In recent years, the Internal Revenue Service (“IRS”) has been taking a keen interest in the functioning of so-called “403(b) plans,” i.e., retirement savings programs based on annuities, custodial accounts, or church retirement funds set up to qualify under Internal Revenue Code (“Code”) section 403(b). This interest was obvious from the guidelines the IRS issued in the Internal Revenue Manual concerning examinations of hospitals and universities, and was reinforced by the final 403(b) examination guidelines it issued last May.
In the past, employers have often paid little attention to the legal constraints on Code Sec. 403(b) plans. They often assumed either that the IRS was unlikely to audit such plans, or that purchasing an annuity or custodial account that had a ruling on its status under Code Sec. 403(b) took care of all problems. However, the new IRS activity has resulted in more employers doing their own internal audits of their 403(b) plans. Typically, they are hoping to ensure that their plans could survive an IRS audit if one arose. Or failing that, they would at least likely to be able to mitigate potential consequences of failure to meet the requirements by entering into one of the new IRS programs for correction of defects in 403(b) plans. This article discusses some areas that should be considered in performing such an audit.
The first point to remember in conducting an audit is that some problems can affect a whole plan, including even employees whose accounts were unaffected by the problem. Other problems affect only the contract of a particular employee. Still others affect only certain contributions. For example, if a 403(b) ineligible employer sponsored a plan or a plan failed to comply with the universal coverage requirements, the whole plan, including all annuity contracts and custodial accounts, would be disqualified. Making an impermissible distribution would disqualify only the contract from which the impermissible distribution was made. (Note, though, that the whole contract rather than just the distributed amount would be penalized.) Contributions to an annuity contract in excess of the exclusion allowance would not be excludable, but would not cause problems for the rest of the annuity contract. Obviously, the first priority for any employer should be correcting those problems that would affect the whole plan and all
of its participants.
Specific issues which employers need to take into account are set forth below.
1. 403(b) plans can cover only common law employees of an eligible employer.
An “eligible employer” is an employer that is either a public school or university, or an organization tax-exempt under Code Sec. 501(c)(3) (relating to charitable, scientific, educational, or religious organizations). This issue comes up in two contexts. First, a taxable organization, or an organization tax-exempt under some section of the Code other than section 501(c)(3) (e.g., a trade association tax-exempt under Code Sec. 501(c)(6), or a union tax-exempt under Code Sec. 501(c)(4)) cannot maintain a 403(b) plan. This rule is straightforward, although a surprisingly large number of employers violate it.
The second context in which the issue arises involves a controlled group in which some entities are public schools or universities, or entities tax-exempt under Code Sec. 501(c)(3), but others are not. The classic example is a university that is either a public university, or a private university tax-exempt under Code Sec. 501(c)(3). Thus, the university itself can clearly have a 403(b) plan for its own employees.
However, it is common for such a university to have affiliates that are neither part of the university, nor tax-exempt under Code Sec. 501(c)(3). For example, a university may have taxable subsidiaries for certain research functions. If it has a medical school, it may run an HMO tax-exempt under Code Sec. 501(c)(4). The university’s 403(b) plan is not permitted to cover employees of the taxable subsidiaries or the HMO.
This rule presents particular pitfalls, because it is common for a university to serve as the common paymaster for itself and all of its affiliates, and then to collect from each affiliate the ratable payroll cost of that affiliate. This is particularly true in instances in which an employee may spend part of his or her time at one entity, and part at another. For example, suppose a physician serves as a member of the medical school faculty, a researcher for a taxable research subsidiary, and a service provider under the HMO. Rather than try to figure out in advance how many hours he or she will spend working for the university, the taxable subsidiary, and the HMO, the various entities may come to an agreement that the university will pay the physician’s salary, and then collect the ratable share of that salary from the HMO and the taxable entities.
Such an arrangement works as an administrative matter, and indeed often provides an advantage to the employers for purposes of Social Security taxes. However, to the extent that individuals are common law employees of a taxable affiliate or an HMO, the university’s 403(b) plan cannot cover them, even if they are paid on the university payroll.
