Rev. Rul. 54-144

Advice is requested with respect to the tax status of the reduced retired pay and the annuities in the hands of the recipients thereof where a member of the uniformed services elects under the Uniformed Services Contingency Option Act of 1953, 67 Stat. 501, to receive retired pay in a lesser amount than that to which he is entitled under the provisions of the Career Compensation Act of 1949, 63 Stat. 802, and other retirement laws in order to provide one or more annuities payable after his death to his surviving spouse, child or children.

The 1953 Act provides a plan whereby an active or retired member of the uniformed services may elect to receive a reduced amount of retired pay in order to provide one or more annuities payable after his death to his widow, child or children. Members of the uniformed services are not compelled to provide annuities for their dependents. It is entirely voluntary whether they participate in the plan. However, they must elect to participate in the plan within a specified period of time or be barred from the annuity program. The act further sets up provisions relative to modification or revocation of the election, and provides for the operation of the act in various eventualities.

The questions with respect to which advice is requested are set forth below.

(A) Will a member's awarded statutory retired or retirement pay or the reduced retired pay constitute his gross income for Federal income tax purposes?

T.D. 5208, C.B. 1943, 65, holds that the amounts deducted and withheld pursuant to the Civil Service Retirement Act of 1930, as amended, from the basic salary pay or compensation of those employees in the civil service of the United States are payments made toward the purchase of annuities under the act and are not allowable deductions for income tax purposes. In like manner the amounts deducted from the retired pay of members of the uniformed services to provide annuities are not allowable deductions for Federal income tax purposes. It is recognized that in some cases the retired pay received by a member will be entirely exempt from Federal income tax and in some cases it will be partially exempt. See Rev. Rul. 256, C.B. 1953-2, 13. Under the provisions of section 22(b)(5) of the Internal Revenue Code amounts received in taxable years beginning after December 31, 1941, as a pension, annuity or similar allowance for personal injuries or sickness resulting from active services in the Armed Forces of any country are exempt from Federal income tax.

(B) Are the annuities includible in the gross income of the annuitants as provided for in section 22(b)(2) of the Internal Revenue Code?

Section 22(b)(2)(A) of the Internal Revenue Code provides that amounts received as an annuity under an annuity or endowment contract shall be included in gross income; except that there shall be excluded from gross income the excess of the amount received in the taxable year over an amount equal to 3 per centum of the aggregate premiums or consideration paid for such annuity (whether or not paid during such year), until the aggregate amount excluded from gross income in respect of such annuity equals the aggregate premiums or consideration paid for such annuity.

(C) Will the fair market value of an annuity be includible in the gross estate of a deceased member of the uniformed services for Federal estate tax purposes?

Section 811(c)(3) of the Code provides, in part, that a transfer of an interest in property by the decedent after October 7, 1949, is includible in the gross estate under section 811(c)(1)(C) (whether decedent did or did not retain any right or interest in the property transferred) if possession or enjoyment can through ownership of such interest be obtained only by surviving the decedent. Therefore, the value of the annuity payable to the widow or other survivors of the retired member is includable in his gross estate for Federal estate tax purposes under section 811(c)(3).

(D) Is the cost of an annuity the aggregate of the amounts by which the decedent's retired pay was reduced or the fair value of the annuity to the annuitant determined under section 113(a)(5) of the Code, which is relative to the adjusted basis of property transmitted at death?

The amendments of section 22(b)(2) and section 113(a)(5) of the Code by section 303 of the Revenue Act of 1951 relate to joint and survivor annuities. The annuity involved in the instant case is devoid of any joint and survivorship features. The widow or child or children are the primary and only annuitants. Therefore, the annuity involved is not a survivorship annuity and the `substituted' cost basis provision of section 22(b)(2) and section 113(a)(5) are not applicable. The annuitant's basis, however, would be determined under section 113(a)(2) of the Code relating to the basis of property acquired by gift.

(E) Will the annuity be subject to the $5,000 exclusion from gross income provided for by section 22(b)(1)(B) of the Code?

Section 22(b)(1)(B) of the Code, as amended by section 302(a) of the Revenue Act of 1951, provides that there shall not be included in gross income and that there shall be exempt from income tax the amounts received under a contract of an employer providing for payment of such amounts to the beneficiaries of an employee, paid by reason of the death of the employee, whether in a single sum or otherwise. The aggregate of the amounts thus excludable by all of the beneficiaries of the employee under all such contracts of any one employer may not exceed $5,000. Section 22(b)(1)(B) of the Code contemplates the case where money is paid by the employer in consideration of past services. The annuity payments under the Uniformed Services Contingency Option Act of 1953 to beneficiaries of retired members are made in consideration of annuity premiums paid by retired members, rather than in consideration of past services. The Government in this case acts like the issuer of an annuity policy. Accordingly, the annuities paid to beneficiaries under the Uniformed Services Contingency Option Act of 1953 are not entitled to the exclusion provided in section 22(b)(1)(B) of the Code.

(F) Will the fact that the decedent's retired pay was excluded from his gross income, in whole or in part, under section 22(b)(5) of the Code, have any effect on the taxable status of the annuity paid to his beneficiaries?

Notwithstanding the fact that the deductions from the decedent's retired pay, which were used for the purpose of providing annuities for the wife or other survivors, flowed from either partially or fully tax-exempt income, the annuity payments to the survivors are subject to tax under the 3 percent rule of section 22(b)(2) of the Code. The survivor will, under the 3 percent rule be entitled to recover as tax exempt, the cost or other basis of the annuity contract, but any income flowing from the annuity contract after the survivor has fully recovered the basis is subject to tax.

(G) Are the annuities subject to withholding under section 1622 of the Code?

Withholding is not required under section 1622(a) of the code on the annuities payable to the widow, child or children. Section 406.207(b) of Regulations 120 provides in part as follows:

In general, pensions and retired pay are wages subject to withholding. However, no withholding is required with respect to amounts paid to an employee upon retirement which are taxable as annuities under the provisions of section 22(b)(2).

(H) Are the annuities subject to withholding under section 143(b) of the Code where the annuitant is a nonresident alien?

Section 143(b) of the Code specifically requires the withholding of Federal income tax at the source on amounts paid to nonresident alien individuals as annuities and the amount of the annuity includible in gross income is subject to withholding tax at the rate of 30 percent unless this rate is reduced by treaty provisions.