403(b) and 457(b) Plan Compliance Challenges: Avoiding Pitfalls in Plan Design and Administration
(Posted on August 27, 2019 by )


A recent Strafford CLE webinar guided employee benefits counsel on key compliance challenges in the design and administration of 403(b) and 457(b) plans and methods to overcome them. A panel discussed complex rules and pitfalls to avoid in plan design, key administrative challenges, the universal availability rule, excess contributions, hardship distributions, and methods to limit claims.

The PowerPoint slides for the portion of the presentation given by Carol V. Calhoun are below.

IRS Permits New Benefits in High Deductible Health Plans
(Posted on July 18, 2019 by )


Internal Revenue ServiceThe IRS has recently issued Notice 2019-45, which increases the scope of preventive care that can be covered by a high deductible health plan (“HDHP”) without eliminating the covered person’s ability to maintain a health savings account (“HSA”).

As background, since 2003, eligible individuals whose sole health coverage is a HDHP have been able to contribute to HSAs. The contribution to the HSA is not taxed either when it goes into the HSA or when it is used to pay health benefits. It can for example be used to pay deductibles or copays under the HDHP. But it can also be used as a kind of supplemental retirement plan to pay Medicare premiums or other health expenses in retirement, in which case it is more tax-favored than even a regular retirement plan.

As the name suggests, a HDHP must have a deductible that exceeds certain minimums ($1,350 for self-only HDHP coverage and $2,700 for family HDHP coverage for 2019, subject to cost of living changes in future years). However, certain preventive care (for example, annual physicals and many vaccinations) is covered without having to meet the deductible. In general, “preventive care” has been defined as care designed to identify or prevent illness, injury, or a medical condition, as opposed to care designed to treat an existing illness, injury, or condition.

Notice 2019-45 expands the existing definition of preventive care to cover medical expenses which, although they may treat a particular existing chronic condition, will prevent a future secondary condition. For example, untreated diabetes can cause heart disease, blindness, or a need for amputation, among other complications. Under the new guidance, a HDHP will cover insulin, treating it as a preventative for those other conditions as opposed to a treatment for diabetes. Read more.

IRS Revenue Procedure Eases Correction Procedures
(Posted on April 22, 2019 by )


Internal Revenue ServiceThe IRS has just issued a new revenue procedure, Rev. Proc. 2019-19, which limits the number of plans that have to make IRS filings under the Voluntary Correction Program (“VCP”) in order to correct past errors.

The guidance adds provisions allowing plans to be corrected under the Self-Correction Program (“SCP”), which does not require an IRS filing, in the case of two sorts of errors:

  • Plan document failures
  • Correction by retroactive plan amendment

The revenue procedure also loosens certain requirements for dealing with plan loan failures.
Read more.

New PowerPoint: Avoiding Fringe Benefit Pitfalls: Tax Traps, De Minimis Rules, Correction Procedures, Fiduciary Risks
(Posted on April 4, 2019 by )


Strafford webinarA recent CLE webinar guided benefits counsel and advisers on recent rules and regulations in providing fringe benefits to employees and avoiding dangerous and costly issues that arise regarding such benefits including personal liability under ERISA. The panel discussed key considerations in structuring fringe benefits, tax traps, de minimis rules, effective correction procedures and methods to minimize fiduciary risks. The PowerPoint presentation for the portion of the webinar dealing with tax aspects is now available at this link.

 

 

Avoiding Fringe Benefit Pitfalls: Tax Traps, De Minimis Rules, Correction Procedures, Fiduciary Risks
(Posted on April 4, 2019 by )


A recent CLE webinar guided benefits counsel and advisers on recent rules and regulations in providing fringe benefits to employees and avoiding dangerous and costly issues that arise regarding such benefits including personal liability under ERISA. The panel discussed key considerations in structuring fringe benefits, tax traps, de minimis rules, effective correction procedures and methods to minimize fiduciary risks.

The PowerPoint slides for the portion of the presentation dealing with tax aspects are below.

Section 403(b) Plan Design and Compliance
(Posted on December 5, 2018 by )


Go to: 403(b) Plan Overview | Eligible Employers and Employees | ERISA Coverage of 403(b) Plans | Qualification Requirements | 403(b) Plan Contributions | 403(b) Plan Distributions | Implementation and Operation | Correcting 403(b) Plan Errors | Terminating 403(b) Plans | EP Subcommittee Report: 403(b) Plan Issues and Recommendations | Advantages and Disadvantages of 403(b) Plans

This practice note discusses the rules that apply when eligible tax-exempt organizations (or their employees) establish tax-sheltered annuities, custodial accounts, or retirement income accounts, as described in Section § 403(b) of the Internal Revenue Code (403(b) plans). While all employers are eligible to set up a defined benefit plan, and most tax-exempt nongovernmental employers are eligible to set up 401(k) plans, 403(b) plans are another option for certain tax-exempt and governmental organizations. These organizations may establish a 403(b) plan (sometimes called a tax-sheltered annuity plan or a TSA), which can fulfill most of the functions of a qualified plan, including allowing for pre-tax employee elective contributions, while offering various advantages to employers over a traditional qualified plan design.
This practice note addresses the following topics:

For more information on 403(b) plans, see Employee Compensation and Benefits Tax Guide ¶ 502.14 and the IRS website resource for 403(b) plans.

403(b) Plan Overview

A 403(b) plan is a type of retirement plan providing for deferred taxation on certain contributions and earnings made by specific kinds of tax-exempt organizations (primarily, public schools and 501(c)(3) tax-exempt organizations) for their employees and by certain ministers. I.R.C. § 403(b)(1). For the participant, a 403(b) plan appears much like a 401(k) plan in that it provides for an individual account for each participant. However, 403(b) plan investment options are more limited. 403(b) plans are subject to some, but not all of the requirements that apply to 401(k) and other retirement plans qualified under I.R.C. § 401(a). A 403(b) plan can allow employees, the employer, or both to contribute to the plan. Also, like a 401(k) plan, a 403(b) plan can include a qualified Roth contribution program.

Although 403(b) plans have been around in some form for over 50 years, the Treasury Department only issued final regulations under I.R.C. § 403(b) in 2007, which generally became effective in 2009. 72 Fed. Reg. 41,127 (July 26, 2007).

Eligible Employers and Employees

Only certain types of employees are eligible to participate in a 403(b) plan, essentially restricting 403(b) plan sponsors to certain tax-exempt organizations, schools (including colleges and universities) sponsored by state and local governments, and ministers or their employers or deemed employers. If a plan permits ineligible employees to participate, the plan may lose its tax-favored status (unless a correction is made under the IRS Employee Plans Correction Resolution System (EPCRS); see Correcting 403(b) Plan Errors later in this practice note).

The following types of employees are eligible to participate in a 403(b) plan:

  • 501(c)(3) employees. Employees of tax-exempt organizations established under I.R.C. § 501(c)(3) and cooperative hospital service organizations (501(c)(3) organizations), as described further below.
  • School employees. Individuals who are (1) involved in the daily operations of a public school, college, or university that is sponsored by a state, local, or Indian tribal governmental body (public school systems), as described further below under “Public School Systems” or (2) civilian faculty and staff of the Uniformed Services University of the Health Sciences. See below for further discussion.
  • Ministers. Ministers described in I.R.C. § 414(e)(5), provided they are:
    • Employed by a 501(c)(3) organization
    • Self-employed –or–
    • Not employed by a 501(c)(3) organization, but functioning as a minister in their daily responsibilities with their employer, such as a chaplain for a state-run prison

I.R.C. § 403(b)(1)(A); 26 C.F.R. § 1.403(b)-2(b); I.R.S. Maintaining Eligibility to Sponsor a 403(b) Plan.

501(c)(3) Organizations

All 501(c)(3) organizations must be organized and operated exclusively for a purpose that is:

  • Charitable
  • Religious
  • Educational
  • Scientific
  • Literary
  • For public safety testing
  • For fostering national or international amateur sports competition –and/or–
  • For preventing cruelty to children or animals

I.R.C. § 501(c)(3).

Other 501(c)(3) organization requirements are that none of its earnings may inure to any private shareholder or individual, and the entity may not attempt to influence legislation as a substantial part of its activities nor participate in any campaign activity for or against political candidates. In addition, assets of the organization must be permanently dedicated to an exempt purpose and, upon dissolution, the assets must be distributed for a charitable purpose. 26 C.F.R. § 1.501(c)(3).

Most 501(c)(3) organizations (or their parent organizations) are required to have an IRS determination as to their status. There is an exception for filing for church and related organizations (and other I.R.C. § 508 excepted organizations) and entities organized before October 9, 1969. An online search tool providing a list of organizations with determination letters can be found on the IRS website at EO Select Check. Information regarding the application process is available in I.R.S. Publication 557, Tax Exempt Status for Your Organization.

A cooperative hospital service organization described in I.R.C. § 501(e) is treated as if it were a 501(c)(3) organization if it is organized and operated solely to perform on a centralized basis certain services for two or more tax-exempt or governmental hospitals. Rev. Rul. 72–329, 1972–2 C.B. 226.

Public School Systems

A public school system eligible to adopt a 403(b) plan is a state-sponsored educational organization that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. Included in this category are employees of public schools and state colleges or universities. 26 C.F.R. § 1.403(b)-2(b)(14).

The employer must be a state, a political subdivision of a state, or an agency or instrumentality of one of these. I.R.C. 403(b)(1)(A)(ii). Implementing regulations interpret “state” to include the District of Columbia and Indian tribal governments as provided under I.R.C. § 7871(a)(6)(B). 26 C.F.R. § 1.403(b)-2(b)(20).

Both faculty and nonacademic staff (e.g., custodial staff) performing services for the educational organization may be covered by the 403(b) plan, but elected or appointed officials (holding positions in which persons that are not education professionals may serve) are not eligible. Members of the school board and university regents or trustees are not eligible. 26 C.F.R. § 1.403(b)-2(b)(10). Additional guidance on this issue may be found in the I.R.S. 403(b) Plan Fix-It Guide.

Employers Not Permitted to Adopt 403(b) Plans

Adoption of a purported 403(b) plan by an organization not qualified to adopt one is a common violation of the I.R.C. § 403(b) rules. Correction under the IRS EPCRS program (discussed below) can preserve the tax-deferred status of contributions made prior to the discovery of ineligibility.

When analyzing employer eligibility, several special situations should be considered:

  • Non-501(c)(3) organizations, even if tax exempt. Only a 501(c)(3) organization can adopt a 403(b) plan. Organizations that are tax exempt under another subparagraph of I.R.C. § 501(c) are not eligible employers. Examples of ineligible employers are trade associations exempt under I.R.C. § 501(c)(6) and unions exempt under I.R.C. § 501(c)(5).
  • Governmental organizations other than public school systems. A governmental organization can adopt a 403(b) plan only if it is a public school system, as described above, with the following exceptions:
    • A governmental organization that is also a 501(c)(3) organization can maintain a 403(b) plan. An organization affiliated with government may qualify for I.R.C. § 501(c)(3) exemption if it is separately incorporated or formed to accomplish one or more exempt purposes. For example, a public hospital may receive 501(c)(3) status. However, an organization may not
      obtain 501(c)(3) status if it has governmental regulatory or enforcement powers that would be beyond those permitted by an organization described in I.R.C. § 501(c)(3).
    • A governmental organization can have mixed functions. For example, a prison would not normally be a public school, and therefore could not maintain a 403(b) plan for its employees. However, employees of the education section of a prison (designed to provide educational opportunities to prisoners) could participate in a 403(b) plan. I.R.S. General Couns. Memo. 38666 (Mar. 27, 1981).
  • Nonqualifying affiliates of a 403(b) plan authorized entity. An affiliate of an organization authorized to maintain a 403(b) plan cannot participate in the plan unless the affiliate also would be an eligible employer. For example, it is common for a private university described in I.R.C. § 501(c)(3) to own a taxable technology start-up to engage in commercialization of
    university-based research. Even though the technology company is wholly owned by the university, and its earnings are paid as dividends to the university, employees of the technology company cannot participate in a 403(b) plan. To the extent that some employees may divide their time between the university and its taxable affiliate, only their compensation from the
    university can be counted for purposes of the 403(b) plan.

ERISA Coverage of 403(b) Plans

Most private employer-sponsored 403(b) plans are subject to the Employee Retirement Income Security Act (ERISA), which has several requirements that parallel rules for qualified defined contribution and qualified defined benefit plans under the Internal Revenue Code, but don’t otherwise directly apply to 403(b) plans, including:

  • Vesting rules under ERISA § 203(a)(2)(B) (29 U.S.C. § 1053(a)(2)(B)) and I.R.C. § 411(a)(2)(B)
  • Asset transfer rules under ERISA § 208 (29 U.S.C. § 1058) and I.R.C. § 414(l)
  • Qualified joint and survivor annuity rules under ERISA § 205 (29 U.S.C. § 1055) and I.R.C. § 401(a)(11)
  • Anti-cutback rules as applied to transfers under ERISA § 204(g) (29 U.S.C. § 1054(g)) and I.R.C. § 411(d)(6)

So, 403(b) plans that are subject to ERISA must also comply with these rules as well as ERISA’s reporting and disclosure requirements, and—perhaps more significantly—such 403(b) plan sponsors are subject to ERISA’s fiduciary and prohibited transaction rules, unless an exemption applies.

For further information on ERISA reporting requirements, see Dep’t of Labor Field Assistance Bulletin 2009-02 (July 20, 2009) and Field Assistance Bulletin 2010-01 (Feb. 17, 2010) (hereinafter, FAB 2010-01).

ERISA fiduciary status may be a particular area of concern in light of recent litigation targeting several university 403(b) plans asserting breaches of fiduciary duty. E.g., Vellali, et al. v. Yale University, et al. 3:16-cv-01345 (D. Conn.), Sacerdote, et al. v. New York University 1:16-cv-06248 (S.D.N.Y.); Sweda, et al. v. The University of Pennsylvania, et al. 2:16-cv-04329 (E.D. Pa.); Clark, et al. v. Duke University, et al. 1:16-cv-1044 (M.D.N.C.); Munro, et al. v. University of Southern California, et al. 2:16-cv-06191 (C.D. Cal.).

Sponsor-Based Exemptions from ERISA Coverage

The ERISA rules do not apply to governmental plans or nonelecting church plans, which are generally exempt from ERISA. (Church plans may elect to be covered by ERISA.) ERISA § 4(b)(1), (2) (29 U.S.C. § 1003(b)(1), (2).

Non-ERISA 403(b) Plans

An exemption from ERISA Title I (governing reporting and disclosure, participation and vesting, funding, and fiduciary requirements) is available even for 403(b) plan sponsors that are subject to ERISA if the arrangement meets certain requirements that minimize employer involvement (non-ERISA 403(b) plans). A non-ERISA 403(b) plan is a program with limited employer involvement that provides for the purchase of annuity contracts or custodial accounts invested solely in mutual funds that is not recognized as an ERISA § 3(2)(A) employee pension benefit plan because it is not treated as “established or maintained by an employer.” 29 C.F.R. § 2510.3-2(f); see Dep’t of Labor Field Assistance Bulletin 2007-02 (July 24, 2007) (hereinafter, FAB 2007-02); FAB 2010-01.

