• IRS Provides Additional Guidance on 403(b) Plan Terminations
  • May 5, 2011 | Author: Laura R. Westfall
  • Law Firm: King & Spalding LLP - New York Office
  • n late February, the Internal Revenue Service (the “IRS”) issued Revenue Ruling 2011-7, providing much-needed guidance on how to implement the termination of a plan that is governed by Section 403(b) of the Internal Revenue Code of 1986, as amended (the “Code”), often referred to as a “403(b) plan.” Although previous guidance promulgated by the IRS allowed 403(b) plans to be terminated, that guidance did not address the practicalities of carrying out such a termination.

    A 403(b) plan may only be established by certain types of entities, such as public educational organizations, organizations that are tax-exempt under Section 503(c) of the Code, and churches. Prior to 2007, no rules existed regarding whether a 403(b) plan could be terminated (for tax purposes), or how such a termination would be accomplished. Employers could freeze their 403(b) plan (i.e., by ceasing contributions to the 403(b) plan), but simply freezing the 403(b) plan did not allow the 403(b) plan to make in-service distributions to its participants.

    The 2007 Final Regulations

    In 2007, the IRS published final regulations, effective beginning in 2009 (the “2007 Final Regulations”), that, among other things, allowed employers sponsoring a 403(b) plan to (i) amend the 403(b) plan to eliminate future contributions for existing participants, or to limit participation to existing participants and employees; (ii) amend the 403(b) plan to provide for plan termination; and (iii) amend the 403(b) plan to allow accumulated benefits to be distributed upon such termination. Under the 2007 Final Regulations, the following requirements must be met for a 403(b) plan to be terminated:

    1. The employer sponsoring the 403(b) plan being terminated (taking into account all of the employer’s affiliates under Section 414 of the Code) may not make contributions to any other 403(b) contract during the period that begins on the date the 403(b) plan is terminated and ends 12 months after distribution of all assets from the terminated 403(b) plan, except where fewer than 2% of the employees eligible for the 403(b) plan being terminated (as of the termination date) are eligible under the other 403(b) plan; and

    2. All accumulated benefits under the 403(b) plan being terminated must be distributed to all participants in the 403(b) plan as soon as administratively practicable after the 403(b) plan’s termination (a “distribution,” for these purposes, includes delivery of a fully-paid individual insurance annuity contract).

    INSIGHT. The 2007 Final Regulations did not state that vendors had to cooperate with the 403(b) plan sponsor to effectuate a termination and distributions. As a result, some vendors pointed out that the contracts they had entered into prior to 2009 did not allow for distribution upon a 403(b) plan termination, and others refused to distribute custodial accounts to participants upon a 403(b) plan termination unless each participant under the 403(b) plan consented to the distribution.

    Revenue Ruling 2011-7

    Revenue Ruling 2011-7 explains the process of terminating a 403(b) plan by providing four factual “situations,” each of which illustrate the steps to be taken in terminating a distinctive type of 403(b) plan. For each of the four situations, the IRS assumes the following:

    1. First, the IRS assumes that the 403(b) plan permits benefit payments to be made after termination from employment or upon the 403(b) plan’s termination, and that the 403(b) plan includes nonelective employer contributions and elective deferrals and holds no amounts from designated Roth contributions or after-tax contributions. The IRS also assumes that the sponsoring employer will not make contributions to another 403(b) plan during the 12-month period discussed above;

    2. Second, the sponsoring employer adopts a binding resolution (either effective immediately or prospectively) under which (i) the employer halts future purchases of annuity contracts under the 403(b) plan, and terminates the 403(b) plan; (ii) all benefits under the 403(b) plan become fully vested and nonforfeitable as of the 403(b) plan’s termination date; and (iii) all benefits will be distributed as soon as practicable after the 403(b) plan’s termination;

    3. Third, the 403(b) plan participants and beneficiaries are notified of the 403(b) plan termination; and

    4. Fourth, distributions pursuant to the terms of the 403(b) plan and the binding resolution are made as soon as administratively practicable after the termination date. (NOTE: Revenue Ruling 2011-7 suggests that Rev. Rul. 89-89’s interpretation of the meaning of “as soon as practicable” apply, which generally means within 12 months.)

    Aside from the above assumptions and steps, which are necessary for the termination of any 403(b) plan in accordance with Revenue Ruling 2011-7, additional considerations and necessary steps for such termination depend on the type of 403(b) plan being terminated. These considerations and steps are outlined below.

    Fact Situation 1: Individual Annuity Contracts.  In Fact Situation 1, the 403(b) plan is funded solely through fully-paid individual annuity contracts issued by an insurance company. In this situation, Revenue Ruling 2011-7 indicates that the 403(b) plan termination would be effectuated by:

    1. Distributing (as soon as practicable) the individual annuity contracts to all 403(b) plan participants, beneficiaries who are alternate payees, and beneficiaries of deceased participants;

    2. Making single-sum payments to 403(b) plan participants, where their contracts permit them to receive payments in that form upon a 403(b) plan termination (and permit such payments to be paid by direct transfer to an individual retirement account (“IRA”) or other eligible retirement plan); and

    3. Providing a timely 402(f) notice to 403(b) plan participants and beneficiaries.

    INSIGHT.  Revenue Ruling 2011-7 states that “because the [403(b)] plan is funded solely through fully-paid individual insurance annuity contracts, no further action is required to be taken in order to distribute the contracts,” because once the 403(b) plan terminates, the participants and beneficiaries are entitled to payments in accordance with the terms of the contracts.

