The IRS took a significant step when it specifically recognized the termination of a 403(b) plans as being a “distributable event” in its 2007 regulations. This then permitted, for the first time, plans to distribute the assets of any 403(b) funds otherwise subject to distribution restrictions (like the elective deferrals in an annuity contract and any contribution to a custodial account) upon plan termination. As some of you may recall, 403(b) plan terminations were never recognized as a distributable event prior to those regulatory changes.
A 403(b) plan termination (just like a 401(k) plan termination) is not complete until all of the assets in the plan are distributed, which must be generally accomplished within 12 months of the initiation of the termination. 403(b) plans, of course, have a unique problem with this rule. How do you distribute assets where the employer has no authority to distribute the assets in that 403(b) contract, either by virtue of the contract reserving to the individual participant the right to direct a distribution or where there is no surrender value in a contract (such as in an “annualized” contract)? The answer is a pretty straightforward one: the IRS permits the terminating plan to actually “distribute” the contract itself to the participant, instead of requiring the contract to be “cashed out.” We generally refer to this as an “in-kind” distribution.*
This is all fine and dandy until (as it seems in most things 403(b)) you pay close attention to the details: how in the world do you effectuate an in-kind distribution of an annuity contract?
From a strictly legal viewpoint, this really is a pretty straight forward task: the duly authorized officer of the organization, in proper exercise of authority granted by the organization, terminates the plan and directs the in-kind distribution of those annuity contracts. The organization then provides documentation of that corporate action to the insurer, with directions to remove the organization from its records as the plan sponsor. The insurer then deals directly with the participant in the same manner as it deals with an IRA holder. Being a distribution, all of the ERISA and Tax Code rules related to consents,** approvals and notices need to be followed. Many of the large 403(b) vendors now have procedures in place to administratively handle these “in-kind” distributions.
But then along comes Bob Lavenberg and Megan Stern, of BDO, probably one of the few auditing firms in the country with a high level of 403(b) audit sophistication. Bob, in particular, has been causing me (well deserved) heartburn for years with his insightful analysis of these quirky 403(b) issues.
Bob and Megan asked me what seems to be a simple question: how do you audit a 403(b) in-kind distribution? There is no financial transaction, no cash changes hands, there is no change in investments. It really is only a nominal change in the records of the insurer. Yet, somehow, GAAP requires that the “transaction” be verified.
Well, there is no answer, yet, to this question, which means the industries (that is, auditors, insurers, and lawyers) will be pressed for finding a standardized approach for bringing audit certainty to this process. It even becomes a bigger issue than 403(b)s: QLACs and other distributed annuity contracts are all able to be distributed as “in-kind” distributions from 401(a) plans as well, and there is no acceptable “recordkeeping” method to audit.
Until then, auditors will be hard pressed to validly document these sorts of distributions.
*Note that the IRS has taken the position that only annuity contracts can be distributed “in-kind”, and not individually owned custodial accounts. The language of neither the statute or the regulations appear support this position but, until the IRS changes that position, there is some risk in attempting an “in-kind” distribution of a custodial account.
**Note there are special rules related to when spousal consents are required on annuity contract distributions. See Rev. Rul. 2012-03.