Department of Labor (DOL) regulations provide safe harbor rules for non-ERISA 403(b) plans. To qualify for the safe harbor, the 403(b) plan must satisfy the following requirements:

  • Voluntary participation. Participation in the plan must be completely voluntary for employees.
  • Employee enforceability. All rights under the arrangement are enforceable solely by the employee, a beneficiary of the employee, or an authorized representative of the employee or beneficiary.
  • Restricted employer involvement. The sole involvement of the employer must be limited to the following activities:
    • Permitting annuity contractors (including any agent or broker who offers annuity contracts or who makes available custodial accounts) to publicize their products to employees
    • Requesting information concerning proposed funding instruments or annuity contractors
    • Summarizing information on funding instruments or annuity contractors for employee review and analysis
    • Collecting contributions as required by salary reduction agreements or by agreements to forego salary increases, remitting such contributions to annuity contractors, and maintaining records of such amounts (i.e., no employer contributions are permitted)
    • Holding in the employer’s name one or more group annuity contracts (including the right to act as an employee representative for contract amendments)
    • Limiting the funding instruments made available to employees, or the annuity contractors who may approach employees, in a manner designed to afford employees a reasonable choice in light of all relevant circumstances (described further below)
  • No employer compensation. The employer receives no direct or indirect consideration or compensation, in cash or otherwise, except reasonable compensation to cover expenses properly and actually incurred in the performance of its duties pursuant to the salary reduction agreements or agreements to forego salary increases.

29 C.F.R. § 2510.3-2(f).

The circumstances that may be considered by an employer desiring to limit the non-ERISA 403(b) plan funding media or products or annuity contractors include (but are not limited to):

  • The number of employees affected
  • The number of contractors who have indicated interest in approaching employees
  • The variety of available products
  • The terms of the available arrangements
  • The administrative burdens and costs to the employer
  • The possible interference with employee performance resulting from direct solicitation by contractors

Id.

Note that the non-ERISA 403(b) plan safe harbor covers only arrangements that are limited to employee elective deferrals. There can be no employer contributions of any kind. 29 C.F.R. § 2510.3-2(f)(3)(iv). The DOL has provided guidance on other issues concerning the safe harbor, as discussed in the following sections.

Employer Administrative Reviews Permitted for Non-ERISA 403(b) Plans

Certain employer activities designed to ensure that a 403(b) plan continues to be tax compliant under I.R.C. § 403(b) are permissible activities that will not take a non-ERISA 403(b) plan out of the safe harbor. This is because employers have an interest separate from acting as their employees’ authorized representatives in ensuring that the 403(b) plan’s annuity contracts and custodial accounts are tax compliant. Specifically, for example, the employer can be liable to the IRS for potentially substantial penalty taxes, correction fees, and employment taxes on employee salary deferrals for noncompliance, even if the violation was caused by an employee or annuity contractor. Thus, an employer’s compliance monitoring activities are consistent with the safe harbor (including in correcting errors). FAB 2007-02; FAB 2010-01; Dep’t of Labor Information Letter (Feb. 27, 1996).

However, to clearly indicate the employer’s limited involvement in the plan, where the written plan document allocates responsibility for performing administrative functions to persons other than the employer, the relevant document(s) should identify the parties that are responsible for administrative functions, including those related to tax compliance. The documents should delineate the employer’s limited role in the activity and allocate discretionary determinations to the annuity provider or participant or other third party selected by the provider or participant. FAB 2007-02; FAB 2010-01.

Impermissible Employer Discretion in Non-ERISA 403(b) Plans

If the employer exercises discretion in administering the plan, it may be deemed to have taken over control as the plan sponsor, resulting in the loss of ERISA Title I exemption (unless it is a governmental or nonelecting church plan, exempt from Title I requirements). Such prohibited exercises of discretion include determinations authorizing, directly or indirectly through a third-party administrator:

  • Administering distributions, including hardship distributions, domestic relations orders, and processing participant loans
  • Satisfying applicable qualified joint and survivor annuity requirements –or–
  • Plan-to-plan transfers or contract exchanges

FAB 2007-02; FAB 2010-01; Dep’t of Labor Adv. Op. 94-30A (Aug. 19, 1994).

Thus, maintaining a non-ERISA 403(b) plan’s exemption from ERISA is practical only if the annuity and/or custodial account providers are willing to take on the bulk of administrative duties under the plan, and the employer is willing to concede control of most plan functions to them. As discussed below, this can lead to compliance issues because each vendor is typically unaware of what other vendors are doing.

Qualification Requirements

The following sections outline the qualification rules for all 403(b) plans to be eligible for tax-favored status under 26 C.F.R. § 1.403(b)-3:

  • Funding restrictions
  • Written document requirement
  • Nondiscrimination rules
  • Contribution and benefit rules and limitations
  • Rollover distribution requirements
  • Required minimum distribution rules
  • Nontransferability rule

These rules are separate from any requirements under ERISA, which would also apply to 403(b) plans that are subject to ERISA (see the discussion in the previous section, ERISA Coverage of 403(b) Plans, regarding non-ERISA 403(b) plans). See 403(b) Plan Distributions for further discussion on distribution requirements.

Funding Restrictions

There are only three categories of funding arrangements that can be used for a 403(b) plan:

  • Annuity contracts (26 C.F.R. §§ 1.403(b)-2(b)(2), -8(c)). Generally, 403(b) plan annuity contracts must be issued by a state-regulated insurance company and offer an annuity form of benefit.
  • Custodial accounts (I.R.C. § 403(b)(7) and 26 C.F.R. § 1.403(b)-8(d)). These are separate accounts that must be held by a financial institution described in I.R.C. § 401(f)(2) and:
    • Be invested solely in mutual funds
    • Comply with the 403(b) plan distribution limitations (described under 403(b) Plan Distributions below)
    • Be operated for the exclusive purpose of providing benefits for participants or their beneficiaries –and–
    • Meet the rules in 26 C.F.R. § 1.403(b)-8(d)(2) regarding distribution limitations
  • Church retirement income accounts (I.R.C. § 403(b)(9) and 26 C.F.R. § 1.403(b)-9). Church sponsors of 403(b) plans may use retirement income accounts to fund plan benefits, which allow for increased investment flexibility. They must:
    • Be maintained under a separate accounting
    • Limit benefits only to gains or losses on invested assets
    • Be operated for the exclusive purpose of providing benefits for participants or their beneficiaries

26 C.F.R. § 1.403(b)-8.

Unlike a qualified plan, a 403(b) plan (other than certain grandfathered self-insured state and local government 403(b) plans or a church retirement income account) cannot be funded through a trust that holds stocks, bonds, or other investments. See 26 C.F.R. §§ 1.403(b)-8(c)(3), -9.
The 403(b) plan must specify which specific contracts will be available under the plan. The issuers of such contracts are known as approved vendors.

Written Document Requirement

A 403(b) plan must be documented in a written defined contribution plan that satisfies certain regulatory requirements and be operated in compliance with the plan. Specifically, the written plan document must set forth all the material terms and conditions regarding the following:

  • Eligibility
  • Contributions and benefits
  • Contribution limitations
  • Contracts available under the plan (approved vendors) –and–
  • Time and form of benefit distributions (including rules for rollover and required minimum distributions)

26 C.F.R. § 1.403(b)-3(b)(3)(i).

The plan also may set forth certain optional features that are consistent with but not required under I.R.C. § 403(b). These include:

  • Hardship withdrawals
  • Plan loans
  • Plan-to-plan transfers (or from annuity contract to annuity contract) –and–
  • Acceptance of rollovers to the plan

Id.

As provided in the final regulations, the existence of a written plan facilitates the allocation of plan responsibilities among the employer, the issuer of the contract, and any other parties involved in implementing the plan. Without such a central document for a comprehensive summary of responsibilities, there is a risk that many of the important responsibilities required under the statute and final regulations may not be allocated to any party. Failure to adopt a written plan document, or to follow its terms, is a common plan defect that is correctable under the IRS EPCRS program. See Correcting 403(b) Plan Errors.

Multiple Documents

The written plan document can consist of more than one document. That is, plans are permitted to incorporate other documents, such as annuity contracts and custodial agreements. 26 C.F.R. § 1.403(b)-3(b)(3)(ii).

Considerations for Non-ERISA 403(b) Plan

Consider advising a tax-exempt employer that wishes to maintain non-ERISA 403(b) plan status to exclude from its written plan document any provisions concerning hardship withdrawal distributions, loans, plan-to-plan transfers, and acceptance of rollovers. Employer involvement in those activities can jeopardize the non-ERISA 403(b) plan status. These provisions may appear instead in the annuity contract, custodial account agreement, or other ancillary document prepared by the third party administering the relevant aspect of the arrangement. Under the safe harbor rules, the employer could presumably limit the funding media or products available to employees, or the annuity contractors who may approach employees, to ones that agreed to include and administer such provisions. 29 C.F.R. § 2510.3-2(f)(3)(vii); FAB 2007-02.

Model Language

The IRS has provided model language for 403(b) plans designed to satisfy requirements under I.R.C. § 403(b) for public school sponsors, which can be modified for other types of eligible employers. Rev. Proc. 2007-71, 2007-2 C.B. 1184 (see March 2015 revised version available on the IRS website). See also the section entitled “Pre-approved 403(b) Plans,” under Implementation and Operation below.

Nondiscrimination Rules

The section 403(b) nondiscrimination rules are designed to ensure that coverage under a 403(b) plan does not discriminate in favor of highly compensated employees. Church-sponsored 403(b) plans are exempt from these rules. I.R.C. § 403(b)(1)(D). Their application to other plans depends on whether the plan is maintained by a government or a private employer:

  • Governmental and private employer plans are subject to the universal availability rule for elective deferrals.
  • Private employer plans are also subject to similar nondiscrimination rules as defined contribution and defined benefit plans qualified under I.R.C. § 401(a).

Universal Availability for Elective Deferrals

Plans of governments and private employers (but not churches) that permit elective deferrals under their 403(b) plans must make them available to all employees, subject to the exceptions for excludable employees noted below. This is the case even if the employee has not met the plan’s age and service requirements for employer contributions. I.R.C. § 410(b)(12)(A)(ii); 26 C.F.R. § 1.403(b)-5.

Aggregation rules are as follows:

  • Individual 501(c)(3) organizations are treated separately, even if related to other 501(c)(3) entities.
  • Government employers are aggregated if they are part of a common payroll.
  • If an employer has historically treated geographically distinct units as separate for employee benefit purposes, then such units can be treated separately for universal availability but only if the unit is run independently on a day-to-day basis. An exception to this exception applies to units within the same Standard Metropolitan Statistical Area.

26 C.F.R. § 1.403(b)-5(b)(3).

Excludable Employees

Certain employee groups may be excluded (on a universally basis) from participation in a 403(b) plan without violating the universal availability rule:

  • Any employee not willing to contribute more than $200 per year
  • Employees who work less than 20 hours per week or any lower number stated in the plan document (I.R.C. § 403(b)(12)(A) (ii)), but only if:
    • The employer expects the employee to work fewer than 1,000 hours for the 12 months beginning on the date of hire, and
    • The employee does work fewer than 1,000 hours in each subsequent plan year (or, if the plan so provides, each subsequent 12-month period) thereafter
  • Employees eligible to make salary deferral contributions to another 403(b), government 457(b), or 401(k) plan of the employer
  • College work-study students described in I.R.C. § 3121(b)(10) –and–
  • Nonresident aliens with no U.S. source income

I.R.C. § 403(b)(12)(A); 26 C.F.R. §§ 1.403(b)-5(b)(3)(i), -5(b)(4)(ii).

Universal availability rule compliance is an issue for many 403(b) plans. For example, a school often hires substitute teachers whose work schedule is unpredictable. The employer may initially not permit elective deferrals based on an expectation they will work less than 20 hours per week and will not exceed 1,000 hours for they year (a permissible exception, as noted above). However, if this is done, the employer needs to carefully track actual hours to ensure that a substitute that ceases to qualify for an exempt category is given the opportunity to participate. As an alternative, many employers simply permit all employees, regardless of hours worked, to make elective deferrals.

In the past, several 403(b) plans misapplied the part-time employee exclusion by extending it to employees for any plan years where an employee did not meet the hours threshold during the immediately prior year, even if they had been permitted to contribute to the plan previously. The IRS has offered limited relief for such plans to bring their plans into compliance under the 403(b) remedial amendment period if they timely amend the plan in accordance with the transition relief and operate the plan in a manner compliant with the once-in-always-in rule for exclusion years beginning on or after January 1, 2019. I.R.S. Notice 2018-95, 2018 IRB LEXIS 617.

Notice Requirement

There is a notice component to the universal availability rule. Employers must provide all eligible employees with an annual notice concerning the opportunity to make salary deferrals to a 403(b) plan offering elective deferrals. The notice must also advise employees how they can make or change the amount designated for salary deferral purposes. I.R.C. § 403(b)(12)(A); 26 C.F.R. § 1.403(b)-5(b)(2).

No Contingent Benefits

Finally, the universal availability rule prohibits 403(b) plans from making an employee’s right to receive any employee benefit contingent on his or her decision to make an employee elective deferral contribution to the 403(b) plan (other than matching contributions, plan loan benefits relating to a deferral amount, or alternative benefits, credits, or cash under a cafeteria plan available in lieu of the 403(b) plan contribution).

Universal Availability Rule Compliance Review

Following are steps for universal availability compliance and monitoring:

  • Review the 403(b) plan document and administrator’s practices and procedures concerning universal availability.
  • Review eligibility rules generally for 403(b) plan compliance. Remember that employers cannot exclude employees based on job classifications, such as visiting professors or adjuncts, student workers or interns, substitute teachers, seasonal or temporary employees, administrative workers, bus drivers, custodial staff, cafeteria workers. Only individuals falling in a permissible excludable class under the terms of the plan can (and must) be excluded.
  • If part-time employees are excluded, establish procedures for determining excludable status and implement periodic testing to ensure the 20-hour-per-week and 1,000-hour-per-year rules continue to be satisfied for all excluded individuals.
  • Ensure the annual notice provides an accurate description of the 403(b) plan eligibility requirements and is distributed each year.

For a thorough discussion of issues relating to universal availability compliance, see the 2015 report by the Employee Plans Subcommittee of the IRS’s Advisory Committee on Tax Exempt and Government Entities (ACT), available at ACT, 2015 Report of Recommendations, pp. 28-38.

Other Nondiscrimination Rules

The plans of private employers, but not governments or churches, are subject to the same as the rules that apply to qualified plans under I.R.C. §§ 401(a)(4) (nondiscrimination in contributions and benefits), 401(a)(17) (compensation limit), 401(m) (matching and after-tax contributions), and 410(b) (minimum coverage). 26 C.F.R. §§ 1.414(c)-5(a)(1).

Unlike the universal availability rule, these nondiscrimination requirements apply on a related-entity basis under the employer aggregation rules of I.R.C. §§ 414(b), (c), (m), and (o), rather than just to the employer maintaining the plan. On their face, I.R.C. §§ 414(b) and (c), which define “controlled group,” apply only to controlled groups of corporations and two or more trades or businesses under common control. However, regulations take the position that these rules apply to tax-exempt organizations as well (other than churches) and provide rules for determining controlled group status in the case of tax-exempt organizations. 26 C.F.R. §§ 1.414(c)-5(a)(4), -5(b)(3).

Contribution and Benefit Rules and Limitations

Benefits under a 403(b) plan are based on contributions made and earnings thereon. The written plan document must specify the types of contributions allowed. 403(b) plan contributions are also subject to limitations, like other qualified plans. In the case of a private employer, such contributions must satisfy certain nondiscrimination requirements, as discussed in the previous section. As with employer contributions under a qualified plan, employer contributions, including those made by the employee under a salary reduction agreement, and earnings are not included in the employee’s income until distributed (except for after-tax and Roth contributions). I.R.C. § 403(b)(1).

