Treasury and Labor both took significant steps in promoting lifetime income from defined contribution arrangements during Mark Iwry and Phylis Borzi’s tenures. The fiduciary rule at the DOL and staff reductions at the IRS seems to take their toll, as focus on this issue lessened dramatically-and then disappeared completely.

The recent uptick in publications from the private sector focusing on lifetime income is now a welcome surprise, complete with studies showing that participants are now wanting elements of guaranteed income ad part of their retirement arrangements. But lifetime income can be a daunting concept for the non-actuarial/non-insurance professional whose practice is focused on defined contribution arrangements. Where does one even start in trying to figure this out, and whether or not to include it your clients DC plans or IRAs?

I strongly recommended that the best place to start to get a fundamental understanding of how DC plans and IRAs can be used to provide lifetime income is to look at the IRS’s guidance on the Qualified Longevity Annuity Contracts, the QLAC.  The preamble to the proposed regulation provides clear (ok, ok,  admittedly highly technical, and mixed in with RMD stuff) guidance on how lifetime income is structured. Don’t be misled that it is structured as relief to the Required Minimum Distribution Rules. The TRUE value of the reg is NOT the RMD relief-the true value is that it describes how 401(k) plans can offer lifetime income.

That preamble should not be read alone. The IRS’s guidance in Revenue Ruling 2012-3 was actually designed to make the QLAC regs work, so you will need to read that as well. Though the Rev Ruling is about when annuitization occurs for purposes of spousal consent, it approves the notion that Lifetime Income in a 401(k) is an investment option, and not a benefit under the plan (thus not subject to 411(d)(6) and other sticky rules).

If you don’t want to look at the regs and rev ruling,  I had put together a basic primer on how the QLACs work (including use of 2012-3) in a paper,which is still current: First Steps to Modernizing DC Annuitization: QLACs and Revenue Ruling 2012-3. This may be useful in figuring out lifetime income. I can’t believe that six years has passed since its writing.

The DOL issues related to the purchase of an annuity (after all, in order to actually guarantee lifetime income, there has to be insurance. Only insurance companies, or the government, can legally provide this sort of promise) are still out there, mostly the “safest available annuity” issue, formal guidance is still on their annual guidance worklist.  They did give some relief in 2015 as well, will the release of FAB 2015-2. I discussed this on a blog of a few years back. If you need more information on Lifetime Income, click on the Lifetime Income Category in this site’s sidebar.

One of the continuing confusions in how 401(a) rules apply to 403(b) plan  involves the reporting rules related to the correction and reporting on the 5500 of one of the most common errors in any elective deferral plan: the late deposit of those deferrals into the plan.  Neither non-ERISA or ERISA 403(b) plans will ever file a Form 5330. Ever. Even when the VFCP program is being used to correct the late deposit.

Adding to the confusion is that the Form 5500 instructions do not differentiate between 403(b) plans and 401(a) plans. It simply states that  all “defined contribution” plans need to file the Form 5330 for late deposits, and pay the penalty tax.  So keep the following in mind:

  • Though late deferrals to an ERISA 403(b) plan do need to be reported under the Compliance portion of  the Form 5500 Schedule H or Schedule I, Form 5330 cannot be filed-in spite of the directions in the Form 5500  instructions. This is because the Tax Code’s prohibited transaction rules, Section 4975, do not apply to 403(b) plans-even if it is an ERISA 403(b) plan. Form 5330 only applies to plans to which 4975 applies.  Tell your auditor NOT to file the Form 5330, and that no 5330 penalty tax is due.
  • Late ERISA 403(b) deposits are, however, violations of ERISA’s prohibited transaction rules under ERISA Section 406.  This means that the DOL’s Voluntary Fiduciary Compliance Program (VFCP)  does apply to these deposits. But your analysis shouldn’t stop there. Note that, unlike the mandatory rule under Code Section 4975, the ERISA 5% penalty on the earnings on these late deposits under ERISA 502(i) is an administrative penalty that may be assessed by the DOL.  The statute only requires that you fix the late deposit (by paying the interest), as it still is, after all, an ERISA prohibited transaction. But there is no statutory requirement that you report it other than on the Form 5500 or mandatorily pay a penalty.
  • An important corollary is that the non-ERISA 403(b) plan is never subject to either the ERISA prohibited transaction rules or the 4975 tax. HOWEVER,  timely deposit is a condition of 403(b) status: the 403(b) regs mandate that the deposits of elective deferrals must be made “within a period that is not longer than is reasonable for the proper administration of the plan. For purposes of this requirement, the plan may provide for section 403(b) elective deferrals for a participant under the plan to be transferred to the annuity contract within a specified period after the date the amounts would otherwise have been paid to the participant. For example, the plan could provide for section 403(b) elective deferrals under the plan to be contributed within 15 business days following the month in which these amounts would otherwise have been paid to the participant.” So, if the deposits are made past the date identified in the plan or, if there is no date, beyond a reasonable period, you have a form and operation problem which needs to be corrected under EPCRS (probably SCP-but that is also a problem if the error is being repeated regularly).
  • Identifying those “late” deposits can be a challenge.  Some insurance companies, in particular, can be notorious about the time in which they take to actually allocate their  deposits to annuity contracts (this can a problem more so in the 401(k) market than 403(b)s, because the 401(k) contracts are typically not subject to the strict SEC rules on posting deposits which are imposed on “registered” 403(b) investments. But even mailing a check to a 403(b) vendor can cause delays that the auditor may improperly raise issues with).  The problem this delay causes on audit is that many auditors pick up the posting date of the contribution to the participant’s contract, and claim that the late posting represents a late deposit, and a prohibited transaction.  This is not the rule. The DOL has recognized this issue of there being time between the deposit and the date it is allocated. It provided and an important example in its preamble to its “deposit” rules under 2510.30-102 that:

Where, for example, an employer mails a check to the plan, the Department is of the view that the employer has segregated participant contributions from plan assets on the day the check is mailed to the plan, provided that the check clears the bank.

Remind your auditor that the test is the date that the money is irrevocably sent from the employer’s account (such as by check or wire), NOT the date the vendor allocates the deposit to the contract.


The Tax Cuts and Jobs Act’s participant loan changes (which delays the account offset on loan defaults related to unemployment or plan termination) triggers something we would all rather not look at:  the “uncomfortable” manner in which ERISA’s fiduciary rules apply to loans and their administration.

These changes should cause plan sponsors and recordkeepers to consider new choices about their handling of loan defaults, something they haven’t had to do in nearly 28 years. This matters because changing a plan’s loan rules is not a minor technical act. Loans are investments subject to the same ERISA prudence rules as any other plan investment, and changes to loan procedures impacts the investment.

There is a temptation to put the loan fiduciary issues to the side, justifying it with the widely misunderstood notion that there is little fiduciary responsibility related to loan accounts because plan loans are effectively a participant “loaning their own funds to themselves.” It worthy to note, however, that the Department of Labor directly disavowed this common misperception when responding to a comment making this sort of claim to its proposed loan regs in 1989: “there is no basis in the statute for departing from the position that participant loans should function as plan investments.” (See 54 FR 30520).

When you think about it, the legal analysis is startling:

  • A participant loan is a commercial transaction between the plan and the participant.
  • The DOL regs treat loan funds as an investment account under the plan.
  • As a plan investment, the loan fund is subject to the ERISA’s prudence standard. According to the DOL, “section 408(b)(1) recognizes that a program of participant loans, like other plan investments, must be prudently established and administered….”
  • The DOL has also separately stated that plan fiduciaries “must assess and monitor loan programs.”

Things get even more uncomfortable when you look at the fundamental “prudence” regs. They require “appropriate consideration to those facts the particular investment involves, including the role the investment or investment course of action plays in that portion of the plan’s investment portfolio with respect to which the fiduciary has investment duties.”  Then fiduciaries must “act accordingly” after giving the investment that “appropriate consideration.”

