This is a story from the newest issue of NPT’s Exempt Magazine
In Revenue Ruling 2011-7 issued earlier this year, the Internal Revenue Service (IRS) provided sponsors of 403(b) plans with some much-needed guidance regarding how to terminate plans. Many 403(b) plan sponsors have been reconsidering whether they want to continue to maintain such plans in light of the final regulations that were issued by the IRS in 2007 covering 403(b) plans.
Until this guidance was issued, the IRS’s position was, generally, that a 403(b) plan could not be terminated, so the guidance is a welcomed step. However, there are issues that have not been addressed by the IRS in the guidance and issues that plan sponsors may need to address to terminate their plans.
Steps to Plan Termination
The guidance outlines the steps a plan sponsor needs to take to effectively terminate a plan and to distribute plan assets. Below is a brief discussion of each of the steps and potential issues that a plan sponsor must consider.
Adopt a Binding Resolution to Terminate the Plan. On or before the date of termination, the plan sponsor must adopt a binding resolution establishing the termination date, freezing contributions to the plan, discontinuing the purchase of annuity contracts or mutual funds, fully vesting all plan participants, approving the distribution of plan benefits and approving the termination of the plan.
This would seem to be relatively simple, except that the IRS assumes that a plan’s document(s) allow the plan sponsor to terminate its plan. However, this is frequently not the case, so plan sponsors must review the plan document to be sure it allows for the termination. If the plan document does not contain termination provisions, then the plan sponsor should consult with a plan advisor to determine if the language authorizing the termination can be added to allow for it.
Freezing/Stopping Plan Contributions. The plan sponsor must stop contributions to the 403(b) plan beginning on the termination date. In addition, if the plan sponsor has a related entity (determined on a controlled group basis) with a 403(b) plan no contributions may be made to that plan for the period that begins with the termination date and ends 12 months after all benefits have been distributed from the terminated plan.
The preceding rule may be disregarded if during the period beginning 12 months before the plan termination and ending 12 months after the distribution of all assets from the terminated plan less than 2 percent of the employees who were eligible to participate in the terminated plan are eligible to participate in the plan of the related entity. Participant Notification. Plan participants and beneficiaries must be notified of the plan’s termination and the related tax consequences. The form of the tax notice is described in Internal Revenue Code section 402(f).
Distribute Plan Assets. Plan assets must be distributed to plan participants and beneficiaries as soon as administratively feasible. The IRS generally considers this requirement to be met if all plan assets are distributed within 12 months of the plan’s termination. It should be noted that 403(b) plans covered by The Employee Retirement Income Security Act of 1974 (ERISA) must comply with the qualified joint and survivor annuity requirements to the extent applicable, meaning if the annuity contracts offered under the plan provide for survivor annuity options, then the required notifications must be provided. Many 403(b) annuity contracts state that if the plan is an ERISA plan then such notices will be provided, but plan sponsors should check with the annuity provider to coordinate notification. The IRS’ guidance also leaves some open issues for plan sponsors as follows:
• Individual annuity contracts — If the plan provides individual annuity contracts, then the notice requires the distribution of fully paid individual insurance annuities to each plan participant and beneficiary. The guidance states that such distributions will not be taxable until amounts are actually taken from the annuity contract.
The guidance is not clear regarding what should be done by the plan sponsor if plan participants already hold individual contracts in their own name, which is fairly typical. Whether the plan sponsor would simply be able to notify the participants and contract providers that the contracts are no longer part of a 403(b) plan is an open question.
• Group annuity contracts — If the plan is funded with group annuity contracts, the IRS guidance contemplates the assets being distributed by issuing individual certificates (as opposed to contracts) evidencing entitlement to fully paid contract benefits to plan participants and beneficiaries. The guidance states that there are no tax consequences to the plan participant until amounts are actually withdrawn from the contract.
From a practical point of view, it might take a very long time (more than 12 months) to issue such certificates because the required paperwork for old contracts is notoriously difficult for the issuing companies to find. Thus, the question is open whether a delay of more than 12 months from the termination date in issuing the certificates would cause the plan termination to be invalid.
• Custodial Accounts — Many plans are funded by mutual fund custodial accounts that are maintained either as individual or group agreements. The IRS guidance assumes that such accounts will be distributed in cash, in-kind, or as a direct rollover from the 403(b) plan to an individual retirement account (IRA) or another eligible retirement plan by a plan participant of beneficiary. The IRS guidance states that amounts distributed from a custodial account will be taxable unless rolled over to an IRA or another eligible retirement plan within 60 days. The IRS’s guidance is not clear regarding what happens if a participant or beneficiary fails to make an election to receive a distribution, i.e., will it cause the termination to fail?
File a Final Form 5500. The 403(b) plans covered by ERISA must file a final Form 5500 by the last day of the 7th month after the date of final distribution of assets from the plan. Other Issues The IRS failed to address some important items that could cause a plan to fail to terminate. Plan sponsors that have these issues might want to delay terminating their plans until IRS issues additional guidance. They include:
• Plans with grandfathered accounts excluded under U.S. Department of Labor’s (DOL) Field Assistance Bulletin 2009-2 need to consider whether these accounts may also be excluded from a plan’s termination;
• Plans that allow loans to participants need to determine with the vendor whether the loans can be transferred to the individual annuity account or contract. If they cannot, then tax guidance is needed from IRS. Also, it needs to be determined how loan payments will be made, if they were being made by payroll deduction prior to the plan’s termination;
• The IRS has not addressed the treatment of 403(b) contracts that include life insurance, nor plans that have Roth 403(b) contributions or after-tax contributions. There needs to be additional tax guidance on the treatment of these items before distributions from accounts with these features can be correctly reported for tax purposes; and,
• The treatment of lost or nonresponsive plan participants needs to be addressed. Given the number of open issues related to the termination of 403(b) plans at this time, many plan sponsors will want to delay attempting to terminate their plan until additional clarification is issued from IRS and possibly also from the DOL. E
Peter Alwardt is partner-in-charge – tax; employee benefit group, EisnerAmper LLP. His email is [email protected] Christine Faris is director – tax; employee benefit group at EisnerAmper LLP. Her email is [email protected]