Opinion ID: 867791
Heading Depth: 2
Heading Rank: 3

Heading: the lees’ profit-sharing plan is a

Text: NON-CONDUIT ENTITY ¶14 Both the Lees and the Tax Commission agree with our analysis up to this point. Both accept that Plan distributions are generally taxable to the beneficiary and that Section 3124 exempts interest on federal obligations under certain circumstances. They disagree as to how these rules interface with each other. The Lees argue that the tax-exempt character of the interest received by the Plan is passed through to them, rendering a portion of their distributions tax-exempt. The Tax Commission argues that the 4 Cite as: 2013 UT 29 Opinion of the Court interest loses its tax-exempt nature when the funds are distributed to the beneficiary. The central question, therefore, is whether the Plan operates as a conduit. ¶15 Conduit entities —for example, mutual funds, S corporations, and some partnerships —allow their funds to retain the same tax character in the hands of the beneficiaries or owners as they had in the conduit entity. 26 U.S.C. § 1366; see also IRS Internal Revenue Manual 8.19.1.2 (Oct. 5, 2012), available at http://www.irs.gov/irm/part8/irm_08-019-001.html. ¶16 However, the Internal Revenue Service has clarified that upon distribution, funds from a qualified plan do not retain the character they had when they were in the plan. Revenue Ruling 5561 states: Although a distribution from an employees’ trust meeting the requirements of section 401 of the Internal Revenue Code of 1954 is made in whole or in part from funds received by the trust as interest on tax-free securities, such distribution, when received or made available, is taxable income to the distributee in the manner and to the extent provided by section 402(a) of the Code. Rev. Rul. 55-61, 1955-1 C.B. 40. Similarly, in Revenue Ruling 72-99, the IRS explained that the character of the funds received by a qualified plan “has no bearing on the treatment of the distribution.” Rev. Rul. 72-99, 1972-1 C.B. 115. When funds are distributed, they lose their separate identity and simply become part of the plan assets. Id. ¶17 Thus, despite Plan funds being invested in U.S. government obligations, distributions from a Section 401 qualified plan are fully taxable. The funds in the Lees’ profit-sharing plan, invested in U.S. government obligations, were exempt from income tax while in the Plan. But upon distribution, those funds became Plan distributions and can no longer be treated as interest on taxexempt securities. The distributions from the Plan are simply income from a qualified plan, subject to taxation under the Internal Revenue Code and Utah law. ¶18 Opinions from other jurisdictions support this view. The Minnesota Supreme Court has held that distributions from a qualified plan that is invested in tax-exempt obligations are taxable as annuities under Internal Revenue Code section 72. Meunier v. Minn. Dep’t of Revenue, 503 N.W.2d 125, 131 (Minn. 1993). Although 5 LEE v. UTAH STATE TAX COMMISSION Opinion of the Court the plan in Meunier was a defined-benefit pension plan, rather than a profit-sharing plan, the tax treatment of the pension plan was dictated by Section 401, which also governs the Lees’ Plan. See id. at 127. In a later case, the Minnesota Tax Court held that distributions from “an employee profit-sharing plan” were not exempt from state income tax under Section 3124. Cherne v. Comm’r of Revenue, Nos. 6601, 6543, 6626, 1996 WL 337043, at  (Minn. Tax Ct. June 14, 1996). The California State Board of Equalization reached the same conclusion: distributions from a qualified plan with assets invested “solely in United States Treasury obligations” are subject to state income tax. In re Shahandeh, No. 41860, 2000 WL 1872954, at ,  (Cal. St. Bd. Eq. Nov. 2, 2000). In an earlier decision, the Vermont Supreme Court held that a lump-sum payment from a retirement plan invested solely in U.S. government obligations was exempt from state income tax because of section 3124. Keys v. Vt. Dep’t of Taxes, 552 A.2d 418, 418 (Vt. 1987). However, we do not find this opinion persuasive because the Keys court did not provide any reasoning to explain its decision. No court has followed it. ¶19 Other courts have also observed that entities treated as conduits for tax purposes tend to have certain characteristics justifying this tax treatment. First, they do not benefit from deferred taxation. Income derived from mutual funds, S corporations, and partnerships is taxable in the year in which it is received. See, e.g., Meunier, 503 N.W.2d at 129 (noting that mutual fund owners pay annual taxes on earnings). In contrast, funds in Section 401 plans, including the Lees’ Plan, are not taxable until distributions are made. The money grows tax-free until the beneficiary begins receiving distributions. See supra ¶ 8. Second, investments in conduit entities are made with after-tax dollars. See, e.g., Meunier, 503 N.W.2d at 129 (noting that mutual fund investments are made with after-tax dollars). In contrast, the Lees’ Plan was funded with the employer’s pre-tax dollars, and the Lees did not pay income tax on the contributions when they were made. Thus, Section 401 plans lack some of the key characteristics of conduit entities. ¶20 Because the Lees’ Plan is not a tax conduit, the funds do not retain their character as interest on U.S. obligations upon distribution to the Lees. Thus, the distributions are fully taxable by Utah under state and federal law.