The Internal Revenue Service has released Revenue Procedure 2007-71, providing guidance on certain aspects of recently finalized comprehensive regulations under Internal Revenue Code section 403(b).The revenue procedure, which is effective on December 17, 2007, provides model plan language that may be used by certain employers to comply with the requirement in the new regulations that 403(b) arrangements be maintained pursuant to a written plan. In addition, Rev. Proc. 2007-71 provides guidance on how to apply the new regulations to certain annuity contracts issued prior to the regulations January 1, 2009 effective date.
While Rev. Proc. 2007-71 does flesh out the final regulations' skeletal written plan requirement, there are at least two potentially significant ramifications flowing from the guidance that will adversely impact 403(b) plan vendors. First, from the vendor’s perspective, supporting the model plan language will require significant effort and expense, and will be difficult to accomplish by the January 1, 2009 effective date. Second, the revenue procedure’s guidance on how to treat contracts issued prior to January 1, 2009 must be clarified in order to be workable.
Model Plan Language
In Rev. Proc. 2007-71, the Service acknowledges that “there may be a potential cost associated with satisfying the written plan requirement for those employers that do not have existing plans documents, such as public schools.” In order to help alleviate some of that cost, the Service provided model plan language that any public school employer may use to comply with the written plan requirement of the regulations. Provided the public school employer “adopts the model language on a word-for-word basis or adopts an amendment that is substantially similar in all material respects,” it can rely on the model language as if it were a favorable private letter ruling.
For tax-exempt entities other than public schools that are eligible to sponsor 403(b) arrangements for their employees, the model plan language can be referred to and used to aid in compliance with the regulations, where appropriate. The Service makes clear, however, that those non-public school employers must "determine the extent to which the model language is appropriate for use in connection with its § 403(b) plan." Even after making that appropriateness determination, however, non-public school employers may not rely on adoption of the model plan language as if it were a favorable private letter ruling.
While intended to alleviate compliance burdens, the model plan language may ultimately not be that useful. That is because the final regulations require 403(b) arrangements to be maintained “in both form and operation” in compliance with the statutory and regulatory requirements of Code section 403(b). That rule, coupled with the requirement in Rev. Proc 2007-71 that employer adopt the model language on a “word-for-word” basis, means that the model language will be valuable only if employers and vendors can actually adhere to its details without modification.
Vendors will likely discover many of the details in the model plan language to be difficult, if not impracticable, to support. The model plan language will conflict with a number of standard insurance clauses, while others create severe operational problems. For instance:
- Conflicts with insurance contracts. The model plan language is inconsistent with several standard provisions found in most 403(b) contracts, including:
- Payments to minors and incompetents are to be determined by the employer, not the insurer, in spite of the contractual obligation in many insurance contracts to the contrary. Insurers will be liable for the employer's decisions on those "contrary" contracts.
- The model plan language appears to impose some responsibility on the employer to locate missing or lost employees, when most insurance contracts provide that these accounts will be governed by the state escheat laws.
- Annuity contract terms, which are in conflict with the model plan terms, are excluded from the plan. This means that following a contract term can result in the 403(b) arrangement losing tax-favored status.
- The model language can be read to require that annuity contracts may have to provide for "information sharing agreements," require vendors to notify the employers of hardship withdrawals, and impose on vendors a duty to obtain data from all other vendors and employers granting a loan.
- Beneficiary accounts: The model plan makes continued tax-favored status dependent upon the employer requiring the insurer to maintain a separate account for each beneficiary upon the employee's death, even though the regulations themselves have no such requirement. Not only is this new requirement being introduced without the benefit of notice-and-comment rulemaking, it poses a logistical nightmare. In particular, individual contracts (which make up a large proportion of 403(b) annuity contracts) cannot have more than one person with an account in any policy. In order to comply with the separate accounting requirement, a new policy would have to be established until all disputes and other logistical issues surrounding beneficiaries are resolved. Group contracts will also face challenges, since systems supporting those contracts typically provide insufficient beneficiary data to establish the new account. Yet establishing it becomes a condition of continued plan qualification.
- Traps for the unwary. Some rules accompanying the adoption of the plan document have unexpected twists which can cause unexpected liability for employers and vendors, including:
- There is a new form requirement. The model language provides that election forms provided to employees MUST contain a beneficiary election and information identifying the funding vehicle selection.
- Employers MUST deposit deferrals within 15 days of being withdrawn from paychecks. Failure to do so will disqualify the entire plan, though this deposit rule is not required by the regulations.
