The Internal Revenue Service (the “IRS”) has issued proposed regulations under Section 403(b) of the Internal Revenue Code (the “Code”), as well as proposed and temporary regulations under related provisions of the Code. Code section 403(b) governs plans that involve retirement annuity contracts, mutual fund custodial accounts for employees of certain tax-exempt organizations and public educational organizations, and retirement income accounts established by churches or church-affiliated organizations.
The IRS first published regulations under Code section 403(b) in 1964. The IRS subsequently added additional regulations to reflect rules relating to eligible rollover distributions and minimum required distributions, but the basic structure of the regulations remained unchanged. In the meantime, however, subsequent legislation (ERISA, TEFRA, TRA ’86, SBJPA, and EGTRRA) had made numerous changes to Code section 403(b). The proposed and temporary regulations, which were published on November 16, 2004, represent the first comprehensive guidance under Code section 403(b) in over 40 years. The purpose of the regulations, as stated in the preamble, is generally to reflect these numerous legal changes. Since a major effect of the legal changes has been to diminish the extent to which the rules applicable to Code section 403(b) plans differ from the rules applicable to Code section 401(k) and Code section 457(b) plans, the proposed regulations reflect the increasing similarity among the various types of deferred arrangements.
Plan sponsors and practitioners should also note that since 1964, when the existing regulations were issued, a number of revenue rulings, notices and other guidance issued to interpret Code section 403(b) have become outdated as a result of changes in the law. Accordingly, the IRS explicitly states in the preamble that it anticipates taking action to obsolete a number of revenue rulings, notices and other guidance under Code section 403(b) once the proposed regulations become final. The preamble contains a footnote with a useful list of the guidance which the IRS expects to be superseded. Of course, positions taken in certain rulings, notices and other guidance which are still valid will be retained.
Although, as noted above, a major effect of the proposed regulations is to enhance the similarity between Code section 403(b) and Code section 401(k) plans, the preamble to the proposed regulations emphasizes three continuing major differences between the types of plans:
- Code section 403(b) plans are limited to certain specified employers and their employees: employees of Code section 501(c)(3) organizations, employees of state public schools, and certain ministers. Code section 401(k) plans are available to all employers and employees, except employees of a state or local government or any agency or instrumentality of a state or local government.
- Contributions under a Code section 403(b) plan can only be made to certain specified funding arrangements: an insurance annuity contract, a custodial account that is limited to mutual fund shares, or a church retirement income account. In contrast, contributions made under a Code section 401(k) plan can be made to a very wide variety of different funding arrangements.
- A universal availability rule applies to Code section 403(b) plans, under which all employees of the eligible employer must be allowed to make elective deferrals if any employee of the employer is allowed to make elective deferrals. In contrast, a Code section 401(k) plan must satisfy an average deferral percentage rule and a minimum coverage rule.
Within this context, some of the highlights of the proposed regulations are as follows.
Written Plan Document — Possible ERISA Implications
Perhaps the most surprising provision of the proposed regulations is a new requirement that a Code section 403(b) arrangement must be maintained pursuant to a written defined contribution plan document that sets forth all the material provisions of the arrangement, including eligibility, benefits, time and form of distribution, the various contracts available under the plan, and relevant limits. The written plan does not necessarily have to be a single document, but could, for example, consist of the employer’s written plan document and the custodian’s written contract taken together. Church plans and defined benefit plans are generally not subject to the requirement.
The new written plan document requirement represents a major change. Currently, an employer sponsor of a Code section 403(b) plan often has little control over the plan. The contractual agreement between the employer and vendor or custodian of the funding arrangements may provide significant control to the vendor. The employer may be little more than the means for the payment of deferrals to the funding vehicle.
