h)(2) of the Code, by a governmental unit and contributed to a qualified plan are not includible in the gross income of employees until these amounts are distributed to the employees.

The issue of whether designated employee contributions have been picked up by an employer, within the meaning of Code section 414(h)(2), is addressed in Rev. Rul. 81-35, 1981-1 C.B. 255, and Rev. Rul. 81-36, 1981-1 C.B. 255. These revenue rulings provide that in order for designated employee contributions to be excluded from an employee's "current gross income," the following 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 contributions directly instead of having them paid by the employer to the plan.

In order to satisfy Rev. Ruls. 81-35 and 81-36 with respect to particular contributions, the required specification of designated employee contributions must be completed before the period to which such contributions relate. If not, the designated employee contributions being paid by the employer are actually employee contributions paid by the employee and recharacterized at a later date. Thus, 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).

In this case, State M enacted legislation on October 30, 1983, necessary for the designated employee contributions to be picked up as employer contributions in lieu of contributions by the employees. A's resolution specifying the pick up of the employees' contributions as of January 1, 1983, was not executed until November 30, 1983. Because the last governmental action necessary to effect the pick up did not occur until November 30, 1983, designated employee contributions to plan X that relate to compensation earned for services prior to November 30, 1983, may not be retroactively recharacterized as employer contributions. Thus, such contributions may not be excluded from current gross income by A's employees.

HOLDING

Under section 414(h)(2), government employees may not exclude from current gross income designated employee contributions to a qualified plan that relate to compensation earned for services prior to the date of the last governmental action necessary to effect the employer pick up.