#10YearChallenge for 403(b) Plans

The #10YearChallenge on social media these days is to post a picture of yourself from 2019, next to one from 2009, hopefully illustrating how little has changed in the 10 year interim. For tax-exempt employers who sponsor Section 403(b) plans, however, 2019 brings a different #10YearChallenge – namely, to bring their plan documents – many of which date back to 2009 – into compliance with current law.

The actual deadline to restate your 403(b) plan (technically, the end of the “remedial amendment period”) falls on March 31, 2020, but vendors of 403(b) documents that have been pre-approved by the IRS will proactively be sending clients document restatement packages this year, in order to avoid the inevitable crunch just prior to the 2020 deadline. The restatement deadline is an opportunity to retroactively restate the plan document (generally, to January 1, 2010) to correct any defects in the terms of the plan documents, such as missed plan amendments. It is also the last chance for tax-exempt employers with individually designed plan documents to restate onto a pre-approved document, as the IRS does not now, and does not intend to, issue approval letters for individually designed 403(b) plans

There are significant differences in the 403(b) document landscape in 2019, as compared to 2009. Back in 2009, which was the year the IRS first required all 403(b) plan sponsors to have a plan document in place, there were no IRS pre-approved documents. Now, in 2019, numerous vendors offer pre-approved documents that individual tax-exempt employers can (somewhat) tailor to their needs (for instance, through Adoption Agreement selections). The IRS pre-approved documents are much lengthier than the documents that were adopted in 2009. For instance, the Fidelity Adoption Agreement from 2009 was approximately 6 pages long, including attachments, but the 2019 restatement version, with attachments, is approximately 49 pages long. This difference is down to changes in the laws governing retirement plans, as well as increased sophistication of plan administration and recordkeeping systems over that time.

Due to increasing complexity in plan design and administration, employers may want to take the restatement opportunity to self-audit their plan administration procedures and to confirm that they are consistent with the way the document, as restated, reads. For instance, does the payroll department, whether internal or outsourced, draw from the correct payroll code sources when processing employee salary deferrals and employer matching or nonelective contributions? Does the plan contain exclusions from the definition of compensation that are being ignored when payroll is processed? Are participant salary deferrals and loan repayments timely being remitted to the plan? The self-audit is a good opportunity to catch any operational errors and correct them under IRS or Department of Labor voluntary compliance programs (e.g. Employee Plans Compliance Resolution System, and Voluntary Fiduciary Correction Program).

Pre-approved document vendors (often also the investment providers) will assist employers in migrating their 2009 (or subsequent) plan document provisions over to the new version of the document, but employers should seek assistance from benefit counsel in this process to limit the chance of errors. Benefit counsel can also help conduct a self-audit, or take employers through the voluntary correction programs in the event any operational errors are uncovered.

Beyond the 403(b) Plan: Top 5 Things to Know About Deferred Compensation for Non-Profit Executives

Tax-exempt employers may offer deferred compensation plans to their select executives to allow for retirement savings over and above the dollar limits applicable under a Section 403(b) plan. However the rules governing these arrangements, which fall under Section 457 of the Internal Revenue Code (Code), are complex and often misunderstood.  Below are five things top things to keep in mind in this area, to get the most that the law offers without unpleasant tax surprises along the way.

1.  It’s complicated……

First, there are two types of 457 plans: 457(b) plans and 457(f) plans.  A tax-exempt employer can use both for the same executives but careful planning is advised.  The (b) plans allow set-aside (in the form of employee deferrals or employer contributions) of only $18,000 (in 2017) per year, with no age 50+ catch-up allowance.  Amounts set aside under a (b) plan are not taxed until they are distributed to the executive, an event which must be delayed until termination of employment/retirement, or on the occurrence of unforeseeable circumstances (narrowly defined).  Taxation is delayed until distribution even though the amounts are generally “vested” (no longer subject to forfeiture) when they are contributed.  By contrast there is no dollar limit on the amount that may be set aside under a 457(f) plan (subject to item no. 4, below), but the amounts are taxable upon completion of a vesting schedule (e.g., from 3 to 10 years).  Therefore distribution in full almost always happens upon completion of vesting.  Put most simply, (b) plans are a good way to double an executive’s 403(b) deferral budget, and (f) plans are a good way to help an executive catch up on retirement savings when a retirement or other departure date is within a 3 to 10 year time horizon. Further, in order for an exemption from ERISA to apply, participation in these plans must be limited to a “select group of management or highly compensated employees,” comprising no more than 5% – 10% of the total workforce, referred to as the “top-hat” group.  In a small tax-exempt employer with 10 or 20 employees this may mean only 1 or 2 executives may participate.