A 403(b) plan can permit any or all of the following types of contributions, but the plan must specify which types are permitted:

  • Elective deferrals
  • Employer contributions (including matching, discretionary, and/or mandatory contributions)
  • Roth contributions
  • After-tax contributions
  • Rollover contributions

Each of these are described in the 403(b) Plan Contributions section below. A 403(b) plan may also provide for automatic enrollment. I.R.C. § 414(w).

Contribution Limits

Similar to contributions under 401(k) plans, contributions to 403(b) plans are subject to:

  • Maximum annual limits under I.R.C. § 402(g) on elective deferrals and Roth contributions
  • Maximum annual additions under I.R.C. § 415 on all types of contributions (other than rollovers)

Annual Limit on Elective Deferrals and Catch-Up Contributions

Elective deferral limit. The normal annual limit on elective deferrals plus contributions under an eligible Roth contribution program to a 403(b) plan is determined under the I.R.C. § 402(g) threshold, as adjusted for inflation ($18,000 in 2017), the same limit that applies to elective contributions under a 401(k) plan. I.R.C. §§ 402(g)(1)(A), 402A(c)(2); 26 C.F.R. § 1.403(b)-3(c). See the paragraph captioned “One-time election to exceed 402(g) limit” in the above discussion of elective deferrals for a special rule allowing a new 403(b) plan participant to exceed the annual limit. I.R.C. §§ 402(g)(3), 403(b)(12).
Timing rules for the return of any excess deferral resulting from a failure to comply with the elective deferral limit are found in 26 C.F.R. §§ 1.403(b)-4(f)(4).

Catch-up contribution rules. There are two catch-up contribution opportunities for eligible employees to increase the elective deferral limit for a year:

  • Age 50 catch-up –and–
  • 15-years-of-service catch-up

Age 50 catch-up contribution. If permitted by the 403(b) plan, employees who are age 50 or over at the end of the calendar year can also make catch-up contributions up to the statutory catch-up limit under I.R.C. § 414(v), as adjusted for inflation ($6,000 in 2017). The amount cannot exceed the employee’s compensation for the year. I.R.C. § 414(v); 26 C.F.R. § 1.403(b)-4(c)(2).
If an employee covered by a 403(b) plan is also covered by a 401(k) plan (or a simplified employee pension or SIMPLE retirement account), the plans are combined in applying the annual limit on elective deferrals and the age-50 catch-up limit. 26 C.F.R. § 1.402(g)-1(b).

15-years-of-service catch-up contribution. A special rule for 403(b) plans under I.R.C. § 402(g)(7) allows plans to provide for a separate catch-up right for employees having at least 15 years of service with a:

  • Public school system
  • Hospital
  • Home health service agency
  • Health and welfare service agency
  • Church –or–
  • Convention or association of churches (or associated organization)

26 C.F.R. § 1.403(b)-4(c)(3)(ii).

If permitted under the plan, this catch-up rule increases the annual limit otherwise applicable by the least of:

  • $3,000
  • $15,000, reduced by the amount of additional elective deferrals made in prior years under this rule
  • $5,000 times the number of the employee’s years of service for the organization, minus the total elective deferrals made for
    earlier years –or–
  • The participant’s compensation for the year (as defined in 26 C.F.R. § 1.403(b)-2)

26 C.F.R. § 1.403(b)-4(c)(3)(ii).

Special rules for determining years of service for this purpose are given in 26 C.F.R. § 1.403(b)-4(e). Several examples applying the catch-up rules are given in 26 C.F.R. § 1.403(b)-4(c). See also I.R.S. Publication 571, Tax-Sheltered Annuity Plans (403(b) Plans), §4.
When both catch-up opportunities are available (because a qualifying individual is age 50 or older by year-end), the employee may utilize both, but regulations require the additional amounts to be applied first to the 15-years-of-service catch-up and then to the age 50 catch-up. 26 C.F.R. § 1.403(b)-4(c)(4).

Due to its complexity and the subsequent introduction of the age-50 catch-up rules, many employers have eliminated the 15-years-of-service catch-up from their 403(b) plans. The I.R.S. 403(b) Plan Fix-It Guide identifies allowing this catch-up to an employee who does not have the required 15 years of full-time service with the same employer as a common plan defect.

Limit on Annual Additions under I.R.C. § 415

The annual additions limit that applies to qualified defined contribution plans also applies to the aggregate of all contributions to a 403(b) plan, other than rollover contributions and age-50 catch-up contributions. I.R.C. § 403(b)(1); 26 C.F.R. § 1.403(b)-4(b).

The limit is the lesser of:

  • The statutory limit, adjusted for inflation under I.R.C. § 415(d) ($54,000 for 2017 limitation years) –or–
  • 100% of includible compensation (as defined in 26 C.F.R. § 1.403(b)-2)

I.R.C. § 415(c)(1); 26 C.F.R. § 1.403(b)-4(b)(2); see also 26 C.F.R. §§ 1.415(b)-1(b)(2), (c) for special application rules relating to 403(b) plans.

It is important to establish a separate account to hold excess contributions to prevent commingling with 403(b) plan-eligible contributions. Failure to do so could taint the tax-qualified status of the entire 403(b) plan. 72 Fed. Reg. 41,136; 26 C.F.R. §§ 1.403(b)-3(b)(2), -4(f).

Special rule for former employee contributions. Where contributions continue for a former employee, the former employee’s compensation for this purpose is based on the amount earned during the most recent year of service for up to the next five taxable years. 26 C.F.R. 1.403(b)-4(d). Thus, it is possible for nonelective employer contributions to a 403(b) plan to continue for up to five years in the case of a retired or terminated participant. See 26 C.F.R. §§ 1.403(b)-3(b)(4), -4(d).

Special rule for Church employees. In lieu of the Section 415 limit, a church employee can choose to use $10,000 a year as the limit on annual additions. This is only useful if the employee’s includible compensation is less than $10,000 and if the total contributions will exceed 100% of the employee’s includible compensation. Moreover, total contributions over the employee’s lifetime under this choice cannot be more than $40,000. See 26 C.F.R. § 1.403(b)-9(b).

Aggregation of contributions under separate plans. Normally, an employee who participates in a 403(b) plan and a qualified defined contribution plan, simplified employee pension, defined benefit plan that provides for employee after-tax contributions, or individual medical benefit account that is part of a pension or annuity plan need not combine contributions made to the 403(b) plan with contributions to the other types of plans for purposes of the Section 415 limit. However, the plans must be combined if the other plan is maintained by a corporation, partnership, or sole proprietorship over which the employee has more than 50% control. I.R.C. § 415(k)(4).

For example, if a tax-exempt organization maintains both a qualified plan and a 403(b) plan, up to the lesser of $54,000 (in 2017) or 100% of compensation could be contributed to each plan. However, if a doctor employed by a tax-exempt hospital also has a qualified plan for his or her own private medical practice, the 403(b) plan of the hospital would have to be combined with the qualified plan of the private medical practice in applying the limit.

Incidental Benefit Rule

Requirements imposed on qualified plans under 26 C.F.R. § 1.401-1(b)(1)(ii) regarding the extent to which incidental life or accident or health insurance benefits may be provided as plan benefits also apply to 403(b) plans. 26 C.F.R. §§ 1.403(b)-3(a)(8), -6(g).

Nonforfeitability/Vesting

In theory, contributions under a 403(b) plan must be nonforfeitable. 26 C.F.R. § 1.403(b)-3(a)(2). As a practical matter, though, there is a workaround build into the regulations whereby forfeitable contributions are treated as not having been made to the 403(b) plan, but rather to a separate I.R.C. § 403(c) annuity (or a tax-exempt employee trust where a custodial account is used), when they are made. (Forfeitable contributions are required to be kept in a separate bookkeeping account than nonforfeitable contributions.) Then, as amounts become vested, and assuming all of the 403(b) plan conditions (other than nonforfeitability) are met for those contributions, those amounts are retroactively treated as having been made to the 403(b) plan for purposes of the maximum limits on contributions when they become nonforfeitable. 26 C.F.R. § 1.403(b)-3(d)(2).

In this way, many 403(b) plans subject employer matches, employer discretionary contributions, and/or employer mandatory contributions to a vesting schedule (vesting for employee elective deferrals would be permissible in non-ERISA 403(b) plans, but is highly unusual).

For example, a plan might provide that an employee would be 20% vested after two years, 40% after three years, 60% after four years, 80% after five years, and 100% (nonforfeitable) after six years. If an employee left after two years with an employer contribution account balance of $5,000, the employee would receive only $2,000. The remaining $3,000 in the account would, depending on the plan terms, be used for plan administrative expenses, divided among the accounts of other employees, or used to reduce future employer contributions.
To avoid participants becoming immediately subject to taxation upon a termination of the plan, however, a 403(b) plan that allows for any type of forfeitable contribution should provide for automatic full vesting upon plan termination (as would be mandatory for a traditional qualified plan).

Vesting Requirements for Plans Subject to ERISA

For 403(b) plans that are subject to ERISA, any vesting schedule must be at least as favorable as is required under ERISA. Thus, such 403(b) plans can subject employer contributions to three-year cliff vesting or six-year graded vesting, as described in the example given above (or more liberal vesting schedules). ERISA § 203(a)(2)(B) (29 U.S.C. § 1053(a)(2)(B)) (parallel provisions under I.R.C. § 411(a)(2)(B)).

Rollover Distribution Requirements

If a participant or beneficiary in a 403(b) plan is entitled to a distribution from the plan, the plan must give the participant or beneficiary the option to have the amount directly transferred to another plan rather than being paid to the participant or beneficiary. The qualified plan rollover rules under I.R.C. §§ 401(a)(31) and 402(c) and (f) apply (other than inherited IRA rules). Thus, 403(b) plan rollovers may be made to qualified plans, other 403(b) plans, and eligible governmental 457(b) plans (including to designated Roth accounts) as well as to I.R.C. § 403(a) annuity plans and traditional and Roth IRAs. I.R.C. § 403(b)(8), (10); 26 C.F.R. §§1.403(b)-3(a)(7), -7(b).

The qualified plan automatic cashout rules also apply, so if a plan calls for certain small benefits in excess of $1,000 to be paid to a participant without the participant’s election, the amount must be automatically directly transferred to an IRA unless the participant elects to the contrary. See I.R.C. § 401(a)(31).

Note that although rollovers out of the plan are required, accepting rollovers into a 403(b) plan is not.

Required Minimum Distributions

A 403(b) plan is treated as an individual retirement plan for purposes of satisfying the required minimum distribution (RMD) rule sunder I.R.C. § 401(a)(9). 26 C.F.R. §§ 1.403(b)-3(a)(6), -6. Special rules of application for 403(b) plans, including treatment of grandfathered benefits accruing before 1987, are found in 26 C.F.R. § 1.403(b)-6(e). Generally, 403(b) plan annuity contracts are treated like individual retirement accounts for purposes of the RMD rules. For further information on RMDs, see Employee Benefits law § 3A.02[m].

Nontransferability

Except in the case of a contract issued before January 1, 1963, 403(b) plan contracts must be nontransferable. Thus, an employee could not sell the contract to a third party. I.R.C. § 401(g); 26 C.F.R. § 1.403(b)-3(d)(2). Nor can a creditor of the employee seize the contract as payment for a debt, even in a bankruptcy situation. 11 U.S.C. § 541(b)(7). Special rules relating to the exchange of annuity contracts within a 403(b) plan and plan-to-plan transfers are considered in the discussion on distributions further below.

403(b) Plan Contributions

This section describes the different types of contributions permitted under a 403(b) plan.

Elective Deferral Contributions

Similar to 401(k) plan deferrals, these contributions to a 403(b) plan are made under a salary deferral agreement on a pre-tax basis and reduce the income shown on the employee’s Form W 2. I.R.C. §§ 402(e)(3), 403(b)(1)(E), 402(g)(3)(C). For example, if an employee whose salary is $50,000 gross contributes $5,000 to the 403(b) plan as an elective deferral, the wages reported on the Form W 2, Box 1, will be $45,000 rather than $50,000.

403(b) plan elective deferrals are subject to the following rules:

  • Annual limit. 403(b) plan elective deferrals are subject to the same annual limit as for 401(k) plans, determined on an aggregate basis for the individual, including the additional amounts for catch-up contributions, discussed further below. I.R.C. § 402(g).
  • One-time election to exceed 402(g) limit. A special rule allows plans to let an employee make a one-time irrevocable election at the time of initial eligibility in a 403(b) plan to contribute without regard to the elective deferral limitation. I.R.C. §§ 402(g) (3), 403(b)(12); I.R.S. Rev. Rul. 2000-35, 2000-2 C.B. 138.
  • Social Security/Medicare taxes apply. Like elective deferrals to a 401(k) plan, elective deferrals to a 403(b) plan are subject to applicable Social Security and Medicare taxes. I.R.C. § 3121(a)(5)(D).
  • Additional tax relief for retired public safety officers. While elective deferrals and earnings thereon from a 403(b) plan are generally all taxable when distributed. However, eligible retired public safety officers may use a distribution of up to $3,000 made directly from a 403(b) plan to pay premiums on accident, health, or long-term care insurance, without including the amount in taxable income. The premiums can be for the employee or the employee’s spouse or dependents. I.R.C. § 402(l) (3)(B).

Employer Contributions

A 403(b) plan may provide for employer matching, discretionary, or mandatory contributions. I.R.C. § 403(b)(1), (7). However, a 403(b) plan that provides for employer contributions cannot be a non-ERISA 403(b) plan. 29 C.F.R. § 2510.3-2(f)(3)(iv). Several types of employer contributions are possible:

  • Employer matching contributions. For matching contributions, the plan states the formula for matching contributions made by the employer based on the amount of the employee’s elective deferrals. For example, the employer may contribute an amount equal to 50% of elective deferrals (or, in some cases, elective deferrals and after-tax contributions). Typically, the
    match will be subject to a cap (e.g., that only contributions equal to the first 6% of an employee’s compensation will be matched).
  • Employer discretionary matching contributions. With a discretionary match, the employer decides how much to contribute toward the match. However, the plan terms must specify how the match is to be divided among employees. For example, it could specify that the match would not apply to contributions that exceeded the first 6% of an employee’s compensation, but
    that the percentage match would depend on the amount the employer chose to contribute for that year.
  • Employer discretionary contribution. With a discretionary contribution, the plan could specify that the employer may decide each year how much to contribute to the 403(b) plan, but the plan terms must set forth how the amount is to be allocated among employees (e.g., in proportion to compensation).
  • Employer mandatory contributions. With a mandatory contribution, the plan document states the amount to be contributed by the employer. For example, an employer may contribute to the 403(b) plan 5% of employee compensation each year.
  • Special rule for former employees. Subject to the limits in 26 C.F.R. § 1.403(b)-4(d), an employer may continue to make contributions on behalf of a former employee for up to five years after the year employment ends.

After-tax Employee Contributions

After-tax employee contributions do not give the employees an immediate tax benefit. However, earnings on the contributions are tax deferred until distributed from the plan, which could positively affect investment returns. I.R.S. 403(b) Plan Basics.

Roth Contributions

A 403(b) plan is recognized as an applicable retirement plan that may include a qualified Roth contribution program. I.R.C. § 402A(b), (e)(1)(B). Thus, 403(b) plans may allow employees to make elective Roth contributions. These contributions must be maintained separately from pre-tax and after-tax elective contributions and, like after-tax contributions, are treated as an elective deferral, but are not excludable from the employee’s gross income. However, for qualified distributions made from a Roth account, the earnings on the contributions are tax free, not merely tax deferred as for pre-tax or after-tax contributions. I.R.C. § 402A(d)(1); 26 C.F.R. § 1.403(b)-3(c) (incorporating rules under 26 C.F.R. § 1.401(k)-1(f)(1), (2)).

