Kute v. United States

Opinions of the United

1999 Decisions States Court of Appeals

for the Third Circuit

9-22-1999

Kute v. United States

Precedential or Non-Precedential:

Docket 99-3195

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Filed September 22, 1999

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 99-3195

WILLIAM T. KUTE and FRANCIS M. KUTE,

Appellants

v.

UNITED STATES OF AMERICA

On Appeal from the United States District Court

for the Middle District of Pennsylvania

(D.C. Civ. No. 98-00299)

District Judge: Honorable Sylvia H. Rambo

Submitted pursuant to Third Circuit Rule 34.1(a)

September 17, 1999

BEFORE: GREENBERG, SCIRICA, and RENDELL,

Circuit Judges

(Filed: September 22, 1999)

Gary M. Lightman

Eric C. Stoltenberg

Lightman & Welby

2705 North Front Street

P.O. Box 911

Harrisburg, PA 17108

Attorneys for Appellants

David M. Barasch

United States Attorney

Loretta C. Argrett

Assistant Attorney General

Teresa E. McLaughlin

Annette M. Wietecha

Donald B. Tobin

Attorneys Tax Division

United States Department of Justice

Tax Division

P.O. Box 502

Washington, DC 20044

Attorneys for Appellee

OPINION OF THE COURT

GREENBERG, Circuit Judge.

I. INTRODUCTION

This matter is before this court on appeal from an order

entered on January 15, 1999, on the parties' cross motions

for summary judgment in the district court in this tax

refund case. The district court entered the order in

accordance with its accompanying memorandum opinion.

The district court had jurisdiction under I.R.C.S 7422(a)

and 28 U.S.C. S 1346(a)(1). We have jurisdiction under 28

U.S.C. S 1291. We exercise plenary review on this appeal,

which involves only legal conclusions. See ACM Partnership

v. Comissioner, 157 F.3d 231, 245 (3d Cir. 1998), cert.

denied, 119 S.Ct. 1251 (1999).

The case arises out of the interplay between state and

federal law and involves the application of the ten percent

tax imposed by I.R.C. S 72(t) on a taxpayer on a nonperiodic

distribution constituting an early withdrawal from a

qualified I.R.C. S 401(a) retirement plan. The germane facts

are not in dispute.1 In 1974, the Commonwealth of

_________________________________________________________________

1. While William T. Kute and Francis M. Kute, his wife, are the taxpayers

and all income tax returns and proceedings involved here have been

2

Pennsylvania enacted the State Employees' Retirement

Code (Retirement Code), 71 Pa. Cons. Stat. Ann.SS 5101-

5956 (West 1990), which continued the earlier established

State Employees' Retirement System (Retirement System)

and the State Employees' Retirement Fund (Fund). See id.

SS 5102, 5932. A Board of Directors (Retirement Board)

administers the Retirement System and the Fund. See id.

SS 5901-5931. The Retirement Board has the authority to

adopt and promulgate rules and regulations for the uniform

administration of the system. See id. S 5902(h).

In April 1987, the Fraternal Order of Police (FOP), Kute's

bargaining agent, initiated collective bargaining procedures

with the Commonwealth to obtain a successor agreement to

its contract effective for 1986 through 1988. Inasmuch as

the negotiations reached an impasse, the FOP invoked the

binding arbitration provisions of 43 Pa. Cons. Stat. Ann.

S 217.4(a) (West 1992). On February 17, 1988, the

arbitration panel awarded a change in pension benefits to

Pennsylvania state troopers with at least 20 years of service

who retire on or after July 1, 1989, eliminating any

requirement that a trooper attain a specific age before

retiring. The award further provided that in lieu of the

standard single life annuity provided under 71 Pa. Cons.

Stat. Ann. S 5702(a)(1), a trooper retiring after at least 20

years of service was entitled to receive an annuity of 50%

of his highest yearly salary and that a trooper retiring after

at least 25 years of service was entitled to receive an

annuity of 75% of his highest yearly salary. The award also

provided that if a court invalidated the pension benefit

increase it would be replaced by a $1,000 pay increase with

appropriate adjustments to reflect rank differential

provisions. The parties refer to the award as the DiLauro

Award in recognition of the chairperson of the arbitration

panel.

