Lee v. Utah State Tax Commission ( 2013 )

This opinion is subject to revision before final
publication in the Pacific Reporter
2013 UT 29IN THE
SUPREME COURT OF THE STATE OF UTAH
CHIN M. LEE and YVONNE E. LEE,
Appellants and Petitioners,
v.
UTAH STATE TAX COMMISSION,
Appellee and Respondent.
No. 20120141
Filed May 14, 2013
Original proceeding in this Court
Attorneys:
Chin M. Lee and Yvonne E. Lee, petitioners pro se
John E. Swallow, Att’y Gen., Stephen M. Barnes, Asst. Att’y Gen.,
for respondent
JUSTICE DURHAM authored the opinion of the Court in which
CHIEF JUSTICE DURRANT, ASSOCIATE CHIEF JUSTICE NEHRING,
JUSTICE PARRISH, and JUSTICE LEE joined.
JUSTICE DURHAM, opinion of the Court:
INTRODUCTION
¶1 Chin and Yvonne Lee appeal the Utah State Tax Commis-
sion’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.
BACKGROUND
¶2 In 1990, Mr. Lee established a defined-benefit plan, which
he converted in 1996 into a profit-sharing plan, both of which were
qualified plans under Internal Revenue Code section 401 (Section
401). Employer contributions to profit-sharing plans are tax-deduct-
ible to the employer at the time of contribution. See infra ¶ 8. Plan
funds grow tax-free until they are distributed, at which time distri-
butions are taxable to the employee as ordinary income. See infra
¶¶ 8-9. Here, Mr. Lee’s sole proprietorship1 contributed funds to the
Plan from 1990 to 1995. These funds were invested entirely in U.S.
government obligations, the interest on which is tax-exempt under
1
The Plan’s governing documents did not allow for employee
contributions.
LEE v. UTAH STATE TAX COMMISSION
Opinion of the Court
31 U.S.C. section 3124(a) (Section 3124). When Mr. Lee became eligi-
ble to receive distributions at age 70 ½, the Lees sought advice from
Tax Commission employees on how to file their income taxes to
account for the interest from the U.S. obligations held by the Plan.
After the employees were unable to help them, they filed their taxes
based on their own research.
¶3 In their 2005 and 2006 tax filings, the Lees reported Plan
distributions and claimed deductions for federal obligation interest
that the Plan earned in those years and in earlier years. The Auditing
Division of the Tax Commission disallowed these deductions.
¶4 The Lees requested a redetermination of their 2005 and
2006 tax liability. After an initial hearing and a preliminary decision
against them, the Lees sought formal review by the Tax Commis-
sion. The administrative law judge concluded that the Lees’ distribu-
tions from the Plan were not exempt from state taxation under Utah
Code section 59-10-114(2)(a), even though the Plan assets were in-
vested solely in U.S. government obligations. The Lees petitioned
this court for review under Utah Code section 59-1-602(1)(a). We
granted their petition and have jurisdiction pursuant to Utah Code
sections 63G-4-403(1) and 78A-3-102(3)(e)(ii).
STANDARD OF REVIEW
¶5 Utah Code section 59-1-610(1) provides that “[w]hen re-
viewing formal adjudicative proceedings commenced before the
[tax] commission, the . . . Supreme Court shall . . . grant the commis-
sion no deference concerning its conclusions of law, applying a cor-
rection of error standard.” Whether a statute has been properly inter-
preted is a question of law. Jacques v. Midway Auto Plaza, Inc., 2010
UT 54, ¶ 11, 240 P.3d 769. Thus, we review the Tax Commission’s
interpretation of Utah Code section 59-10-114(2)(a) for correctness.
ANALYSIS
¶6 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 deter-
mine 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.
2
Cite as: 2013 UT 29Opinion of the Court
I. THE LEES’ PLAN IS A QUALIFIED PLAN UNDER
SECTION 401 OF THE INTERNAL REVENUE CODE
¶7 The parties agree that both the Lees’ profit-sharing plan
and their previous defined-benefit plan were Section 401 qualified
plans. Section 401 defines a qualified plan as
[a] trust created or organized in the United States . . . if
contributions are made to the trust by such employer, or
employees, or both, or by another employer who is enti-
tled to deduct his contributions under section
404(a)(3)(B) . . . for the purpose of distributing to such
employees or their beneficiaries the corpus and income
of the fund accumulated by the trust in accordance with
such plan.
26 U.S.C. § 401(a). Section 401 discusses three types of qualified
plans: stock bonus plans, pension plans, and profit-sharing plans. Id.¶8 Under federal law, an employer can deduct its contribu-
tions to qualified plans when made. Id. § 404(a). Accordingly, contri-
butions by Mr. Lee’s sole proprietorship were tax-deductible to the
business in the year of contribution. As a further tax benefit, em-
ployer contributions are not included in the employee’s gross in-
come at the time of contribution. Employees are taxed on the funds
only when they receive distributions. Id. § 402(a).
¶9 Internal Revenue Code section 402(a) states that “any
amount actually distributed to any distributee by any employees’
trust described in section 401(a) . . . shall be taxable to the
distributee, in the taxable year of the distributee in which distrib-
uted, under section 72.” That is, distributions made from any Section
401 qualified plan are taxed as annuities under Internal Revenue
Code section 72. Section 72 provides that every distribution “re-
ceived as an annuity”—which under section 402(a) includes distribu-
tions from a qualified plan—must be included in gross income. Id.