Meeting this standard is typically handled in the periodic investment review of a plan’s investment funds. But when is the last time you saw this review take into account the loan fund activity under the plan? I would guess rarely, if ever. But according to a leading Wharton study (“Borrowing from the Future: 401(k) Plan Loans and Loan Defaults”, Timothy (Jun) Lu, Olivia S. Mitchell, Stephen P. Utkus, and Jean A. Young,2014) approximately 10% of loan principal is lost to defaults annually. This is made all the more pointed by the fact that the loan fund is usually one of the larger investment funds under the plan. Loans are generally utilized by 20% of plan participants at any one time, with some 40% of plan participants taking out loans over a any given five year period.  A 3(21) adviser would be expected to subject any other plan investment of this magnitude (and performance!) to periodic fiduciary review.

What makes this all very uncomfortable is that loans are a necessary evil, in large part because of the common occurrence of default and the subsequent “leakage” offset of account balances upon job loss. But 401(k) or 403(b) plans would be unsuccessful without them. Participation and contribution rates exist at their current levels due in part to loan access under the plan. It then really becomes a balancing act between implementing the basic fiduciary requirements to preserve a retirement benefit and to protect the plan’s assets with making the plan attractive to participants. Or, as the DOL has put it, “The Department does not believe that the purpose of the (loan) exemption is to encourage borrowing from retirement plans but rather to permit it in circumstances that are not likely to either diminish the borrower’s retirement income or cause loss to the plan.”

This is not an easy balancing act to perform, and it’s deceiving to believe that it could be addressed by merely providing an account offset as a way to “protect” the plan upon a default. This ignores the seriousness of reducing a participant’s retirement benefit, particularly where the default follows involuntary unemployment-effectively making it a forced default and forfeiture beyond the participant’s control.

An uncomfortable task, for sure, but one that probably should be given serious consideration.

There is a little noticed change in the IRS’s recent update of Publication 571 (which is the IRS’s 403(b) technical guide). In a highlighted box on page 4 is the following, under how the limits on “annual additions”-otherwise known as the 415 limits- apply:

More than one 403(b) account. If you contributed to more than one 403(b) account, you must combine the contributions made to all 403(b) accounts maintained by your employer. If you participate in more than one 403(b) plan maintained by different employers, you don’t need to aggregate for annual addition limits.

This innocuous seeming statement is actually pretty outstanding, finalizing a quiet morphing over a generation of the way the IRS applies a regulation in a way we rarely see.  The change: the employee is effectively no longer considered the employer for 415/403(b) purposes, but the rules have not really changed. In Gemology, according to Evan Giller-who first put me on notice to this “gem” of a change in 571- this type of change would be considered a “pseudomorph.” Pseudomorph is the name given to a crystal (or other gem) where one mineral replaces the mineral which actually formed the crystal without actually changing the the form or shape of the crystal.

Okay, I admit to taking some literary license with the analogy, but it seems appropriate here.

1.415(f)-(1)(f) of the tax regulations reflects its history: “the participant, and not the participant’s employer who purchased the section 403(b) annuity contract, is deemed to maintain the annuity contract…” This technically means that the employee is the employer for 415 purposes, and that all contributions to all 403(b) contracts of an individual count against the 415 limit-regardless of which employer plan it came from. For those who were around back then, I seem to recall that this was also the way we would run the 403(b) Maximum Exclusion Allowance (the now extinct “MEA”).

With the demise of the MEA, and with the growing focus of the IRS on employer accountability, we saw a shift over the years to treating the 415 limit as an employer-based limit, not an individual limit. This actually makes a lot of sense, as this limit is virtually impossible to enforce if applied beyond an employer.

The 2007 403(b) regulations actually were a bit ambiguous on this point, as they never touched on that pesky 415 reg. It only mandated the aggregation of 403(b) contracts of the same employer (with the exception of other companies under the participant’s control).  There has always been this uncertainty since then, because if the employee was the employer (as per 415), it still was an individual limit. The question was whether we could now effectively read the new 403(b) reg together with the old 415 reg to apply the 415 limit on an employer by employer basis, rather than treating the employee as the employer. The language under 415 could actually be read that way, if looked at generously (I guess).