To be a qualified Roth distribution, the distribution from the 403(b) plan must be made, and must be:

  • Made at least five years after the employee first contributes to the Roth account –and–
  • Meet one of the following criteria:
    • Occur on or after the date the employee becomes age 59½
    • Be made to a beneficiary, or to the employee’s estate, after the death of the employee
    • Be attributable to the employee’s being disabled (as defined under I.R.C. § 72(m)(7)) –or–
    • Be used to pay for qualified first-time homebuyer expenses (as defined under I.R.C. § 72(2)(F))

I.R.C. § 402A(d)(2).

Rollover Contributions

A 403(b) plan can (but is not required to) permit rollovers from:

  • A qualified plan
  • Another 403(b) plan
  • A governmental 457(b) plan –or–
  • An IRA from which an employee is receiving a distribution

I.R.C. § 402(c)(1), (8).

Such rollovers continue the tax deferral on the amounts from the other plan. Id.

403(b) Plan Distributions

This section describes 403(b) plan distribution rules, describing when benefit distributions are generally permitted and special distributions rules for plan terminations, domestic relations orders, and plan loans. Certain permitted exchanges and transfers that are not treated as distributions are also discussed.

General Distribution Restrictions

A 403(b) plan’s distribution provisions must limit distributions to take into account limitations under I.R.C. § 403(b)(10) similar to defined contribution qualified plans. Certain distributions that are permitted will give rise to penalties on the plan participant. A plan may, but is not required to, limit distributions to avoid penalties on the participant.

Generally, a 403(b) plan can permit a distribution to be made only once the employee:

  • Reaches age 59½
  • Has a severance from employment
  • Dies
  • Becomes disabled (within the meaning of I.R.C. § 72(m)(7)
  • Encounters financial hardship, but only for elective deferral contributions (excluding income), as described below –or–
  • Is eligible for a qualified reservist distribution

26 C.F.R. §§ 1.403(b)-6(b) to (d).

26 C.F.R. §§ 1.403(b)-6(b) to (d).

However, the restrictions above do not apply to after-tax contributions. Id. Rollover contributions are also exempt. 26 C.F.R. § 1.403(b)-6(i). Thus, for example, a plan can permit in-service withdrawals of such amounts, even if the employee has not attained age 59½.

Hardship distribution rules. To be a hardship distribution, the same rules apply as under the qualified plan distribution rules. They are only permissible for an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need. The need of the employee includes the need of the employee’s spouse or dependent. IRS regulations provide certain safe harbors under which a distribution will be assumed to meet these tests. 26 C.F.R. § 1.403(b)-6(d)(2); see 26 C.F.R. § 1.401(k)-1(d)(3). For additional compliance information, see Hardship and Unforeseeable Emergency Distribution Checklist.

Distributions Subject to Penalties

As with distributions from qualified plans, two sorts of penalties can apply to distributions from a 403(b) plan, even if the withdrawals are permitted under the plan:

  • 10% additional tax (in addition to normal income taxes) on early withdrawals under I.R.C. § 72(t) –and–
  • Loss of the special tax treatment for Roth contributions distributed within the five-year nonexclusion period under I.R.C. § 402A(d)(2)(B)

Because these limitations apply to the participant, they need not be included in the plan document. However, some plans attempt to limit plan distributions to those that will not give rise to the penalties. The 10% additional tax applies only to the amount of the distribution that is subject to income tax. For example, it would not apply to a distribution to the extent it consisted of after-tax employee contributions, but it would apply to the portion of the distribution that consisted of earnings on those contributions. It also does not apply to the extent that taxes are deferred by rolling the distribution over to another plan. The additional tax applies unless one of the exceptions under I.R.C. 72(t) is met.

For example, a 30-year-old employee could be permitted to take a distribution of elective deferrals from a 403(b) plan upon termination of employment or hardship. However, unless the distribution was rolled over, it would generate normal income taxes plus the 10% additional tax.

Distributions upon Plan Termination

Distributions can be made regardless of the above limitations upon termination of the 403(b) plan. However, if the 403(b) plan contains elective deferrals or is funded through custodial accounts, termination of the plan and the distribution of accumulated benefits is permitted only if the employer (taking into account all entities that are treated as the employer under I.R.C. §§ 414(b), (c), (m), and (o) on the date of the termination) does not make any contributions to any 403(b) plan that is not part of the terminating plan during the period beginning on the date of plan termination and ending 12 months after distribution of all assets from the terminated plan. An exception to this rule exists when less than 2% of eligible employees are eligible under the other 403(b) plan during the restricted period. 26 C.F.R. § 1.403(b)-10(a)(1).

See also Terminating 403(b) Plans below for other issues in terminating a 403(b) plan.

Domestic Relations Orders

The 403(b) regulations include a specific exception to the distribution limitation rules for domestic relations orders. 26 C.F.R. 1.403(b)-10(c). A domestic relations order is defined as any judgment, decree, or order (including approval of a property settlement agreement) that:

  • Relates to the provision of child support, alimony payments, or marital property rights to a spouse, former spouse, child, or other dependent of a participant –and–
  • Is made pursuant to a state domestic relations law (including a community property law)

I.R.C. § 414(p)(9).

A governmental or nonelecting church plan can comply with any domestic relations order (and may be subject to state domestic relations laws regarding distributions). Other plans can comply only if the order is a domestic relations order that meets certain requirements for qualified domestic relations orders (QDROs) under I.R.C. § 414(p) and ERISA § 206(d)(3) (29 U.S.C. § 1056(d)(3)). See Rev. Proc. 2007-71.

Remember that sponsors of non-ERISA 403(b) plans should not conduct any discretionary administration of the plan’s domestic relations order distributions.

Plan Loans

Loans from 403(b) plans are permissible, depending on the facts and circumstances of the loan arrangement, including whether there is a fixed repayment schedule, the reasonability of the interest rate, and the presence of repayment safeguards that a prudent lender would rely on. As for 401(k) plan loan programs, the prohibited transaction exemption requirements under ERISA § 408(b)(1) (29 U.S.C. § 1108(b)(1)) apply for ERISA-governed plans, and tax treatment is governed by I.R.C. § 72(p).

The plan document (or ancillary document) must contain material terms and conditions for the loans and identify the person responsible for administering the program. If the participant fails to repay a 403(b) plan loan, the participant’s account under the plan can be used for repayment similar to other qualified plan loans. 26 C.F.R. § 1.403(b)-6(f); see also 29 C.F.R. § 2550.408b-1 and 26 C.F.R. § 1.72(p)-1.

The taking out of a loan is not treated as an impermissible distribution. A loan that is in default is generally treated as a taxable distribution from the plan of the entire outstanding balance of the loan (a deemed distribution). A deemed distribution is treated as an actual distribution for purposes of determining the tax on the distribution, including any early withdrawal penalty. However, a deemed distribution is not treated as an actual distribution for purposes of determining whether a plan satisfies the limitations on in-service distributions. 26 C.F.R. §§ 1.403(b)-7(d), 1.72(p)-1, Q&A12, 13.

For more information on the rules for qualified plan loans, see Plan Loan Program and Plan Loan Program Checklist.

Exchanges and Transfers Not Treated as Distributions

Subject to applicable requirements, three types of in-service exchanges or transfers, described further in the following sections, are permitted without violating the 403(b) plan distribution (or nontransferability) rules:

  • Contract exchanges
  • Plan-to-plan transfers –and–
  • Asset transfers to governmental plans for purchase of permissive service credit

26 C.F.R. § 1.403(b)-10(b)(1); see also I.R.S. Retirement Plans FAQs regarding 403(b) Tax-Sheltered Annuity Plans.

Such exchanges and transfers are distinguished from rollovers (even direct rollovers from one plan to another). As discussed in the section entitled “Rollover Distribution Requirements” under Qualification Requirements above. Rollovers are available only when a distribution event has occurred. Remember that sponsors of non-ERISA 403(b) plans should not undertake any discretionary actions concerning such exchanges or transfers.

Contract Exchanges

A 403(b) annuity contract or custodial account can be exchanged for (1) another 403(b) contract or custodial account issued by an approved vendor under the same plan that receives plan contributions, or (2) another 403(b) contract or custodial account issued by a vendor that is not expressly authorized by the 403(b) plan terms (an unapproved vendor). However, an unapproved vendor exchange is permitted only if:

  • The 403(b) plan permits exchanges with unapproved vendors
  • The amount of the transferred accumulated benefit after the exchange is at least the same as before the exchange
  • The unapproved vendor’s contract is subject to distribution restrictions at least as stringent as the plan’s terms –and–
  • The 403(b) plan sponsor and the unapproved vendor enter an agreement to share information for tax reporting and plan compliance purposes (including information under 26 C.F.R. § 1.403(b)-10(b)(2)(i)(C))

26 C.F.R. § 1.403(b)-10(b)(2); Rev. Proc. 2007-71.

Plan-to-Plan Transfers

A 403(b) plan may transfer a contract or custodian account to a different employer’s 403(b) plan (e.g., on behalf of transferring employees upon a corporate transaction), subject to the following conditions:

  • The participant whose assets are being transferred is an employee (or former employee) of the employer (or business of the employer) sponsoring the receiving plan (or the assets belong to a beneficiary of such a participant)
  • The terms of both plans allow for such plan-to-plan transfers
  • The amount of the accumulated benefit after the transfer is at least the same as before the transfer
  • The receiving plan imposes distribution restrictions on the transferred assets that are at least as stringent as the transferring plan’s rules –and–
  • If the transferred assets are not the participant’s entire interest in the plan, then the receiving plan treats the amount transferred as a continuation of a pro rata portion of their interest in the transferring plan (e.g., with respect to pre-tax versus after-tax contributions)

26 C.F.R. § 1.403(b)-10(b)(3); Rev. Proc. 2007-71.

Certain Contract-to-Plan Transfers to Governmental Plans

A 403(b) plan may transfer assets held in the plan to an I.R.C. § 414(d) governmental defined benefit plan in three circumstances:

  • Purchase of permissive service credit. A governmental plan that allows participants to make voluntary contributions (in addition to any employee contributions required under the plan) to acquire deemed service credit that will be used for purposes of calculating plan benefits (so-called permissive service credit, described in I.R.C. § 415(n)(3)) may accept such
    additional permissive service credit contributions through the transfer from a 403(b) plan. 26 C.F.R. § 1.403(b)-10(b)(4)(ii)(A). This is an exception from the general rule prohibiting assets transfers between 403(b) plans and plans qualified under I.R.C. § 401(a) or eligible governmental deferred compensation plans under I.R.C. § 457(b). 72 Fed. Reg. 41,132.
  • Repayments of contributions. The assets from a 403(b) plan account can be transferred to a governmental plan where the amount is treated as a repayment of contributions for an amount previously refunded upon a forfeiture of service credit under the plan, as described in I.R.C. § 415(k)(3). 26 C.F.R. § 1.403(b)-10(b)(4)(ii)(B).
  • Rollovers. Participants may choose to roll over any eligible rollover distribution from a 403(b) plan to a governmental defined benefit that accepts rollovers. I.R.C. § 403(b)(8).

Implementation and Operation

To receive and maintain tax-favored treatment, 403(b) plans must comply in form and operation with the requirements described in this practice note. For plan document compliance, employers who adopt prototype and volume submitter pre-approved plans are able to rely on the IRS determination letter program established for pre-approved plans, described below under “Pre-approved 403(b) Plans.“ By contrast, sponsors of individually designed plans have no way to receive IRS blessing on their 403(b) plans, since the IRS decided not to adopt a determination letter program for such plans. See Rev. Proc. 2013-22, 2013-1 C.B. 985.

Adopting a pre-approved plan simplifies 403(b) plan administration for employers since the sponsor of the pre-approved plan is responsible for plan updates, among other things. Individually designed 403(b) plan sponsors must remain vigilant regarding required plan amendments due to changes to the Internal Revenue Code, Treasury Regulations, or other guidance published by the IRS.

All 403(b) plan sponsors (whether directly or via a third-party administrator) must ensure that the day-to-day operational requirements concerning eligibility, nondiscrimination, contributions, funding vehicles, and distributions continue to be satisfied. Non-ERISA 403(b) plan sponsors may take an active role in ensuring compliance (including facilitating corrections of noncompliance) without jeopardizing the plan’s safe harbor status. FAB 2007-02; Dep’t of Labor Information Letter (Feb. 27, 1996).

ERISA Considerations

If ERISA applies to the 403(b) plan (see ERISA Coverage of 403(b) Plans above), the plan must satisfy the disclosure and reporting obligations under ERISA Title I, such as:

  • Providing updated summary plan descriptions and, as needed, summaries of material modifications to participants for amendments
  • Making plan-related documents available
  • Filing Form 5500 annual reports
  • Meeting ERISA fiduciary responsibilities and avoiding prohibited transactions

For a summary of ERISA responsibilities, see ERISA Title I Fundamentals.

Pre-approved 403(b) Plans

The IRS has established a pre-approved 403(b) plan program for prototype and volume submitter plans. The sponsors of such pre-approved plans can obtain opinion or advisory letters on their plan designs, providing reassurance that their plan documents meet the necessary requirements. I.R.S. Announcement 2009-34, 2009-1 C.B. 916. The determination letter application procedures are found in Rev. Proc. 2013-22, as modified by Rev. Proc. 2014-28, 2014-1 C.B. 944, and Rev. Proc. 2015-22, 2015-1 C.B. 2015-11. Rev. Proc. 2019-4, 2019-1 I.R.B. 146.

For more information, see Pre-approved 403(b) Plans. See also IRS, 403(b) Pre-approved Plan Program – Key Provisions. The initial remedial amendment period for 403(b) plans will be March 31, 2020. This means that employers who adopt a pre-approved plan by that date can obtain retroactive relief for qualification defects arising since 2010. Rev. Proc. 2017-18, 2017-5 I.R.B. 743.

After receipt of the favorable opinion or advisory letter from the IRS, the pre-approved plan sponsor for a prototype plan or volume submitter plan must take the steps below to maintain compliance:

  • Amend plan for legal changes. Amend the plan pursuant to changes in the Internal Revenue Code, Treasury Regulations, or other guidance published by the IRS.
  • Document adopting employers. Maintain a written record of the eligible employers that have adopted the prototype plan or volume submitter plan. The list must include the names, addresses, and employer identification numbers of all eligible employers that, to the best of the plan sponsor’s knowledge, have adopted the plan. The plan sponsor must present the list
    to the IRS, if requested.
  • Disclose plan-related documents. Provide to the adopting employers the plan document, any restatements thereof, all amendments, and all opinion or advisory letters, in electronic or hard copy form, and comply with the notice requirements under the program or other written guidance.
  • Adopt notification procedures. Establish a procedure to notify adopting employers of plan amendments and restatements and of the need to timely adopt the plan and any plan restatements and the consequences for failing to do so or failing to operate the plan in accordance with plan changes.
  • Meet obligations upon discovery of noncompliance. Upon determining that a 403(b) preapproved plan as adopted by an employer may no longer satisfy the requirements of 403(b) (in a manner that is not or cannot be corrected by the preapproved plan sponsor under the EPCRS):
    • Notify the employer that the plan may no longer satisfy I.R.C. § 403(b)
    • Advise the employer that it may incur adverse tax consequences –and–
    • Inform the employer about the availability of the EPCRS

Rev. Proc. 2013-12, as modified by Rev. Proc. 2014-28 and Rev. Proc. 2015-22.

Pre-approved Plan Document Must Prevail over Conflicting Investment Arrangement

In the event of any conflict between the terms of the pre-approved plan and the terms of investment arrangements under the plan (or of any other documents incorporated by reference into the plan), the terms of the pre-approved plan must govern. An eligible employer may not rely on an opinion or advisory letter issued for a 403(b) pre-approved plan if any investment arrangement under the plan provides that the terms of the investment arrangement govern in the event of a conflict. Rev. Proc. 2013-12, § 4.01(9).

