Originally published at www.calpensions.com

The IRS is taking a new look at whether public pension systems qualify for tax deferrals, raising questions about nonprofit charter schools in CalSTRS and county systems using “excess” earnings to fund retiree health care.

Taxes on employer-employee contributions to pension systems and their investment earnings can be avoided until retirees are paid. But if the rules are not followed, the IRS can change the tax status and impose fines and penalties.

As public pension funding problems surfaced during the economic downturn, the U.S. Internal Revenue Service began encouraging retirement systems to seek compliance reviews and make voluntary changes.

Some large systems, such as the California State Teachers Retirement System, have not had full tax reviews in recent decades, relying instead on IRS approval of specific issues.

(The giant California Public Employees Retirement System and the University of California Retirement System did not respond to queries last week about the status of their tax compliance reviews.)

Last April, CalSTRS said in a letter to the IRS that a proposed new rule, aimed at excluding non-government employees from public pensions, could make more than 10,000 charter school employees now in CalSTRS ineligible for the retirement system.

CalSTRS said “590 out of a total 908 charter schools that elected to join CalSTRS are run by nonprofit corporations and will likely be deemed ineligible” under tests about board selection and role, sovereign authority and responsibility for debt.

The employees of charter schools, given more independence to innovate than traditional schools, were allowed to join CalSTRS in “private letter rulings” in 1995 from the IRS and the U.S. labor department.

“The vast majority of California’s charter schools take a form that is substantially similar, if not identical, to the charter school described in these rulings,” the CalSTRS letter said.

Saying that it was a plan administrator and taking no position on whether charter school employees should be in a governmental plan, CalSTRS offered some points to consider as the IRS develops the regulation:

Charters are granted by local school boards or the state education board, funding is apportioned like traditional schools, teachers must have a state credential and state educational standards must be met.

If the IRS determines charter school employees are ineligible, CalSTRS requested guidance on whether current members should continue unchanged, continue but accrue no new benefits, or be denied pensions and repaid for contributions.

CalSTRS mentioned the legal problem of impairing the “contractual relationship” with members. Because CalSTRS members are not in Social Security, denying pensions for prior years may mean workers were not in any retirement system, a federal violation.

At a town hall meeting in Oakland last March, said CalSTRS, the advance notice of new eligibility rules was called a “blueprint” by IRS employees. CalSTRS said the final version should be unambiguous and clear that the IRS makes final decisions.

“Although a less-stringent determination methodology may initially seem pragmatic, it could ultimately prove detrimental to plan administrators such as CalSTRS because they could be looked upon by potential plan participants as the final source of judgment for participant eligibility,” said CalSTRS.

It seems possible that government pension eligibility also may be an issue for CalPERS, which includes a number of special districts, and for the UC system, which has large research and medical operations.

The 20 county retirement systems that operate under a 1937 act, ranging from Los Angeles to Mendocino, have about 170 separate government employers, some of them small special districts that may face eligibility questions.

All of the county systems applied for an IRS compliance ruling, a “letter of determination,” before the deadline for the most recent cycle, January 31 of last year, said Robert Palmer, executive director of the State Association of County Retirement Systems.

Palmer said the systems hired outside tax counsels and, when needed, are making changes through a voluntary compliance program intended to avoid or reduce any IRS penalties, which can be severe.

The county systems operate under a law that allows “excess” investment earnings, amounts exceeding 1 percent of total assets, to be used to fund retiree health, give retirees a bonus and reduce employer contributions.

In an era when some view underfunded public pensions as a national problem, skimming off excess earnings in good years can look like a built-in mechanism to boost pension contributions from taxpayers.

Pension systems accused of concealing massive debt by using overly optimistic forecasts of future earnings, often 7.5 percent or more, had disastrous earnings in 2008, many with losses of 20 to 25 percent.

The fiscal year ending June 30 was another bad year: CalPERS reported earnings of 1 percent, CalSTRS 1.8 percent. If a county system diverts “excess” earnings in good years, what offsets losses — higher employer contributions?

Palmer said the diversion of “excess” earnings is an option seldom used now as most reserves are depleted. He said the option originated during the period when all pension funds were invested in bonds, and a 1 percent reserve was a significant cushion.

Proposition 1 in 1966 allowed pension funds to put 25 percent of their money in blue-chip stocks. Proposition 21 in 1984 allowed any “prudent” investment. Now pension systems expect to get about two-thirds of their revenue from investments.

How one of the county systems, Alameda, used excess earnings to fund retiree health is described on page 75 of the final report issued by the California Public Employee Post Employment Benefit Commission in January 2008.

In Mendocino County, a watchdog website, “Yourpublicmoney.com” edited by John Dickerson, was an early critic of the diversion of “excess” earnings. He thinks an IRS San Diego city ruling means county pension health funding will not be allowed.

A story about troubled New Jersey pension funds applying for an IRS compliance review last year said one of the changes demanded by the IRS in San Diego and New Hampshire was “the separation of pension funds from medical benefit accounts.”

Palmer said the first of the California county systems being reviewed by the IRS is Orange County. Any changes needed in Orange County could be adopted by policy or legislation for all of the 1937 act systems, perhaps leading to approval for all of them.

Orange County has been waiting three years for an IRS ruling on a cost-cutting plan negotiated with a union that gives current workers the option of choosing a lower pension, similar in some ways to a reform approved by San Jose voters last month.

In these polarized times, IRS action in both cases may be seen through the political lense of their affect on public employee unions:

Does delaying a ruling on the employee option slow reforms, and would denying pensions at nonprofit charter schools hamper that movement?

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at http://calpensions.com/ Posted 30 Jul 12