Publication 571 seems to have solved this for us. It appears that the transition is now complete. There is no 415 aggregation of contributions to 403(b) contracts from unrelated employers (except, of course, for that weird “control” rule).  A Pseudomorph….





There has been increasing interest in the market to put together Multiple Employer Plans for 403(b) plans, and with good reasons. Tax exempt entities are really well suited to the sorts of economies of scale that a MEP can bring, and they often organize well around common associations.

But a 403(b) MEP is really complicated when you get down to it because-like anything 403(b), it seems-of the devil that exists in the details.  For example, besides  having to deal with the DOL 2012 Advisory Opinion on all MEPs; and  the fact that the Tax Code Section governing 401(a) MEPS does not apply to 403(b) plans (which means you can never really have a 403(b) MEP for tax purposes); and that the ERISA Section governing all ERISA MEPs (including 403(b) MEPs) requires compliance with that Tax Code Section which doesn’t cover 403(b) MEPS; you still have to deal with the complications of dealing with those legacy contracts of the various participating employers in the MEP. Then there is the issue of dealing with those combination of ERISA and non-ERISA 403(b) plans commonly sponsored by a 403(b)participating employer. These require use of traditional state law agency rules to make them work.

Yes, this is all manageable if you can have a MEP in the first place. The point here is that there are a lot of moving pieces in a 403(b) MEP that you don’t have to deal with in a 401(a) MEP. Using the aggregation model (see, for example, Section 202 of the recently introduced Retirement Enhancement and Savings Act of 2018 (“RESA”) which describes this model well) instead of the MEP -which many school districts actually do and call them MEPS- is so often more attractive.

What makes it all the more challenging is that you are dealing with the DOL’s regulatory processes which are geared to MEPs, while also dealing (on the same arrangement) with IRS regulatory processes which deal with each participating employer in a MEP as a single employer plan. The impact on this really falls on the IRS. The Form 5500 epitomizes the problem.

It starts with Form 5500 Section 1 which requires that you identify the plan as a MEP or a single employer plan.  For ERISA purposes, the answer is MEP, and you must check the box. However, for Tax Code purposes, it is not a MEP-do you also check the single employer box?

What flows from that may cause the IRS heartburn. The financial statements are driven by ERISA’s rules and not the Code’s, though the IRS relies upon the DOL information when performing their own compliance activities. This means that such  information is  required to be reported on an aggregated MEP basis, not on a single employer basis. The only “single employer” data provided on the 5500 is each participating employer’s EIN, along with something called “percentage of contributions” for each of those employers. The compliance questions will also be answered on the consolidated MEP basis, not on the “single employer” basis, which may be of a concern to the IRS.

It’s also likely to become messy when the IRS is looking for an individual plan Form 5500 for the 403(b) plan under the EIN of the employer and with a plan number and doesn’t find one. This is exacerbated by the way a plan joins the MEP: it typically merges with the plan of the lead sponsor, but the merger is with a “plan” the IRS doesn’t recognize as a plan.

Let’s not forget about the Form 8955 SSA, either.  This is a tax form, and it is required of all 403(b) plans subject to ERISA’s vesting standards. It is not an ERISA form. With each participating employer under a 403(b) MEP being considered an individual plan, a separate 8955-SSA has to be signed and filed on behalf of each participating employer. The IRS will have difficulty tying this back to the MEP’s Form 5500.

I truly doubt that the IRS’s systems are up to all of this and other process issues I haven’t mentioned, especially given the IRS’s budgetary strain. Even the provisions in RESA which will permit Open MEPS® won’t address these issues. It is likely to exacerbate them. So be prepared to deal with some bizarre regulatory twists in dealing the IRS when working with a 403(b) MEP,  to manage through this lack of regulatory processes, or to seriously consider the aggregation model.



There is a growing public policy concern regarding the ability of workers in the gig economy to access the ability to accrue retirement savings,. Though IRA’s and SEPs are, of course, available, they are nowhere near as effective as worksite retirement plans. Troy Tisue’s testimony at yesterday’s congressional hearing on retirement plans for the gig economy addresses how Open Meps® may help address this issue. In addition to his written testimony, Troy also discussed at the hearing on how there are ways in which aggregation programs-which are currently available- can be used to address this need. To read Troy’s testimony, click here.


