A number of private letter ruling (PLR) requests reportedly pending before the Internal Revenue Service (IRS) have helped to spur the IRS and the Treasury Department to consider issuing additional guidance on Internal Revenue Code Section 414(h)(2) employer pick-ups under IRS Revenue Ruling 2006-43. The specific issue involves the ability of a governmental defined benefit plan to offer current participants a choice between two benefit formulas, and whether this gives rise to a cash-or-deferred arrangement (CODA) which could result in plan disqualification. There is growing pressure from Capitol Hill and elsewhere for a response to these PLR requests. However, depending on how this question is answered, issues could be raised with the ability to use pick-ups in connection with not just elective tiers but other employee elections/options as well, such as the purchase of service credit and DROP arrangements.
Perhaps the most discussed PLR request related to this issue involves Orange County, California. There, as part of pension reform, a plan was devised whereby newly-hired workers were given the option of choosing a lower defined benefit pension with a government-matched 401(k)-type component. Orange County is seeking permission from the IRS to allow current workers to opt into this hybrid retirement plan as well, which requires lower employee contributions resulting in approximately a 7 percent increase in their take-home pay.
Revenue Ruling 2006-43
IRS Revenue Ruling 2006-43 deals with what actions are required in order for a State or local government employer to "pick up" employee contributions to a qualified plan so that the contributions are treated as employer contributions pursuant to § 414(h)(2) and therefore tax-deferred. It clarifies that in order for employee contributions to be considered made, or picked up, by the employer:
- Contributions, although designated as employee contributions, are to be paid by the employer pursuant to formal action taken by the employing unit to provide that the contributions on behalf of a specific class of employees of the employing unit, although designated as employee contributions, will be paid by the employing unit in lieu of employee contributions; and
- A participating employee, from and after the date of the “pick-up”, cannot be permitted to have a cash or deferred election right with respect to designated employee contributions. That is, participating employees must not be permitted to opt out of the “pick-up”, or to receive the contributed amounts directly instead of having them paid by the employing unit to the plan.
Based on one reading of this Revenue Ruling, Orange County’s optional defined benefit plan tier for current employees -- because it changes the level of the “picked-up” employee contribution – could be viewed as a prohibited cash or deferred arrangement (CODA) under the plan. The Orange County PLR seeks to determine if the second part of this Revenue Ruling requirement would indeed prevent it from offering its new tier as an individual option to its current employees. That is, would the Revenue Ruling not only prohibit any employee from opting out of the pick-up, but also from making any election that would changes the amount of the employee’s picked-up contribution since it would result in the employee “electing” to have more current or deferred compensation?
The answer to this question, depending upon what it is, or on what circumstances it might be conditioned, could also significantly affect other employee elections in addition to opting into a new benefit tier that has a different employee contribution rate, such as electing to purchase service credit through a salary reduction, or electing a deferred retirement option plan whereby the employee contributions to the plan cease.
A reading unfavorable to Orange County would also appear to overturn past favorable IRS rulings that specifically allowed use of pickups where individual employees make an irrevocable election to have contributions made to a plan on their behalf by payroll deduction. It would also contradict Congressional intent. For example, under the Tax Reform Act of 1997, Congress stated that nothing in the new purchase of service credit provisions were meant to interfere with pickups to purchase service credits. Also, under the Pension Protection Act of 2006, Congress specifically reaffirmed the ability of public employees to purchase service under a plan whereby “a lower level benefit is converted to a higher benefit level otherwise offered under the same plan.”
Current Status
Discussions have been underway with Treasury to address the potential unintended impact of such a reading. For example, any action by Treasury that officially affirms this reading of Revenue Ruling 2006-43, even in part, could raise serious issues for many plans. It could also impact a number of changes being considered by some to enhance sustainability. There is also concern that a proscriptive outline by Treasury of the timing, circumstances, financial condition, etc. under which a new tier or plan can receive picked-up contributions could be interpreted as a one-size-fits-all Federal model that employers are encouraged to follow.
Public plan organizations, representatives and attorneys are currently urging the Service to consider a ruling position with regard to Revenue Ruling 2006-43 that clarifies that a CODA does not include an irrevocable election to prospectively modify contributions or accruals under an existing broad-based qualified governmental defined benefit plan (available to all similarly situated individuals in a reasonably equivalent manner), if made pursuant to any provision of federal, state, or local law (including any administrative rule or policy and any collectively bargained provision adopted in accordance with such law).
However, certain public employee unions – but not all -- are concerned with the implications of the Orange County plan and the temptation it presents to current employees to waive their constitutional guarantees to their current benefits. These unions have urged Treasury and the IRS to follow a strict interpretation of Revenue Ruling 2006-43 and find that individually elected contributions should continue to be excluded from treatment as employer “pick-up” contributions.
There is clearly a feeling at the IRS and Treasury that this is becoming a major political problem. The fact that there is not unanimity as to a resolution of the issue among the various public sector organizations is also viewed as a problem and has likely been a factor in the delayed response. There are also reports that the IRS is considering a very narrowly-drawn, fact-specific PLR that simply recites the facts of the Orange County situation and states that this does not present a CODA.
In any case, it appears that pressure from Capitol Hill for a response to the pending PLR requests means that something is likely to happen sooner rather than later.
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