IRS decision due on hybrid plan

The IRS is expected to make a formal decision soon on requests to allow certain employees of the Orange County, Calif., defined benefit plan to move to a newer hybrid plan.

Executives of the county and the Orange County Employees Association, the largest union representing county employees, want the Internal Revenue Service to ease restrictions of a 5-year-old ruling that has severely limited the scope of the hybrid plan, even though the ruling itself wasn't related to the county or to the new plan.

Implemented in May 2010, the hybrid plan has defined benefit and defined contribution components, including an employer match for the DC portion. It came about as a result of collective bargaining between the county and the union as well as a 2009 state law authorizing creation of hybrid plans.

All new employees have a choice between the DB and the hybrid plan, but executives also wanted to give existing employees a one-time, irrevocable chance to switch to the hybrid from the DB plan (Pensions & Investments, June 28).

However, a 2006 IRS revenue ruling discouraged the county from allowing existing employees to switch. Representatives of the county and the union have been talking to the IRS since 2009.

This ruling “stopped us in our tracks with respect to existing employees,” said Carl Crown, Orange County human resources director, based in Santa Ana, Calif.

“We've been able to negotiate real pension reform that will save money,” said Jennifer Muir, communications director for the Orange County Employees Association. “It's frustrating. We're stuck here waiting.”

Now it looks like a decision on the Orange County plan might come soon. In December, the IRS issued its latest “priority guidance plan,” a report on issues “that are priorities for allocation of the resources of our offices during the 12-month period from July 2010 through June 2011.” The report listed 310 priorities; one was guidance on section 414(h)(2) of the Internal Revenue Code — the section affecting the Orange County hybrid.

In an e-mail, an IRS spokesman would only say that “federal law prohibits the IRS from discussing or commenting on any particular taxpayer situation or case.”

Because this is a question of tax policy, rather than plan design, an IRS ruling might have implications beyond Orange County. Last year, for example, several municipalities and government associations asked the agency to change its policy. Representatives from Contra Costa County (Calif.) and the city of San Diego wrote said a favorable ruling would encourage their governments to consider flexible pension plans.

“Like Orange County, we have been waiting to see what the IRS might do,” David J. Twa, the Contra Costa County administrator, wrote in an e-mail.

The roadblock is IRS revenue ruling 2006-43, which interprets the “pickup” status of employee contributions under section 414(h)(2). This section “provides that for any plan established by a governmental unit, where the contributions of employing units are designated employee contributions, but the employer "picks up' the contributions, the contributions are treated as employer contributions,” according to the IRS website.

If a contribution is deemed a pickup, it is treated as pre-tax. However, a contribution can lose its pickup status if it fails to meet certain standards.

For example, the IRS “does not permit a participating employee, from and after the date of the "pickup,' to have a cash or deferred election right with respect to designated employee contributions,” the IRS website says. “Participating employees must not be permitted to opt out of the "pickup,' or to receive the contributed amounts directly instead of having them paid by the employing unit to the plan.”

Thus, when applied to Orange County, the ruling interprets the opportunity to elect another lower retirement formula via the hybrid as meaning employees' contributions would no longer be considered “picked up” and would lose their pre-tax status, Mr. Crown said.

“The 2006 ruling was sort of a sleeper,” said Louis Mazawey, principal and head of the tax group at the Groom Law Group, Washington, which is representing Orange County in its discussions with the IRS. “A lot of people in the public sector were not focused on it as applicable to the redesign of public sector programs.”

Mr. Mazawey said the ruling was designed to prevent abuses, such as governments retroactively adopting pickup arrangements. However, California law guards against abuses in public plans “because employers can't act unilaterally” to change plans, he said.

Mr. Mazawey said he hopes the IRS will issue a ruling in a few months.

The Orange County hybrid took effect last year, and all new employees hired after May 7, 2010, are eligible. The majority of new employees picked the traditional plan. The amount of assets in the hybrid could not be immediately determined nor could the amount of the DB plan.

Both plans are administered by the $8.7 billion Orange County Employees Retirement System, Santa Ana, which also administers other public employee pension plans. TIAA-CREF, New York, handles the DC component. Mr. Crown said the hybrid also is available to new county employees represented by the Alliance of Orange County Workers, the International Union of Operating Engineers and the Orange County Managers Association, as well as some non-union county officials. In the aggregate, unions representing more than 12,000 of the county's approximately 17,000 employees could be eligible for the hybrid if the IRS allowed existing workers to switch.