2.  You (usually) can’t roll to an IRA.

Generally when an executive is ready to take distribution of benefits from a 457(b) or (f) plan a taxable cash distribution is required, and rollover to an IRA is not an option. (One exception is when the executive moves to a new employer that maintains a 457(b) plan that accepts rollover contributions).  Under a (b) plan, which may allow installment distributions over a period of years, the lack of an IRA rollover option is not so severe, but in a 457(f) plan setting, which generally calls for lump-sum distributions, the tax impact can be severe and the executives should be advised to do advance tax planning with their own CPAs or other tax advisors, well ahead of their planned retirement date or other vesting trigger.  In my experience, lack of the IRA rollover option often comes as an unwelcome surprise to the covered executives.

3.  The assets belong to the organization.

Section 457 plans are non-qualified meaning in relevant part that they assets the plans hold belong to the tax-exempt organization that sponsors the plan until the date(s) they are paid out to the participants. The assets must be held in an account in the name of the organization “FBO” the 457 plan account for the name of the executive.  There is no form of creditor protection but it is possible to put in place a “rabbi trust,” so called because the trust format was first approved by the IRS on behalf of a synagogue for its spiritual leader.  The rabbi trust will not protect the 457 assets from the organization’s creditors, but it will prevent the organization from reneging on the deferred compensation promise to an executive.  This is particularly helpful for an organization that anticipates changes in its board structure after approval of a 457 arrangement.

4.  The normal “reasonable compensation” rules still apply.

Tax-exempt organizations must pay only reasonable compensation, in light of the services provided, to employees and other individuals who comprise “disqualified persons,” a category that includes executive directors and other “C-suite” members. Under the “intermediate sanction” regime the IRS imposes excise taxes on individuals who benefit under, and organization managers (e.g., board members) who approve, compensation arrangements that fail the reasonableness standard.  Deferred compensation arrangements must be reasonable in light of all other compensation and benefits provided to the executives in question and in most cases this will require a third-party compensation consultant’s evaluation and review.  This is a vitally important and often-overlooked piece of deferred compensation compliance in the tax-exempt arena.

5.  DOL notification is required.

As part of the ERISA exemption for top-hat deferred compensation plans, a tax-exempt organization must provide a “top-hat notification letter” to the Department of Labor within 120 days of implementing such a plan. Top-hat letters must be filed electronically.  Failure to timely file a top-hat letter could mean that your deferred compensation plan is liable for ERISA penalties for failure to file annual information returns (Form 5500), to hold plan assets in trust, to make certain disclosures to participants, and on a host of other compliance points.  The Department of Labor permits late filing of top-hat notification letters for payment of a modest fee.  If your organization has a deferred compensation plan in place you should have ready access to a copy of the top-hat notification letter (or confirmation of its online filing) and should consider the DOL correction program if you cannot do so.

Having practiced law in Santa Barbara, California, a haven for charitable organizations, for over 20 years I have had the privilege of working with these special deferred compensation plan rules in many different factual settings and would be happy to help your organization navigate them in order to best retain and reward your valued executives.

Chart of Section 457(f) Carve-Outs Under New Proposed Regulations

The IRS recently announced proposed regulations under Internal Revenue Code (“Code”) Section 457 that update prior, final regulations issued in 2003 and other subsequent guidance from IRS.  Section 457 governs deferred compensation rules for government employees, and for executives of private, tax-exempt organizations it permits deferrals from compensation over and above limits set forth in Code § 403(b).  The proposed Section 457 regulations impact “ineligible” deferred compensation plans under Code § 457(f) more substantially than “eligible” deferred compensation plans under Code § 457(b) which were more comprehensively covered in the 2003 final regulations.

By contrast to eligible Section 457(b) plans, which limit annual contributions to $18,000, as adjusted for inflation (and without the age 50 catch-up for private non-profit executives), there is no dollar limit on annual contributions to a Section 457(f) plan (although as explained below other laws do set reasonableness limits upon nonprofit executive compensation in general).   However, amounts set aside under Section 457(f) plans must be included in the executive’s taxable compensation once the amounts are no longer subject to a substantial risk of forfeiture, for instance upon completion of a vesting schedule, even if amounts are not physically paid out from the plan.  Due to the requirement that income inclusion/taxation occur when the substantial risk of forfeiture lapses, Section 457(f) plans generally work best when retirement is in the fairly near future (e.g., 5 to 7 years out), and where vesting occurs on or near the anticipated retirement date.