Limited Reliance

Even for pre-approved plans, however, the opinion or advisory letter addresses whether the plan document complies with I.R.C. § 403(b). It does not address ERISA requirements (if applicable), investment arrangement terms, other documents incorporated by reference, or whether the plan operates in a compliant fashion.

For general information on pre-approved plans, see
Pre-approved Plan Design and Compliance.

Correcting 403(b) Plan Errors

EPCRS for Qualification Errors

The Employee Plans Compliance Resolutions System (EPCRS) is the IRS correction program to address noncompliance issues in tax-favored retirement plans, including 403(b) plans. IRS guidance issued in 2013 substantially expanded the program’s application to 403(b) plans. The most recent iteration of EPCRS is found in I.R.S. Rev. Proc. 2018-52, 2018 IRB LEXIS 524 (effective as of January 1, 2019, updating Rev. Proc. 2016–51, 2016-2 C.B. 466), which incorporates intervening guidance regarding pre-approved 403(b) plans. See IRS, Updated Retirement Plan Correction Procedures for an overview.

The EPCRS can resolve 403(b) plan operational and documentation failures within one of the three EPCRS units:

  • Self Correction Program (SCP)
    • No filing with the IRS or penalty is involved, but the sponsor or administrator must have reasonably designed compliance practices and procedures in place.
    • Available for unintentional (1) operational violations that are either insignificant, or (2) nonegregious significant failures that are timely addressed (generally before the end of the year after the year the violation occurred).
    • Not available for documentation errors.
  • Voluntary Correction Program (VCP)
    • Formal filing with the IRS along with the payment of a penalty is required.
    • Available for (1) documentation errors (i.e., failing to have, or follow the terms of, a compliant plan document), and (2) operational failures.
    • Results in a compliance statement showing IRS approval of proposed correction method.
  • Audit Closing Agreement Program (Audit CAP)
    • Program for plans under IRS audit.
    • Involves negotiated correction of an identified failure and the payment of a sanction varying depending on nature and severity of the error.

Common 403(b) plan errors corrected under SCP include failures to follow the terms of the plan document, to permit eligible employees to make salary deferrals in violation of the universal availability rule, and to comply with the annual addition limits in I.R.C. § 415. The VCP must be used for documentation errors, including to unwind a plan upon discovery that the employer is not eligible to sponsor a 403(b) plan, to correct a plan document that fails to satisfy the applicable requirements, and to correct a failure to follow the plan document or a significant operational failure after the SCP timeliness limit.

Significance of an error is based on the facts and circumstances, taking into consideration factors such as the extent, scope, and duration of the violation, the percentage of plan assets involved and number/percentage of participants affected, the timeliness of correction, and the reason for the failure.

Fiduciary Violations

Common 403(b) plan errors corrected under SCP include failures to follow the terms of the plan document, to permit eligible employees to make salary deferrals in violation of the universal availability rule, and to comply with the annual addition limits in I.R.C. § 415. The VCP must be used for documentation errors, including to unwind a plan upon discovery that the employer is not eligible to sponsor a 403(b) plan, to correct a plan document that fails to satisfy the applicable requirements, and to correct a failure to follow the plan document or a significant operational failure after the SCP timeliness limit.
Significance of an error is based on the facts and circumstances, taking into consideration factors such as the extent, scope, and duration of the violation, the percentage of plan assets involved and number/percentage of participants affected, the timeliness of correction, and the reason for the failure. 71 Fed. Reg. 20135 (April 19, 2006); Dep’t of Labor, Voluntary Fiduciary Correction Program.

General IRS Correction Guidance

The I.R.S. 403(b) Plan Fix-It Guide also serves as a quick reference for practitioners handling potential 403(b) plan mistakes. This guide contains information on how to identify and avoid errors, along with corrective actions. The Guide contains links to other relevant IRS resources on 403(b) plan rules and compliance topics.

Terminating 403(b) Plans

The 403(b) plan regulations explicitly permit employers to terminate their plans. 26 C.F.R. § 1.403(b)-10(a)(1); see also Rev. Rul. 2011-7, 2011-1 C.B. 534 (analyzing the termination of 403(b) plans and an annuity benefit money purchase plan).

In some circumstances, however, plan termination is not possible. As a precondition to termination, all plan assets must be distributed. Id. However, in some cases, plan sponsors cannot distribute some custodial accounts because the participants have not cooperated. The regulation states that “delivery of a fully paid individual insurance annuity contract is treated as a distribution,” but does not refer at all to a custodial account. 26 C.F.R. § 1.403(b)-10(a)(1). And vendors of custodial accounts often take the position that because the contracts are owned by the participants, the plan sponsor has no right to force a distribution of cash without participant consent. In some cases, participants with custodial accounts cannot be cashed out because they cannot be located or refuse to consent to the distribution. This issue was highlighted in ACT, 2015 Report of Recommendations, pp. 43-48.

The inability to terminate a 403(b) plan extends the obligations of the sponsor (e.g., if covered by ERISA, it must continue to file an annual Form 5500). A sponsor that attempts to terminate a plan without fully complying with the rules risks tainting the termination and invalidating any rollover distributions made to participants who would not have had a distribution event were it not for termination of the plan.

EP Subcommittee Report: 403(b) Plan Issues and Recommendations

A 2015 report by the Employee Plans (EP) Subcommittee of the IRS’s Advisory Committee on Tax Exempt and Government Entities (ACT), titled “Employee Plans: Analysis and Recommendations Regarding 403(b) Plans,” analyzes several issues affecting 403(b) plans and their sponsors. ACT, 2015 Report of Recommendations, pp. 15-83. The report identifies specific areas of widespread noncompliance and recommends enhanced IRS formal or “soft” guidance and educational outreach. These areas of concern include the following:

  • Universal availability nondiscrimination rule. As discussed above, many employers, particularly those with many short-term or part-time personnel, struggle over interpreting or implementing the universal availability rule regulations. Others are simply unaware of its existence. But the consequences of noncompliance are severe (disqualification of the plan in its entirety). The subcommittee recommended steps to increase awareness of the rule and singled out employee exclusion rules as an area deserving further clarification.
  • Orphan 403(b) contracts. The 403(b) regulations required written plans to be in place generally by 2010, and for available contract vendors to be listed in the plan documentation. Plan sponsors are also required to coordinate plan administration with the vendors of former contracts via information-sharing agreements if any further contributions were to be made during
    or after 2008. 26 C.F.R. § 1.403(b)-10(b). So-called orphan contracts, issued before 2009 and frozen to new contributions (as described in Rev. Proc. 2007-71) raise some compliance questions not directly addressed in the regulations. For example, there is uncertainty as to whether operational compliance under an employee’s orphan contract could taint the status of his
    or her active 403(b) plan contracts and accounts.
  • 403(b) plan terminations. The EP Subcommittee raised the issue discussed above under Terminating 403(b) Plans wherein some employers intending to terminate a 403(b) plan are unable to because of participant or vendor noncooperation or due to missing participants. Recommendations include further clarification of the current IRS position and, if possible, creation of a good faith or de minimis rule allowing employers to treat their 403(b) plans as terminated.

The EP Subcommittee also had several recommendations to improve the EPCRS program as it relates to 403(b) plans:

  • Expand the SCP to allow corrections of certain plan loan errors.
  • Extend the availability of the DOL’s VFCP Earnings Calculator to compute lost earnings in more circumstances.
  • Develop new VCP schedules focused specifically on common 403(b) plan problems.
  • Consider lower fees for 403(b) plan sponsors due to their nonprofit status.

ACT, 2015 Report of Recommendations, pp. 49–55.

Advantages and Disadvantages of 403(b) Plans

Compared with a qualified plan such as a 401(k) plan, a 403(b) plan has several advantages:

  • Simplicity. Often vendors will fulfill most functions.
  • No nondiscrimination testing required. A 403(b) plan avoids the actual deferral percentage (ADP) test applicable to elective contributions in 401(k) plans and merely requires that elective contributions be universally available. This simplifies testing for the employer and means that highly compensated employees will not have their contributions limited because lower paid employees make low or no contributions.
  • Plan language available. The IRS provides prototype language that can be used directly by preapproved plans and as a guide for individually designed plans.
  • Generous catch-up contributions. Catch-up limitations on elective deferrals are more favorable than for 401(k) plans.
  • Limited excise taxes. Excise taxes on excess contributions apply only if the 403(b) contract is a custodial account described in I.R.C. § 403(b)(7), as opposed to an annuity contract.
  • Excess contributions do not disqualify plan. If excess contributions are made, only the amount in excess of the contribution limits is taxable, as opposed to disqualifying the entire plan due to the separate accounting rules under 26 C.F.R. § 1.403(b)-3.
  • Ability to avoid ERISA for nongovernmental/nonchurch employers. By adopting a non-ERISA 403(b) plan, an eligible 403(b) plan sponsor that would normally be subject to ERISA can avoid ERISA coverage.

Notwithstanding the advantages noted above, 403(b) plans have some disadvantages compared with qualified plans that need to be considered:

  • Employees, particularly those who have not previously worked for tax-exempt or governmental employers, may have less familiarity with 403(b) plans.
  • Hardship withdrawals are available only for elective deferrals themselves, not for income on them as they would be under a 401(k) plan.
  • In-service withdrawals are available for employer contributions only upon attainment of age 59½. This contrasts with a 401(k) plan, which can provide for in-service withdrawals of employer contributions as early as:
    • Five years after the employee begins plan participation –or–
    • Two years after the money is contributed to the plan (Rev. Rul. 1968-24, 1968-1 C.B. 150; Rev. Rul. 71-295, 1971-2 C.B. 184)
  • Some states (e.g., New Jersey and Pennsylvania) impose income taxes on all 403(b) contributions.
  • Fewer providers and more limited types of providers for 403(b) plans may result in relatively higher fees.

This excerpt from Lexis Practice Advisor®, a comprehensive practical guidance resource providing insight from leading practitioners, is reproduced with the permission of LexisNexis. Reproduction of this material, in any form, is specifically prohibited without written consent from LexisNexis.

Preapproved 403(b) Plans
(Posted on November 29, 2018 by )


Go to: What Is a 403(b) Plan?|What Is a Pre-approved 403(b) Plan?|What Are the Advantages of a Pre-approved 403(b) Plan?|What Are the Legal Pitfalls of a Pre-approved 403(b) Plan?|What Operational Issues Can Arise for a Pre-approved Plan?|What Practical Issues Can Arise for a Pre-approved Plan?|When Should an Employer Adopt a Pre-approved 403(b) Plan?|Can the Employer Cure Past Plan Issues by Adopting a Pre-approved 403(b) Plan?|What Should an Employer Do If It Did Not Comply with the Written Plan Document Requirement in the Past?

This practice note discusses pre-approved Internal Revenue Code (I.R.C.) § 403(b) plans (403(b) plans), including their advantages, legal pitfalls, and other issues that an eligible employer may consider when determining whether to convert its existing 403(b) plan into a pre-approved plan. In March 2017, the Internal Revenue Service (IRS) began issuing advisory and opinion letters to the first pre-approved retirement programs described in I.R.C. § 403(b).

This practice note discusses:

For discussion of 403(b) plan requirements, design, and operation, see Section 403(b) Plan Design and Compliance. For discussion of 403(b) plans in general, see Employee Compensation and Benefits Tax Guide P 502, 502.14.

What Is a 403(b) Plan?

A 403(b) plan is a type of retirement plan providing for deferred taxation on certain contributions and earnings made by specific kinds of tax-exempt organizations (primarily, public schools and I.R.C. § 501(c)(3) tax-exempt organizations) for their employees and by certain ministers. I.R.C. § 403(b)(1). 403(b) plans are defined contribution plans, with the exception of certain grandfathered church defined benefit plans. 26 C.F.R. § 1.403(b)-10(f)(1).

For the participant, a 403(b) plan appears much like a 401(k) plan in that it provides for an individual account for each participant (except in the case of grandfathered church defined benefit plans). However, 403(b) plans are funded by an annuity contract with an insurance company, a custodial account, or a retirement income account—as opposed to a trust—and investment options are more limited. In addition, 403(b) plans are subject to some, but not all of the requirements that apply to 401(k) and other retirement plans qualified under I.R.C. § 401(a).

Public schools and universities and I.R.C. § 501(c)(3) nonprofit organizations have for many years maintained 403(b) plans, sometimes referred to as tax-deferred annuities or tax-sheltered annuities. When I.R.C. § 403(b) was enacted, its provisions were fairly simple. However, over time, 403(b) plans have become more complex, both in the types of plans available and in the legal requirements applicable to them. For example, prior to December 31, 2009, 403(b) plans were not subject to the plan document requirement, which was imposed by regulations issued in 2007. 72 Fed. Reg. 41,128 (July 26, 2007) (the effective date of which was delayed by I.R.S. Notice 2009-3, 2009-1 C.B. 250). Today, they resemble the better-known 401(k) plans.

For more information on the I.R.C. requirements applicable to 403(b) plans, see Section 403(b) Plan Design and Compliance.

Requesting IRS Ruling Letters for 403(b) Plans

As the requirements for 403(b) plans have become more complex, employers have often sought assurances from the IRS that their plans meet the legal requirements. At one time, employers would typically obtain ruling letters from the IRS. However, in Rev. Proc. 2013-22, 2013-1 C.B. 985, the IRS announced that it would no longer issue such letters to individual employers. Instead, it would issue only advisory or opinion letters to sponsors of pre-approved plans.

The guidance on requesting advisory or opinion letters on pre-approved plans is contained in Rev. Proc. 2013-22, as modified by Rev. Proc. 2014-28, 2014-1 C.B. 944, and clarified by Rev. Proc. 2017-18, 2017-5 I.R.B. 743, and Rev. Proc. 2015-22, 2015-11 I.R.B. 754. See also IRS, 403(b) Pre-Approved Plan Program FAQs.

What Is a Pre-approved 403(b) Plan?

A pre-approved plan is a form plan document developed by a plan sponsor for use by at least 15 different employers, except that a church-related organization is eligible to sponsor a 403(b) prototype plan that is intended to be a retirement income account under I.R.C. § 403(b)(9) without regard to the number of eligible employers that are expected to adopt the plan. Rev. Proc. 2014-28, Section 3.02; Rev. Proc. 2013-22, Section 11.01. The plan document will include certain required provisions, but allow for an employer to choose various permissible options. Rev. Proc. 2013-22, Sections 8.04-8.10 and 4.01. A pre-approved 403(b) plan may take one of three forms, and can generally be adopted by any eligible employer for any type of 403(b) plan, with certain exceptions, as discussed in the following sections.

What Types of Pre-approved 403(b) Plans Are Available?

Employers may choose among three types of pre-approved 403(b) plans. Pre-approved 403(b) plans may take one of three forms:

  • Standardized prototype plans
  • Nonstandardized prototype plans
  • Volume submitter plans

A prototype plan receives an opinion letter from the IRS if it is found to meet the 403(b) requirements. For a volume submitter plan, the letter is referred to as an advisory letter.

Standardized and Nonstandardized Prototype Plans

A prototype plan (standardized or nonstandardized) takes the form of a basic plan document and an adoption agreement. The basic plan document contains all provisions that are the same for all employers. The adoption agreement contains choices regarding certain plan features and the employer checks boxes to indicate which features it wants to adopt. For example, the basic plan document might provide for the investment choices available but the adoption agreement might allow the employer to choose to allow for employee pretax deferrals, employee after-tax contributions, Roth contributions, employer matches, employer mandatory contributions, employer discretionary contributions, or some combination.