2. A salary reduction arrangement in a 403(b) plan must cover all employees not excluded by Code Sec. 403(b)(12).
This has been one of the biggest areas of noncompliance among 403(b) plans. The only employees that a 403(b) plan can exclude are (a) those who are participants in 401(k) or 457 plans, (b) nonresident aliens, (c) students performing certain services, and (d) employees who normally work less than 20 hours a week. Some employers mistakenly believe that a salary reduction arrangement need not cover temporary or intermittent employees. For example, they might exclude medical residents or substitute teachers from the plan, even though such employees might work more than 20 hours per week. Because this is an issue that can disqualify the whole plan, not just an individual employee’s contract, it is critical that the employer provide for participation by all employees who do not fall within the narrow exclusions.
This coverage rule also creates problems when it is unclear who is the employer of a particular employee, or when a single employee performs services for two or more related entities. As described above, covering employees of a taxable subsidiary in a university’s 403(b) plan is impermissible. At the same time, it is impermissible to exclude the university’s own employees (unless an exception described above covers them) from at least the salary reduction portion of a 403(b) plan. Thus, the employer must be scrupulous in determining which entity an employee works for, and in apportioning salary for purposes of the 403(b) plan in the case of an employee who works for more than one entity.
3. Imposition of a minimum percentage of compensation as a deferral violates nondiscrimination rules.
Often, employers want to impose minimum percentage of contribution limits on deferrals as a matter of administrative convenience, so that they will not end up having to handle very small deferral amounts. However, the final 403(b) examination guidelines treat such requirements as violating the nondiscrimination rules of Code Sec. 403(b)(12), and therefore as impermissible. The IRS’s theory seems to be that imposing the same percentage of compensation minimums on highly compensated employees and on other employees is discriminatory, because highly compensated employees are more likely to have the spare cash to make contributions at the higher levels.
4. Employees cannot defer, or treat as includible compensation, amounts accrued in prior years.
In many instances, employees receive sizable amounts of pay at the time of termination or retirement. For example, all accrued but unpaid sick or vacation leave may be paid off at retirement. An employee who receives a large payment at the time of retirement may well feel that the best use of it is to put it aside in a 403(b) contract.
However, the final examination guidelines for 403(b) plans do not allow this. If an employee receives accrued but unpaid sick leave at the time of retirement, only the amount that the employee accrued in the year of retirement can be treated as compensation subject to deferral.
5. Improperly omitting contributions to qualified plans in calculating amounts previously excluded is a focus of IRS examinations.
Code section 403(b) requires that the maximum exclusion allowance be reduced by all prior employer contributions to “annuities.” However, the regulations under Code Sec. 403(b) have taken the approach that any contribution to any qualified employer plan or annuity is a contribution to an annuity for this purpose.
These rules are particularly complex and difficult to apply in the case of defined benefit plans. For example, suppose that a school system contributes to a statewide defined benefit retirement system. Suppose that the school is obligated to contribute 3% of payroll, and each employee is required to contribute an additional 3% of payroll.
An employer might assume that it could determine the prior employer contributions by adding together 3% of compensation for each year of the employee’s employment. However, this is not the correct method. First, the regulations treat all picked up contributions as employer contributions, not employee contributions. Second, the regulations say that the employer is not really contributing 6% of compensation on behalf of each employee. Rather, the 6% represents an average of the amounts needed to fund each employee’s benefits. Employees who are close to retirement actually receive more of a benefit from the contributions than younger employees do, and therefore should be imputed to have a larger employer contribution.
While the regulations are correct in theory, the practical effect is that calculating the exclusion allowance for an employee covered by a defined benefit plan is extraordinarily complex. To calculate prior employer contributions, it is necessary first to calculate the projected benefit at normal retirement age. This can be a tremendously difficult calculation all by itself, especially if the plan provides for full benefits (and potentially normal retirement age) not just at a predetermined age (e.g., age 65), but at some lesser age with a specified amount of service (e.g., age 55 with 30 years of service).
