[Federal Register Volume 72, Number 222 (Monday, November 19, 2007)]
[Rules and Regulations]
[Pages 64939-64942]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 07-5730]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 31

[TD 9367]
RIN 1545--BH00


Payments Made by Reason of a Salary Reduction Agreement

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulation.

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SUMMARY: This document promulgates a final regulation that defines the 
term salary reduction agreement for purposes of section 3121(a)(5)(D) 
of the Internal Revenue Code (Code). The final regulation provides 
guidance to employers (public educational institutions and section 
501(c)(3) organizations) purchasing annuity contracts described in 
section 403(b) on behalf of their employees.

DATES: Effective Date: This regulation is effective November 15, 2007.
    Applicability Date: This regulation applies to contributions to 
section 403(b) plans made on or after November 15, 2007.

FOR FURTHER INFORMATION CONTACT: Neil D. Shepherd, (202) 622-6040 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This final regulation amends the Employment Tax Regulations (26 CFR 
part 31) by providing guidance relating

[[Page 64940]]

to section 3121(a)(5)(D). The Federal Insurance Contributions Act 
(FICA) imposes taxes on employees and employers equal to a percentage 
of the wages received with respect to employment. Section 3121(a) 
defines wages for FICA tax purposes as all remuneration for employment 
unless otherwise excepted. Section 3121(a)(5)(D), added by the Social 
Security Amendments of 1983 (Public Law 98-21 (97 Stat. 65)), generally 
excepts from wages payments made by an employer for the purchase of an 
annuity contract described in section 403(b). However section 
3121(a)(5)(D) expressly excludes from the exception payments made by 
reason of a salary reduction agreement (whether evidenced by a written 
instrument or otherwise). Thus, payments made under a salary reduction 
agreement to purchase a section 403(b) annuity contract are included in 
wages for FICA purposes. A temporary and proposed regulation defining 
the term ``salary reduction agreement'' for purposes of section 
3121(a)(5)(D) was published in the Federal Register (69 FR 67054) on 
November 16, 2004.
    For income tax purposes, contributions made by an employer to a 
section 403(b) contract, including contributions made pursuant to a 
cash or deferred election or other salary reduction agreement, are 
generally excluded from income. Sec.  403(b); see also section 1450(a) 
of the Small Business Job Protection Act of 1996 (Pub. L. 104-188 (110 
Stat. 1755)). Conversely, for FICA tax purposes, contributions made by 
an employer to a section 403(b) contract pursuant to a cash or deferred 
election or other salary reduction agreement are included in wages. 
Sec.  3121(a)(5)(D); see also S. Rep. No. 98-23, at 40-41, 98th Cong., 
1st Sess. (1983).

Summary of Comments and Explanation of Provisions

    This regulation finalizes the temporary and proposed regulation 
without change. The final regulation provides that the term ``salary 
reduction agreement'' includes (1) a plan or arrangement whereby a 
payment will be made if the employee elects to reduce his or her 
compensation pursuant to a cash or deferred election as defined at 
Sec.  1.401(k)-1(a)(3) of the Income Tax Regulations, (2) a plan or 
arrangement whereby a payment will be made if the employee elects to 
reduce his or her compensation pursuant to a one-time irrevocable 
election made at or before the time of initial eligibility to 
participate in such plan or arrangement (or pursuant to a similar 
arrangement involving a one-time irrevocable election), and (3) a plan 
or arrangement whereby a payment will be made if the employee agrees as 
a condition of employment (whether such condition is set by statute, 
contract, or otherwise) to make a contribution that reduces the 
employee's compensation.
    Comments were submitted with respect to the definition of the term 
``salary reduction agreement'' for purposes of section 3121(a)(5)(D) 
and with respect to the applicability date of the temporary and 
proposed regulation.

Salary Reduction Agreement

    Commentators asserted that Congress intended the term ``salary 
reduction agreement'' in section 3121(a)(5)(D) to apply only to 
voluntary reductions in salary and not to salary reductions required as 
a condition of employment. In support of this view, commentators cited 
the legislative history underlying section 3121(a)(5)(D), particularly 
the following language from the Senate Report:

    The bill also provides that any amounts paid by an employer to a 
tax-sheltered annuity by reason of a salary reduction agreement 
between the employer and the employee would be includible in the 
employee's social security wage base. The committee intended that 
the provision would merely codify the holding of Revenue Ruling 65-
208, 1965-2 Cum. Bull. 383, without any implication with respect to 
the issue of whether a particular amount paid by an employer to a 
tax-sheltered annuity is, in fact, made by reason of a ``salary 
reduction agreement.''

