May 14, 2013, Utah Supreme Court Case Summaries

May 14, 2013

Utah Supreme Court Case

Lee v. Utah State Tax Commission, 2013 UT 29, No. 20120141 (May 14, 2013)

ISSUE: State Tax Liability on Distributions From Qualified Profit-Sharing Plans which was invested in U.S. Government Obligations

Justice Durham,

Chin and Yvonne Lee appeal the Utah State Tax Commission’s decision finding state tax liability on distributions from their qualified profit-sharing plan (Plan). The Tax Commission held that the Plan did not act as a conduit; therefore, the tax-exempt character of any funds in the Plan was lost upon distribution. We affirm.

At ¶ 1.

In determining whether the distributions from the Plan are exempt from state taxation, we analyze the federal tax treatment of qualified plans, discuss applicable Utah income tax statutes, and examine the nature of conduit and non-conduit entities. We determine that because the Plan is a non-conduit entity, the tax-exempt character of the federal obligation interest does not pass through the Plan to benefit the Lees.

At ¶ 6

The Court reviews the Lee’s policy and determines that it is not tax exempt, unless it qualifies as a proceeds of a U.S. government obligation.

At ¶¶ 7-10.

. . . [U]nder some circumstances, federal law prohibits states from taxing the proceeds of U.S. government obligations. Federal law provides that “[s]tocks and obligations of the United States Government are exempt from taxation by a State or political subdivision of a State. The exemption applies to each form of taxation that would require the obligation, the interest on the obligation, or both, to be consider ed in computing a tax.” 31 U.S.C. § 3124(a). The U.S. Supreme Court has said that “the interest on the obligation is ‘considered’ when that interest is included in computing the taxpayer’s net income or earnings for the purpose of an income tax or the like.” Neb. Dep’t of Revenue v. Loewenstein, 513 U.S. 123, 129 (1994). Thus, if a taxpayer receives income directly from U.S. obligations that is included in the taxpayer’s reported net income, then that income is exempt from state taxation.

At ¶¶ 10-11.

Utah recognizes this exemption through Utah Code section 59-10-114(2)(a)(i), which provides that “the interest or a dividend on an obligation or security of the United States” is deductible from state adjusted gross income if it is (1) “included in adjusted gross income for federal income tax purposes for the taxable year” and (2) “exempt from state income taxes under the laws of the United States.”

At ¶ 12.

Although income received as interest on U.S. government obligations is exempt from state taxation, the income the Lees claimed to be exempt was not received as interest on U.S. obligations, but rather as distributions from a qualified Section 401 plan. Thus, the distributions qualify for a tax exemption only if the Plan acted as a conduit, allowing the funds to retain their tax-exempt character after distribution.

At ¶ 13

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 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.

At ¶ 14

Conduit entities . . . 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. . . .

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 55-61 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.

Thus, despite Plan funds being invested in U.S. government obligations, distributions from a Section 401 qualified plan are fully taxable. . . .

At ¶ 15-17.

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.

At ¶ 20