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Tax Treatment of Retirement Assets and Pension Benefits

Pension benefits and retirement savings often constitute a client’s most valuable assets, and are viewed as a safety net. For that reason, many assume that such assets are beyond the reach of the tax authorities. Depending on the facts of the particular case, this may or may not be true. Therefore, taxpayers are wise to consult with a knowledgeable tax lawyer or CPA. 

This article will give you a better understanding of the rules defining how these assets are treated by the Collection Division and the courts so that you can properly advise your clients and protect their legal and financial interests.

Social security benefits--Even those who don’t have employer provided pension benefits or personal retirement savings vehicles like Keogh plans or IRAs often have social security benefits. Of course, a taxpayer who’s only sustenance comes from social security benefits may have a total income low enough that in applying the IRS’s standardized “allowances” for food, clothing, housing, utilities and transportation it would be determined that there is no “ability to pay,” thus leading the IRS to post his or her delinquent accounts “currently not collectible.” However, this begs the question of whether the Service has the power to seize such benefits. This can be a crucial question for a taxpayer who is not in current compliance, or who for other reasons has incurred the wrath of the Collection Division and is therefore being treated to the full range of the Service’s “powers of persuasion.”

With social security benefits there is no “lump sum” available, so the only question is the Service’s ability to intercept some or all of the stream of monthly checks. The Internal Revenue Manual gives Revenue Officers information about social security benefits specifically so that they can decide when and how to levy on such benefits in an effort to collect delinquent federal taxes. They are informed that there are actually two kinds of “social security” benefits: Retirement, Survivors, and Disability Insurance (RSDI), and Supplemental Security Income (SSI).  RSDI is based on the social security taxes that are paid during a person’s working years. Such payments are not based on need, and they can be levied. SSI payments, however, are for people who are elderly, blind, or disabled, and are exempt from levy.

Recently, the IRS announced the “Federal Payment Levy Program,” an initiative to begin continuous levies on federal payments due to delinquent individual and business taxpayers. The program is based on provisions of the Taxpayer Relief Act of 1997, which permit the Service to levy up to 15% of various federal payments, including some which might otherwise be exempt from levy. The Service stated that levies will not be imposed in hardship situations, or against certain particular federal payments such as black lung benefits or SSI payments.

Civil service and military retirement benefits--Another important issue, particularly here in the Huntsville area, is whether civil service and military retirement benefits are subject to levy. And while we who represent taxpayers might at least entertain the thought that civil service benefits are somehow given a special status, the IRS harbors no such misconceptions.  Indeed, the IRS' Manual doesn’t even waste the ink to tell Revenue Officers that such benefits are subject to levy; it just gets right down to telling them how to accomplish such a levy.

A small class of recipients of military retirement benefits, however, fares somewhat better.  Specifically, an exemption is provided for special retirement benefits paid to Medal of Honor winners, and to annuities paid under the Retired Serviceman’s Family Protection Plan and Survivor Benefit Plan. Thus, for military retirees and their families, it is important to know exactly what kind of military pension is being received.

Types of private pension benefits and retirement savings--For most people employed in the private sector, the bulk of their retirement income will come from employer-provided pension plans. Many also have retirement savings in IRAs and 401(k) plans which they have funded themselves. Indeed, some people roll over benefits from employer-sponsored plans into IRAs when separated from service or when these plans are terminated.

Any discussion of how such assets are treated by the IRS Collection Division must start with two important distinctions: The first is the difference between levying on periodic distributions which a retired participant is receiving from a pension plan, versus levying on the assets of the plan itself, as in the case of someone who has not yet reached retirement age, or who has not yet started receiving payments from the plan. The second crucial distinction is between so-called “qualified” plans (i.e. plans which are designed to meet the complex requirement of IRC §401 the Employee Retirement Income Security Act of 1974, or ERISA), and other kinds of “non-qualified” pension vehicles such as IRAs and 401(k) plans.

Levying on retirement income--The IRS’s lien rights extend to any “fixed and determinable right to property” possessed by a taxpayer. Thus, the IRS can reach both current distributions from pension plans and future payments at such time as the taxpayer would have received those payments, even in a case where the taxpayer has not begun receiving payments at the time the levy is served. Although the Internal Revenue Manual directs Revenue Officers to “(u)se discretion before levying retirement income,” it is quite clear that as a matter of law distributions from pension plans can in fact be seized by levy.

Levying on retirement assets--The more difficult question is whether the IRS can reach the underlying assets which have been set aside to fund periodic retirement or pension payments. Obviously, a Revenue Officer would prefer to seize the underlying assets, which may be sufficient in amount to pay the tax in full, rather than waiting around for the taxpayer to begin receiving small monthly payments at some time in the future. However, whether such funds are available to the IRS depends on the kind of plan involved, and whether such funds are available to the taxpayer. Finally, even if such assets are in theory available to the IRS, it is important to know when the Service will exercise its administrative discretion to forego taking levy action.

