New IRS regulations on tax-sheltered annuity or "403(b)" arrangements for eligible tax-exempt organizations and public schools went into effect on January 1, 2009. A last-minute extension of the plan document deadline gives sponsors a reprieve until the end of this year to comply with the plan document requirement. 403(b) plan sponsors must act now to ensure operational compliance and to ensure that they meet the final deadline for adopting plan documents. The IRS is already reviewing 403(b) plan compliance with the final regulations.
Here are eight things tax-exempt organizations and public schools must address before the IRS comes knocking on the door.
Is there a plan document that complies with the new regulations?
Under the regulations, a 403(b) plan must be in writing, and must contain all the material terms and conditions for eligibility, benefits, applicable limitations on contributions and benefits, the contracts available under the plan, and the time and form in which benefit distributions will be made. The written plan must also provide for any optional features, such as hardship distributions, loans, acceptance of rollover contributions, or plan-to-plan or annuity contract-to-annuity contract transfers, in a manner that satisfies the regulations governing those features. The 403(b) plan needs also to allocate and coordinate administrative responsibility among the employer and the providers.
For almost all employers, the written 403(b) plan document will be in addition to the written annuity contract (or custodial account agreement) actually providing the benefits. The 403(b) plan document may incorporate the terms of the annuity contract or custodial account. At a minimum, the plan document must at least be consistent with the terms of the annuity contract or custodial account, and the providers' own procedures for administering benefits under those contracts. Even though only the employee and the issuer (and not the employer) are normally parties to these contracts, the employer must obtain and review them in the course of preparing the employer's written plan.
Has the plan been operated in compliance with the new regulations?
IRS Notice 2009-3 extended the date for having a compliant plan document in place to December 31, 2009, provided that the following two conditions are met: (1) During 2009, the plan must operate in accordance with a reasonable interpretation of the statute, taking the new regulations into account; and (2) before the end of 2009, the employer must make its "best efforts" to correct any operational failure. This means, of course, that the employer must first take steps to identify any operational failures by reviewing plan operation, using the final regulations as a checklist. 403(b) plans are eligible for correction through the IRS Employee Plans Compliance Resolution System, Rev. Proc. 2008-50, which gives guidance on correction methods.
Does the employer really make deferral opportunity universally available?
Eligible employers with 403(b) plans (including governmental public schools) have long been required to make the opportunity to defer compensation "universally available" to all employees from day one of their employment. The new regulations expand this by eliminating many of the exceptions that formerly applied. The only exceptions now left are for employees covered under another 403(b) arrangement or a 401(k) plan, nonresident aliens, students whose wages from the school are exempt from employment taxes, and employees who normally work fewer than 20 hours per week -- and the last two exceptions are subject to further limiting conditions.
The regulations emphasize that universal availability must exist in practice, not just on paper. IRS compliance questionnaires ask employers how the right to make elective deferrals is communicated to employees (for instance, through hiring packages or other communications). Employees should check their employee communication materials, since this could become a prime area for IRS investigation in future audits.
Is the exempt organization now in a broader "controlled group?"
For benefit plan purposes, all employees of a controlled group of entities are treated as employed by one employer. The existing rules were based only on stock ownership or profits or capital interests, so tax-exempt organizations were rarely included in a controlled group except with their direct stock or for-profit subsidiaries.
The new regulations retain those rules but also added a new form of controlled group based on interlocking board (or trustee) relationships. A controlled group exists if 80 percent of the board (or trustees) of one tax-exempt organization are representatives of, or controlled by (through the power to elect or appoint), another organization. (Exempt organizations that have a common benefit plan for employees and regularly coordinate their activities may elect to be treated as a controlled group.) Thus, separate tax-exempt hospitals with a common affiliation may find themselves all in a single controlled group as of 2009.
The new controlled group rules mean the nondiscrimination tests for employer contributions must be performed taking all employees within the controlled group into consideration. Indeed, the controlled group rules may have broader impact, since the revised regulations are automatically incorporated into the regulations under the Employee Retirement Income Security Act of 1974 (ERISA) governing when one employer is responsible for another employer's pension plan funding shortfall. Tax exempt organizations should review their governance structure and determine whether they are now in a controlled group with other entities and evaluate the consequences of that determination.
Note that the controlled group rules do not apply to the universal availability requirement for elective deferrals. The universal availability requirement is applied separately with respect to each controlled group member that has a 403(b) plan.
Who is responsible for the plan?
It is up to the employer to ensure that the 403(b) plan is tax compliant. If 403(b) contracts fail to be part of a compliant plan or fail otherwise to satisfy the tax requirements, even if due to the acts or omissions of an employee or the annuity issuer, the employer can be liable for potentially substantial penalty taxes, correction fees, and employment taxes (as well as having some very unhappy employees).
