Rev. Rul. 56-82

Advice has been requested whether annual amounts contributed by a state or political subdivision thereof to employees' tax-exempt pension funds prior to January 1, 1939, may be added to contributions of employees, under section 72(f)(2) of the Internal Revenue Code of 1954, in computing the consideration paid for contracts for the purpose of arriving at the exclusion ratio, under section 72(b) of the 1954 Code, used in computing the portion of an annuity which is to be excluded from gross income.

In addition to the contributions required of employee-participants in the retirement system of the instant state, certain annual contributions are also required of the state or political subdivision participating in the plan. The plan has been held to meet the requirements of section 165(a) of the 1939 Code (section 401(a) of the 1954 Code).

Under the income tax laws in effect for the years 1913 through 1938, compensation of all officers and employees of a state, or a political subdivision thereof, for personal services rendered in the exercise of an essential governmental function, as distinguished from a proprietary function, was not includible in gross income unless paid directly or indirectly by the United States or an agency or instrumentality thereof. Public Salary Tax Act of 1939, C.B. 1939-1 (Part I) 428, as amended; T.D. 5214, C.B. 1943, 1188.

Section 402 of the 1954 Code provides that amounts distributed by an employees' trust, described in section 401(a) of the Code, which is exempt from tax under section 501(a) of the Code, shall be taxable in the year in which distributed, in accordance with section 72 of the Code, except that section 72(e)(3) shall not apply.

Section 72 of the Code provides for the taxation of amounts received as annuities under a contract whereby amounts received which are considered to be a return of the investment in the contract are excluded from gross income. Subsection (d) of section 72 provides that where part of the consideration paid for the contract is contributed by the employer and the aggregate amount receivable by the employee during the three-year period beginning with the date of the first payment is equal to or greater than the consideration for the contract contributed by the employee, then all amounts received shall be excluded from gross income until there has been excluded an amount equal to the consideration for the contract contributed by the employee; thereafter, all amounts so received shall be included in gross income. Where that portion of the cost of the contract which is contributed by the employee is not so recoverable within the first three years, commencing with the first date of payment, subsection (b) of section 72 provides an exclusion ratio whereby there is excluded from gross income an amount which bears the same ratio to the amount received as the employee's investment in the contract bears to the expected return under the contract.

Bubsection (f) of section 72 of the Code provides that in the computation of the consideration paid for the contract the amount contributed by the employee shall include amounts contributed by the employer to the extent that (1) such amounts were includible in the gross income of the employee or (2) if such amounts had been paid directly to the employee at the time they were contributed, they would not have been includible in the gross income of the employee under the law applicable at the time of such contribution. See T.D. 6118, C.B. 1955-1, 698, at p. 702.

In view of the foregoing, it is held that amounts contributed prior to January 1, 1939, by a state, or a political subdivision thereof, to employees' tax-exempt pension funds may be added to the amounts contributed by the employees, in computing the consideration paid for annuity contracts, for the purpose of arriving at the exclusion ratio used in computing the portions of annuity payments which may be excluded from gross income, to the extent that the amounts so contributed represent compensation for personal services rendered in the exercise of an essential governmental function, as distinguished from a proprietary function, and were not contributed directly or indirectly by the United States or an agency or instrumentality thereof.