The Internal Revenue Service (the “IRS”) released Revenue Ruling 2011–7 (the “Ruling”) on February 22, 2011, to clarify tax issues with respect to the termination of 403(b) plans. In the Ruling, the IRS addresses the requirements for termination of a 403(b) plan, and the resulting tax consequences to participants. While the Ruling provides guidance on certain tax issues, practical problems still remain.
Background on 403(b) Plan Terminations
Prior to the issuance of the final Treasury Regulations under Internal Revenue Code section 403(b) (the “Final Regulations”), employers could not terminate their 403(b) plans and force distributions to plan participants or beneficiaries because plan termination was not a distributable event. Therefore, an employer who wanted to terminate its 403(b) plan could not distribute a participant’s account balance until the participant incurred a distributable event (e.g. termination of employment). As a work around, some employers froze their 403(b) plans, ceasing all contributions to the plan. However, the plans were not terminated, and the employer had continuing compliance obligations under the Internal Revenue Code and, if applicable, the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) (e.g. filing the annual Form 5500).
In 2007, the IRS issued the Final Regulations (generally effective January 1, 2009) which made significant changes to 403(b) plans, including expressly permitting plan terminations. The Final Regulations permit employers to include provisions in their 403(b) plans that allow for distributions of accumulated benefits to plan participants or beneficiaries upon plan termination. As a result, plan sponsors who previously froze their 403(b) plans now may be able to terminate their frozen 403(b) plans and make distributions to participants or beneficiaries. Upon plan termination, participants or beneficiaries may elect a taxable distribution or roll over their balances to an eligible retirement plan, such as an individual retirement account or annuity, or another employer-sponsored plan (e.g., a 401(k) plan). The following items highlight some of the particulars of the Final Regulations:
- The employer generally is prohibited from contributing to another 403(b) plan during the period beginning on the date of the plan termination and ending 12 months after the date on which all assets from the terminated plan are distributed. If, however, for the period 12 months before plan termination and ending 12 months after distribution of all plan assets from the terminated plan, fewer than 2% of the employees who were eligible under the terminated plan are eligible under an alternative 403(b) plan, the employer may disregard the alternative plan. Note that a 401(k) plan is not an alternative plan and thus an employer can terminate its 403(b) plan and immediately contribute to a 401(k) plan.
- All accumulated benefits under the 403(b) plan must be distributed to all participants and beneficiaries as soon as administratively feasible after plan termination.
- Delivery of a fully paid individual insurance annuity contract is considered a distribution for plan termination purposes.
- The mere provision for and making of distributions to participants or beneficiaries upon plan termination does not cause a contract to stop being a Section 403(b) contract.
However, while this was good news for some employers, uncertainty remained on a number of matters including the following:
- The status of distributions from custodial accounts, given that the Final Regulations only expressly addressed distribution of fully paid individual annuity contracts
- Whether contracts distributed upon termination must continue to comply with the 403(b) rules after termination
- An employer’s right to compel distributions when the plan contains individual annuity contracts or individual custodial accounts
Revenue Ruling 2011–7
Issued on February 22, 2011, the Ruling provides guidance on the tax consequences of 403(b) plan terminations. The Ruling describes the tax consequences of distributions made under four fact patterns. Each fact pattern involves a non-ERISA governmental plan that is timely amended to provide for termination and that distributes benefits as soon as administratively feasible after termination. The facts patterns varied by funding vehicles and manner of distributions as follows:
- Situation 1: a plan funded by fully paid individual annuity contracts, with distribution of fully paid individual insurance annuities
- Situation 2: the same as Situation 1, but the plan is also funded by group annuity contracts, with distribution of individual certificates
- Situation 3: the same as Situation 2, but the plan is also funded by individual and group custodial accounts, with distribution from a custodial account to the participant or beneficiary occurring in cash or in kind, or rolled over to an eligible retirement plan
- Situation 4: an ERISA money purchase plan funded by group and individual annuity contracts and custodial accounts, with distribution of purchased annuities satisfying the joint and survivor annuity rules
The IRS concluded that the four plans described above comply with the Final Regulations so long as the terminations incorporate formal corporate action and notification to employees regarding termination, including notification on rollover treatment. The Ruling provides that delivery of a fully-paid individual annuity contract or an individual certificate under a group annuity contract is treated as a distribution from the 403(b) plan. However, the Ruling also provides that so long as the contract continues to comply with the requirements for a 403(b) plan in effect when the contract is distributed, the value of the contract is not included in gross income until the amounts are actually paid to the participant (which depends on the terms of the underlying contract). For all other methods of distribution, such as a payment from an individual or group custodial account, the distribution must be included in gross income in the year when it is distributed unless it is rolled over into an eligible retirement plan.
Remaining Issues after Revenue Ruling 2011–7
While the tax consequences have been clarified, other questions remain. For example, the Ruling requires distributed annuity contracts and individual certificates to remain compliant with the Section 403(b) rules until payment is made to the participant or beneficiary from the contract. However, it is not clear who is responsible for maintaining Section 403(b) compliance after delivery but prior to payment (the participant, the third party provider, etc.). In addition, the Ruling does not address whether plan termination is possible for individually owned custodial accounts — contracts between the individual employee and a third-party provider — that prohibit or are silent regarding plan termination. This is an important issue because employers likely do not exercise control over such contracts, and many 403(b) plans are funded by individual custodial accounts. Further guidance may be forthcoming on these and other issues that arise under the new plan termination rules. Please call us if you have any questions regarding these plan termination rules.