Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 57-75

1957-1 C.B. 28

Sec. 72

IRS Headnote

In determining the consideration paid for annuities by employees of states and their political subdivisions whose salaries were not subject to Federal income taxes prior to 1939, the amounts contributed by the employer to be included, pursuant to section 72(f) of the Internal Revenue Code of 1954, where the employer's contributions prior to 1939 were used to purchase individual contracts for specified employees, or were allocated among specified employees under a group contract, or were allocated among specified employees in a self-insured fund, are the amounts so allocated to each individual employee. Where the employer's contributions prior to 1939 were not allocated for the benefit of specified employees at the time the contributions were made, an estimated allocation among individual employees may be made for the purpose of applying section 72(f) of the Code, provided the method used for marking the estimated allocation is reasonable and consistent with the circumstances and the provisions of the plan under which such contributions were made.

Full Text

Rev. Rul. 57-75

Advice has been requested whether, under an employees' pension plan of a state or political subdivision thereof, where the amounts contributed by the employer during the years prior to 1939 were not allocated for the benefit of specified employees, an estimated allocation among individual employees may be made for the purpose of applying section 72(f) of the Internal Revenue Code of 1954.

Section 72 of the Code provides for the taxation of amounts received as annuities under annuity contracts under two methods which exclude from gross income amounts received which are considered to be a return of the investment in the contract, as defined in section 72(c)(1). Subsection (d) of section 72 provides that where part of the consideration paid for the contract is contributed by the employer and the aggregate amount receivable by the employee during the three-year period beginning with the date of the first payment is equal to or greater than the consideration for the contract contributed by the employee, then all amounts received shall be excluded from gross income until there has been excluded an amount equal to the consideration for the contract contributed by the employee; thereafter, all amounts so received shall be included in gross income. Where that portion of the consideration for the contract which is contributed by the employee is not recoverable within the first three years, commencing with the first date of payment, subsection (b) of section 72 provides an exclusion ratio whereby an amount which bears the same ratio to the amount received as the employee's investment in the contract bears to the expected return under the contract, shall be excluded from gross income.

Section 72(f) of the Code provides that, for the purposes of determining the consideration contributed by an employee for an annuity, amounts contributed by the employer shall be included to the extent that (1) such amounts were includible in the gross income of the employee, or (2) if such amounts had been paid directly to the employee at the time they were contributed, they would not have been includible in the gross income of the employee under the low applicable at the time of such contribution. See section 1.72-8 of the Income Tax Regulations.

Under the Federal income tax laws in effect for the years 1913 through 1938, compensation of officers and employees of a state or political subdivision thereof engaged in the exercise of essential governmental functions, including public school teachers, was, in general, excluded from gross income unless paid directly or indirectly by the United States or an agency or instrumentality thereof. See T.D. 5214, C.B. 1943, 1188. Employer contributions paid into a pension plan during such years, which would have been so excludable had they been paid directly to the employees, may be treated as consideration paid by the employees under section 72(f). See Rev. Rul. 56-82, C.B. 1956-1, 59.

Where there is available a record of the amount of employer contributions actually allocated to individual employees at the time such contributions were paid, such entries should be used in determining the amount of the section 72(f)(2) consideration. Where there is no record of the actual allocation of employer contributions paid, or where such amount is not readily ascertainable from the records maintained during the pre-1939 period, an estimated allocation may be made using a method reasonable and consistent with the provisions of the plan in effect at the time the employer's contributions were paid in respect of each participant, as well as the circumstances under which such employer contributions were required to be used to meet the cost of the current benefits payable at that time. In making such an estimated allocation, the general principles in the two following paragraphs should be observed.

If there was any unfunded liability under the plan as at January 1, 1939, it cannot properly be assumed that the employer's full share of the cost of benefits accrued prior to 1939 was actually contributed prior to 1939. Furthermore, if the respective employer's contributions were paid into the retirement fund over a period of years, it cannot reasonably be assumed that the funds to meet the entire cost of the benefits accrued before 1939 were contributed by the employer in a lump sum immediately before January 1, 1939. Instead, it must be assumed that contributions were made in such amounts and at such times as will be reasonably consistent with the actual method of funding used during the specified period the employee actually performed services prior to 1939 in an essential government function.

Since section 72(f)(2) refers only to actual employer contributions which would not have been income to the employee if paid to him at the time the contributions were paid into the fund, it is necessary that the method used to estimate each employer's contributions for the benefit of any individual over a period of years eliminate any interest or subsequent forfeitures and increment on the trust assets which may have been used to provide his benefit. The amounts estimated to have been contributed by the employer for benefits accrued prior to 1939 should be consistent with the assumptions (interest, mortality, etc.) used for valuation purposes for the years prior to 1939, rather than those used in valuation at the time of retirement occuring subsequent to such period, since the employer's actual contributions presumably would have been determined on the former actuarial basis. Similarly, the amounts should be calculated with reference to the anticipated retirement benefit used in the last valuation of the plan before 1939, if that benefit was substantially different from the benefit actually paid at retirement. Furthermore, section 72(f)(2) consideration shall not include employer contributions, or that portion of an estimated allocation of any such contribution, where the participant at the time the contribution was actually paid, or deemed to have been paid, was not an employee performing services for the employer in connection with an essential governmental function. See Mim. 3838, C.B. 1938-1, 181.

Although the Internal Revenue Service does not assume responsibility for proposing methods of allocating employer contributions in particular plans, because the provisions of such plans and the circumstances of contributions vary widely, an adaptation or refinement of the following procedure may produce reasonable and acceptable results in determining the consideration paid by an employee for an annuity where, as in the instant case, contributions of the employer were made prior to 1939 but were not then allocated for the benefit of the specified employees:

(a) determine the total contributions of the political subdivision, with respect to current service costs, in each year prior to 1939 for which any living retired employee had service credited under the plan, expressed as a percentage of total compensation considered under the plan for all covered employees in the particular year;

(b) apply such percentage to the covered compensation in each respective year for each employee then covered under the plan for whom a determination must be made, to determine the employer contributions paid in each such year on behalf of each such employee for current service;

(c) aggregate the annual amounts so determined for each employee for whom a determination must be made; and

(d) if the political subdivision made any additional contributions before 1939, such as with respect to original prior service under the plan, and if any living retired employee had credited service to which such additional contributions were applicable, a portion of such additional contributions should also be allocated to each such employee, taking account, in some reasonable manner, of the actual prior service credits of each such employee as compared to those of the whole group for which such contributions were made.

The sum of the amounts determined in (c) and (d), if any, and the amount contributed by the employee himself would constitute the retired employee's consideration paid for the annuity under section 72 of the Code.

Accordingly, it is held that, in determining the consideration paid for annuities by employees of states and their political subdivisions whose salaries were not subject to Federal income taxes prior to 1939, the amounts contributed by the employer to be included, pursuant to section 72(f) of the Code, where the employer's contributions prior to 1939 were used to purchase individual contracts for specified employees, or were allocated among specified employees under a group contract, or were allocated among specified  employees in a self-insured fund, are the amounts so allocated to each individual employee. Where the employer's contributions prior to 1939 were not allocated for the benefit of specified employees at the time the contributions were made, an estimated allocation among individual employees may be made for the purpose of applying section 72(f) of the Code, provided the method used for making the estimated allocation is reasonable and consistent with the circumstances and the provisions of the plan under which such contributions were made.