Business of Benefits : Employee Benefits Lawyer & Attorney : Law Office of Robert J. Toth, Jr. : 403(b) Plans, Annuity & Insurance Law : Business of Benefits Blog

 The IRS issued its long awaited guidance on the termination of 403(b) plans, with Revenue Ruling 2011-7. TEGE was well attuned to the challenges of terminating 403(b) plans, and its staff moved quickly to address some of the basic issues related to this "newly found" ability, provided by the 403(b) regulations, to treat the 403(b) plan termination as a distributable event. The delay in the final issuance of this guidance was due to factors well beyond the control of the TEGE, which had pressed to have it approved much earlier.

A number of practitioners are likely to be disappointed by the limited scope of this ruling. However, it establishes a fundamental structure within which to work, and clarified things at which we could only guess in the past.  A number of issues are left unresolved, which I hope will be addressed over time by the IRS. But this provides us with an important starting point.

In dealing with anything as complex and new as a 403(b) termination, guidance will be a mixed bag. Here, there are Clarifications and things that still leave us In the Fog. 

Clarifications

1. We now know the process to be followed under which the IRS will recognize a plan as being terminated and as a distributable event occurring: a binding resolution; notification to participants and beneficiaries of the termination; 402(f) notice of rollover rights; cessation of all 403(b) contributions to other 403(b) plans within the controlled group (or at least, per the regs, 98% of the group); and distributions are made within 12 months, including distributions of  "a fully paid individual insurance annuity contract."
2. Certificates under a group annuity contract will be considered as the distribution of  a "fully paid individual insurance annuity contract" as long as all of the other rules are met.
3. The distributed annuity contract will still be considered a 403(b) contract.
4. Amounts from this distributed contract can still be rolled over.
5. The IRS formally recognized the legitimacy of the group custodial arrangement

In the Fog

1. The revenue ruling is silent on whether or not, or under what conditions, the distribution of a custodial account can be treated as a "fully paid individual insurance annuity contract." I would hesitate to treat this silence as meaning it can't be done, as the ruling doesn't change the legal basis used by those who distribute custodial accounts. it may exist. But the custodian must agree to the "distribution"  treatment if that is what you choose-and, in any event, the revenue ruling doesn't provide support for this position.
2. It cites "Situation #3," where a participant elects payments from a custodial account upon termination of the plan, either cash or in kind. It is silent on what happens when no election is made. I assume the termination then fails, but this is unclear. 
3. There is no guidance on what constitutes delivery of a "fully paid" contract. Hopefully, in the case of an individual contract, it merely means notifying the individual that the contract is no longer part of the plan. 
4. It creates some confusion on vesting in non-ERISA governmental plans: the tax regs don't seem require full vesting of non-vested amounts on termination, as they are treated as 403(c) monies. It only requires that 403(b) amounts be non-forfeitable. I THINK all this ruling says is that the 403(c) amounts can never become 403(b) upon termination if they do not vest-but that is unclear.
5. The ruling is silent on what happens to the distributed (and rolled) amounts if all of the assets cannot be distributed by the end 12 month period-which can be a real problem for 403(b) plans which generally doesn't exist for 401(k) plans.

AND, perhaps the Grandest Fog:

How does a distributed contract, with no employer being responsible for it, maintain its status as a 403(b) contract? A colleague has pointed out that it appears to require a permanent grandfather of the rules as of the date of  distribution-which is incredibly unworkable from a vendor view given the amount of change that occurs in this area. Or, as my good friend and mineral collector Evan Giller colorfully puts it, it preserves each year's then current rules "like bugs in Amber..." (though, as Evan also points out, Amber is not really a mineral).

There are other questions along the same lines.  Can you roll funds into it, as permitted under 403(b)? Can you process loans, and can the vendor rely upon participant representations? What of transfers and exchanges?

This Revenue Ruling also raises a related question, for future guidance, that is, the question on whether or not there will be a determination letter process for 403(b) terminations.

This is a nice start. But there is still a lot of work to be done.