In the case of a prototype plan, the employer may not make any changes to the plan or the plan will be treated as an individually designed plan. The employer would then lose the protection of the IRS opinion letter issued to the plan sponsor. In some instances, a plan sponsor chooses the prototype form specifically for this reason. For example, a firm that provides an investment platform for the plan may offer a prototype plan document specifying that only the investment options provided in that platform are permissible options for investment by the plan. As another example, a third-party administrator may find administration more efficient if all of its employer clients have the same plan document.

Difference between Standardized and Nonstandardized Plans

A standardized 403(b) prototype plan allows employee salary deferrals. If it allows other types of contributions, the plan must:

  • State they will be made for all eligible employees
  • Make all benefits, rights, and features of the plan available to all benefiting employees
  • Have provisions for allocating employer nonelective contributions that meet I.R.C. § 401(a)(4) design-based safe harbor provisions
  • Define compensation in a way permissible under:
    • I.R.C. § 415(c)(3) (disregarding I.R.C. § 415(c)(3)(E) (i.e., elective deferrals under I.R.C. § 402(g)(3) and employer contributions not includible in the employee’s gross income by reason of I.R.C. §§ 125, 132(f)(4), or 457))) –or–
    • 26 C.F.R. § 1.414(s)–1(c)

Rev. Proc. 2013-22, Section 6.01.

A nonstandardized 403(b) prototype plan is a plan that doesn’t meet the requirements to be a standardized plan. One example of such a plan would be a 403(b) prototype plan that allows the adopting employer to select (in the adoption agreement) a method for allocating nonelective employer contributions that isn’t an I.R.C. § 401(a)(4) design-based safe harbor, and therefore must meet the I.R.C.’s nondiscrimination testing rules (except in the case of the plan of a public school or university or a church, who are exempt from such testing).

Volume Submitter Plan

A volume submitter plan is based on a sample plan, known as a specimen plan, which can take the form of a basic plan document and an adoption agreement, as with prototype plans. In the alternative, it can take the form of a single plan document from which all provisions not selected by the employer are removed. The latter approach takes more work on the part of the plan sponsor but may be less confusing to the employer.

The major advantage of a volume submitter plan is that an employer is permitted to make changes to the plan, so long as they are not material, without having the plan lose its status as a volume submitter plan. In many instances, a law firm or consultant will offer a volume submitter plan in order to give adopting employers the most flexibility in individualizing the plan.

Employers must take care to ensure that any amendments are not material, so as not to jeopardize the plan’s pre-approved status. An employer that makes minor changes to a volume submitter plan can request a determination letter on the modified plan.

Which Types of 403(b) Plans May Use a Pre-approved Plan Document?

A 403(b) plan can be a pre-approved plan unless it is one of the following types of grandfathered plans:

  • Church 403(b) defined benefit plans. Section 251(e)(5) of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), P.L. 97-248, permitted certain arrangements established by a church-related organization and in effect on September 3, 1982 (TEFRA church defined benefit plans) to be treated as I.R.C. § 403(b) contracts even though they are defined benefit arrangements, though such arrangements cannot be pre-approved plans.
  • Self-insured state and local governmental 403(b) plans. Rev. Rul. 82-102, 1982-1 C.B. 62, reversed previous rulings that had permitted certain arrangements that were neither annuities nor custodial accounts to be treated as 403(b) plans. However, it provided that the revenue ruling would not be applied to an arrangement established by an employer on or before May 17, 1982, if (1) the contract(s) issued pursuant to the arrangement (including self-insured arrangements) would have met the requirements of I.R.C. § 403(b) except that the contract(s) was not purchased from an insurance company, and (2) the arrangement only covered current and future employees of that employer. Such arrangements can be individually designed 403(b) plans, but cannot be pre-approved plans.

Rev. Proc. 2013-22, Section 13.04. In the case of self-insured state and local governmental 403(b) plans, the employer may wish to modify the plan to provide for investment in annuities or custodial accounts, at least going forward.

If a church wishes to continue to offer a 403(b) defined benefit plan, it will likely have to do so without an IRS approval letter. Even if it already has a ruling on its plan document, it will have to monitor carefully future changes in law, regulations, or administrative guidance to ensure that its plan does not go out of compliance.

What Organizations Sponsor Pre-approved Plans?

A wide variety of organizations, ranging from law firms to church benefit boards, sponsor plans. A complete list of those plan sponsors that have applied for IRS opinion or advisory letters can be found here.

What Are the Advantages of a Pre-approved 403(b) Plan?

The primary advantages of pre-approved 403(b) plans over individually designed plans are:

  • Cost. Drafting one plan document for 15 or more employers costs less per employer than drafting a plan just for one employer. The reduction in cost typically gets passed on to the adopting employers. In some instances, a plan sponsor may even offer the plan document free for those employers that use other bundled services (e.g., investment services or third-party administration services).
  • Reliance. An advisory or opinion letter from the IRS provides assurances that a plan meets IRS requirements. Even if the IRS later changes its interpretation of a particular legal requirement, it will typically provide retroactive relief to plans that have obtained such letters. In contrast, there is no determination letter program for individually designed 403(b) plans.
  • Ability to correct retroactively. If an employer amends its plan document to take the form of a pre-approved 403(b) plan, the IRS will allow it to correct certain past errors without penalty. Rev. Proc. 2017-18, Section 3. Because there is no determination letter program for individually designed 403(b) plans, there is no provision for retroactive correction.
  • Updates. A plan document must be revised to reflect new legislative, regulatory, and administrative requirements as they are created. As with the initial plan drafting, plan sponsors can amend pre-approved plan documents at less cost per employer as compared to the cost associated with drafting amendments for many individual employers.
  • Bundled third-party services. A pre-approved plan is often part of “one-stop shopping” for the employer. The plan sponsor or an affiliate may also provide investment choices under the plan and third-party administrative services. This saves the employer from having to find different vendors for each of the functions under the plan. In addition, the vendors may be able to operate more efficiently if they need to become familiar with only one plan document, instead of a different one for each employer.

In many instances, employers adopting a pre-approved plan assume that if the plan is issued by a well-established sponsor and has an IRS opinion or advisory letter, the employer need not obtain any kind of legal review of the plan. However, as discussed in the following sections, there are a number of legal and practical issues that may arise even if the plan document itself is pre-approved.

What Are the Legal Pitfalls of a Pre-approved 403(b) Plan?

There are legal pitfalls of a pre-approved 403(b) plan. An advisory or opinion letter on a pre-approved plan will not cover certain issues:

  • The advisory or opinion letter will not cover whether investment agreements such as annuity or custodial account agreements meet all legal requirements, even if they are incorporated into the 403(b) plan document. This issue arose when participants in retirement plans for 12 major universities sued plan fiduciaries asserting breaches of fiduciary duty arising from allegedly excessive fees for administrative and investment management services, imprudent selection and monitoring of recordkeepers and investment options, underperforming plan investment options, and the offering of too many investment options (leading to decision paralysis on the part of the participants). See Doe v. Columbia Univ. et al (S.D.N.Y. filed Aug. 16, 2016).
  • The advisory or opinion letter will not address whether the plan is subject to the Employee Retirement Income Security Act (ERISA) and, if so, whether it meets ERISA’s requirements.
  • The advisory or opinion letter will not cover whether the plan operates in such a way as to meet the I.R.C.’s requirements (as opposed to just the plan document meeting such requirements).

Moreover, the advisory or opinion letter merely assures that the plan meets I.R.C. requirements. It does not assure that the plan will meet a particular employer’s objectives or that the terms of the plan are understandable or easy to apply. In many instances, employers assume that if a plan is pre-approved, they need not obtain any kind of review of the plan before adopting it. This can be risky if, for example, the terms of a plan are not what the employer intended or are so unclear that the employer unwittingly violates IRS or Department of Labor (DOL) rules in operating the plan.

What Operational Issues Can Arise for a Pre-approved Plan?

The IRS has identified some common issues that may occur, even if the plan language meets legal requirements. These operational issues include:

  • Adoption by an ineligible employer. Nonprofits other than those described in I.R.C. § 501(c)(3), such as unions or trade associations, cannot sponsor 403(b) plans. These failures sometimes occur due to a change in the employer, such as when a private nonprofit hospital that maintains a 403(b) plan is taken over by a governmental entity that is ineligible to maintain the 403(b) plan.
  • Excess contributions, including:
    • Violating the 15-year catchup rule under I.R.C. § 402(g)(7) (which permits certain additional 403(b) contributions by employees of an adopting employer who have at least 15 years of full-time service with the same employer if the employer is an educational organization, hospital, home health service agency, health and welfare service agency, church, or convention or association of churches) –and–
    • Violating the maximum aggregate limit on employer and employee contributions (the annual additions limit) under I.R.C. § 415(c)

    Violation of these limits frequently occurs when an employee participates in more than one 403(b) plan and the employer fails to take account of contributions to one plan when determining the limits on contributions to the other(s).

  • Excluding eligible employees from participation:
    • Eligible employees include part-time employees that would qualify to participate. With very limited exceptions (e.g., employees who normally work less than 20 hours per week), all employees must be permitted to make pretax contributions to a 403(b) plan if any employee is permitted to make such contributions. I.R.C. § 403(b)(12)(i). This is known as the universal availability rule. Compliance with the universal availability rule is especially an issue with casual employees such as substitute teachers, as the hours they will work are impossible to know in advance.
    • Contributions other than pretax (or Roth, if permitted) employee contributions must be tested to ensure the employer does not impermissibly discriminate in favor of highly compensated employees under the nondiscrimination rules. I.R.C. § 403(b)(12)(ii). If the employer excludes certain individuals from the calculation of the number of eligible employees under the plan, this will skew the nondiscrimination testing.

    Churches are exempt from both the universal availability rule and the nondiscrimination rules by reason of I.R.C. § 403(b)(1)(D), and governmental employers are exempt from the nondiscrimination rules by reason of I.R.C. § 403(b)(12)(C).

    Issues with either the universal availability rule or the nondiscrimination rules can arise, for example, if an employer excludes individuals, it believes to be independent contractors from the plan and the IRS later determines that such individuals are employees.

  • Plan loan issues. Plan loan issues arise when (1) participants fail to make required payments when due, resulting in default of the entire loan; (2) loans are poorly documented; and (3) when loans from multiple vendors result in the aggregate of plan loans to one participant exceeding permissible limits. (I.R.C. § 72(p) provides limits on the maximum amount of loans, and I.R.C. § 72(p)(2)(D) provides that all plans of an employer and its controlled group are aggregated for purposes of applying the limits.)
  • Hardship withdrawal issues. These include failure to obtain documentation of the hardship or distributions from multiple vendors that exceed the amount necessary to relieve the hardship. (I.R.C. § 403(b) requires that distributions not begin before age 59½, severance from employment, death, or disability, except in the case of hardship. 26 C.F.R. § 1.401(k)-1(d)(3) requires that the determination of the existence of an immediate and heavy financial need and of the amount necessary to meet the need must be made in accordance with nondiscriminatory and objective standards set forth in the plan, and that the amount cannot exceed the amount necessary to relieve the hardship.)

For further discussion of issues related to 403(b) and 457 plans, see Top Ten Issues For IRC 403(b) and 457 Plans.

What Practical Issues Can Arise for a Pre-approved Plan?

Even if a 403(b) plan meets all IRS requirements, certain provisions may cause practical pitfalls for the employer. Counsel employers to be mindful of the following issues:

  • Plan provider issues. These include issues with responsibilities, indemnification, and resolution of claims against the plan provider. For example, the plan may call for the provider to handle certain administrative requirements. However, if those requirements are not handled in an acceptable manner, participants may sue the employer, but the plan may not give the employer any recourse against the provider or indemnification against liability that the employer may have to participants. Or the plan may provide that such claims must be resolved through arbitration rather than lawsuits or those lawsuits must be filed in the plan sponsor or practitioner’s home state (which may be far from where the employer is located).
  • Insufficiency of plan provisions to protect the employer. While the advisory or opinion letter on a plan will generally provide comfort that the plan is qualified in form, it may omit crucial protections for the employer. For example, if the plan document does not give the employer the right to interpret the terms of the plan, a court may hold that provisions have a meaning quite different from that which the employer assumed. In addition, the plan may either omit a statute of limitations on bringing claims for benefits or provide one that is shorter than the maximum statute of limitations available under state law.
  • Poor plan communications. Many lawsuits are based on plan communications. An employer with a 403(b) plan subject to ERISA should ensure that the Summary Plan Description (SPD) and all other employee communications accurately describe the essential provisions of the pre-approved plan. See, e.g., Burstein v. Retirement Account Plan for Employees of Allegheny Health Education and Research Foundation, 336 F.3d 365 (3d Cir. 2003), in which the court found that when an SPD conflicted with the terms of a plan, the terms of the SPD controlled. In the case of a plan of a public school, the formal SPD requirements do not apply but the public school maintaining the plan typically uses some form of summary to communicate plan features to participants.
  • Failure to correctly identify whether the plan is subject to ERISA and to adopt an appropriate document. Governmental plans (403(b) plans of public schools or universities) are exempt from ERISA. Church plans are exempt from ERISA unless they have made an election to be covered by it. ERISA § 4 (29 U.S.C. § 1003). The 403(b) plans of other nonprofits are subject to ERISA unless they provide only for employee deferrals and have minimal levels of employer involvement. 29 C.F.R. § 2510.3-2(f).
    Use of a non-ERISA 403(b) plan document for an ERISA plan, or use of an ERISA plan document for a non-ERISA plan, can create problems for the employer. An ERISA 403(b) plan is subject to a variety of reporting, disclosure, fiduciary, and prohibited-transaction rules. If an employer adopts a plan document designed for a non-ERISA plan when its plan is subject to ERISA, it may not be aware of the ERISA requirements with which it needs to comply. Conversely, if an employer adopts a plan document designed for an ERISA plan when its plan is not subject to ERISA, it may contractually subject itself to requirements with which it would not otherwise be required to comply. This can be a particularly serious issue in the case of the prohibited transaction requirements of ERISA § 406 (29 U.S.C. § 1106). Prohibited transactions requirements prohibit certain transactions between a plan and certain closely related entities. A plan that is subject to such requirements under ERISA can apply for an exemption from the DOL, whereas a plan that is subject to them under contract may be unable to escape them at all.

    For a checklist describing ERISA prohibited transactions, see Prohibited Transaction and Parties in Interest Checklist (ERISA Rules).

When Should an Employer Adopt a Pre-approved 403(b) Plan?

The IRS issued the first opinion and advisory letters on pre-approved plans in March 2017. Rev. Proc. 2017-18, 2017-05 I.R.B. 743, announced that employers have until March 31, 2020 to convert their 403(b) plans to pre-approved form.

Best Practice Is to Adopt a Pre-approved 403(b) Plan Early

There are advantages to adopting early. A 403(b) plan is required to operate in accordance with IRS requirements, even if the plan document has not yet been amended to incorporate such requirements. To prevent the confusion that can result if the rules under which the plan must operate differ from what is stated in the plan document, an employer will typically want to use the pre-approved document as soon as possible.

Can the Employer Cure Past Plan Issues by Adopting a Pre-approved 403(b) Plan?

Rev. Proc. 2013-22, as clarified by Rev. Proc. 2017-18, announced relief for an employer that adopted a formal written document in order to satisfy the written plan requirements in the 403(b) regulations by the later of January 1, 2010, or the plan’s effective date. Such an employer can retroactively correct defects in the form of its plan by either adopting a 403(b) pre-approved plan or otherwise amending its 403(b) plan on or before March 31, 2020.

