by Jeffrey P. Cairns

In December 2004, the Internal Revenue Service published proposed regulations providing guidance for complying with the tax rules applicable to Internal Revenue Code Section 403(b), the section authorizing tax-sheltered annuity arrangements for employees of public schools and tax-exempt organizations described in Section 501(c)(3) (public charities). The existing regulations have been in effect since 1964 only to be supplemented by a 1989 notice, Notice 89-23, and rules describing eligible rollover distributions and minimum required distributions under Section 401(a)(9).

In many respects the proposed regulations, which will take effect no earlier than 2006, make the nondiscrimination rules and elective deferral procedures for 403(b) plans comparable to those in place for 401(k) plans.

Elective Deferrals
Elective deferrals to 403(b) arrangements must satisfy annual dollar limits imposed on elective deferral arrangements under Section 402(g)(1), and must be coordinated with all other elective deferral arrangements sponsored by the same employer that are subject to these limits. These provisions must be written into the 403(b) annuity contract or custodial agreement. Proposed regulations would allow participants to enroll and make changes in elections on the same basis as 401(k) plans for elective deferrals. The proposed rules would provide that excess deferrals exceeding the annual dollar limitation in Section 402(g) ($14,000 for calendar year 2005) may be distributed with earnings on or before April 15 of the following calendar year.

The regulations would also adopt the anti-conditioning rule described in Section 401(k)(4), which provides that benefits other than matching contributions may not be conditioned on an employee agreeing to make elective deferrals to the plan.

Plan Document Requirement
Unlike the 1964 regulations, in order for the arrangement to be tax qualified, the proposed rules would require a 403(b) plan to be maintained pursuant to a written plan document setting forth all of the requirements for 403(b) plans under the Internal Revenue Code. Currently, only plans sponsored by Section 501(c)(3) tax-exempt entities are subject to a formal plan document requirement, and then only to the extent that the plan is subject to Title 1 of the Employee Retirement Income Security Act of 1974 (ERISA) as a result of the employer providing matching or employer contributions or otherwise not satisfying the exemption for salary deferral only arrangements outlined in the Department of Labor Regulations. Under these proposed rules, all plans other than church plans (including governmental 403(b) plans) would require formal written plan documents.

For example, the plan document would need to include language regarding the universal availability rule for elective deferrals and elective deferral contribution limits. The plan document would also have to incorporate the same nondiscrimination rules regarding employer contributions that apply to qualified plans; for example, matching contributions would be subject to the Section 401(m) average contribution percentage ("ACP") test and Section 401(a)(4) would apply to all other employer contributions. (The proposed regulations would preserve the exemption from these nondiscrimination rules with respect to governmental plans, however, with the exception of the compensation limit under Section 401(a)(17).)

Section 403(b) annuity contracts and custodial agreements would also have to include language regarding minimum required distribution requirements of Section 401(a)(9) (the age 70 1/2 rules), the incidental benefit requirements of Section 401(a), and the rollover distribution rules of Section 402(c). Contracts would also have to include language that the contributions may not exceed the limits of Section 415 (the annual additions limitations for defined contribution retirement plans).

Life Insurance Prohibited
Life insurance and endowment contracts would not qualify as funding vehicles after February 14, 2005.

Catch-Up Contributions
Certain Section 403(b) arrangements allow for an increased limit on contributions for employees with 15 years of service. The proposed regulations include an ordering rule which provides that if the individual is eligible for the 15-year catch-up, that limit must be applied before the EGTRRA post-age-50 catch-up limitation would be applied. In addition, employers may make contributions for former employees up to the 415(c) limit for up to 5 years after separation, subject to applicable nondiscrimination rules.

Nondiscrimination Rules
In 1989, the Internal Revenue Service released guidance permitting certain employees to be excluded from participating in a 403(b) plan without violating the nondiscrimination rules applicable to such plans. Sponsors of 403(b) plans could rely on these "safe harbor" exclusions to exclude certain participants. In the same guidance, Notice 89-23, the Internal Revenue Service indicated that sponsors could rely on a good faith reasonable interpretation of the nondiscrimination standards. The proposed regulations would repeal the reasonable standard safe harbors in Notice 89-23 and would limit the safe harbor exclusions from participation to certain situations described in the Code and regulations. Of particular difficulty is the exception in the Code that allows employers to exclude from participation "employees that normally work fewer than 20 hours per week." Under the proposed regulation, an employee would be treated as normally working fewer than 20 hours per week only if:

• for each 12-month period beginning on the date of the employee’s initial employment, the employer "reasonably expects" the employee to work fewer than 1,000 hours of service per year; and
• for each plan year ending after the close of that first 12-month period beginning on the date the employee’s employment commenced, the employee worked fewer than 1,000 hours of service in the preceding 12- month period.

This test would be performed on a common-law employer basis, rather than on a controlled group basis, and employers could continue to treat geographically distinct units as separate entities for employee benefit purposes if the units are operated independently on a day-to-day basis. (For example, state chapters of a national nonprofit organization could operate independent employee benefit plans and test them separately if they are operated independently of their national or regional affiliates.) Of course, employers subject to ERISA could not exclude from participation those employees who have completed one year of service (1,000 hours of service during a 12-month measuring period) simply because the employee was regularly scheduled to work fewer than 20 hours per week.

The IRS is inviting plan sponsors to submit comments on whether these additional exclusions should be restored, including an exception for employees who make a one-time election to participate in a governmental plan instead of a 403(b) plan, employees covered by a collective bargaining agreement, certain visiting professors, and employees affiliated with religious orders who have taken vows of poverty.

Controlled Group Rules
The tax code rules governing controlled entities and their accompanying regulations do not specifically address how non-stock tax-exempt entities are to be aggregated for these purposes. The proposed regulations would include new rules under Section 414(c) that would require separate entities to be treated as a single employer where 80% or more of the directors of one entity are either representatives of or directly or indirectly controlled by the other organization. Unlike the rules that require for profit employers jointly sponsoring plans to be treated as multiple employer plans, the proposed regulations would also allow permissive aggregation of tax-exempt organizations that are not under common control if they maintain a single plan and regularly coordinate their day-to-day activities with the other tax-exempt entity.

Plan Terminations
Current IRS rules do not permit termination of 403(b) plans. The proposed regulations would for the first time allow these plans to be terminated and benefits to be distributed if, as under the 401(k) rules, no other entity in the same controlled group makes contributions to a 403(b) plan under which 2% or more of the employees in the terminated plan participate within 12 months before or after the date of plan termination.

Effective Date
The proposed regulations would be effective for taxable years beginning after December 31, 2005. As the regulations are solely in proposed form (not temporary), they cannot be relied on until published in final form. Existing 403(b) plans should continue to operate under Notice 89-23 and current guidance until the regulations are finalized.