When pension assets are involved, the Service will want to carefully examine the documents defining the taxpayer’s rights under the plan, particularly with respect to his or her ability to obtain a lump sum distribution. The Service’s position is that if the taxpayer can demand a distribution, the Collection Division can step into his shoes and do so. Conversely, if under the terms of the plan the taxpayer hasn’t worked for the employer long enough to have accrued “vested” rights under the plan, then there is no present interest in property or rights to property which the Service can reach by means of a lien or a levy. The Internal Revenue Manual directs that a Revenue Officer with a question about a taxpayer’s entitlement under a pension plan should consult with the IRS Employee Plans Group, with the Special Procedures Office, or if necessary with the IRS District Counsel’s Office.

Often, whether amounts accumulated for retirement can be reached by one’s creditors depends on whether the funds in question are held in a “qualified” or “non-qualified” plan. Employer sponsored profit sharing plans, money purchase pension plans, defined benefit plans, and variations thereof such as target benefit plans, are typically “qualified” plans designed to meet the rigorous requirements of IRC §401 and ERISA. In order for such a plan to be qualified in the first place, the funds contributed thereto must be held in a trust that has certain “anti-alienation” provisions. In addition, many states have laws that protect pension and retirement assets from creditors to some extent. However, these state and federal statutes are not effective against the federal government itself, or its duly appointed collection agency, the Internal Revenue Service.

The general law concerning federal tax liens is not in dispute. If a taxpayer neglects to pay federal taxes after demand, a lien securing the tax is created in favor of the United States on “all property and rights to property, whether real or personal, belonging to such person.”. . . The tax lien will attach to the taxpayer’s present and future property interests, and will remain until the amounts it secured are paid, or the statute of limitations on the collection of such liabilities expires.

The conclusion there, that the bankruptcy trustee cannot get access to a debtor’s ERISA qualified pension plan, does not have a significant bearing on the rights of the IRS to reach the same assets under the Internal Revenue Code. The IRS had a valid lien on all of the Debtor’s assets, including the pension plan in the amount of its claim. These and many similar cases leave little doubt that neither ERISA nor state statutes aimed at protecting pension benefits and retirement savings from creditors can interfere with the operation of the federal tax lien or with the IRS’s right to levy on qualified or non-qualified pension assets to enforce that lien.

The Retirement Equity Act--In other contexts we have noted that it sometimes comes to pass that only one spouse of a married couple is liable for a particular tax debt. In that situation it may be useful to argue that the legal rights of the non-liable party in his or her spouse’s pension benefits decrease the realizable value of those benefits. Specifically, the Retirement Equity Act of 1984, or REA, provides that a husband or wife has an enforceable right in his or her spouse’s pension. Among other consequences, these rights result in the requirement that the non-participant spouse consent to any lump sum distribution to be made to the participant. For the same reason, qualified plans are required to offer as the normal form of benefit a “joint and survivor annuity,” under which payments will continue to the non-participant spouse even after thedeath of the plan participant.

In some situations, funds held in a pension plan in which a taxpayer’s spouse had survivorship annuity rights under REA have been treated as being held in trust for the spouse’s benefit, and thus not subject to an IRS levy. For example, see Toledo Plumbers and Pipefitters Retirement Plan and Trust v U.S., (DC OH 1991) 91-2 USTC ¶50343. In that case, the wife was not liable for the participant’s taxes, and under REA her consent was required before the plan could distribute any part of his plan interest to him. This can be quite useful in negotiating with the IRS Collection Division to protect at least a portion of a couple’s retirement savings from an IRS levy.

Treatment of pension benefits in offers in compromiseIn the context of structuring and negotiating an offer in compromise, the valuation of the taxpayer’s present or future pension benefits and retirement savings is crucial. The Service, of course, will argue for the highest possible value; and vigorous advocacy requires that you argue for the lowest reasonable value. Certainly if only one spouse is liable for the taxes at issue, one argument to advance is that under the Retirement Equity Act, as discussed above, the value of the participant’s future pension entitlements are diminished by the non-liable spouse’s legal rights.

More generally, in such negotiations it must first be decided whether the pension rights and retirement savings will be used in the computations as a lump sum asset, or as a series of future payments. Viewing the pension entitlement as a series of future payments is often preferred by the taxpayer because the computation of “ability to pay” for this purpose looks to the taxpayer’s cash flow over a future period of 48 months, which could add up to much less than the actual amount of cash in the plan or the “present value” of the participant’s vested accrued benefits. The Internal Revenue Manual supports this approach in stating that “if the taxpayer is close to retirement, in appropriate cases, pension and profit sharing plans may be viewed as future income rather than as an asset.” However, for those situations in which the retirement savings is to be treated as an asset rather than as the source of future income, it is necessary to reduce the net realizable value by the early withdrawal penalties and current period income taxes which would result if the funds were in fact to be distributed to the taxpayer.

Conclusion--Although the IRS may sometimes exercise administrative discretion in this area, and will proceed against pension and retirement benefits only as a “last resort”, from a strict legal perspective, with only a few exceptions, both qualified and non-qualified pension benefits and retirement savings are readily “available” to the IRS Collection Division. And this is the case even where such assets would be protected by state or federal law from other creditors. This harsh reality may come as a great shock to clients who have always believed that their IRAs and pension benefits are safe from the IRS.  Knowing how such benefits are in fact treated by the Internal Revenue Code and by the Collection Division pursuant to guidance given in the Internal Revenue Manual and relevant judicial precedent is crucial to effectively representing clients before the IRS and in fashioning appropriate remedies for their tax difficulties.