The Commonwealth judicially challenged the DiLauro

Award on the ground that 71 Pa. Cons. Stat. Ann.S 5955

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joint, as a matter of convenience we refer to William T. Kute as the sole

taxpayer. We note that the complaint recites that Kute's wife's name is

"Frances." Nevertheless, we refer to her as "Francis" in accordance with

the caption used in the district court pleadings in this case.

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barred collective bargaining over pension benefits. The

Supreme Court of Pennsylvania, however, upheld the

award. See Commonwealth of Pennsylvania v. State

Conference of State Police Lodges of the Fraternal Order of

Police, 575 A.2d 94, 97 (Pa. 1990) ("Fraternal Order of

Police"). In particular, the court held that the Retirement

Code "prohibits only collective bargaining agreements from

determining pension rights" but "does not prohibit

bargaining over pension benefits [nor] pension benefits from

being affected by arbitration awards." Id. at 96-97. The

court further concluded that the award was "a mandate to

the legislature to enact whatever legislation [was] necessary

to implement or fund the arbitration award." Id. at 97.

In response to Fraternal Order of Police, the Retirement

Board voted to implement the DiLauro Award as follows:

The awarded benefits of 50% of the highest year's

salary after 20 years of service or 75% of the highest

year's salary after 25 years of service shall be inserted

into the Retirement Code structure in lieu of the

standard single life annuity for purposes of calculating

a withdrawal or superannuation annuity under Section

5702(a)(1).

The resolution further provided that "[a]ll other [Retirement]

Code benefits remain in full force and effect and all optional

benefit payment plans . . . remain in effect."

The legislature then amended section 5955, effective

August 5, 1991, to provide in relevant part:

Regardless of any other provision of law, pension rights

of State employees shall be determined solely by this

part or any amendment thereto, and no collective

bargaining agreement nor any arbitration award

between the Commonwealth and its employees or their

collective bargaining representatives shall be construed

to change any of the provisions herein, to require the

[Retirement Board] to administer pension or retirement

benefits not set forth in this part, or otherwise require

action by any other government body pertaining to

pension or retirement benefits or rights of State

employees. Notwithstanding the foregoing, any pension

or retirement benefits or rights previously so established

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by or as a result of an arbitration award shall remain

in effect after the expiration of the current collective

bargaining agreement between the State employees so

affected and the Commonwealth.

71 Pa. Cons. Stat. Ann. S 5955 (West Supp. 1999)

(emphasis added). In 1992, after nearly 30 years of service

as a state trooper, Kute retired at the age of 51 years, and

became eligible to receive retirement benefits.

Kute elected an alternative annuity option (Option 4)

under 71 Pa. Cons. Stat. Ann. S 5705(a)(4)(iii), which was

the actuarial equivalent of the maximum single life annuity

provided by section 5702. Under Option 4, a portion of the

retirement benefit (not in excess of the total accumulated

deductions standing to the member's credit) may be paid as

a lump sum, and the balance of the present value of the

maximum single life annuity is paid as an annuity.

Consequently, Kute received a monthly retirement benefit of

$3,132.42 and a one-time payment of $49,607.13, as well

as post-termination interest of $385.20. The $49,607.13

payment was composed of nontaxable member

contributions of $13,593.94, taxable member contributions

of $19,079.34, and interest on the contributions of

$16,933.90. The ten percent tax on a portion of the

payment of $49,607.13 is at issue here.

On his 1992 federal income tax return Kute reported and

paid the ten percent additional tax in the amount of $3,700

under I.R.C. S 72(t), attributable to the distribution of

$36,998 in taxable member contributions and interest.

Kute then filed an administrative claim for refund of the

additional tax. The IRS disallowed the claim, and Kute then

brought this timely suit for refund.2

The parties thereafter submitted a stipulation of

uncontested material facts and exhibits and served and

filed cross-motions for summary judgment. The exhibits

_________________________________________________________________

2. In its brief, the government points out that the sum of the taxable

member contributions of $19,079.34 and interest of $16,933.90 was only

$36,013.24. We also note that there seem to be some other de minimus

numerical discrepancies in the numbers involved. No further mention of

these problems appears in the briefs and thus we do not deal with them.

5

included a declaration of Dale Everhart, Assistant Executive

Director of the Retirement System, setting forth that the

IRS has treated the Retirement System as a qualified plan

under I.R.C. S 401(a) since at least 1982 and that because

the IRS has treated the Retirement System as a qualified

plan, the Retirement System had not requested a

determination letter from the IRS regarding its status as a

qualified plan. Kute does not contest this point on this

appeal.

