1975, April, Pg. 661. The Pension Reform Act of 1974: Part 5.

• Author: by R. Michael Sanchez

4 Colo.Law. 661

Colorado Lawyer

1975.

1975, April, Pg. 661.

The Pension Reform Act of 1974: Part 5

661Vol. 4, No. 4, Pg. 661The Pension Reform Act of 1974: Part 5by R. Michael Sanchez, James F. Wood, Constance L. Hauver, and Douglas M. CainThe Employee Retirement Income Security Act of 1974 (the Act) provides a new method for the taxation of lump sum distributions from qualified corporate and Keogh (H.R. 10) plans. To qualify as a lump sum distribution, all of the funds in an employee's account must be distributed within one taxable year of the recipient. Also, the distribution must be made by reason of the employee's death, his attainment of age 59 1/2 years, or his separation from service. For self-employed individuals, death or disability, rather than separation from service, is required to achieve lump sum distribution treatment for distributions made before age 59 1/2. Provided the limitations are met, the tax treatment for Keogh plans now approximates the treatment of distributions from corporate plans.

An employee must have been a participant in the plan for five years to qualify as a recipient for a lump sum distribution. An employee's beneficiary, however, can receive lump sum treatment even if the employee did not complete five years of participation before his death.

Lump sum distributions must be made to either a single individual or estate, or to a trust or multiple trusts. The limitation on multiple distributions to individuals will have considerable consequences on estate planners. Distributions to multiple trusts are aggregated for tax purposes, with the tax liability prorated among the trusts.

Generally, an express election is required to take advantage of lump sum treatment. Only one election may be made after an individual has attained age 59 1/2. An individual may revoke his election within the time for making a claim for a refund or credit for the taxable year in which the election was made. If two lump sum distributions are made within a six-taxable-year period after 1973, the taxpayer must aggregate the two distributions and determine the tax as if one distribution had been made, and can deduct the tax paid on the prior distribution.

Lump sum distributions now will be subject to two kinds of taxes---a 10-year forward averaging tax for benefits attributable to participation in a plan after 1973, and a capital gain tax for benefits attributable to participation before 1974. The portions of the distributions to be subject to the respective taxes are determined by years of participation before 1974 or after 1973 and not by the amount of contributions made before or after such dates.

All benefits derived from post-1973 participation now are deemed to be ordinary

662income and are subject to the 10-year averaging provisions. The tax attributable to the ordinary income portion of the distribution is computed by first determining the total taxable amount of the distribution. A minimum distribution allowance, which is phased out on a graduated basis with no allowance for distributions of $70,000 or more, is available to reduce the taxable amount. An initial separate tax is computed by figuring the tax which would be imposed on one-tenth of the taxable amount; the tax is figured on the rates for unmarried individuals and is computed without regard to other income of the recipient. This figure is then multiplied by ten to obtain the initial separate tax. The ordinary income portion of the distribution is obtained by multiplying the total taxable amount by the fraction composed of the number of the employee's years of active participation in the plan after 1973 over the total number of years of participation. To compute the tax attributable to the ordinary income portion, the initial separate tax is multiplied by yet another fraction, which consists of the ordinary income portion as numerator and the total taxable amount as denominator.The portion of the total taxable amount (determined without subtracting a distribution allowance) which is attributable to participation before 1974 is taxed as a capital gain. Except for self-employeds who must elect lump sum treatment, no election is necessary to have capital gain treatment for pre-1974 participation benefits.

Distributions from individual retirement accounts generally are subject to ordinary income treatment for the year in which payment is received. Distributions from individual plans do not qualify for either 10-year forward averaging or capital gain treatment, but do qualify for averaging under the general income-averaging provisions of the Internal Revenue Code.

A distribution of an annuity contract from a qualified plan is treated as a hybrid under the Act. Proceeds from the annuity still are taxed as received. However, the value of the annuity is added to the total taxable amount to determine the tax on other portions of the lump sum distribution, with the tax attributable to the value of the annuity being credited against the tax owed on the remainder of the lump sum distribution.

Proceeds from life insurance on an employee are treated as a distribution in the amount of the cash surrender value of the policy just prior to death and are taxable to the extent the proceeds exceed employee contributions and constructive employee contributions.

Distributions of non-employer securities are treated as cash distributions. Taxation is deferred on the net unrealized appreciation attributable to employer securities if the securities are distributed in a qualifying lump sum distribution without regard to the five-year participation requirement. Capital gain treatment will be available upon the later disposition of the securities.

Tax-free transfers of assets from various plans to other plans now are made possible by the Act's rollover provisions. The provisions impose certain time restrictions on transfers and limit the type of property which can be transferred.

The $5,000 exclusion from income tax for death benefits remains unavailable for self-employeds under Keogh plans. The exclusion is available for distributions of interests which were vested immediately before the employee's death, if a qualifying lump sum distribution from a qualified plan is made.

Under present Colorado law, none of the ordinary income portion of a lump sum distribution is subject to state tax if the 10-year forward averaging provisions are elected.

The taxation of distributions from a qualified retirement plan to a beneficiary by reason of the death of the employee remains unchanged by the Act. Because any payments from a Keogh plan to the beneficiary of a partner or sole proprietor are subject to federal estate tax, principals under corporate plans still enjoy a major advantage over principals under Keogh

663plans. Similarly, because the gift tax exclusion is limited to the proportion of the value of the joint and survivor annuity which is attributable to employer contributions, payments on behalf of a self-employed individual for a joint and survivor annuity will be deemed to be payments made by the employee and will be subject to federal gift tax in full.TAX CONSEQUENCES OF LUMP SUM DISTRIBUTIONS

Definition of Lump Sum DistributionsThe Employee Retirement Income Security Act of 1974 changes materially the manner of taxation of lump sum distributions from retirement plans. A lump sum distribution is a distribution or a payment to a recipient of the balance to the credit of an employee. The payment must be completed within one taxable year of the recipient, and must be payable by reason of (1) the employee's death, (2) the attainment by the employee of age 59 1/2 or anytime thereafter, (3) the employee's separation from service(fn694) or (4) the disability of a self-employed individual.(fn695) To clear the balance to the credit of an employee, the balance to his credit in all plans of the employer in a given category must be distributed. The categories are pension plans, profit-sharing plans and stock bonus plans.(fn696) Thus, an employee participating in two profit sharing plans and a money purchase pension plan who receives a distribution either from both profit sharing plans or the pension plan can qualify for a lump sum distribution. The distribution must be from a qualified trust or a qualified annuity plan.(fn697)

Corporate and Keogh Plans EligibleThe special tax treatment accorded lump sum distributions applies to all qualified plans whether corporate or Keogh.(fn698) For Keogh plans, however, self-employed persons must attain age 59 1/2 to qualify for the special tax treatment, and separation from service prior to that age will not qualify the distribution unless the self-employed person also has died or become disabled.(fn699) Even with these limitations on Keogh plans, the Act substantially liberalizes the tax treatment of distributions from Keogh plans. For the first time, Keogh plans receive essentially the same income tax treatment of distributions as corporate plans. Even the limitation on special treatment for distributions prior to age 59 1/2 seems less intended as a limitation than as a recognition of the difficulty in foreclosing abuses by defining separation from service for a self-employed person. In any event, the Act transforms contributions on behalf of a self-employed person made before 1974 into capital gains.

Eligibility for Lump Sum DistributionsIn order to qualify for the 10-year averaging treatment accorded the ordinary income portion of a lump...