Very serious business: sense and nonsense under section 403(b) of the Internal Revenue Code of 1986.

• Author: Pratt, David A.
• Position: Tax-exempt organizations

1. INTRODUCTION II. DEVELOPMENT OF SECTION 403(b) III. WHAT IS A 403(b) ARRANGEMENT? IV. WHICH EMPLOYERS MAY SPONSOR A 403(b)

   ARRANGEMENT?

   A. In General

   B. Eligible Employers

   C. Ineligible Employers

   D. Suggested Changes V. WHO MAY PARTICIPATE IN A 403(b) ARRANGEMENT? VI. FUNDING VEHICLES VII. SALARY REDUCTION CONTRIBUTIONS VIII. LIMITATIONS ON CONTRIBUTIONS TO A 403(b)

   ARRANGEMENT

   A. Dollar Limit on Elective Salary Reduction

   Contributions

   1. General Rule

   2. Higher Limit for Certain Employees

   3. Coordination with Other Plans

   4. Excess Deferrals

      B. Limitations Under Section 415

   1. General Rule

   2. Special Elections

      1. The A Election

      2. The B Election

   3. Special Section 415 Rules for 403(b)

      Arrangements

   4. Effect of Excess Contributions

      C. The Exclusion Allowance

   1. General Rule

   2. Includible Compensation

   3. Years of Service

   4. The "C Election"

   5. Other Rules

      D. Vesting

      E. Excise Tax

      F: Conclusion and Comments IX. TAX TREATMENT OF 403(b) ARRANGEMENT

      PARTICIPANTS X. ROLLOVERS AND TRANSFERS XI. DISTRIBUTION REQUIREMENTS

      A. Minimum Distribution Rules

      B. Restrictions on Distributions

   1. Salary Reduction Contributions

   2. Custodial Accounts

   3. Plan Termination

   4. Exceptions XII. NONDISCRIMINATION REQUIREMENTS

      A. Salary Reduction Contributions

   1. General Rule

   2. Employees Who May Be Disregarded

   3. Results of Noncompliance

      B. Other Employer Contributions XIII. COMPLIANCE WITH SECTIONS 410(b), 401(a)(26)

      AND 401(a)(4)

      A. In General

      B. The Safe Harbors Under Notice 89-23

   1. The Maximum Disparity Safe Harbor

   2. The Lesser Disparity Safe Harbor

   3. The No Disparity Safe Harbor

      C. Definition of Employer

      D. Excludable Employees

      E. Compensation

      F. The Plan Year

      G. The Testing Method XIV. APPLICABILITY OF ERISA

      A. In General

      B. Consequences of ERISA Coverage XV. CONCLUSION

1. INTRODUCTION

   Until 1958, employees of certain tax-exempt organizations could defer all or part of their income from the organization through the use of a tax-sheltered annuity arrangement.(1) In 1958, Congress added section 403(b) to the Internal Revenue Code (IRC),(2) restricting the amount of compensation that could be deferred for tax-purposes.(3) Under the legislation, an employee's deferral for tax-purposes was limited to the "exclusion allowance," a calculation based on the employee's compensation and length of service with the employer.(4) From these modest beginnings, section 403(b) has become an integral part of the benefit packages of eligible employers.(5)

   A 403(b) arrangement has, until recently, been easier to design and administer than a plan which is qualified under section 401(a). In addition, since the Tax Reform Act of 1986 (TRA 1986) prohibits the adoption of new 401(k) plans by governmental and tax-exempt employers,(6) a 403(b) arrangement is clearly the best vehicle available to employees of tax-exempt employers who wish to make tax-deductible salary deferrals into a retirement plan. The only alternative, an eligible deferred compensation plan under section 457,(7) is clearly less satisfactory, as (1) the employee simply becomes a general creditor of the employer with respect to amounts deferred, and income thereon,(8) and (2) in order to comply with both the requirements of section 457 and the requirements of the Employee Retirement Income Security Act of 1974 (ERISA),(9) as amended, a private tax-exempt employer must generally limit participation in its section 457 plan to a select group of management or highly compensated employees.(10)

   Accordingly, many tax-exempt organizations use a 403(b) arrangement as their primary retirement plan while others, such as public school districts, maintain 403(b) arrangements, often funded exclusively by employee deferrals, to supplement their primary plans.(11)