S. Rep. No. 98-23, at 40-41, 98th Cong., 1st Sess. (1983).
    Commentators maintained that Revenue Ruling 65-208 distinguishes 
between voluntary and mandatory salary reduction contributions and that 
the legislative history reflects Congress' intent to treat only 
voluntary salary reduction contributions as having been made by reason 
of a salary reduction agreement. While the Senate Report indicates a 
Congressional intent to ``codify the holding of Revenue Ruling 65-
208,'' the revenue ruling does not address any distinction between 
voluntary and mandatory reductions in salary. The critical distinction 
drawn in Revenue Ruling 65-208 is between situations ``where an 
organization uses its own funds for the purchase of an annuity 
contract'' (a supplemental contribution) and situations ``where the 
employee takes a voluntary reduction in salary to provide the necessary 
funds'' (a salary reduction contribution). At the time Revenue Ruling 
65-208 was issued the statutory standard under section 3121(a)(2) for 
determining whether to include contributions to section 403(b) annuity 
contracts in wages for FICA purposes was whether the contributions had 
been paid by the employer or by the employee. Thus, in determining 
whether the employer or the employee has paid the contribution, the 
revenue ruling distinguishes between supplemental contributions funded 
by the employer and salary reduction contributions funded by the 
employee. Whether a salary reduction contribution was voluntary or 
mandatory is irrelevant in establishing that the employee funded the 
contribution through a reduction in salary.
    Several courts have discussed Revenue Ruling 65-208 and confirmed 
that it addresses the distinction between salary supplements and salary 
reductions. See Temple University v. United States, 769 F.2d 126, 130 
(3d Cir. 1985), discussing the distinction drawn by Revenue Ruling 65-
208 between supplemental contributions and salary reduction 
contributions, and Canisius College v. United States, 799 F.2d 18, 20-
21 (2d Cir. 1986), distinguishing between ``salary supplement plans'' 
and ``salary reduction plans.'' See also University of Chicago v. 
United States, No. 06 C 3452, 2007 U.S. Dist. LEXIS 61632, at *8 (N.D. 
Ill. Aug. 21, 2007) concluding that ``the distinction that was being 
drawn in [Revenue Ruling 65-208] was between annuity purchase funds 
that come from employee contributions and those that come from employer 
contributions.'' The Treasury Department and the Internal Revenue 
Service (IRS) continue to believe that it is consistent with the 
legislative history of section 3121(a)(5)(D) and with the codification 
of Revenue Ruling 65-208 to treat both voluntary salary reductions and 
salary reductions to which the employee agrees as a condition of 
employment as payments made pursuant to a salary reduction agreement.
    Commentators suggested that the term ``salary reduction agreement'' 
for purposes of section 3121(a)(5)(D) should mean an elective deferral 
within the meaning of section 402(g)(3)(C), which defines the term 
elective deferral for purposes of the section 402(g)(3) limit on the 
exclusion of elective deferrals from gross income. In their view, 
because salary reduction contributions made pursuant to a one-time 
irrevocable election or as a condition of employment are not elective 
deferrals under section 402(g)(3)(C) and its accompanying regulations, 
such contributions are not made pursuant to a salary reduction 
agreement and, consequently, are excluded from wages under section 
3121(a)(5)(D).

[[Page 64941]]

    Section 402(g)(3)(C) provides that the term ``elective deferral'' 
includes ``any employer contribution to purchase an annuity contract 
under section 403(b) under a salary reduction agreement (within the 
meaning of section 3121(a)(5)(D)).'' However, when enacting section 
402(g)(3), Congress made the following statement about the relationship 
among mandatory salary reduction contributions, elective deferrals, and 
salary reduction agreements: ``if an employee is required to contribute 
a fixed percentage of compensation to a tax-sheltered annuity as a 
condition of employment, the contributions are not treated as elective 
deferrals.'' H.R. Rep. No. 99-841 at II-405 (1986). Similarly, in 1988 
Congress added the flush language of 402(g)(3) providing that a one-
time irrevocable election will not be treated as an elective deferral. 
Congress added the flush language to clarify that the term ``elective 
deferral'' excludes contributions ``made pursuant to a one-time 
election to participate in the tax-sheltered annuity even though such 
contribution would be considered made under a salary reduction 
agreement under section 3121(a)(5)(D).''
    S. Rep. No. 100-445, at 151, 100th Cong., 2d Sess. (1988). Congress 
explained the clarification to section 402(g)(3) as follows:

    The bill conforms the statutory language to the legislative 
history by providing that contributions to a tax-sheltered annuity 
are not considered elective deferrals if the contributions are made 
pursuant to a one-time irrevocable election made by the employee at 
the time of initial eligibility to participate in the annuity or are 
made pursuant to a similar arrangement specified in regulations. The 
bill does not change the definition of salary reduction agreement 
for purpose of section 3121(a)(5)(D).

Sen. Rep. 100-445, 100th Cong., 2d Sess. (1988) 151.
    Thus, as reflected in both the statutory language of section 402(g) 
and in its legislative history, Congress intended the definition of 
salary reduction agreement for purposes of section 3121(a)(5)(D) to be 
distinct from the definition of elective deferral for purposes of 
section 402(g)(3)(C).
    Furthermore, Congress intended that the term wages would have 
different meanings for income tax withholding and FICA tax purposes. 
The broader scope of the term for FICA tax purposes is consistent with 
the general policy underlying the FICA. See S. Rep. No. 98-23, at 39, 
98th Cong., 1st Sess. (1983) relating to the Social Security Amendments 
of 1983 (Pub. L. 98-21 (97 Stat. 65)). Moreover, the legislative 
history to section 3121(a)(5)(D) cited in this preamble describes 
Congress's intent to codify the holding in Revenue Ruling 65-208 (see 
Sec.  601.601(d)(2)(ii)(b)), which provides that certain amounts 
included in income and amounts included in wages with respect to 
contributions used to purchase a 403(b) annuity contract are not the 
same. Based on the statutory language and the legislative history of 
section 3121(a)(5)(D) and related provisions, including section 
3121(v)(1)(B) as discussed in this preamble, the Treasury Department 
and the IRS continue to believe that the term ``salary reduction 
agreement'' in section 3121(a)(5)(D) includes salary reduction 
contributions made pursuant to a one-time irrevocable election or as a 
condition of employment.
    The term ``salary reduction agreement'' is used not only in section 
3121(a)(5)(D) but also in another subsection of section 3121, 
specifically section 3121(v)(1)(B), which provides that wages include 
``any amount treated as an employer contribution under section 
414(h)(2) where the pickup referred to in such section is pursuant to a 
salary reduction agreement (whether evidenced by a written instrument 
or otherwise).'' Commentators contended that the term ``salary 
reduction agreement'' should be interpreted differently for purposes of 
sections 3121(a)(5)(D) and 3121(v)(1)(B) because section 3121(v)(1)(B) 
applies only to salary reduction contributions made under a section 
414(h) pick-up plan established by a State or local government 
employer. By definition, the salary reductions that fund these employer 
contributions are mandatory whereas contributions to section 403(b) 
annuity plans may be mandatory or voluntary. While it is correct that 
salary reductions in connection with section 414(h) pick-up plans are 
mandatory, we see no evidence in the statute or legislative history 
that Congress intended to interpret the same language differently or to 
treat similarly situated employees differently for FICA purposes. Both 
section 3121(a)(5)(D) and section 3121(v)(1)(B) include salary 
reduction contributions in wages for FICA tax purposes. Neither the 
statute nor the legislative history gives a basis for concluding that 
mandatory salary reductions made in connection with a section 414(h) 
pick-up plan should be included in wages for FICA purposes while 
mandatory salary reductions made in connection with a section 403(b) 
annuity plan should be excluded from wages. Thus, the Treasury 
Department and the IRS continue to believe that it is appropriate to 
give a consistent interpretation to identical language in two 
subsections of the same statutory section enacted only one year apart.
    Similarly, as discussed in the preamble to the temporary and 
proposed regulation, the Tenth Circuit's decision in Public Employees' 
Retirement Board v. Shalala, 153 F.3d 1160 (10th Cir. 1998) supports 
the view that a mandatory salary reduction contribution nonetheless 
requires the employee's agreement. In Public Employees' Retirement 
Board the Court of Appeals held that the term ``salary reduction 
agreement'' includes mandatory salary reduction contributions made as a 
condition of employment. As the Court said, ``[A]n employee's decision 
to go to work or continue to work * * * constitutes conduct manifesting 
assent to a salary reduction.'' 153 F.3d at 1166. The employment 
relationship itself is a voluntary relationship, and the employee 
manifests his or her agreement with the terms and conditions of the 
employment relationship by accepting employment. See University of 
Chicago v. United States, No. 06 C 3452, 2007 U.S. Dist. LEXIS 61632, 
at *7 (N.D. Ill. Aug. 21, 2007) citing Public Employees' Retirement 
Board for the proposition that ``a salary reduction agreed to as a 
condition of employment constitutes a salary reduction agreement 
because `the employee has ``agreed'' to the salary reduction by 
continuing employment.' '' The temporary and proposed regulations, and 
now the final regulations, read the term ``agreement'' for purposes of 
section 3121(a)(5)(D) as the Tenth Circuit read it for purposes of 
section 3121(v)(1)(B), as both an agreement to accept employment 
subject to a mandatory salary reduction and an agreement to a specified 
salary reduction.
    Accordingly, the final regulation adopts the definition of salary 
reduction agreement as proposed.