Kute argued in the district court that I.R.C. S 72(t) did

not apply to his lump sum one-time distribution. In this

regard, he contended that the section applies only to

distributions from "qualified plans" under I.R.C. S 401(a), so

that in his view the tax was not applicable as his

distribution came from the DiLauro Award rather than from

the Retirement System. The government argued that the

payment fell within I.R.C. S 72(t) as it was from a qualified

plan and resulted from Kute's election of an alternative

annuity option provided in the Retirement Code.

The district court granted the government's motion for

summary judgment, holding that I.R.C. S 72(t) applied to

the distribution. The court rejected Kute's assertion that

the arbitration award created a benefit distinct from the

Commonwealth's qualified pension plan. The district court

held that the DiLauro Award was integrated into the

Commonwealth's qualified pension plan. It pointed out that

the Pennsylvania Supreme Court had determined that the

arbitration board had the authority to issue an award

affecting police retirement benefits and that the award was

"a mandate to the legislature to enact whatever legislation

[was] necessary to implement or fund the arbitration

award." The district court further noted that the legislature

had recognized the award when it amended section 5955 of

the Retirement Code prospectively to prohibit arbitration

awards from amending the Retirement Code by including

language stating that "any pension or retirement benefits or

rights previously so established by or as a result of an

arbitration award shall remain in effect after the expiration

of the current collective bargaining agreement between the

State employees so affected and the Commonwealth." 71

Pa. Cons. Stat. Ann. S 5955.

6

The district court concluded that, in upholding the

DiLauro Award, "the Pennsylvania Supreme Court

determined that pension benefits under the Retirement

Code could be modified by an arbitration award governing

the contract between the Commonwealth and the state

police." The court further observed that "[p]ursuant to the

terms of the [Retirement] Board resolution, the increased

pension benefits were `inserted' into the Retirement Code."

The court also noted that Kute's lump sum payment was

made pursuant to an option provided under the Retirement

Code. See 71 Pa. Cons. Stat. Ann. S 5705(a)(4)(iii).

The court rejected Kute's argument that his retirement

payments must be allocated between amounts received

under the arbitration award and amounts received under

the Retirement Code, as it concluded that Pennsylvania

State Troopers Ass'n v. Pennsylvania State Employees'

Retirement Board, 677 A.2d 1329, 1330 (Pa. Commw. Ct.

1996), alloc. denied, 689 A.2d 237 (Pa. 1997), prohibited

such a result. The court determined that, under that

decision, the arbitration award and formulas replaced the

other benefits to state troopers under the Retirement Code

and were not separate from benefits payable under the Code.3

II. DISCUSSION

On this appeal, Kute summarizes his argument as

follows. While he recognizes that the Retirement System is

treated as a qualified retirement plan under I.R.C. S 401(a),

he contends that his lump sum pension benefit was not

attributable to that system, but rather was derived from the

DiLauro Award, which eliminated any age requirement for

pension eligibility and provided that a trooper with 20 years

of service was eligible for a pension benefit in an amount

equal to 50% of his highest year's salary, and that a

trooper, such as Kute, retiring with 25 years of service was

eligible for an annuity equal to 75% of his highest year's

_________________________________________________________________

3. The district court also rejected Kute's assertion that the payments at

issue did not flow from a qualified plan because their source was the

State Police benefit account established by 71 Pa. Cons. Stat. Ann.

S 5936, rather than the Retirement Fund itself. Kute does not challenge

this holding on this appeal.

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salary. The award further provided that should the pension

increase be judicially overturned, it would be replaced by

an across-the-board pay increase of $1,000. This award4

affected Kute's annual pension amount, the timing of when

that amount is due, and the timing and amount of the

return of his contributions. As such, the pension benefits

were derived from the DiLauro Award rather than from the

Retirement System. The Retirement Code makes no

reference to the pension benefit under which he retired.

While those benefits were inserted into the Retirement

Code's structure for ease of administration, the award as

opposed to the Retirement Code established them.

Moreover, the legislature never amended the Retirement

Code to add the benefits. Thus, the district court, in Kute's

view, erred in determining that the lump sum amount was

taxable under I.R.C. S 72(t).

As we have indicated, we are concerned here with a

qualified pension plan under I.R.C. S 401(a). Under I.R.C.