The DOL’s proposed regulation permitting Association Health Plans which cover unrelated employers is likely to have a significant impact on the market’s ability to offer Multiple Employer retirement plans to unrelated employers. This is because the regulation permits AHPs through the modification of the ERISA regulatory definition of the term “employer” under Section 3(5). It was this definition that the DOL used to turn down the idea of an Open MEP in Advisory Opinion 2012-04. To be an “employer,” the DOL claimed there must be “commonality” of employment between employers who “controlled” the plan.

The DOL makes a stunning admission in the AHP reg preamble about its historical application of the “commonality” rule. It sounds an awful lot like the argument we made in requesting the MEP advisory opinion:

These definitional terms are ambiguous as applied to a group or association in the context of ERISA section 3(5), and the statute does not specifically refer to or impose the particular historical elements of the “commonality” test on the determination of whether a group or association acts as the “employer” sponsor of an ERISA covered plan within the scope of ERISA section 3(5). Accordingly, that determination may be more broadly guided by ERISA’s purposes and appropriate policy considerations, including the need to expand access to healthcare and to respond to statutory changes and changing market dynamics.

In a nutshell, the DOL is proposing the following:

  • An association can sponsor a health plan which can permit other, unrelated employers to join.
  • The association can be formed for the sole purpose of offering the plan, lifting the long-standing prohibition against associations being formed for the sole purpose of providing the benefit plan.
  • The “commonality” requirement will be met if the members of the association are in the same trade, industry, or state or metropolitan area (even if it crosses state lines).
  • The direct or indirect “control” requirement will be met if the members of the association elect the directors or officers of the association

Interestingly enough, the AHP definition of employer will permit companies with no employees, but with only  “owner-employees,” to participate-which was always a bugaboo with MEPS to begin with. There is also a health care related “non-discrimination” rule which doesn’t apply to retirement plans.

It is highly unlikely that the  DOL will be able to hold the line now against MEPs formed through associations meeting the criteria outlined above, or what I call “AMEPS” (for “Association MEPs), especially considering what the DOL stated in its MEP advisory opinion:

“In your submission, you urge that the Department’s historical interpretation of “employer” under section 3(5) of ERISA regarding multiple employer welfare arrangements (MEWAs) should be restricted to welfare plans and that a less restrictive interpretation be applied to retirement plans. The Department is of the view, however, that the term “employer” should have the same meaning in this context whether applied to the term welfare plan or pension plan. See Sullivan v. Stroop, 496 U.S. 478, 484 (1990).”

 Does this mean that we now run out and establish AMEPs? That, I think, would be ill-advised given that there are likely to be a number of changes to the proposed regs before they become final, and there really are a number of issues related to the proposal which need to be answered. For example, the ERISA language under 3(5) enabling one employer to act for another does not require any sort of trade or geographical link and, given the ways companies morph and move, such a requirement seems to unnecessarily deny modern business realities. Lets see, under the reg, you don’t have to be in same trade as long as you are in a large metro area. But if you have a multi-state, international business in a small town or state (yes, there are many of us like this, given the digital nature of  business),  you can’t belong to an Association plan of an unrelated trade which is based in another state.  There’s sound policy behind this archaic thought? That seems counterintuitive, and restricts small business access to true competitive pricing- particularly where the benefits are not inherently “trade based.” But at the very least,  it does give us a strong basis to advocate the same treatment for association MEPS as AHPs. And for this, no statutory change would be needed.







We have now begun the “season of restatement” for 403(b) plans, which will run until March 2020. This is not a joyous yuletide sort of season; it is instead one of reckoning, I’m afraid. This is because we have been able to effectively ignore a number of difficult issues involving plan documents until now, because it was never critical to address them. But now we must.  It really is going to be a season of learning for us all-for the regulators at the IRS and DOL and practitioners as we try to weave our way to some sort of sensible solutions.