Applicability Date

    Commentators asked the IRS to confirm that the definition of salary 
reduction agreement provided in the temporary and proposed regulation 
would apply prospectively only and, therefore, would not affect 
contributions to a section 403(b) plan made prior to November 16, 2004, 
the date the temporary and proposed regulation went into effect. As 
explicitly set forth in Sec.  31.3121(a)(5)-2T the temporary and 
proposed regulation was applicable to contributions to section 403(b) 
annuity plans made on or after November 16, 2004. Therefore, the 
Internal Revenue

[[Page 64942]]

Service will not apply the temporary and proposed regulation to 
contributions made to any section 403(b) plan prior to November 16, 
2004, for purposes of determining whether such contributions were 
subject to FICA tax. The final regulation will apply only to 
contributions made to any section 403(b) plan on or after November 15, 
2007.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) and (d) of the Administrative Procedure 
Act (5 U.S.C. chapter 5) do not apply to this regulation, and because 
the regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply.

Drafting Information

    The principal author of this regulation is Neil D. Shepherd, Office 
of Division Counsel/Associate Chief Counsel (Tax Exempt and Government 
Entities). However, other personnel from the IRS and Treasury 
Department participated in its development.

List of Subjects in 26 CFR Part 31

    Employment taxes, Income taxes, Penalties, Pensions, Railroad 
retirement, Reporting and recordkeeping requirements, Social security, 
Unemployment compensation.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 31 is amended as follows:

PART 31--EMPLOYMENT TAXES

0
Paragraph 1. The authority citation for part 31 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

0
Par. 2. Section 31.3121(a)(5)-2 is added to read as follows:


Sec.  31.3121(a)(5)-2  Payments under or to an annuity contract 
described in section 403(b).

    (a) Salary reduction agreement defined. For purposes of section 
3121(a)(5)(D), the term salary reduction agreement means a plan or 
arrangement (whether evidenced by a written instrument or otherwise) 
whereby payment will be made by an employer, on behalf of an employee 
or his or her beneficiary, under or to an annuity contract described in 
section 403(b)--
    (1) If the employee elects to reduce his or her compensation 
pursuant to a cash or deferred election as defined at Sec.  1.401(k)-
1(a)(3) of this chapter;
    (2) If the employee elects to reduce his or her compensation 
pursuant to a one-time irrevocable election made at or before the time 
of initial eligibility to participate in such plan or arrangement (or 
pursuant to a similar arrangement involving a one-time irrevocable 
election); or
    (3) If the employee agrees as a condition of employment (whether 
such condition is set by statute, contract, or otherwise) to make a 
contribution that reduces his or her compensation.
    (b) Effective/applicability date. This section is applicable on 
November 15, 2007.


Sec.  31.3121(a)(5)-2T  [Removed]

0
Par. 3. Section 31.3121(a)(5)-2T is removed.

     Approved: November 13, 2007.
 Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 07-5730 Filed 11-14-07; 1:17 pm]
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