As summarized in the chart, below, the proposed regulations clarify how certain pay arrangements are carved out from Section 457(f) compliance, either because the arrangement is not deemed to provide for a deferral of compensation, or because it defers compensation but not in a manner that does not fall under Code § 457(f). Where no deferral of compensation occurs, the pay arrangement generally is also exempt from the “Enron rules” applicable to for-profit deferred compensation plans under Code § 409A, and related regulations.  (Final regulations under Code § 409A were published in 2007; the second of two sets of proposed regulations were published the same day as the proposed Section 457 regulations).  The proposed Section 457 regulations clarify that Section 457(f) arrangements generally are also subject to Code § 409A, although there are some important distinctions between the two sets of rules which I will address in a future post.

457(f) Chart

IRS, DOL Increase Scrutiny of Section 403(b) Plans

Tax-exempt organizations are now two and a half years into a major overhaul of the tax regulations and other rules governing Internal Revenue Code Section 403(b) retirement plans. Final regulations under Section 403(b) that issued in 2007, and were effective for most plans on January 1, 2009, for the first time required that all Section 403(b) arrangements – not just those that are subject to ERISA – be set forth in writing. Department of Labor (“DOL”) guidance also expanded the annual reporting duties of Section 403(b) plans effective in 2009, including for the first time the requirement that Section 403(b) plans with more than 100 participants obtain annual audited financial statements. These changes are part of an effort by the Internal Revenue Service (“IRS”) and DOL to bring Section 403(b) plans more into line with Section 401(k) and other plans maintained by for-profit employers.

Against this background, the IRS and DOL recently have increased their scrutiny of 403(b) plans and their sponsors. This increased scrutiny takes several forms.

A. Questionnaire re: “Universal Availability” in College, University Plans
I earlier wrote about an IRS questionnaire being sent to institutions of higher learning, to determine the extent to which they comply with the universal availabilty rule. Under that rule, if a Section 403(b) plan permits any employee to make salary deferrals to the plan, then it must offer the same opportunity to all employees (with limited optional exclusions). Colleges and universities often have many different categories of academic staff with widely varying work schedules, some of which end up classified as benefit-ineligible, at least with regard to group health coverage. Once an employee is classed as ineligible for group health coverage, it is not uncommon that they not be offered enrollment in other benefit plans, even those, such as Section 403(b) plans, that may have less restrictive eligibility. This is the kind of oversight that the questionnaire project is targeting. The Service will offer closing agreements to institutions that appear to be complying with the universal availability rule, and for those that improperly are excluding employees from making deferrals under the plan, it will extend the opportunity to self-correct. Self-correction would entail allowing impro9perly excluded employees to enroll in the plan and restoring (with employer money) missed deferrals the employees would have made if timely enrolled, plus earnings.

B. Increase in EBSA Audits of Tax-exempt Employers
In addition to the questionnaire project, there is at least anecdotal evidence that tax-exempt employers may also now be subject to increased plan audit activity from the DOL’s employee plans division, the Employee Benefits Security Administration. The Ryding Company, a long established administrative firm, reports an uptick in “full-blown” plan audit letters sent to its tax-exempt clients in Southern California.

According to Patricia Neal Jensen, J.D. , the company’s Senior Vice President, Marketing, EBSA inquiries have focused on timely deposit of salary deferrals (which is as soon as they reasonably can be segregated from payroll, or within 7 days for plans with fewer than 100 participants), and compliance with the written plan document rule. In addition to these issues, however, Ms. Jensen is noting for the first time inquiries about rates of return on plan investments, plan/investment committee agendas and minutes, investment policy statements, and due diligence reports on plan investment vendors and other service providers.

In Ms. Jensen’s experience, 403(b) investment vendors have not traditionally assisted clients with plan/investment committee guidance, or provided investment policy statements. Even now, when some vendors might be extending such services, plan sponsors should be wary of conflicted advice, particularly from vendors that have had a monopoly on plan investment options. Third party advisors who work in this area are offering fiduciary training for the plan/investment committee members, and helping employers put in place the procedural steps and documentation needed to demonstrate proper fiduciary functions.
I asked Ms. Jensen for her top recommendations to a tax-exempt employer, based on the audit activity she is seeing, and she replied as follows:

• Deposit employee salary deferrals and loan repayments within the 7-day safe harbor (small plans) or as soon as reasonably possible;
• Make sure your plan document is up to date and that you are administering the plan in compliance with the document;
• Hire a qualified, third party advisor who can work at the plan level… not from the perspective of the investment vendor;
• Have him or her take the plan out to bid to check on investment costs and performance
• Maintain investment/plan committee agendas and minutes; and
• Have an Investment Policy statement and do what it says.