What Should an Employer Do If It Did Not Comply with the Written Plan Document Requirement in the Past?

If the organization did not have a written plan document by the deadline, the IRS will permit the issue to be corrected using the principles of the Employee Plans Compliance Resolution System (EPCRS). The details of EPCRS can be found in Rev. Proc. 2018-52, 2018 IRB LEXIS 524.

For further discussion of correction of 403(b) plan errors under EPCRS, see Section 403(b) Plan Design and Compliance — Correcting 403(b) Plan Errors.

Consult Legal Counsel to Avoid IRS and DOL Scrutiny

Pre-approved 403(b) plans can provide significant advantages to nonprofit employers and public schools and universities. However, they do not provide complete assurances that the plan will in operation meet IRS requirements or that it will meet employer needs. Legal advice is still critical to avoid both IRS and DOL scrutiny and potential participant lawsuits.

This excerpt from Lexis Practice Advisor®, a comprehensive practical guidance resource providing insight from leading practitioners, is reproduced with the permission of LexisNexis. Reproduction of this material, in any form, is specifically prohibited without written consent from LexisNexis.

Nonqualified Deferred Compensation Rules for Tax-Indifferent Entities (Section 457A)
(Posted on October 26, 2018 by )


Lexis Practice AdvisorThis practice note explains the application of Internal Revenue Code Section 457A, which restricts the ability of certain tax-indifferent entities (so-called nonqualified entities) to defer compensation for services provided by their service providers. It provides guidance on practical steps for attorneys advising such entities on nonqualified deferred compensation plans.

This practice note is divided into the following topics:

Purpose of Section 457A

Section 457A of the Internal Revenue Code (the IRC) was enacted shortly after Section 409A, which both govern nonqualified deferred compensation. However, where Section 409A regulates the timing of the payment of nonqualified deferred compensation, Section 457A effectively eliminates the payment of nonqualified deferred compensation by so-called nonqualified entities. This is because Section 457A requires that the nonqualified deferred compensation be included in the employee’s (or other service provider’s) income either (1) as soon as it is no longer subject to a substantial risk of forfeiture (using the limited definition under Section 457A) if the amount is determinable at that time or (2) as soon as the amount becomes determinable after ceasing to be subject to a substantial risk of forfeiture, in which case, the service provider is subject to an additional 20% tax on the deferred amount plus an interest penalty. Section 457A, therefore, causes the service provider to pay tax on determinable amounts of nonqualified deferred compensation once the amount is nonforfeitable, so there is no advantage to defer payment. Moreover, the 20% tax and interest penalty provisions for arrangements where the amount is indeterminate at the time it becomes nonforfeitable are essentially strictly punitive.

The policy behind Section 457A is to limit the payment of nonqualified deferred compensation by entities that are indifferent to when they receive a deduction for the compensation expense (i.e., the so-called nonqualified entities). In a taxable entity, any benefit a service provider obtains by deferring compensation is mitigated by the fact that the deferral delays the entity’s tax deduction until the time of payment. Thus, deferral will be respected for income tax (although potentially not for FICA tax) purposes, provided that it complies with certain rules set forth in Section 409A of the IRC. However, in the case of an entity not subject to tax, this mitigation does not occur, and therefore the entity has no incentive to limit the payment of nonqualified deferred compensation. Section 457A is in many ways the analog of Section 457(f), which imposes similar (but not identical) rules on nonprofit and governmental entities.

A nonqualified entity, therefore, does not have as much freedom as most other entities to defer taxation through nonqualified deferred compensation arrangements. Ideally, nonqualified entities should structure their compensation arrangements so as to avoid Section 457A. To the extent a compensation arrangement is subject to Section 457A (a Section 457A arrangement), consideration must be given to the tax consequences to the service providers. Moreover, Section 457A arrangements must be carefully drafted to take into account not only Section 457A, but the nonqualified deferred compensation rules of Section 409A, the FICA tax rules of Section § 3121(v), and (in the case of a domestic partnership or other entity over which the U.S. has jurisdiction) the Employee Retirement Income Security Act (ERISA). Each of these concerns are addressed in this practice note.

Application of Section 457A

Section 457A applies to amounts paid:

  • By a nonqualified entity
  • To a service provider
  • Under a nonqualified deferred compensation plan

Such an amount becomes includible in income for tax purposes:

  • When it ceases to be subject to a substantial risk of forfeiture (i.e., when vested, as determined for Section 457A) –or–
  • If an amount is not determinable when vested, when it becomes determinable

In addition, if the amount of nonqualified deferred compensation is not determinable when vested, the service provider will be subject to (1) an additional 20% tax on the amount and (2) an interest penalty, determined at the underpayment rate plus 1% as if the amount had been included in income when vested. I.R.C. § 457A(a), (c). See Tax Effect of Section 457A for more details.

Substantial Risk of Forfeiture

Compensation subject to Section 457A is taken into account for income tax purposes when it ceases to be subject to a substantial risk of forfeiture, assuming the amount is determinable at that time. In general, the rights of a service provider to compensation are treated as subject to a substantial risk of forfeiture only if the person’s rights to compensation are conditioned upon the future performance of substantial services by any individual.

Section 457A provides that, to the extent provided in future regulations, if compensation is determined solely by reference to the amount of gain recognized on the disposition of an investment asset, such compensation is to be treated as subject to a substantial risk of forfeiture until the date of such disposition. I.R.C. § 457A(d)(1)(b)(i). For this purpose, an investment asset means any single asset (other than an investment fund or similar entity):

  • Acquired directly by an investment fund or similar entity
  • With respect to which such entity does not (nor does any person related to such entity) participate in the active management of such asset (or if such asset is an interest in an entity, in the active management of the activities of such entity) –and–
  • Substantially all of any gain on the disposition of which (other than such deferred compensation) is allocated to investors in such entity

I.R.C. § 457A(d)(1)(b)(ii).

No such regulations have been promulgated to implement the above provision. However, the intent may have been to deal with “side pocket” and other identified investments. In a side pocket investment, a hedge fund will identify a specific illiquid asset, and will allocate it entirely to present participants in the hedge fund. Future investors do not receive any portion of the side pocket. And present investors do not receive any of its value when they cash out of the hedge fund, but only when the side pocket investment is liquidated. If the anticipated holding period of the side pocket investment is significantly longer than the vesting period, this could cause issues under Section 457A without further relief. In theory, this rule offers the opportunity for some relief for these kinds of arrangements if the IRS wants to give it. However, the absence of regulations to date means that such arrangements would be hazardous for the recipient.
Section 457A has a more restrictive definition of substantial risk of forfeiture than is provided in several other IRC sections that use the same term. For example, a substantial risk of forfeiture for purposes of Section 457A cannot be created by, for example, a provision that the payment will be made only if certain earnings goals are met, even though a substantial risk of forfeiture for purposes of Section 409A can in some instances be created by such an agreement. See Substantial Risk of Forfeiture under the IRC and Substantial Risk of Forfeiture Definition Comparison Chart for detailed comparisons of the definitions under the various IRC provisions.

Nonqualified Entities

Any entity that is determined to be a nonqualified entity is subject to Section 457A. The entity subject to the determination (and potential nonqualified entity status) is the entity that would be entitled to a compensation deduction under U.S. federal income tax principles if the entity paid the deferred amounts to the service provider in cash in the relevant taxable year. I.R.S. Notice 2009-8, 2009-1 C.B. 347, Q&A 14. The plan sponsor is typically, but not always, the employer of the service provider.

The rules governing nonqualified entities depend on whether the entity is a corporation or a partnership. Specifically, the tests turn on whether “substantially all” of an entity’s income is derived from certain sources (in the case of a corporation) or is allocated to (in the case of a partnership) specific kinds of parties. The rules are described in the sections that follow.

Corporations

Only foreign corporations (as defined in I.R.C. § 7701(a)(3)), (e.g., corporations, associations, joint-stock companies, and insurance companies that are not domestic (as defined in I.R.C. § 7701(a)(4))) may be nonqualified entities. I.R.S. Notice 2009-8, Q&A 7. A foreign corporation is a nonqualified entity unless substantially all of its income:

  • Is subject to U.S. tax due to being effectively connected with the conduct of a trade or business in the United States (see “Effectively Connected Income Test” below)
  • Is subject to a comprehensive foreign income tax (see “Comprehensive Foreign Income Tax Test” below) –or–
  • Is eligible for the benefits of a comprehensive income tax treaty between the applicable foreign country and the United States

I.R.C. §§ 457A(b)(1)(A), (B); 457(d)(2)(A).

Effectively Connective Income Test

Substantially all of the income of a foreign corporation is treated as effectively connected with the conduct of a trade or business in the United States only if, for the taxable year of the foreign corporation ending with or within the service provider’s relevant taxable year, at least 80% of the gross income of the foreign corporation is effectively connected with the conduct of a trade or business in the United States under I.R.C. § 882 that is not exempt from U.S. federal income tax pursuant to a treaty obligation of the United States (e.g., because the income is not attributable to a permanent establishment). I.R.S. Notice 2009-8, Q&A 9.

Comprehensive Foreign Income Tax Text

Substantially all of the income of a foreign corporation is subject to a comprehensive foreign income tax if, for the taxable year of the foreign corporation ending with or within the service provider’s relevant taxable year (as described under “When to Determine Nonqualified Entity Status” below), such foreign corporation:

  • Is not taxed by the foreign corporation’s country of residence under any regime or arrangement that is materially more favorable than the corporate income tax otherwise generally imposed by such country –and–
  • Either:
    • Is eligible for the benefits of a comprehensive income tax treaty between its country of residence and the United States –or–
    • Demonstrates that it is resident for tax purposes in a foreign country that has a comprehensive income tax

I.R.S. Notice 2009-8, Q&A 8(a).

Notwithstanding the above test, substantially all of the income of a foreign corporation will not be treated as subject to a comprehensive foreign income tax if the foreign corporation’s:

  • Taxable income (determined under the laws of its country of residence) excludes, in whole or in part, nonresidence source income realized by the foreign corporation –and–
  • Aggregate amount of nonresidence source income that is excluded for the relevant taxable year exceeds 20% of the gross income of the foreign corporation

I.R.S. Notice 2009-8, Q&A 8(b).

Partnerships

A partnership (as defined in I.R.C. § 7701(a)(2)) is a nonqualified entity unless substantially all of its income is allocated to persons other than:

  • Tax-exempt organizations –or–
  • Foreign persons with respect to whom such income is not either
    • Subject to a comprehensive foreign income tax –or–
    • Eligible for the benefits of a comprehensive income tax treaty between the applicable foreign country and the United States

I.R.C. § 457A(b)(2).

Substantially all of a partnership’s income is treated as allocated to eligible persons with respect to a taxable year only if at least 80% of the gross income of the partnership for such taxable year is allocated to eligible persons. I.R.S. Notice 2009-8, Q&A 11(a).
Note that while a corporation can be subject to Section 457A only if it is a foreign corporation, a partnership need not be a foreign partnership in order to be subject to that section. A domestic partnership can be subject to Section 457A based on having either tax haven or tax-exempt partners.

S Corporations

It would appear that an S corporation would be treated as a partnership rather than a corporation due to I.R.C. § 1372. While the language is not entirely clear (Section 1372 refers to “fringe benefits,” and it is unclear whether deferred compensation should be treated as a fringe benefit or cash), treatment of an S corporation as a partnership would appear to be appropriate, given an S corporation’s pass-through status.

When to Determine Nonqualified Entity Status

The determination of whether a plan sponsor is a nonqualified entity is made as of the last day of each of the service provider’s taxable years in which the nonqualified deferred compensation is no longer subject to a substantial risk of forfeiture and remains deferred. Whether a partnership is a nonqualified entity as of the last day of the service provider’s taxable year is determined based on the allocations (or deemed allocations) of gross income by the partnership for the partnership’s taxable year ending with or within the service provider’s taxable year. If a partnership does not yet have a taxable year that has ended or ends on the last day of the service provider’s taxable year, a reasonable, good faith estimate of such allocation (or deemed allocation) of the partnership for its current taxable year must be used to determine whether it is a nonqualified entity. I.R.S. Notice 2009-8, Q&A-13.

Service Providers

The term service provider includes nonemployee service providers as well as employees. A service provider subject to Section 457A may be:

  • An individual
  • A corporation
  • A subchapter S corporation
  • A partnership
  • A personal service corporation
  • A noncorporate entity that would be a personal service corporation if it were a corporation

I.R.S. Notice 2009-8, Q&A-5.

However, an independent contractor is not a service provider subject to Section 457A if an arrangement with respect to the independent contractor would be excluded from coverage under 26 C.F.R. § 1.409A-1(f)(2) (generally excluding arrangements with independent contractors having multiple unrelated clients, but not excluding arrangements with such independent contractors that provide management services). Id.

Note that to the extent a Section 457A arrangement covers service providers of an entity subject to U.S. law (typically, a domestic partnership), it will typically have to be structured as a plan for a select group of management and highly compensated employees (i.e., a top hat plan), to avoid various requirements under ERISA. For more information, see Top Hat Plan Statement Filing Rules and Procedures.

Nonqualified Deferred Compensation Plans

The definition of nonqualified deferred compensation plan under Section 457A and the exceptions from such definition are very similar to those under Section 409A, with certain important differences. In many places terms defined under Section 409A are incorporated by reference.

General Rule

With certain exceptions, an arrangement is a nonqualified deferred compensation plan for purposes of Section 457A if the arrangement:

  • Is described in I.R.C. § 409A(d) (generally, an arrangement where the service provider has a legally binding right to compensation that is or may be payable in a future tax year) –or–
  • Provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient

I.R.C. § 457A(d)(3). This is true regardless of whether the arrangement is a formal plan, or a less formal arrangement (e.g., part of an employment contract with a single individual).

With regard to equity arrangements, Section 457A does not apply to restricted stock includable in income under I.R.C. § 83. However, stock appreciation rights (other than those discussed in “Exempt Equity Arrangements,” below (and presumably, comparable rights in a noncorporate entity) would be subject to Section 457A unless they qualified for the short-term deferral exemption, even though they would not be subject to Section 409A. See I.R.S. Notice 2009-8, Q&A 2. See “Exempt Equity Arrangements,” below, for a more complete listing of the types of equity arrangements covered.

Short-Term Deferral Exceptions

Section 457A provides for two so-called short-term deferral exceptions from the general rule, as follows:

  1. The service provider actually receives payment within 12 months after the end of the taxable year of the service recipient (for this purpose, the entity for which the service provider is directly providing services) during which the right to the payment of such compensation is no longer subject to a substantial risk of forfeiture.
  2. The arrangement qualifies as a short-term deferral under 26 C.F.R. § 1.409A-1(b)(4) applied using the definition of substantial risk of forfeiture under Section 457A.

I.R.C. § 257A(d)(3)(B); I.R.S. Notice 2009-8, Q&A 4.

As earlier noted in the section entitled Substantial Risk of Forfeiture, the IRS is authorized to implement special rules for compensation based on the appreciation of a specified investment asset, extending the period in which such amounts are subject to a substantial risk of forfeiture until the disposition of the asset. If those rules are put in place, the 12-month short-term deferral rule under (1) above will not be available for those arrangements (although they may still be exempt from Section 457A if the Section 409A short-term deferral rule requirements as described in (2) are satisfied). I.R.C. § 457(d)(1)(B)).

