On November 16, 2004, the IRS issued comprehensive proposed regulations applying to tax-sheltered annuities (also known as 403(b) annuities or tax-deferred annuities). This type of benefit is available only to employees of organizations exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code and to employees of public educational institutions. Despite the availability in recent years of both 401(k) retirement plans and 457(b) deferred compensation plans, most exempt organizations have continued to offer 403(b) annuities because of the unique features they provide. As a result, the first comprehensive guidance on 403(b) arrangements in more than 40 years (according to the U.S. Department of the Treasury) is a welcome development.
The proposed regulations include not only expected restrictions and changes, but also new forms of flexibility that are quite unexpected. The combination of clear guidance and some new types of flexibility, if adopted as final regulations, should tip the scales to make these regulations a favorable development for exempt organizations and public educational institutions. The proposed regulations become effective for taxable years beginning after 2005, although church-related organizations whose 403(b) programs can be amended only by a church convention generally are given an additional year. In the meantime, the proposed regulations specifically provide that organizations may not rely on the regulations until they are issued in final form.
Highlights of the regulations include the following:
Every 403(b) Arrangement Must Be Governed by a Plan Document
This plan document will cause many 403(b) arrangements to be treated for the first time as plans governed by the Employee Retirement Income Security Act (ERISA), although the IRS states in these regulations that having a plan document would not necessarily lead to the application of ERISA. The U.S. Department of Labor is expected to provide guidance on the circumstances in which having a plan document (complying with the new regulations) will cause ERISA to apply.
The issue lurking behind this plan document requirement is whether the plan document will effectively supersede and control the main contractual document between the employer and the 403(b) vendor (such as a 403(b) group annuity contract issued by an insurer). Exempt organizations have found it difficult to assert control over their 403(b) programs, because annuity contracts and custodial account agreements have provided significant control to the vendors. Employers may wish to use the plan document requirement as an opportunity to assert greater control over their programs, and, as a result, the respective responsibilities of employers and vendors may have to be revisited.
General Nondiscrimination Rules Apply to Employer Contributions to 403(b) Plans
The regulations discard the safe harbor nondiscrimination rules that were provided as a stop-gap measure in IRS Notice 89-23 (15 years ago) and, instead, apply the general 401(a)(4) nondiscrimination rules to employer contributions to 403(b) plans. These are the same rules that apply to qualified retirement plans. Employer contribution formulas that do not provide a uniform percentage of pay to all covered employees may encounter added complexity in the nondiscrimination testing process.
Employers Can Continue Contributing for Terminated Employees for Five Years
When an employee terminates employment, the employee’s compensation rate is treated as remaining in effect for the rest of that year and for five additional years. The employer can make nonelective contributions to the 403(b) plan for the terminated employee over the five-year period (up to the annual limit in each year — $41,000 in 2004, and $42,000 in 2005). The unstated problem with this approach is that the general nondiscrimination rules may limit or prohibit this strategy for a former employee who was a highly compensated employee, because significant post-employment contributions for highly compensated employees could be discriminatory.
Employers Have Flexibility in Transferring Assets Between 403(b) Vendors or Between 403(b) Plans
In the past, 403(b) vendors and employers frequently disagreed over the authority of the employer to move 403(b) assets to another vendor. Vendors often have taken the position that only employees can authorize such a transfer. The regulations make it clear that the employer is permitted under the 403(b) rules to make such transfers, and employee consent is not one of the conditions. This change is likely to lead to a reexamination of the contractual relationship between employers and vendors, because employers are likely to assert in their plan documents that they have the right without employee consents to transfer plan assets to other vendors or to other contracts or custodial accounts.
Employers Can Terminate Their 403(b) Plans
Historically employers found it difficult to terminate their 403(b) arrangements, because 403(b) vendors insisted the primary relationship between vendor and employee had to continue. The regulations state that an employer, in its 403(b) plan document, may permit termination of the 403(b) plan and may then distribute the 403(b) assets to the employees. The employer will have to demonstrate that the plan termination was bona fide — the employer will not be permitted to terminate the plan if it contributes to another 403(b) plan within 12 months before or after the termination. This is another area in which the balance of power between employers and 403(b) vendors is likely to shift.
Employers Have More Flexibility under the Universal Availability Rule
As a general rule, all employees must have the right to make elective deferrals to a 403(b) annuity, if any single employee has that right. The regulations provide several new and helpful exceptions: the rule is applied separately to each separate common-law employer; the rule can be applied separately to geographically distinct and independent operating units; and the employer can exclude employees who are eligible to make elective deferrals to a 401(k) plan or to a 457(b) deferred compensation plan. This flexibility is similar to the change made in the 2001 tax law that enables sponsors of 401(k) plans to exclude from consideration, when testing their 401(k) plans for nondiscrimination, those employees who are eligible to participate in 403(b) plans.
The Board Control Test Finally Becomes Official
The IRS stated in an internal legal opinion in 1987 that in certain circumstances 80 percent-or-greater board control or board overlap would cause two nonprofits to be treated as a single employer for many employee benefit purposes. For many years exempt organizations have wondered whether this so-called board control test would become official. The 403(b) regulations finally adopt this approach, but apply it to all employee benefit rules — not just for 403(b) rules. Once the regulations become effective, exempt organizations will no longer have the option of ignoring the board control test when it is in their best interest to do so, and they will have to revisit the coverage and nondiscrimination testing that was done in the past while disregarding the board control test.
Unvested Amounts in 403(b) Plans Are Subject to Other Tax Law Rules until Vested
If contributions to the 403(b) plan are not vested when made (as required by the 403(b) rules), they are treated as contributions to a Section 403(c) annuity plan. When they become vested, they are then treated as 403(b) contributions unless the participant had already elected to include the contributions in taxable income when first made. The regulations do not state whether the contributions are applied against the annual 403(b) limits when they are made or when they vest — but beware of an IRS interpretation that contributions do not apply against the annual limits until they become vested. This could cause excess contribution problems in future years in plans that apply a vesting schedule — the bunching of contributions in the year of vesting could cause the limits to be exceeded.
Special Catch-Up Rule Must Be Applied Before the Age 50 Catch-Up
Contributions to 403(b) plans potentially qualify for two special catch-up rules. One is for employees of certain types of organizations (including hospitals) who have at least 15 years of service. Another is generally available to any employee who will attain age 50 before the end of the year. The regulations provide that, if contributions exceed the annual limit (and can be made only by relying on these catch-up rules), the amount will be treated as being made first under the special 15-year catch-up, and only after that will it be treated as coming under the age 50 catch-up rule. This is a trap for the unwary, because it could unwittingly cause an employee to use up the limited amount available under the special 15-year catch-up — without ever having actually used it.
No Right Can Be Conditioned on Making 403(b) Elective Deferrals
This “no conditioning” rule, which long has applied to 401(k) plans, will now apply also to 403(b) plans. Employers should examine their 403(b) arrangements closely to confirm that no benefit or right (other than employer matching contributions) is conditioned on making elective deferrals.
Distribution Events Are Liberalized
A “severance from employment” (which permits distribution of 403(b) assets) means ceasing to be employed by the employer maintaining the 403(b) plan, even if the employee remains employed by another employer in the controlled group.
These rules provide much needed clarification on key issues that have long bedeviled employers with 403(b) arrangements. The plan document requirement in particular will take 403(b) arrangements into a new era of certainty and responsibility for exempt organizations. Employers should begin examining their 403(b) arrangements and should begin planning how they intend to structure the relationship with their 403(b) vendors, to comply with, or take advantage of, the new rules once they are finalized.