The application of the Spousal Consent and Joint and Survivor Annuity rules is one such issue which we need to consider.  In the 401(a) space, dealing with this issue is pretty straightforward.  The rules apply uniformly to all 401(a) plans through 401(a)(11) and 417, which is well coordinated with ERISA’s requirements under Section 205. As long as the default form of benefit under the plan is not a J&S benefit; and the spouse is entitled to the survivor benefits upon the participant’s death unless the spouse consents otherwise; the rules are met. If, however,  the plan is a money purchase plan, or holds money transferred in from a money purchase plan or a defined benefit plan, or the plan’s default distribution is an annuity payment, the spouse must consent to a lump sum distribution-or even to a loan. Many will remember the efforts we went through years ago cleansing those annuity payment requirements from plans and products, just so no spousal consent would be required for lump sum distributions or loans.

Now, though, we have to deal with documenting these rules as they apply to 403(b) plans. Its not so simple:

  • 401(a)(11) and 417 do NOT apply to 403(b) plans This means the only way the spousal rights rules apply to 403(b)plans  is through ERISA Section 205.  This means that if you have a non-ERISA 403(b) plan, the spousal rights rules DO NOT apply. Be careful to avoid inadvertently applying them in the restatement.
  • HOWEVER, many non-ERISA 403(b) annuity contracts impose the spousal rights rules as a matter of contract language, even though they may not be imposed as a matter of law. Because the underlying contract is technically part of the plan document, this means those spousal rights will apply as a matter of a plan term. Be careful with your documentation of this. There is an interesting problem here: if the central “wrap” plan document states there are no spousal rights, but the underlying contract states that there are, there is a conflict-and  IRS rules says that the wrap plan document language will govern. But the problem is that the insurer is legally bound to honor the spousal rights as a matter of contract, and CANNOT legally ignore such claims. Screwing up the plan document language will inevitably lead to litigation, especially given when large account balances are involved, so be careful.
  • ERISA 403(b) plans are covered by the spousal rights rules, by virtue of ERISA Section 205. If the underlying annuity contract provides that the default payment is an annuity-as many old contracts, particularly individual ones will-ERISA will require spousal consents for lump sum payments and loans. Even if the wrap plan document makes the normal form of payment a lump sum in an attempt to “cleanse” this problem, the DOL has never concurred with the IRS’s position that the centralized plan documents control. The insurer is legally bound to follow the contract terms; and it is a registered security, which can cause security law problems if this language is ignored. So, again, be very careful in your restatement, especially if you have legacy contracts in the plan.
  • Finally, there’s the “money purchase plan” issue. It is typical for a 403(b) plan to provide a set percentage of pay as the employer benefit under the plan, much like a money purchase plan. There is a very real and unresolved issue as whether or not this set formula makes the plan a “money purchase plan” which is subject to the J&S rules, even if you have avoided the “annuity” language problem noted above. There is a sound position that such plans are NOT money purchase plans. [*] This  is a substantial issue and one upon which you will need to make a determination when you restate the 403(b) plan.

[*] A money purchase plan is defined only by Code Section 401(a)(27), as a 401(a) tax qualification requirement-which does not apply to 403(b) plan. Under ERISA 205, an individual account plan becomes subject to the J&S rules only if it is a “money purchase plan” under Section302(a)(2)(B).  ERISA does not define “money purchase plan,” and it would be difficult to apply any other definition than that which is contained in the Code-which, here, does not apply to 403(b) plans.


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.

On November 14, the Office and Management and Budget received from the DOL a proposed rule which would broaden the definition of employer under ERISA to allow more businesses to join association health plans.

This was in response to the  Oct. 12 executive order which directed the DOL to “consider expanding the conditions that satisfy the commonality‑of-interest requirements under current Department of Labor advisory opinions interpreting the definition of an “employer” under section 3(5) of the Employee Retirement Income Security Act of 1974.”

