Taxpayer with Zero Exclusion Ratio Is Fully Taxable on Pension Payments.
(Parker's Federal Tax Bulletin: August 6, 2013)

A court rejected a taxpayer's argument that pre-tax contributions made by his employer to a qualified plan satisfied the "exclusion rule" of Code Sec. 401, and thus exempted such payments from federal income tax. Blue v. U.S., 2013 PTC 209 (Fed. Cl. 7/22/13).

From 1973 to 1998, Gregory Blue worked for King Kullen Grocery Co., Inc., as an inventory control checker. During this time, Gregory was a member of a union, the Local 282 of the International Brotherhood of Teamsters. The union administered a pension trust fund that required Gregory's employer to make weekly contributions on behalf of the union employees, including Gregory.

In 2007, Gregory began receiving monthly pension payments. The gross amount of his first pension payment was $1,613 and federal taxes of $68 were withheld. Shortly thereafter, Gregory filed Form W-4P, Withholding Certificate for Pension or Annuity Payment, with the union. Gregory indicated on the form that he did not want any federal income tax withheld from future pension payments. The Pension Trust Fund manager responded and explained that, if not enough tax was withheld from Gregory's benefits, he might have to pay estimated taxes during the year, or a tax penalty at the end of the year. Thereafter, for the rest of 2007, the Pension Trust Fund reported federal tax withholding as $0 per month. Subsequently, Gregory was provided with a 2007 Form 1099-R, which reported pension income in the amount of $19,365. Line 2a stated that $19,365 of that amount was taxable income. On his 2008 Form 1040, on Line l2a, Gregory reported $19,365 in pension payments, for which he claimed $0 as taxable on Line 12b. Gregory's employer reported that the amounts were taxable to Gregory. After an audit, the IRS assessed tax deficiencies.

Gregory and the IRS exchanged a series of letters regarding the tax assessment, but no agreement was reached. Gregory paid the deficiency and filed suit in Tax Court, seeking a refund of the $2,847 paid. The Tax Court dismissed Gregory's suit because the suit was filed 575 days after the IRS notice regarding the deficiency and beyond the 90-day limitations period for filing such claims. On March 23, 2012, Gregory filed suit in the Court of Federal Claims seeking a refund of $2,847 plus interest paid for the alleged overpayment of 2007 taxes.

Although Gregory recognized that pension income generally is taxable, Gregory argued that his pension payments qualified for exclusion. Gregory maintained that the pre-tax contributions made by his employer to the Pension Trust Fund satisfied an "exclusion rule" under Code Sec. 401, exempting such payments from federal income tax.

The IRS argued that Gregory's 2007 pension income was subject to federal income tax as gross income, unless it previously was taxed. The IRS cited Code Sec. 402, which provides that payments distributed from a Code Sec. 401 qualified employer plan are taxable to the distributee, in the tax year of the distributee in which distributed under Code Sec. 72. According to the IRS, Gregory was mistakenly maintaining that he was entitled to an exemption under the "general rule of exclusion income." Under that rule, an employer's contribution is nontaxable at the time it is made to a qualified plan. The amount of a distribution that may be excluded from income is calculated using the exclusion ratio under Code Sec. 72. In Gregory's case, the union allowed only employers to contribute to the Pension Trust Fund, not employees. Since Gregory never contributed to the Pension Trust Fund, his exclusion ratio was zero. Therefore, the IRS said, Gregory's receipt of 2007 pension income was taxable.

The Court of Federal Claims held that Gregory's pension was not excludible from income and that Gregory was liable for tax on his pension income. The Pension Trust Fund, the court noted, was qualified as an employer plan under Code Sec. 401(a). As such, all income received by Gregory under the Pension Trust Fund, either as a pension or annuity, is includible in his gross income and subject to ordinary federal income tax, unless that income previously was taxed or otherwise is exempt. The "exclusion ratio," the court noted, is the percentage amount that a taxpayer has invested in a pension or annuity. Since Gregory invested nothing, the exclusion ratio did not apply. Gregory elected, on Form W-4P, to opt out of withholding federal taxes from his monthly payments. However, the court noted, this only affected his monthly withholding, not the federal income tax due. The exclusion from income for annuities under Code Sec. 72(b) provides that gross income does not include that part of any amount received as an annuity under an annuity, endowment, or life insurance contract that bears the same ratio to such amount as the investment in the contract (as of the annuity starting date) bears to the expected return under the contract (as of such date). Gregory had no investment and, therefore, his exclusion ratio was zero.

For a discussion of the tax treatment of distributions from qualified plans, see Parker Tax ¶131,515. For a discussion of the exclusion ratio, see Parker Tax ¶71,915.

Parker Tax Publishing Staff Writers

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