Special rules for State and local governmental plans Some defined benefit pension plans require employee contributions. In many cases, governmental employees are required to participate in and contribute to a defined benefit pension plan as a condition of employment.327 In such cases, the required employee contributions are generally withheld from employees' salaries. In some cases, a governmental plan may cover employees of different governmental entities. For example, a plan established by a State may cover employees of various State agencies or employees of the State and of local governments within the State. In such cases, the plan may provide employers with the option of paying required employee contributions on behalf of their employees, rather than withholding the required contributions from employees' salaries. Under a special rule, in the case of a plan maintained by a State or local government, if contributions are designated as employee contributions, but the State or local governmental employer "picks up" (i.e., pays) the contributions, contributions so picked up ("pick-up contributions") are treated as employer contributions. As a result of being treated as employer contributions, pick-up contributions are not includible in employees' income at the time of contribution. 328 Legislative history indicates that the pick-up rules were intended to apply to situations in which amounts are designated as employee contributions under a State or local governmental plan, but the governmental employer pays all or a part of the employee's contribution without withholding the amount from the employee's salary. In this situation, the portion of the contribution that is "picked up" by the government was viewed as, in substance, an employer contribution for Federal tax purposes, even though designated as an employee contribution for purposes of State law. 329 IRS guidance has applied pick-up treatment in situations in which employees' salaries are reduced by the amount of the contribution as long as individual employees are not given the option of choosing to receive amounts directly instead of having them paid by the employer to the plan. The IRS has issued numerous private letter rulings to taxpayers that deal with the application of the pick-up rules to particular arrangements. Many of these rulings apply pick-up treatment to employee contributions to a State or local governmental pension plan that are 330 327 A governmental plan may also allow an employee to purchase additional service credit (such as credit for military service) by making additional employee contributions. Sec. 414(h)(2). 328 329 330 See H.R. Rep. No. 93-807, at 145 (1974). See, e.g., Rev. Rul. 81-36, 1981-1 C.B. 255. (The employer must also specify that the contributions are being paid by the employer in lieu of contributions by the employee.) Compare Rev. Rul. 81-35, 1981-1 C.B. 255, which denies pick-up treatment to contributions made pursuant to an individual employment agreement under which the employer contributes a certain percentage of the employee's salary to the State's pension plan on behalf of the employee. required as a condition of employment and withheld from employees' salary. The IRS also has ruled favorably on arrangements that allow individual employees to make an irrevocable election to have contributions made to a plan on their behalf by payroll deduction if a State statute or similar provision provides that the contributions are being paid by the employer in lieu of contributions by the employee.331 The rulings conclude that, in these circumstances, the employee does not have the option of receiving the amounts directly and that pick-up treatment applies. Although pick-up contributions are treated as employer contributions for income tax purposes, pick-up contributions made pursuant to a salary reduction agreement are wages for FICA tax purposes. However, compensation of State and local government employees who are covered by a qualified retirement plan may be generally exempt from FICA tax. 332 333 Reasons for Change The pick-up rules result in inconsistent tax treatment of employee contributions to qualified retirement plans. Employee contributions made to plans maintained by private employers or by the Federal government are includible in income. However, the pickup rules allow employee contributions to State and local governmental plans to be made on a pretax basis. In many cases, inconsistent treatment applies also for FICA tax purposes. These inconsistencies cause inequity in the tax system. Description of Proposal Under the proposal, the pick-up rules are repealed. Accordingly, contributions to a State or local government plan that are designated as employee contributions under the plan are treated as employee contributions for Federal tax purposes. Thus, such contributions are includible in income and are wages for FICA purposes. 331 See, e.g., Priv. Ltr. Rul. 200423040 (March 9, 2004) (employees may elect whether to participate in a defined benefit pension plan that requires employee contributions) and Priv. Ltr. Rul. 200317034 (October 10, 2002) (employees may elect to have contributions made to a defined benefit pension plan by payroll reduction to purchase additional service credit). In addition, under Priv. Ltr. Rul. 200317024 (September 30, 2002), pick-up treatment applies to contributions made to a defined contribution plan at the election of employees. This ruling suggests that the pick-up rules may be used to make pretax employee contributions to a defined contribution plan without complying with the rules applicable to elective deferrals. 332 Sec. 3121(v)(1)(B). For this purpose, salary reduction agreement includes any arrangement in which there is a reduction in the employee's salary in connection with the employer's contribution of a corresponding amount to a pension plan on the employee's behalf, regardless of whether the employee approves or chooses participation in the plan or whether participation is mandatory. See H.R. Rep. No. 98-861, at 1415 (1984), and State of New Mexico v. Shalala, 153 F.3d 1160 (10th Cir. 1998). 333 Sec. 3121(b)(7)(F). Effective Date The proposal applies to employee contributions made in taxable years beginning after the date of enactment. 