   As originally enacted, section 403(b) was relatively straightforward.(12) However, the statute has been amended numerous times,(13) so that the governing rules have become a complex mixture of (1) rules applicable only to 403(b) arrangements, (2) rules applicable to qualified plans under section 401(a), which have been extended to 403(b) arrangements, often with complex modifications, and (3) special rules applicable only to certain types of employers.(14) Furthermore, until recently, 403(b) arrangements received little attention from the Internal Revenue Service (IRS) and no IRS program exists for approving plan documents, comparable to the determination letter program for qualified plans.(15) The extraordinary difficulty of complying with the section 403(b) rules is exacerbated by the fact that, after many years of benign neglect, the IRS has recently discovered, as part of its ongoing program of auditing tax-exempt colleges and hospitals, that there is a high level of noncompliance.(16) Substantial sanctions have been imposed on certain employers; according to Richard J. Wickersham, technical adviser to the director, IRS Employee Plans Technical and Actuarial Division negotiated compliance settlements relating to defects in 403(b) arrangements have been in the "million dollar ranges."(17)

   James J. McGovern, assistant commissioner of IRS for employee plans and exempt organizations, has stated that section 403(b) noncompliance is the hottest employee benefit issue for the IRS.(18) All future audits of exempt organizations will include a review of their 403(b) arrangements.(19) This Article argues that the present rules are simply too complex and unwieldy, particularly for small tax-exempt organizations which do not have access to expert advice. It then recommends changes to simplify the rules for 403(b) arrangements. In view of its past inactivity, the IRS should, at the very least, give employers who have acted in good faith a reasonable period of time to bring their plans into compliance.(20)

2. DEVELOPMENT OF SECTION 403(b)

   Section 403(b) arrangements were originally limited to organizations that were tax-exempt under section 501(c)(3), and it only allowed such arrangements to be funded by annuity contracts.(21) In 1961, section 403(b) was extended to employees of public educational institutions, including colleges and universities.(22) Then in 1974, Congress allowed a second funding alternative to be used, namely a custodial account in which contributions are invested in mutual funds.(23) In 1982, Congress added a third funding alternative for church employers, called a retirement income account.(24)

   In creating ERISA, Congress enacted section 415, thereby imposing limitations on the amount of contributions and benefits that could be provided under qualified plans.(25) These rules were made applicable, with some modifications, to 403(b) arrangements. Accordingly, contributions to 403(b) arrangements were subject to two entirely separate limitations, the limitations under section 415 and the exclusion allowance under section 403(b)(2).(26) Congress also added an alternative method of calculating the exclusion allowance.(27) This calculation was further refined, with respect to church employees, by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA).(28) In 1978, Congress modified the rules governing distributions from 403(b) arrangements, by prohibiting distributions from a custodial account unless one of several specified events occurred,(29) and by providing for tax-free rollovers from a 403(b) arrangement to either another 403(b) arrangement or to an Individual Retirement Account (IRA).(30)

   Prior to 1986, 403(b) arrangements (unlike qualified plans) were not subject to specific nondiscrimination rules. TRA 1986(31) imposed rules similar to those for qualified plans under section 401(a), including: (1) a calendar year dollar limit (generally $9,500) on elective deferrals,(32) (2) nondiscrimination rules for elective contributions and employer contributions,(33) which do not apply to church plans,(34) (3) minimum distribution requirements,(35) and (4) restrictions on the withdrawal of salary reduction contributions.(36) Finally, the Unemployment Compensation Amendments of 1992 added new rollover and income tax-withholding rules, which apply to 403(b) arrangements as well as qualified plans.(37)

   The requirements for 403(b) arrangements were originally much less onerous and complex than those for qualified plans. As a result of the statutory changes that are summarized above,(38) however, 403(b) rules are now unexpectedly complex. 403(b) arrangements are subject to some of the rules for qualified plans (sometimes with complex modifications), as well as their own separate set of rules. The rules also vary according to the type of contribution, employer, funding arrangement, and the extent of the employer's involvement in the arrangement. All of these variables illustrate why it is often difficult to precisely determine which rules apply to a specific employer's 403(b) arrangement.

3. WHAT IS A 403(b) ARRANGEMENT?

   A 403(b) arrangement is a special type of employee retirement plan which may be made available only by an eligible employer(39) to its employees.(40) Under section 403(b), contributions to the program receive tax-deferred treatment,(41) subject to the limitations discussed below,(42) and the investment earnings on the contributions to the arrangement also qualify for tax-deferred treatment.(43)

   A section 401(a) qualified plan document must incorporate the numerous qualification requirements under section 401(a) and the regulations thereunder.(44) By contrast, there are few documentation requirements for a 403(b) arrangement.(45) Furthermore, there may not be a single 403(b) arrangement document, but rather the plan may be evidenced by a collection of documents, including salary reduction agreements, annuity contracts, custodial agreements, summary plan descriptions, and additional information distributed to employees.(46) Again, unlike a qualified plan, the scope of the employer's involvement will vary significantly. In some cases, the employer does not even choose the available investment options, but simply signs salary reduction...