    Fact Situation 2: Individual and Group Annuity Contracts.  In Fact Situation 2, the 403(b) plan is funded by both individual and group annuity contracts issued by an insurance company. In this situation, Revenue Ruling 2011-7 indicates that the 403(b) plan termination would be effectuated by:

    1. Following the same steps as in Situation 1, for the individual annuity contracts; and

    2. Issuing “individual certificates” for the group annuity contracts to each participant and beneficiary evidencing his or her interest in the group contract. (The certificates function much like separate individual contracts for tax purposes, and constitute a distribution of the participant’s or beneficiary’s participant’s/beneficiary’s accumulated benefit in the group annuity contract.)

    Fact Situation 3: Individual and Group Annuity Contracts, Plus Mutual Funds in Custodial Accounts under Either Individual or Group Agreements.  In Fact Situation 3, the 403(b) plan is funded by individual and group annuity contracts, as well as mutual funds in custodial accounts under either individual or group agreements. In this situation, Revenue Ruling 2011-7 indicates that the 403(b) plan termination would be effectuated by:

    1. Following the same steps as in Situation 1, for the individual annuity contracts;

    2. Following the same steps as in Situation 2, for the group annuity contracts; and

    3. Making distributions in cash (or in-kind) to 403(b) plan participants and beneficiaries in an amount equal to their account balances under the custodial account. Depending on the participant’s or beneficiary’s election, the distribution is either made to an IRA established for him, or to another eligible retirement plan, including an IRA established by the same custodial account provider that permits investment in the same mutual fund in which such participant’s or beneficiary’s custodial account is invested (and, in either case, the custodial account provider permits such an eligible rollover distribution to be paid by direct transfer).

    Fact Situation 4: Money Purchase Pension 403(b) Plan.  In Fact Situation 4, the facts are the same as in Situation 3, except that the 403(b) plan is a money purchase pension 403(b) plan that is subject to the participation and vesting requirements and minimum funding standards of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), as well as the Code’s qualified joint and survivor annuity (“QJSA”) rules. In this situation, Revenue Ruling 2011-7 indicates that the 403(b) plan termination would be effectuated by:

    1. Following the same steps as in Situation 1, for the individual annuity contracts;

    2. Following the same steps as in Situation 2, for the group annuity contracts;

    3. Following the same steps as in Situation 3, for the custodial accounts;

    4. Purchasing and distributing a fully-paid individual insurance annuity contract, where amounts held in the custodial accounts for participants in the 403(b) plan are to be made in the QJSA form; and

    5. Filing a final Form 5500 for the plan year that includes the final distribution.

    Tax Consequences to 403(b) Plan Participants of Termination.  Revenue Ruling 2011-7 also discusses the tax consequences to 403(b) plan participants and beneficiaries upon termination of the 403(b) plan. Whether the termination will result in immediate inclusion in the participant’s or beneficiary’s income depends on the form of distribution. The delivery of a fully-paid individual annuity contract, or an individual certificate evidencing fully-paid benefits under a group annuity contract (as contemplated in Situations 1 and 2) is not included in a 403(b) plan participant’s or beneficiary’s gross income until amounts are actually paid to such participant or beneficiary, so long as the annuity contract continues to comply with the requirements for a 403(b) plan in effect when the contract is distributed.

    Any other kind of distribution made to effectuate a 403(b) plan termination (such as amounts from a custodial account, as contemplated in Situation 3, or a lump-sum payment from an annuity contract), is includable in a participant’s or beneficiary’s income when distributed (except to the extent the amount is rolled over to an IRA or other eligible retirement plan by a direct rollover or timely transfer).

    INSIGHT.  As discussed above, Revenue Ruling 2011-7 requires the annuity contract to continue to comply with “the requirements for a 403(b) plan in effect when the contract is distributed.” However, it is not clear in Revenue Ruling 2011-7 what such requirements would include.

    Outstanding Issues

    Several issues regarding 403(b) plan terminations remain outstanding, in spite of Revenue Ruling 2011-7’s additional guidance, such as:

    Distribution of Individually-Owned Custodial Accounts.  Revenue Ruling 2011-7 does not address the distribution of individually-owned custodial accounts under a terminating 403(b) plan. Because such accounts are contracts between the custodian and an individual 403(b) plan participant, the employer sponsoring the 403(b) plan being terminated may not have the right to compel a surrender of the account for cash upon a termination of the 403(b) plan.  Because the IRS did not address these accounts in Revenue Ruling 2011-7, it is not clear if 403(b) plans with such accounts can be terminated without impacting the tax status of the underlying custodial account (or, whether the termination of the 403(b) plan is even possible, given the 2007 Final Regulations’ requirement that all accumulated benefits under the 403(b) plan being terminated must be distributed to all participants in the 403(b) plan as soon as administratively practicable after the 403(b) plan’s termination ).

    Vendor Issues.  Several vendor-related issues remain uncertain after the issuance of Revenue Ruling 2011-7.  For instance, prior to the IRS’s issuance of the 2007 Final Regulations, 403(b) plan participants could transfer their contracts and accounts to new vendors without notifying or coordinating with the employer sponsoring their 403(b) plan. Revenue Ruling 2011-7 does not address whether the sponsoring employer is required to notify such participants (and their new vendors) that the 403(b) plan has been terminated, nor does it explain how such notice would be provided (given that the sponsoring employer would not have contact information for the new vendors).

    In conclusion, Revenue Ruling 2011-7 provides helpful guidance for sponsoring employers on many of the procedural aspects of effectuating a 403(b) plan termination, but practical questions may still arise in the implementation.