334 Discussion The pick-up rules provide a special tax benefit for contributions made by State and local government employees that is not available to contributions made by employees of private employers or employees of the Federal government. Moreover, application of the pickup rules to employee contributions to defined contribution plans could be a means of avoiding the requirements applicable to elective deferrals. In conforming the treatment of contributions made by State and local government employees to the treatment of contributions made by other employees, the proposal furthers consistency in the tax system. The pickup rules also lead to complexity, both with respect to whether contributions are eligible for pick-up treatment (as evidenced by the number of IRS rulings in this area) and particularly with respect to whether pickup contributions are made pursuant to a salary arrangement and are thus subject to FICA tax. Under the proposal, the designation of contributions as employee contributions under the terms of the plan determines the status of the contributions for Federal tax purposes. As a result, the need to make a separate determination of the character of the contributions for income or FICA tax purposes is eliminated. 335 Repeal of the pick-up rules may have the effect of increasing income taxes for participants in some State or local government plans with respect to employee contributions that are no longer eligible for pick-up treatment and thus are includible in income. Alternatively, some State and local governmental employers may choose to redesign their plans so that contributions that are currently designated as employee contributions are instead treated as 334 In the case of changes to the rules for qualified retirement plans, a delayed effective date is often provided with respect to governmental plans in order to provide sufficient time for making necessary plan amendments. If the proposal is adopted, it may be appropriate to consider whether a delayed effective should apply. 335 Designation of contributions as employee contributions under a State or local government plan generally has significance under the terms of the plan (and under State or local law). For example, the plan might subject benefits attributable to employer contributions to a vesting requirement, but provide that benefits attributable to employee contributions are immediately vested. Similarly, the plan may include special distribution terms applicable only to employee contributions. The fact that the designation of contributions as employee contributions has significance under the plan (and under State or local law) provides further support for treating them as employee contributions for Federal tax purposes. 336 The present-law FICA standard depends on the facts and circumstances and is sometimes a source of confusion. In eliminating a distinction based on whether contributions are made pursuant to a salary reduction agreement, the proposal may lead to increased FICA tax compliance. employer contributions. In that case, such employer contributions would not be includible in employees' income or wages for FICA purposes. In the case of employee contributions that are includible in income under the proposal, after-tax treatment of such contributions results in basis, so that a corresponding portion of the plan distributions made to participants is treated as a nontaxable return of basis. The need to determine the portion of a distribution that is includible in income may add complexity for participants. However, this information is generally required to be provided on the tax statements (Form 1099-R) that a qualified retirement plan provides to participants. To the extent that the portion of a distribution that is includible in income is reported on the Form 1099-R, participants would not have to make this determination themselves. The proposal may add administrative complexity for some qualified retirement plans by creating the need to keep records on after-tax employee contributions. However, because pickup contributions are employee contributions under the plan and may therefore receive special treatment under the plan, some plans may already keep such records. The proposal may have the effect of increasing FICA taxes for some employers and employees (subject to the ability of State and local governmental employers to redesign their plans as discussed above), as well as increasing revenues for the Social Security and Medicare programs. Similarly, the proposal may result in additional wages for Social Security and Medicare purposes, which would be likely to increase benefits for some individuals, as well as long-term costs under such programs. V. CORPORATE AND PARTNERSHIP PROVISIONS A. Modify Extraordinary Dividend Rules for Common Stock (sec. 1059) Present Law A corporation that receives a dividend from another corporation is entitled to at least a 70 percent dividends received deduction if holding period requirements are met. 337 Thus the maximum rate on such a dividend is 10.5 percent (35 percent, the maximum corporate tax rate, times the 30 percent of the dividend that is taxable.) Under section 1059, if the dividend is an "extraordinary" dividend (as defined), the recipient corporation must reduce its basis in the dividend paying stock by an amount equal to the "nontaxed" portion of the dividend (the amount of the dividends received deduction with respect to the dividend). A dividend received by an individual generally is taxed at a maximum rate of 15 percent. If a dividend received by an individual is an “extraordinary" dividend, any loss on the stock is treated as a long term capital loss to the extent of the dividend.338 Thus, the loss will reduce the individual's net long-term capital gain (if any) before reducing the net short-term capital gain. 339 An extraordinary dividend is generally defined to include any dividend that (1) is paid within two years of the purchase of the stock and (2) exceeds 10 percent of the taxpayer's adjusted basis in the stock (five percent in the case of preferred stock). If the aggregate of all dividends received within a year exceeds 20 percent of a taxpayer's adjusted basis, then such dividends are also extraordinary dividends. All dividends received by the taxpayer that have ex-dividend dates within the same period of 85 days are aggregated to apply the 10-percent test or five percent of preferred stock. If the taxpayer establishes to the satisfaction of the Secretary the fair market value of the stock as of the day before the ex-dividend date, then the taxpayer can use such fair market value in lieu of adjusted basis for purposes of applying the 10 percent and other thresholds. Reasons for Change Present law is intended to prevent "dividend stripping" transactions. In such transactions, a taxpayer purchases stock prior to a very large dividend for a price that reflects the expectation of the dividend, receives the dividend, and then sells the stock for a loss after the dividend, at a price that reflects the reduction in value following the payment. If the dividend is taxed at a rate lower than the rate imposed on income that can be sheltered by the loss, and if the basis of stock |