The employer must see that applicable contribution limits and nondiscrimination rules (including universal availability) are satisfied. Other matters of particular concern to the IRS include ensuring that distributions permitted only on termination of employment occur only upon termination of employment, that hardship distributions occur only upon hardship, and that limitations on contract loans are properly applied taking into account all outstanding loans to the employee under all of the employer's benefit plans (including any 401(k) plan and all annuity contracts under any 403(b) plan). Only the employer can verify those facts, even though the issuer, not the employer, normally receives the request for, and makes, those distributions.
If the employer has and has always had only one issuer for its 403(b) annuity contracts and custodial accounts and does not allow employees to transfer funds to a different issuer, coordination may be relatively simple: the exempt organization need only agree with its one issuer how necessary information will be communicated and how other plan responsibilities will be allocated. If, however, the employer has several current issuers, plan administration necessarily falls exclusively on the employer and the coordination burden grows, since few if any issuers will be willing, or able, to take responsibility for other issuers' annuity or custodial account products. Internally, employers should ensure that responsibilities that fall to the employer are assigned to (and performed by) the appropriate staff personnel.
Is an information sharing arrangement in place with issuers where required?
Administrative coordination becomes even more of a problem when employees have kept contracts or custodial accounts with issuers that are no longer receiving employee or employer contributions (or with issuers that never received contributions from the employer but to which the employee transferred his or her contract). The regulations require that these contracts must be treated as part of the plan for purposes of complying with the section 403(b) requirements. This means that loans and hardship withdrawals under these contracts must be taken into account in determining whether loans and hardship withdrawals from other contracts under the plan comply with the section 403(b) requirements.
The IRS provided some guidance on contracts held by former issuers in Rev. Proc. 2007-71. In general, contracts issued after December 31, 2004 by issuers no longer receiving contributions under the plan will be treated as covered by the plan, even though the issuer is not currently "in" the plan, if the employer makes a reasonable, good faith effort to enter into an information-sharing arrangement with the issuer. Information that the employer must provide its former issuers includes notice of severance and hardship (or other distribution events), outstanding loans, information about the employees' other contracts needed for that coordination, and most importantly, who at the employer is the contact person for providing that information. The employer in return should ensure that issuers advise it about the individual's loans and distributions.
Rev. Proc. 2007-71, does not address contracts issued before January 1, 2005 by issuers no longer receiving contributions under the plan. This suggests that no information sharing arrangement with those issuers is required. Also, information sharing about contracts of former employees is required only to the extent that if the individual requests a loan, the issuer must try to determine from the employer whether other loans to that individual are outstanding from other employer plans.
Is the plan an ERISA plan?
Governmental plans (including most public schools), and most church plans, are exempt from ERISA. Section 403(b) plans of nongovernmental employers that have employer contributions have been subject to ERISA since that statute became effective. Department of Labor "safe harbor" regulations exempt 403(b) plans that only allow employee deferrals, as long as employee participation is voluntary, only the employee has rights under the annuity contract, the employer receives no compensation (consideration from the annuity provider) other than reimbursement of expenses, and the involvement of the employer is limited to certain specified activities.
In Field Service Advisory 2007-02, the Department of Labor instructed its agents that it is possible for an employer to adopt a bare-bones plan incorporating the annuity contracts and providing for coordination among different issuers, without necessarily creating an ERISA plan -- provided the document correctly describes the employer's limited role and does not permit the employer to make any discretionary determinations.
Tax-exempt employers with elective-deferral-only 403(b) arrangements can, therefore, choose whether to live within the Department of Labor guidance and avoid ERISA, or to accept regulation under ERISA. If the plan will be an ERISA plan, it can be structured to reduce the fiduciary liability exposures and other negative consequences of ERISA, while taking advantage of several of ERISA's favorable (for the employer) aspects, such as preemption of state law and deferential standard of judicial review. Employers must make it clear, however, from the face of the plan document, whether the plan is intended to be an ERISA plan or exempt from ERISA. Having an ERISA plan and not knowing it (and not having planned for it) can put the employer in a very difficult position.
Does the employer have the information needed for the Form 5500?
Until this year, 403(b) plans that were ERISA plans nevertheless had only minimal financial reporting obligations on Form 5500. New Department of Labor regulations (independent of the new 403(b) tax regulations) effective for 2009 now impose on ERISA 403(b) plans the same reporting requirements applicable to (for instance) 401(k) plans. Notably, 403(b) plans with more than 100 participants must supply an audited financial statement as part of their filing. Form 5500 schedules themselves have been expanded to collect new and detailed information about plan arrangements with insurance companies and other service providers. These schedules may need to include information relating to annuity contracts held by former employees. Affected employers must engage an accountant for the plan, and ensure they have systems in place to obtain, track and report the required information.