The DOL’s advisory Opinion on MEPs in 2012 was specifically premised on the DOL’s interpretation of   the definition of “employer,” for health plan (MEWA)  purposes. The DOL ‘s position was that it had no authority to redefine their historical definition of employer it developed for MEWA purposes merely for retirement plan purposes, that it was bound by the statute to apply the same “employer” definition to both health plans and retirement plans. Does this mean that the new proposed definition of “employer” will, necessarily, by operation of statute, be expanded for retirement plan purposes as well? If this is the case, MEPS would be opened up to unrelated employers under the same set of circumstances as they would for health plan purposes.

No one has seen the specific language of the proposed regulation, of course. But it would seem that the DOL (in its own collective mind) really has no authority to expand the definition of “employer” for ACA/Association Health plan purposes without also expanding it for retirement plans.

We will watch closely for this new proposed reg when it is published. But it’s hard to see how this would not also apply to retirement plans, and thereby opening up MEPS. Even if the language of the proposed reg is limited to health plans, there will be an opportunity under the comment process to make the case that there, legally, can be no difference-at least according to the DOL’s own rules….


Anyone who has had the pleasure of dealing with the 403(b) annuity recognizes that it is truly an “odd duck” – especially when looking at it through the lens of the 401(a) experience.  So it should come as no surprise that this “odd-duckiness” shows up in settlements under the EPCRS’s Closing Agreement Program” (or CAP).

The CAP is the portion of EPCRS which is used when the IRS discovers uncorrected plan errors on audit. Ultimately, it involves the plan sponsor negotiating a final settlement with the IRS. This inevitably also involves the agreeing to pay a CAP sanction which, under current guidance, cannot be less than the fee that would be payable had the sponsor corrected under the IRS’s Voluntary Compliance Program.

There are formally 10 different factors under EPCRS which the IRS takes into account when proposing the sanction amount. One of those elements (and what used to be the most significant factor before the 2106 modifications to the program under 2016-51) is the “Maximum Payment Amount” (the MPA). The IRS agent is required to calculate the MPA as part of the CAP process, which is the tax which the IRS could collect because of the failure of the plan to meet the tax compliance rules. This includes the:

  • tax on the “trust;”
  • additional income tax on the employer from the loss of employer deductions (plus interest and penalties arising from the loss);additional income tax on the individual from the failure (including taxability of a loan);and
  • any other tax which may result from the failure that would apply but for the CAP settlement.

This number in the 401(a) world can be a very large number, even for a small plan, especially when taken over a number of years.

But it’s interesting to see the effect on a 403(b) plan going through this process:

  • There is no tax exempt trust here that is enjoying 501(a) tax exempt treatment. An annuity contract or a custodial account are not, themselves, taxpayers-or entities which can be taxed. The individual who owns the contacts can be taxed (so, the third bullet point applies), but that’s it. This number should be zero.
  • The employer is a tax-exempt entity. This means there should be no loss of deduction, except in the very rare case where a tax exempt might have been taxed under the UBIT rules.
  • The individual will suffer taxation, the amount of which should be included in the MPA. But there are a couple of important factors which come into play here:
    • “Inside buildup.” The tax rules which apply to “non-qualified” annuities (which is the terms we use to describe annuities sold outside of 401(a) and 403(b) plans) defer the taxation of earnings of the investments inside that contract (including the “separate account” investments) until those amounts are distributed-and even then, those earnings might only be taxed (if it’s considered a “distribution as an annuity”) using something called the “exclusion ratio.” The exclusion ratio has the effect of back loading the tax into much later years. Because most 403(b) annuity contracts will qualify as annuities for “inside buildup” purposes-even if they fail 403(b) treatment- the earnings should be excluded from the MPA. Note this treatment will not apply to custodial accounts.
    • Finally, virtually all of the operational errors (except for non-discrimination) will only impact the contracts against which the error occurred. So, for example, a 415 violation will only impact the particular contract to which the excess was made, and only to the extent of the excess. It does NOT “blow up” the entire plan. So, the MPA should only include the tax on portion of the excess in the account of the affected individual.

Though the MPA has a much more limited impact on the sanction amount than prior to 2016, it still can affect the ultimate sanction by showing that many errors may not really be all that egregious (especially when compared to a 401(a) sanction amount on the same type of error).