§ 72(a)(1).
¶10 Consequently, the distributions Mr. Lee received from his
qualified plan are taxable as ordinary income, just as any distribu-
tion from a retirement or pension plan. The parties disagree, how-
ever, as to whether distributions from the Plan are tax-exempt be-
cause the Plan funds were invested in U.S. government obligations.
3
LEE v. UTAH STATE TAX COMMISSION
Opinion of the Court
II. FEDERAL LAW LIMITS UTAH’S ABILITY TO TAX PRO-
CEEDS FROM U.S. GOVERNMENT OBLIGATIONS
¶11 The Lees are correct that under some circumstances, fed-
eral law prohibits states from taxing the proceeds of U.S. govern-
ment 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 considered in computing a tax,” with cer-
tain exceptions not relevant to the Lees’ appeal. 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 tax-
payer’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.
¶12 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.”
¶13 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.
III. THE LEES’ PROFIT-SHARING PLAN IS A
NON-CONDUIT ENTITY
¶14 Both the Lees and the Tax Commission agree with our
analysis up to this point. Both accept that Plan distributions are
generally taxable to the beneficiary and that Section 3124 exempts
interest on federal obligations under certain circumstances. They
disagree as to how these rules interface with each other. 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
4
Cite as: 2013 UT 29Opinion of the Court
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.
¶15 Conduit entities —for example, mutual funds, S
corporations, and some partnerships —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; see also IRS Internal
Revenue Manual 8.19.1.2 (Oct. 5, 2012), available at
http://www.irs.gov/irm/part8/irm_08-019-001.html.
¶16 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.¶17 Thus, despite Plan funds being invested in U.S.
government obligations, distributions from a Section 401 qualified
plan are fully taxable. The funds in the Lees’ profit-sharing plan,
invested in U.S. government obligations, were exempt from income
tax while in the Plan. But upon distribution, those funds became
Plan distributions and can no longer be treated as interest on tax-
exempt securities. The distributions from the Plan are simply income
from a qualified plan, subject to taxation under the Internal Revenue
Code and Utah law.
¶18 Opinions from other jurisdictions support this view. The
Minnesota Supreme Court has held that distributions from a
qualified plan that is invested in tax-exempt obligations are taxable
as annuities under Internal Revenue Code section 72. Meunier v.
Minn. Dep’t of Revenue, 503 N.W.2d 125, 131 (Minn. 1993). Although
5
LEE v. UTAH STATE TAX COMMISSION
Opinion of the Court
the plan in Meunier was a defined-benefit pension plan, rather than
a profit-sharing plan, the tax treatment of the pension plan was
dictated by Section 401, which also governs the Lees’ Plan. See id. at
127. In a later case, the Minnesota Tax Court held that distributions
from “an employee profit-sharing plan” were not exempt from state
income tax under Section 3124. Cherne v. Comm’r of Revenue, Nos.
6601, 6543, 6626, 1996 WL 337043, at *2 (Minn. Tax Ct. June 14, 1996).
The California State Board of Equalization reached the same
conclusion: distributions from a qualified plan with assets invested
“solely in United States Treasury obligations” are subject to state
income tax. In re Shahandeh, No. 41860, 2000 WL 1872954, at *1, *4
(Cal. St. Bd. Eq. Nov. 2, 2000). In an earlier decision, the Vermont
Supreme Court held that a lump-sum payment from a retirement
plan invested solely in U.S. government obligations was exempt
from state income tax because of section 3124. Keys v. Vt. Dep’t of
Taxes, 552 A.2d 418, 418 (Vt. 1987). However, we do not find this
opinion persuasive because the Keys court did not provide any
reasoning to explain its decision. No court has followed it.
¶19 Other courts have also observed that entities treated as
conduits for tax purposes tend to have certain characteristics
justifying this tax treatment. First, they do not benefit from deferred
taxation. Income derived from mutual funds, S corporations, and
partnerships is taxable in the year in which it is received. See, e.g.,
Meunier, 503 N.W.2d at 129 (noting that mutual fund owners pay
annual taxes on earnings). In contrast, funds in Section 401 plans,
including the Lees’ Plan, are not taxable until distributions are made.
The money grows tax-free until the beneficiary begins receiving
distributions. See supra ¶ 8. Second, investments in conduit entities
are made with after-tax dollars. See, e.g., Meunier, 503 N.W.2d at 129
(noting that mutual fund investments are made with after-tax
dollars). In contrast, the Lees’ Plan was funded with the employer’s
pre-tax dollars, and the Lees did not pay income tax on the
contributions when they were made. Thus, Section 401 plans lack
some of the key characteristics of conduit entities.
¶20 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.
CONCLUSION
¶21 Although we respect the Lees’ diligent efforts to comply
with the law and their pro se appellate advocacy, we ultimately
agree with the Tax Commission that no portion of the Plan
6
Cite as: 2013 UT 29Opinion of the Court
distributions was tax-exempt under Utah Code section 59-10-
114(2)(a). Accordingly, we affirm the decision of the Tax
Commission.
7