After calculating the projected benefit at normal retirement age, it is necessary to determine the actuarial value of the contributions made for the employee in all prior years. Again, this calculation can be quite complex, as it requires the determination of appropriate interest rates and mortality tables to use in calculating actuarial values. While the state system may have its own actuaries who can make such calculations, it may be quite difficult for a school system or public university that contributes, to but does not run, the system to do them.
6. Confirmation that pre-1987 account balances are subject to their own minimum distribution and minimum incidental death benefit rules.
Beginning in 1987, 403(b) plans became subject to minimum distribution rules, under which account balances had to be distributed beginning at the later of attainment of age 70-1/2 or retirement. They also became subject to minimum incidental death benefit rules, which provided that a participant could not select an annuity in which more than half of the actuarial value could be anticipated to be paid out to beneficiaries, as opposed to the participant. However, pre-1987 account balances (not including post-1987 earnings on such account balances) were exempt from such rules. Thus, many employers and participants believed that no minimum distribution rules or minimum incidental death benefit rules would apply to the pre-1987 balances.
While nothing in the Code applied any minimum distribution or minimum incidental death benefit rules to pre-1987 balances, the IRS had taken the position in private letter rulings before 1987 that 403(b) annuities were intended to be used for retirement purposes, and that because of that, they were subject to certain nonstatutory minimum distribution and minimum incidental death benefit rules. These rules required that pre-1987 account balances must be distributed by the end of the calendar year in which the participant turned 75 (or would have turned 75 had he or she lived that long). (In the pre-Age Discrimination in Employment Act days in which such rulings were issued, the IRS did not appear to consider the possibility that a participant might still be working past age 75.) The private letter rulings also required that at least half the actuarial value of an annuity must be payable to the participant, as opposed to death beneficiaries.
The final 403(b) examination guidelines spell out that the pre-1987 rules continue to apply to pre-1987 account balances. Thee examination guidelines clarify, however, that the distribution date will be based on the later of attainment of age 75 or retirement, as opposed to applying at age 75 regardless of retirement status.
7. In the absence of a “C” election, a 403(b) plan is aggregated with a Keogh or other retirement plan maintained by an entity controlled by the employee in applying maximum limits on contributions.
Code Sec. 415(e)(5) (regarding the combined plan limits) provides that in the absence of an election under Code Sec. 415(c)(4)(C) (a “C election”), a 403(b) contract will be treated as a defined contribution plan maintained by each employer over which the participant has control. This is the rule that has been used to avoid aggregation of 401(a) plans and 403(b) plans in applying the maximum limits on contributions under Code Sec. 415(c). Although Code Sec. 415(e)is repealed effective in the year 2000, it is anticipated that a legislative technical correction will reinstitute section 415(e)(5). Pending such technical correction, high level IRS officials have announced informally that they will continue to apply section 415 as though section 415(e)(5) were still in effect.
Code Sec. 415(e)(5) is normally seen as beneficial, inasmuch as it provides a double deduction under section 415(c) to those employees who do not have their own businesses. However, the IRS included a reminder that the Code Sec. 415(e)(5) rule may actually be unfavorable to those employees who have their own businesses. For example, suppose that a medical school professor also practices medicine on his or her own. If the medical school has no defined contribution plan other than the 403(b) plan, and if the 403(b) plan were treated as a plan of the medical school, contributions to the medical school’s 403(b) plan on behalf of the professor could be as high as the full 415(c) limits, if no other limitations applied. However, because the 403(b) plan is treated as though it were a plan of the professor’s medical practice, contributions to a Keogh plan or other retirement plan of the medical practice must be combined with contributions to the 403(b) plan in applying the 415(c) limits.
Obviously, this rule presents practical problems for an employer that sponsors a 403(b) plan. The medical school in our previous example has no independent way to verify whether the professor has a Keogh plan, or what level of contributions he or she is making to that plan. The medical school does not want to have its 403(b) plan disqualified due to the professor’s contributions to a Keogh plan.
The medical school may want to consider a couple of ways to reduce its risk. First, it might wish to warn its employees that if they have independent businesses, they must offset the maximum contribution under plans of those businesses by contributions to their 403(b) plans in applying the Code Sec. 415(c) limits, unless they have made C elections.
