Rev. Rul. 81-26

1981-1 C.B. 200, 1981-4 I.R.B. 12.

                       Internal Revenue Service
                                 Revenue Ruling

                    DISTRIBUTIONS; EMPLOYEE BECOMING PARTNER

                          Published: January 26, 1981

SECTION 402.--TAXABILITY OF BENEFICIARY OF EMPLOYEES' TRUST, 26 CFR 1.402(a)-1: Taxability of beneficiary under a trust which meets the requirements of section 401(a)

  Distributions; employee becoming partner. A distribution from an exempt employees' trust established by a partnership to a participant whose status has changed from that of a common-law employee to that of a partner may not be treated as a distribution on account of separation from service within the meaning of section 402(e)(4)(A)(iii) of the Code; Rev. Rul. 73-414 superseded.

  The purpose of this revenue ruling is to restate Rev. Rul. 73-414, 1973-2 C.B. 144, in view of the enactment of the Employee Retirement Income Security Act of 1974, Pub. L. 93-406, 1974-3 C.B. 1.

  The issue is whether, under the circumstances described below, distributions from a qualified profit-sharing plan described in

section 401(a) of the Internal Revenue Code may be treated as distributions on account of separation from the service within the meaning of section 402(e)(4)(A)(iii).

  A partnership established a qualified employees' profit-sharing plan for the benefit of its common-law employees.  The plan provides that a participant who becomes a member of the partnership shall no longer be entitled to participate in plan contributions or allocations.  All amounts credited to the new partner's account, to the extent vested, become payable as if the individual had severed all business connections with the partnership on the date the common-law employer-employee relationship ceased to exist.

  Section 402(a)(1) of the Code states that amounts distributed or made available to any distributee by an employee's trust described in section 401(a) and exempt from tax under section 501(a), shall be taxable to the distributee, in the year in which distributed or made available, under section 72 (relating to annuities).

  However, a lump-sum distribution, as defined in section 402(e)(4)(A) of the Code, is accorded special tax treatment.  A distribution will be a lump-sum distribution as defined in section 402(e)(4)(A), if the balance to the credit of an employee is paid or distributed from the plan within one taxable year of the recipient, and if the distribution is made upon the occurrence of certain requisite events.  One of the events triggering lump-sum distribution tax treatment is an employee's separation from the service of an employer.

  Rev. Rul. 79-336, 1979-2 C.B. 187, states that an employee is separated from the service of the employer, for purposes of section 402(a)(2) and 402(e) of the Code, only on death, retirement, resignation, or discharge, and not when the employee continues on the same job for a different employer as a result of the liquidation, merger, consolidation, etc., of the former employer. Although Rev. Rul. 79-336 is concerned primarily with an employee's separation from the service of a corporate employer, for purposes of section 402(e)(4)(A)(iii) the reasoning involved is equally applicable to an unincorporated employer.  See also Rev. Rul. 80-129, 1980-1 C.B. 86.

  Rev. Rul. 72-596, 1972-2 C.B. 395, provides that, for purposes of social security and unemployment taxes, a partner is not considered an employee of the partnership.  However, this rule is not determinative of whether or not a separation from the service of a partnership has occurred under section 402(e)(4)(A)(iii) of the Code.

  In this case, the change in a participant's status from that of a common-law employee to that of a partner does not result in a separation from the service because the participant has not retired or resigned; nor has the participant been discharged, but instead continues to render service in the on-going business.

  Accordingly, distributions from the exempt employees' trust to participants who become members of the partnership may not be treated as distributions on account of separation from the service within the meaning of section 402(e)(4)(A)(iii) of the Code.

  Rev. Rul. 73-414 is superseded because the position stated therein is restated under current law in this revenue ruling.

Rev. Rul. 81-26, 1981-1 C.B. 200, 1981-4 I.R.B. 12.