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What Happened

One of the biggest disappointments arising from the issuance of the 403(b) regs has been the inability of employers to effectively terminate their plans.  At first, the IRS caused quite a favorable stir when it announced that the regs would specifically classify the termination of a 403(b) plan as a distributable event, and would  further permit the distribution of a "fully paid individual insurance annuity contract" as a terminating distribution. This seemed almost too good to be true as employers (who were willing to pay the cost of termination, including the full vesting of employer contributions) and consultants now had another tool with which to manage the complicated changes coming out of the new 403(b) scheme. Those of us familiar with the intricacies of individual 403(b) contracts were also well familiar with the administrative methods under which an employer could actually distribute an individually owned 403(b) contract without violating the individual's contractual rights.  Life, for a moment, seemed wonkishly swell.

Reality then hit. IRS officials soon started making public statements that individually owned custodial accounts would not be honored as annuity contracts for purposes of terminating plan distributions. Some unusual comments were even made that distributing certificates under group annuity contracts (a standard method of dstribtuing annuities under terminated defined benefit plans) also would not be honored as valid terminating distributions.

These positions had the practical effect of making most 403(b) plan terminations impractical. Because all of the assets of a terminated 403(b) plan need to be distributed within 12 months of the date of termination, and because employers cannot typically force the distributions out of an individual custodial account (and often not from the certificate of a group annuity contract), any attempt at termination would have a high likelihood of failure. If an employer could not convince all of the plan's custodial account owners to take a cash distribution from their accounts, the termination would fail.  If the termination fails, then the funds of all of those who had rolled funds into an IRA from the supposedly terminating 403(b) plan or had taken a "fully paid insurance annuity contract" all becomes taxable.

 This is an absurd result. It completely eviscerates  the IRS's own termination provision and takes away a valuable planning tool from the marketplace.  

Solutions

The draconian position taken by the IRS in drawing a distinction between an individually owned annuity and a custodial account is hard to understand. From a strictly statutory view, it seems to have little support. The language of 403(b)(7) is unambiguous:

"for purposes of this tilte, amounts paid by an employer described in paragrph (1)(A) to a custodial account which satisfies the provisions of 401(f) shall be treated as amounts contributed by him for an annuity contract for his employee...."

The only 403(b) distinctions between a custodial account and an annuity contract (related to the ability to withdraw employer contributions without a "distributable event") are in 403(b)(7) itself. There seems to be little statutory authority for allowing terminating annuity distributions and not allowing custodial account distributions. For 403(b) purposes, a custodial account IS an annuity contract.  What is really interesting about the 403(b) regualtions, is that a fair reading of it doesn't seem to prevent the distribution of a custodial account as an annuity contract.

As a practical matter, the IRS's public position makes even less sense.  If you start with the proposition that 403(b) contracts have been administered for years as individual pensions and that- to many custodial account administration systems- it mattered little whether or not the account was associated with an employer. Many non-ERISA, individually owned 403(b) custodial accounts have actually been administered by mutual fund companies on the same systems that administers their IRA accounts.

It is truly hard to understand the basis for the IRS's odd position in this matter. There is no longer any potential for employer abuse, as any relationship with the employer has been terminated, and the terms of the contracts continue to regulate participant's activity.

So, now what? The Investment Company Institute has recently suggested a complex solution to the IRS to solve the IRS's "problem".  It involves waiting periods, switching the taxability of the account, issuuing deemed distribution notices and the like. All of this seems terribly complex and unnecessary, creating even more tax horror for paritcipants and administrative nightmares for vendors.

Isn't the answer really much simpler than all that?Is there any reason why a "distributed custodial account" couldn't be administered in the way non-ERISA contracts had been administered in the past, or in the manner IRAs are currently administered?  

Perhaps if there is a distaste for that past, allow the distribution of a custodial account from a terminated 403(b) plan, and treat it under the same tax rules as distributed annuity contracts. After all, those distributed annuity contracts often hold mutual funds in their variable accounts. Outline a simple set of rules for both of those types of contracts, based upon the former 403(b) rules but infused with a dose of any anti-abuse the IRS see as a risk. Require simple annual reporting as a line on the existing IRA reporting form, Form  5498.  Perhaps even allow it to be treated in the same manner as plan distributed annuities.

Does the IRS fear so much that relying upon the representations of terminated 403(b) plan participants without employer oversight will so undermine the system as to be destructive, in a system where those funds could also be transferred to a relatively unregulated IRA,  where such a vast amounts of assets are held?

I just don't get it.

Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.  

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