Example (short-term deferral (1)). Suppose that Bob, a calendar year taxpayer, is an employee of X Corporation, which has a taxable year ending June 30. Under an agreement with X Corporation, Bob has a legally binding right to receive a bonus payment on June 30, 2022 based on his performance in the year ending June 30, 2019, provided that his employment continues until at least July 1, 2020. If payment is timely made, the arrangement will not be subject to Section 457A because the payment became nonforfeitable July 1, 2020, which was in X Corporation’s taxable year ending June 30, 2021, and was made within 12 months after the end of that taxable year.

Under the short-term deferral rule described in (2) above, an amount is not subject to the rules of Section 409A (and therefore is not subject to the rules of Section 457A) if the amount is required by the arrangement to be, and is actually (or constructively) received, by the later of the date that is:

  • 2½ months after the end of the service provider’s first taxable year in which the compensation is no longer subject to a substantial risk of forfeiture –or–
  • 2½ months after the end of the first taxable year of the service recipient in which the compensation is no longer subject to a substantial risk of forfeiture

26 C.F.R. § 1.409A-1(b)(4)(i)(A).

Obviously, this short-term deferral rule will in most cases be superfluous because the applicable 2½ month period will end before 12 months after the end of the taxable year of the service recipient in which the substantial risk of forfeiture lapsed. However, there are at least two circumstances where the Section 409A short-term deferral rule could play a role.

First, if the IRS implements the special substantial risk of forfeiture rules for compensation based on appreciation of a specified investment asset, the Section 409A short-term deferral rule will be the only short-term deferral rule available for those arrangements.
The second situation involves extensions of the Section 409A short-term deferral rule’s applicable period. The applicable 2½ month period can be extended for any of the following reasons:

  • It was administratively impracticable for the service recipient to make the payment by the end of the applicable 2½ month period for a reason that was not foreseeable when the arrangement was entered into.
  • Making the payment by the end of the applicable 2½ month period would have jeopardized the service recipient’s ability to continue as a going concern, provided further that the payment is made as soon as administratively practicable or as soon as the payment would no longer have such effect.
  • The service recipient reasonably anticipates that a deduction for the payment would not be permitted under I.R.C. § 162(m) for a reason that was not foreseeable when the arrangement was entered into.
  • The payment would violate Federal securities laws or other applicable law.

26 C.F.R. § 1.409A-1(b)(4)(ii); Prop. Treas. Reg. § 1.409A-1(b)(4)(ii)) (81 Fed. Reg. 40,569, 40,578–79 (June 22, 2016)).

Thus, in the rare instances where one of these exceptions are triggered, an arrangement may be exempted from Section 457A by reason of the short-term deferral rule of Section 409A.

Example (short-term deferral (2)). Suppose that Susan is supposed to receive a bonus from Corporation Y before March 15, 2020, based on work performed in 2019. The bonus is nonforfeitable as of December 31, 2019. Both Susan and Corporation Y are on a calendar year. However, due to reasons unforeseeable at the time the arrangement was entered into, payment of the amount before March 15, 2020 would jeopardize Corporation Y’s ability to continue as a going concern. The first time the payment can be made without having that effect is July 1, 2021. That is more than 12 months after the end of Corporation Y’s taxable year in which the payment became nonforfeitable. However, because the arrangement is excluded from coverage under Section 409A due to its extended short-term deferral rules, it will not be treated as covered by Section 457A.

Exempt Plans

Section 457A does not apply to certain arrangements which receive special tax benefits, including the following:

  • A qualified plan described in I.R.C. § 401(a)
  • A qualified annuity (as described in I.R.C. § 403(a))
  • Any tax-sheltered annuity or account (as described in I.R.C. § 403(b))
  • Any simplified employee pension (within the meaning of I.R.C. § 408(k))
  • Any simple retirement account (within the meaning of I.R.C. § 408(p))
  • Certain grandfathered pension plans to which only employees make contributions (as described in I.R.C. § 501(c)(18))
  • Any eligible deferred compensation plan of a government or tax-exempt employer (within the meaning of I.R.C. § 457(b))
  • An excess benefit plan (as described in I.R.C. § 415(m))
  • Certain pension, etc., plans created or organized in Puerto Rico (as described in ERISA § 1022(i)(2))
  • Any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan

See I.R.C. § 409A(d) (incorporated by reference in I.R.C. § 457A(d)(3)(A)).

Exempt Equity Arrangements

Certain equity arrangements are exempt from Section 457A, as follows:

  • Restricted stock or other restricted property taxable under I.R.C. § 83
  • A stock appreciation right which by its terms at all times must be settled in service recipient stock, and is settled in service recipient stock (and otherwise meets the requirements of 26 C.F.R. § 1.409A-1(b)(5)(i)(B))
  • Nonstatutory stock options on service recipient stock issued with an exercise price not less than fair market value at the date of grant and with no other deferral feature
  • Incentive stock options

By contrast, the following equity arrangements are subject to Section 457A, unless an exception (such as a short-term deferral exception (discussed above under “Short-Term Deferral Exceptions”)) applies:

  • Nonstatutory stock options that do not have a readily ascertainable fair market value
  • Nonstatutory stock options issued with an exercise price less than fair market value at the date of grant
  • Stock appreciation rights not described in the list of exempt arrangements, above
  • Restricted stock units

See I.R.S. Notice 2009-8, Q&A 2.

Tax Effect of Section 457A

The timing of income inclusion for nonqualified deferred compensation under Section 457A depends on whether the amount of such compensation is determinable at the time when it is no longer subject to a substantial risk of forfeiture.

Income Inclusion for Determinable Amounts

The calculation of the amount to be included in income is consistent with the rules under Section 409A, which are currently in the form of a notice and proposed regulations. See Notice 2008-115, 2008-2 C.B. 1367; Prop. Treas. Reg. 1.409A-4 (73 Fed. Reg. 74,380). The IRS has stated that taxpayers may rely on this guidance until further guidance is issued. I.R.S. Notice 2009-8, Q&A 16.

For determinable amounts, the amount deferred is subject to tax under Section 457A when it is no longer subject to a substantial risk of forfeiture. I.R.C. § 457A(a). The earnings on that amount are subject to tax on an annual basis, to the extent they are nonforfeitable. However, the service provider is entitled to a loss deduction if the right to the nonqualified deferred compensation is later forfeited. I.R.S. Notice 2009-8, Q&A 15, 16, 18.

Example. Wanda is promised an amount equal to $10,000, plus compounded interest at a rate of 4%, on attainment of age 65. The amount is nonforfeitable. Assuming that 4% is a reasonable rate of interest, she will immediately be taxed on $10,000 because there is no substantial risk of forfeiture. In year 2, she will be taxed on the interest accrued for that period, 4% of $10,000, or $400. In year 3, she will be taxed on 4% of the total accrued principal ($10,000 + $400), or $416. This will continue through the final year of interest accrual.

If no interest is credited, or the rate of interest is not reasonable, the initial amount will be adjusted to reflect the present value of the future deferred compensation, and then imputed interest based on a reasonable rate will be credited each year. I.R.S. Notice 2009-8, Q&A 15.

Example (no interest credited). George is promised a flat amount of $100,000 in 10 years. The amount is nonforfeitable. Again, assume that 4% is a reasonable rate of interest throughout the entire period. He will be taxed on the present value of $100,000 (which would be $67,556.42) this year. In each subsequent year, he will be taxed on the interest on $67,556.42, at a 4% rate of interest.

Example (excessive interest credited). Meredith is promised $20,000, plus interest at a rate of 25% a year, after 10 years. Thus, the total amount that will be paid is $186,264.51. The amount is nonforfeitable. Assume that 4% is a reasonable rate of interest. Instead of being taxed this year on $20,000, Meredith will be taxed this year on the present value of $186,264.51, or $125,833.63. She will then be taxed on each subsequent year on the earnings on $125,833.63 at a 4% rate of interest.

Income Inclusion and Interest and Penalty Taxes for Indeterminable Amounts

If the amount deferred under Section 457A is not determinable at the time the substantial risk of forfeiture lapses, it will be included in income as soon as it becomes determinable. In addition, the service provider is subject to:

  • An additional 20% income tax –and–
  • Interest at the underpayment rate (as determined under I.R.C. § 6621) plus 1% on the underpayment of federal taxes that would have occurred if the amount had been included in income when no longer subject to a substantial risk of forfeiture

I.R.C. § 457A(c).

An amount is determinable if it is paid under an account balance plan (i.e., a plan under which a specific amount is deferred, and credited with earnings thereafter). If not, it will be considered not to be determinable if it is a formula amount unknown at the end of the taxable year because it is based upon factors that remain variable as of the end of such year. For example, an amount based on future profits of the service recipient would not be determinable.

I.R.S. Notice 2009-8, Q&A 19; Prop. Treas. Reg. § 1.409A-4(b)(2)(iv) (73 Fed. Reg. 74,380, 74,396 (Dec. 8, 2008)).

Relationship between Section 457A and FICA Taxes

In theory, a determinable amount subject to Section 457A is subject to income taxes when it ceases to be subject to a substantial risk of forfeiture, and also to FICA taxes when it ceases to be subject to a substantial risk of forfeiture under I.R.C. § 3121(v). Nevertheless, the amount subject to tax may be different for income and FICA tax purposes. For purposes of income taxes, the amount deferred is taxed when the substantial risk of forfeiture lapses. If the amount is not paid immediately, future earnings on the deferred amount are subject to income tax on an annual basis. By contrast, FICA taxation applies only to the initial deferral, not to earnings thereon.
Moreover, an amount may be subject to income tax in one year, and FICA tax in another, due to differences in how the term substantial risk of forfeiture is defined for purposes of Sections 457A and 3121(v). For example, suppose that an amount is subject to forfeiture if a former employee does not comply with the terms of a noncompetition agreement. FICA taxation may be delayed until the noncompetition agreement ends, while income taxation may apply immediately. For further details, see Substantial Risk of Forfeiture under the IRC.

Relationship between Sections 457A and 409A

When drafting an arrangement subject to Section 457A, it is also important to consider the impact of Section 409A. While the details of Section 409A are beyond the scope of this practice note, that section imposes a 20% penalty on any nonqualified deferred compensation arrangement that does not meet its rules (plus an interest penalty, where applicable). Regulations clarify that Section 409A applies to nonqualified deferred compensation plans (as defined therein) separately and in addition to the rules under Section 457A. 26 C.F.R. § 1.409A-1(a)(4). Thus, it is critical that a Section 457A arrangement be drafted so as either to avoid coverage by, or meet the terms of, Section 409A. For further details on Section 409A, see Section 409A Fundamentals.

Being subject to Section 457A will not in itself make a deferred compensation arrangement exempt from Section 409A. However, most arrangements subject to Section 457A provide that compensation will be paid as soon as it ceases to be subject to a substantial risk of forfeiture, because there is no tax advantage in deferring it beyond that point. Such arrangements will typically not be subject to Section 409A due to the short-term deferral rule described above.

Moreover, an arrangement that provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient (e.g., a stock appreciation right that does not meet the exemption discussed on “Exempt Equity Arrangements,” above) may be subject to Section 457A, but not to Section 409A.

However, to the extent that an arrangement is structured to avoid Section 457A by paying the deferred compensation no later than 12 months after the end of the taxable year of the service recipient during which the right to the payment of such compensation is no longer subject to a substantial risk of forfeiture, the arrangement will still be subject to Section 409A if amounts are payable beyond the applicable 2½ month short-term deferral period under Section 409A.

Conversely, if payment of deferred compensation is dependent on the service recipient’s meeting certain earnings goals, the compensation will be considered subject to a substantial risk of forfeiture under Section 409A, but not under Section 457A (due to the difference in how each section defines the term). As a result, the amount deferred would be immediately taxable under Section 457A if the amount were not paid by the end of the service recipient’s taxable year following the taxable year in which the amount was deferred (i.e., when the right to the compensation became legally binding since the amount was never subject to a substantial risk of forfeiture for purposes of Section 457A). Nevertheless, the arrangement may be subject to Section 409A rules that will prevent the amount from being paid at the time it is subject to tax under Section 457A without triggering the Section 409A interest and penalty taxes. These rules can create hardships if an agreement is not properly structured.

Example. Suppose that Adrian is to receive deferred compensation after 10 years, assuming that certain earnings goals are met for the first five years. He will be taxed on the amount deferred immediately under Section 457A, because the amount is considered nonforfeitable. However, he may not have the money to pay that tax immediately. And the arrangement cannot be modified to permit him to be paid immediately (either the whole amount, or even an amount necessary to pay the tax) without triggering the 20% tax and interest penalty under Section 409A, except as permitted under certain transitional relief described in the next section.
In addition, as described in the next section, Section 409A may be a concern with respect to arrangements adopted before the effective date of Section 457A.

Effective Date and Transitional Rule

Section 457A was added by Section 801(a) of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, Div. C of Pub. L. No. 110-343 (TEAMTRA). It generally applies to amounts deferred that are attributable to services performed after December 31, 2008.

Under a transitional rule, deferred amounts attributable to services performed before January 1, 2009 are includible in gross income in the later of:

  • The last taxable year beginning before 2018 –or–
  • The first taxable year in which there is no substantial risk of forfeiture of the rights to such compensation

TEAMTRA § 801(d).

Obviously, arrangements adopted before TEAMTRA were not structured with Section 457A in mind. This has created issues, as described below, for coordinating Section 457A and Section 409A.

Deferrals Made and Vested before 2005

Section 409A does not apply with respect to amounts deferred and vested in taxable years beginning before January 1, 2005, if the arrangement under which the deferral is made is not materially modified after October 3, 2004. 26 C.F.R. § 1.409A-6. However, Section 457A applies to such pre-2005 deferrals, subject to the transitional rule above.

In many instances, the sponsor of an arrangement subject to Section 457A, but grandfathered under Section 409A, wanted to modify the arrangement to provide that amounts will be paid out at the time such amounts are subject to tax. Under the transitional rule of Section 457A, the amounts (being already vested) would be taxable in the last taxable year beginning before 2018. I.R.S. Notice 2017-75, 2017-52 I.R.B. 602, provided that modifying the plan to pay the amounts out when they became taxable would not be treated as a material modification for purposes of 26 C.F.R. § 1.409A-6.

Example. Susan deferred amounts in 2003, and those amounts were immediately vested. Those amounts were originally supposed to be paid when she attained age 65, which will not be until 2023. However, under the transitional rule to Section 457A, she was taxable on those amounts in 2017. Her employer was permitted to modify the arrangement to pay those amounts in 2017, without that modification being considered a material modification that would subject the plan to Section 409A and thus trigger the 20% penalty and interest that would apply to accelerations of benefits.

2005 through 2008 Deferrals and Pre-2005 Deferrals That Vested in 2005 or Later

Plans set up between 2005 and 2008 were generally set up to comply with Section 409A. However, under the transitional rule to Section 457A, benefits from those years will be includible in gross income in the later of:

  • The last taxable year beginning before 2018 –or–
  • The first taxable year in which there is no substantial risk of forfeiture of the rights to such compensation

In general, Section 409A does not permit the acceleration of benefits. However, I.R.S. Notice 2017-75 permits acceleration of benefits in order to pay the tax due under Section 457A.

Note that the rules for pre-2005 deferrals are different from the rules for 2005 through 2008 deferrals. For the former, the entire amount can be paid at the time taxes are imposed. For the latter, only an amount necessary to pay the taxes can be paid at that time.

Example. Jordan was covered by an arrangement in 2005 under which, if he remained in employment until 2020, he would receive payment beginning at age 65 (which would occur in 2030). Under the transitional rule to Section 457A, he is taxable on those amounts in 2020. If his employer were to accelerate the entire amount of deferred compensation, he would be subject to the 20% penalty plus the interest penalty under Section 409A. However, I.R.S. Notice 2017-75 permits the employer to accelerate just that portion of the payment necessary to pay the tax due in 2020.

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