An important possible consequence of the new requirement of a written plan document is that certain Code section 403(b) plans maintained by non-governmental, non-church employers may now become subject to the requirements of Title I of ERISA, including requirements relating to reporting and disclosure, qualified joint and survivor annuities, fiduciary standards and claims procedures. ERISA Title I applies to “employee benefit pension plans.” For purposes of ERISA, “employee benefit pension plans” do not include a Code section 403(b) salary reduction arrangement if, among numerous other factors, the employer’s control over and role with respect to the plan is limited to issues such as choosing annuity providers. In contrast, if the employer makes certain decisions (for example, decisions concerning disability or hardship benefits), the arrangement is an “employee benefit pension plan” and subject to Title I. In the preamble to the proposed regulations, the IRS states that the Department of Labor has advised it that, although it does not appear that the plan document requirement would necessarily cause a Code section 403(b) salary deferral arrangement to become an “employee pension benefit plan,” there does exist the possibility that in establishing a plan document the employer may undertake responsibilities that would constitute establishing an “employee pension benefit plan” and lead to coverage under Title I. The Department of Labor will analyze these matters on a case by case basis.
The potential ERISA issue will not apply to governmental and church plans since they are generally excluded from coverage under Title I of ERISA. Code section 403(b) arrangements that provide for employer contributions are generally already subject to Title I of ERISA.
Special Rule for Former Employees
Under Code section 403(b), a former employee is deemed to have includible compensation for Code section 403(b) purposes until the end of the taxable year of the employee in which he or she terminates employment and through the end of the next five taxable years of the employee. The proposed regulations specify that an employer may continue to make nonelective employer contributions for a former employer for this five year period in an amount up to the lesser of the dollar amount specified in Code section 415(c)(1)(A) or the former employee’s annual includible compensation based on the former employee’s compensation during his or her most recent year of service.
Exclusive Benefit; Commingling Assets
The proposed regulations provide that both custodial accounts and retirement income accounts would be subject to an exclusive benefit requirement similar to that applicable to qualified plans. Additionally, once the regulations become final, the assets in custodial or retirement income accounts may be pooled with trust assets held under qualified plans to the extent permitted by future guidance.
Controlled Group Rules for Tax-Exempt Entities
Included in the proposed regulations are potentially highly significant controlled group rules under Code section 414(c) for entities that are tax exempt under Code section 501(a). Under the rules, the employer of a plan maintained by an entity exempt from taxation under Code section 501(a) includes not only the organization whose employees participate in the plan, but also any other exempt entity with which it is under common control. For these purposes, common control is based on at least 80% of the directors of one of the exempt organizations being representatives of or directly or indirectly controlled by another exempt entity. In addition, the proposed regulations contain an anti-abuse rule and would also allow tax exempt organizations to choose to be permissively aggregated if they maintain a single plan covering one or more employees of each organization and the organizations regularly coordinate their exempt activities. Generally, the proposed regulations would not apply to public schools or to certain church entities.
The significance of the proposed controlled group rules lies in two factors. First of all, the rules would generally be relevant for purposes of the nondiscrimination requirements as well as the Code section 415 contribution limitations, Code section 403(b) catch-up contributions and Code section 401(a)(9) minimum distribution rules. (The universal availability rule, however, does not use the controlled group rules but instead applies the concept of legal entity with permissive aggregation.) Secondly, it appears as though the rules will apply to any employee benefit plan which is subject to Code section 414(c) and not just to Code section 403(b) plans.
Currently Code section 403(b) plans can not be terminated; instead, a plan sponsor may only amend them to eliminate future contributions. The proposed regulations would change this by allowing a Code section 403(b) plan to include a provision that permits distribution of benefits upon a plan termination. However, the distribution of benefits would only be permitted if the employer (determined by applying the controlled group rules) does not make contributions to another Code section 403(b) plan during the 12 month periods before and after the date of termination. Under the regulations, in order for a Code section 403(b) plan to be fully terminated, all benefits accumulated under the plan must be distributed to participants and beneficiaries as soon as administratively feasible after termination.
The proposed regulations also contain provisions dealing with, among other things, exchanges and transfers of assets, maximum contribution limits, catch-up contributions, funding, determination of years of service, and nondiscrimination and the universal availability rule.
Proposed Effective Date
The regulations are generally proposed to be effective for taxable years beginning after December 31, 2005. Special transition rules and effective dates will govern, among other things, Code section 403(b) contracts maintained under certain collective bargaining agreements or by certain church-related organizations. The proposed regulations can not be relied upon until adopted in final form. The IRS will hold a public hearing on the proposed regulations on February 15, 2005. Comments are due by February 14.