The regulations under Code Sec. 415 suggest another possible step. They state that if contributions to each of two plans are within the section 415 limits, but the combined contributions to the two plans exceed the limits, the employer gets to choose which of the two plans to disqualify. The participant’s business is treated as the employer, for Code Sec. 415 purposes, with regard to both its own plan and any 403(b) plan for the participant’s benefit. Thus, the entity that actually maintains the 403(b) plan may wish to require, as a condition of participation, that each participant sign a statement electing to have any other plans he or she maintains, not the 403(b) plan, be disqualified under those circumstances.
8. 415(e) limits still apply for 1999.
Code Sec. 415(e), which imposed extremely complicated maximum combined limits on benefits under defined benefit and contributions under defined contribution plans, has been repealed. However, the final 403(b) examination guidelines remind us that these tests still need to be run for 1999, in any case in which a 403(b) plan needs to be combined with a defined benefit plan. (See previous paragraph for a description of the rules on aggregating plans.)
9. IRS will impose FICA, FUTA, and excise taxes even for problems corrected under its various self-correction programs.
Rev Rul 99-13, 1999-5 IRB 52, and Rev Rul 98-22, 1998-12 IRB 11, set forth three ways for an employer to correct 403(b) plan defects: the Administrative Policy Regarding Self-Correction (“APRSC”), the Tax Sheltered Annuity Voluntary Correction Program (“TVC”), and a closing agreement program for organizations that fall into an examination (“Audit CAP”). APRSC is a way of correcting minor defects without IRS involvement. TVC allows for the correction of certain kinds of problems if the employer approaches the IRS at a time when the employer is not under IRS audit. The Audit CAP program is available for the most serious defects, or if the employer is already under audit before it has taken action to correct defects.
The final 403(b) examination guidelines point out that only income taxes are dealt with by these programs. Thus, excise taxes, FICA (Social Security and Medicare), FUTA (unemployment) and state unemployment taxes may still be due.
These taxes are not normally an issue for an employer that maintains a salary-reduction-only 403(b) plan that invests entirely in annuity contracts. However, the taxes can be an issue in two circumstances: (1) if the 403(b) plan includes contributions that are not salary reduction contributions, or (2) if the 403(b) plan invests in custodial accounts described in Code section 403(b)(7), rather than just annuities.
Salary reduction contributions to 403(b) plans are subject to FICA, FUTA and state unemployment taxes at the later of the time the contributions were made or the time they became vested (usually, these are the same time). Thus, even if the IRS later disqualified the 403(b) plan, the employer would already have payed the FICA and unemployment taxes on a timely basis. By contrast, other employer contributions to a 403(b) plan are normally exempt from FICA, FUTA, and state unemployment tax withholding. Thus, if an employer mistakenly believed that its 403(b) plan was qualified, and later realized that defects in the plan disqualified it, the employer could end up owing back FICA, FUTA, and state unemployment taxes. Moreover, the employer would typically discover the problem only after contributions had been made to the plan without proper withholding. Thus, the employer itself would be liable for both the employer’s and employee’s share of FICA taxes, without an obvious way to recoup the employee’s share from the employee.
Also, the trend in recent years has been for more 403(b) plan participants to invest in contracts that qualify as custodial accounts under Code Sec. 403(b)(7) (“mutual funds”), as opposed to annuity contracts. Excess contributions to an annuity incur no penalty other than being nondeductible, and decreasing maximum allowable contributions in subsequent years. By contrast, excess contributions to a mutual fund generate an excise tax of 6 % of the excess amount. Code Sec. 4973(a)(3). The final examination guidelines specify that the employer’s decision to enter into a correction program does not reduce this tax.
As the above discussion indicates, internal audits of 403(b) plans have become increasingly critical, both to avoid problems in the first place, and to provide a basis for participation in a self-correction program if a problem has already occurred. Unfortunately, the rules of Code section 403(b) are not always straightforward and easy to apply, so any such internal audit will need to take into account the many problems that can arise.