S 402(a)(1) (now I.R.C. S 402(a)), an amount distributed is

taxable to the distributee in the year in which it is

distributed under I.R.C. S 72. I.R.C. S 72(a) provides that in

general gross income includes any amount received as an

annuity, but I.R.C. S 72(b) excludes amounts attributable to

the taxpayer's investment in the contract. While a plan can

seek an advance determination from the IRS that it is

qualified under I.R.C. S 401(a), it is not required to do so.

See Cornell-Young Co. v. United States, 469 F.2d 1318,

1320 (5th Cir. 1972). In this case, as we have indicated, the

Commonwealth has not sought a determination that the

plan is qualified but no one has challenged that it has that

status. While we need not set forth in detail the additional

tax implications of a plan being qualified, we do point out

that a qualified plan gives employees the benefit of deferring

taxes until when they receive distributions from the plan.

There are, however, limitations on the tax advantages of

an I.R.C. S 401(a) plan intended to discourage early

withdrawals. In particular, as effective in 1992, and as

_________________________________________________________________

4. In his brief Kute indicates that the "pension benefit" had these

consequences, br. at 10, but we believe he is referring to the DiLauro

Award.

8

germane here, I.R.C. S 72(t)(1) provided that the tax on any

amount includable in gross income received from a

qualified plan shall be increased by an amount equal to ten

percent of that amount, except for distributions made on or

after the date on which the employee attains age 59. There

is, however, a restriction on the imposition of the additional

tax, as the tax does not apply to part of a series of

substantially equal periodic payments (not less frequently

than annually) made for the life or life expectancy of the

employee. See I.R.C. S 72(t)(2)(A)(iv). Kute, of course, began

receiving the monthly payment long before he reached 59

years of age, but by reason of I.R.C. 72(t)(2)(A)(iv), his

monthly payments have not been subject to the additional

tax.

The lump sum payment, however, is another matter. As

we have stated, Kute concedes that the plan is qualified.

Moreover, he does not contend that an exception to the

requirement for the additional tax is applicable. Instead, he

contends that the distribution, rather than being from a

qualified plan, was attributable to the DiLauro award so

that I.R.C. S 72(t) was simply not applicable to it.

The district court rejected that argument and so do we as

it does not conform to the realities of the situation. See,

e.g., Geftman v. Commissioner, 154 F.3d 61, 68 (3d Cir.

1998). In Fraternal Order of Police the Supreme Court of

Pennsylvania held that the pension benefits due to state

troopers could be modified by an arbitration award. See

575 A.2d at 96-97. Then the Retirement Board, pursuant to

its authority to adopt rules and regulations, 71 Pa. Cons.

Stat. Ann. S 5902(h), passed a resolution on September 26,

1990, to implement the award. The resolution provided that

the increased benefits would be "inserted into the

Retirement Code structure," and that "[a]ll other Code

benefits remain in full force and effect and [that] all

optional benefit payment plans . . . remain in effect."

Moreover, the Retirement Board's resolution expressly

inserted the DiLauro Award "into the Retirement Code

structure."

There can be no doubt that the Retirement Board had the

authority to implement the changes it did without further

legislative action as the Commonwealth Court in

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Pennsylvania State Troopers Ass'n upheld the Retirement

Board's action. See 677 A.2d at 1332. Furthermore, the

legislature, which apparently was dissatisfied with the

DiLauro Award, amended 71 Pa. Cons. Stat. Ann. S 5955 to

provide, but only prospectively, that the Retirement Code

alone would be the source of state employees' pension

rights. But at the same time it effectively ratified the

DiLauro Award because amended section 5955 provides

that "[n]otwithstanding the foregoing, any pension or

retirement benefits or rights previously so established by or

as a result of an arbitration award shall remain in effect

after the expiration of the current collective bargaining

agreement between the State employees so affected and the

Commonwealth."

Kute himself demonstrated by his actions that he

received the lump sum payment from a qualified plan as he

elected to obtain the benefit pursuant to Option 4 of the

Retirement Code, which provides that an employee may

receive a portion of his benefit in that form. Nothing in the

DiLauro Award even mentions such an option, as the award

dealt only with periodic payments. Overall, we are satisfied

that the district court clearly reached the correct result.

III. CONCLUSION

For the foregoing reasons the order for summary

judgment entered January 15, 1999, will be affirmed.

A True Copy:

Teste:

Clerk of the United States Court of Appeals

for the Third Circuit

10