Rev. Rul. 81-36

Advice has been requested whether, pursuant to section 414(h)(2) of the Internal Revenue Code, an employee may exclude from current gross income, for federal income tax purposes, contributions made by the employing governmental unit to a pension plan qualified under section 401(a) under the circumstances described below.

A is employed by a city within a state whose statutes require that employees contribute 10 percent of salary to the state's pension plan. The plan is qualified under section 401(a) of the Code, and its trust is exempt from federal income tax under section 501(a).

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 salary to the state's pension plan.

Section 414(h)(1) of the Code states that amounts contributed to a plan qualified under section 401(a) may not, for tax purposes, be treated as employer contributions if they are designated as employee contributions. Section 414(h)(2) provides an exception to this rule, however, by allowing contributions (otherwise designated as employee contributions) to government plans to be treated as employer contributions if the employer "picks up" the contributions.

Rev. Rul. 77-462, 1977-2 C.B. 358, specifies the federal income tax treatment to be accorded contributions "picked-up," within the meaning of section 414(h)(2) of the Code, by a governmental unit and paid to a plan qualified under section 401(a). It concludes that such "picked-up" contributions are not includible in the gross income of the employees until these amounts are distributed or made available to the employees.

Contributions are considered "picked-up" by the employer, for purposes of section 414(h)(2) of the Code, 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 contributions by the employee. Second, the employee must not be given the option of choosing to receive the contributed amounts directly instead of having them paid by the employer to the pension plan.

Rev. Rul. 81-35, page 255, this Bulletin, 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, as provided in Rev. Rul. 77-462.

Rev. Rul. 81-35 is distinguished.