- The model language appears to assume that all plan loans are repaid by payroll deduction. In practice, however, most loans are not repaid in that way. Moreover, the model plan language would require employers to tell the vendors when loan defaults occur, which will not always be knowable by the employer.
- Employers MUST provide that the section 402(f) distribution notices are the responsibility of the vendor. This means that the vendor’s failure to provide employer with a 402(f) notice can result in the plan losing its tax-favored status.
- Imposes duties on transferor plan to properly prorate tax characterization treatment.
- Plan design choices. The plan document is far from neutral. Instead, embedded in the plan language are several plan design choices made by the Service, which include:
- Immediate participation. Relying on the model plan language will require employers to permit immediate participation in the arrangement for new hires. Contrary to the model language, the regulations allow up to a one-year wait.
- Loan Defaults. Requires adoption of the six-month suspension rule for loan defaults. This requires the employer not only to know when a loan is defaulted, but then to impose a six-month suspension on deferrals.
- Rollovers. Only rollovers in cash are permitted, meaning that rollovers of mutual fund shares or rolling of annuity contracts are not permitted.
- Student Teachers. Eliminates "student teachers" and those with less than 20 hours of service. This raises potential collective bargaining issues. Odd rules. Some rules accompanying the model plan language raise more questions than are answered. For instance:
- Employee Reporting. There is a provision in the model plan language regarding automatic enrollment plans that seems to require employees to file a beneficiary designation with the "funding vehicle." The employee apparently does not have to identify the vendor providing that funding vehicle. Moreover, there is no indication of what an employer should do if the employee does not comply with this rule.
- Plan Contribution Limits. The model plan language requires employers to take into account any other contributions to any other plan of an unrelated employer that the employee "tells" of and which the employer "accepts." That presents a potential collective bargaining issue.
- Vendor Contact Information. The model language requires employers to maintain a list of current and former vendors, and to keep each vendor informed of name and contact information at employer. This seems to mean that all vendors must be notified of a change in contact name, whenever it happens.
In response to comments by the regulated community, the Service determined that it would be unreasonable to require employers to comply with the written plan requirement with respect to certain contracts issued under the plan that were no longer active. Section 8 of Rev. Proc. 2007-71 indicates that a 403(b) arrangement will not fail the written plan requirement for a year merely because it does not contain information about contracts issued after December 31, 2004 and before January 1, 2009, provided two conditions are met. First, the contracts must not have received any contributions under the plan in the year after the contract was issued. Second, the employer must make a “reasonable, good-faith effort to include the contract as part of the employer’s plan” that satisfies the written plan rule.
Under Section 8.02 of the revenue procedure, an employer will be deemed to make a reasonable good faith effort to include old contract terms as part of the written plan by "collecting available information" about the issuers whose contracts have received contributions after January 1, 2005, and "notifying [those issuers] of the name and contract information for the person in charge of administering the employer's plan for the purpose of coordinating information necessary to satisfy § 403(b)." Alternatively, the Service indicates that the employer's duty to make a reasonable, good faith effort to include old contracts in its written plan can be satisfied by the "issuer taking action before making any distribution or loan to the participant or beneficiary which constitutes a reasonable, good faith effort to contact the employer and exchange any information that may be needed in order to satisfy § 403(b) with the person in charge of administering the employer's plan."
Under this rule, it seems clear that employers do not need to collect data for old contracts (issued before January 1, 2005) to current employees, as long as no contributions have been made to those contract since December 31, 2005. In addition, the revenue procedure clarifies that only a reasonable, good faith effort is needed to collect data for contracts issued to current employees between January 1, 2005 and January 1, 2009 and to which no contributions have been made in any year following its issue. It also seems clear that 403(b) arrangements will not lose its tax-favored status for failing to include contracts issued to former employees and beneficiaries prior to January 1, 2009 to which no new contributions are made thereafter, as long as a reasonable effort is made to ensure that arrangement is complying with rules on plan loans.
That clarity gives way to some significant problems, however. For instance,
- For contracts issued prior to January 1, 2009 to current employees to which no contributions have been made, Section 8.02 indicates, such contracts “continue to be subject to the requirements of § 403(b) and the 2007 regulations to the extent applicable.” It is not entirely clear which part of the 2007 regulations remain applicable.
- For contracts issued prior to January 1, 2009 to former employees and beneficiaries, there is no language that states that they are subject to the “2007 regulations to the extent applicable.” This lack of clarity raises several issues, such as whether or not any of the 2007 regulations apply, and if they apply differently than for contracts of existing employees.