The proposed regulations generally permit (but do not require) a plan sponsor to make available plan accounts holding elective deferrals, QNECs, QMACs, and traditional safe harbor contributions, and all earnings thereon.

Some special rules apply to 403(b) plans.  First, income attributable to section 403(b) elective deferrals continues to be ineligible for a hardship distribution because the Tax Cuts and Jobs Act (TCJA) did not amend that restriction on distributing such income under Code section 403(b)(11).

Second, QNECs and QMACs in a 403(b) plan that are in a 403(b)(7) custodial account continue to be ineligible for hardship distributions.

However, QNECs and QMACs in a non-custodial 403(b) annuity plan (e.g., under 403(b)(1) annuities or 403(b)(9) church retirement income accounts) are eligible for hardship distribution.

If they have not already done so already, 403(b) plan sponsors should consider how to implement these TCJA changes during 2019.

Keeping an eye on the 403(b) expense litigation – and reviewing best practices

Numerous lawsuits continue to wind through the courts concerning the fiduciary duties of 403(b) plan sponsors (mainly ERISA, but also non-ERISA) and their monitoring of investments and plan expenses.

Some universities have had favorable decisions (Washington University, NYU, Penn and Northwestern), and other suits have settled (Chicago and Duke), while appeals and other suits continue.

These cases serve as an important reminder to all 403(b) plan sponsors to review their fiduciary practices for those plans and monitor their investment line-ups and fees in order to mitigate litigation risk.

Church 403(b) plans – taking into account lessons from the church plan litigation

Church-related nonprofits won their case before the Supreme Court in Advocate Health Care Network et al. v. Stapleton et al., but that decision was limited to upholding the traditional interpretation of the definition of church plan, and that such church-related entities could sponsor church plans.

Litigation continues, however, over whether particular church-related entities meet the specific requirements of the church plan exemption, such as what a “principal purpose” organization administering the plan can be, and what it means to be “controlled by or associated with” a church or convention or association of churches.

Plaintiffs have also begun to bring various fiduciary breach-like claims under state law in the event the plan is found to be a church plan exempt from ERISA.

Church-related entities would be advised to review their own posture under the church plan definition, as well as consider possible exposure to ERISA-like fiduciary claims under state law and whether remedial actions to reduce litigation risk might be taken.

Non-QCCOs in 403(b)(9) plans – should you be doing anything?

It is understood that the IRS has recently begun to interpret the regulations under 403(b) to preclude the participation of non-qualified church controlled organizations (“Non-QCCOs”) in 403(b)(9) retirement income account plans.

Most church-related hospitals, colleges, universities, nursing homes, cemetary corporations and other entities providing goods and services to the general public for fees or reliant on government grants are Non-QCCOs.

This position has been challenged by the church plan community, and a retroactive legislative fix has been proposed.  Because that fix seems likely to be made, few Non-QCCOS with such plans have been making changes.

Until that fix becomes law, however, Non-QCCOs should closely monitor this issue.

Preparing for the March, 2020 403(b) plan document amendment deadline

The IRS has issued its first batch of opinion letters and pre-approved 403(b) plan documents, and those documents are not available from vendors.  They do not have to be adopted until March 31, 2020, so there is currently plenty of time to prepare an amended and restated plan document.  However, there are a number of drafting pitfalls to be aware of:

When that plan document is adopted, it will be retroactive to January 1, 2010, or, if later, the date the plan was adopted.  Because the plan document will be retroactive, it is important to capture the plan terms accurately throughout the period.

Interim amendments and their effective dates need to be reflected accurately.  For ERISA plans, retroactive amendments cannot result in cutbacks.

The IRS has given some informal guidance on this on its website, including how such amendments can be reflected under a pre-approved document by the use of an addendum.

Care should always be taken in completing pre-approved plan documents that they match up with how the plan is actually administered.  Particular attention should be given to the eligibility provisions, how compensation is defined, and how service is counted.

Individually designed 403(b) plans will likely become rarer, but will still continue in areas where special provisions are needed.  Sponsors of those plans should also consider whether they need to be amended or restated under the same remedial amendment period for pre-approved plans.

Staying on top of the “universal availability” rule for 403(b) plans

The universal availability rule of 403(b) – generally, that if the plan allows elective deferrals, it must offer them to every employee, with only a handful of exceptions, is both one of the advantages of a 403(b) plan, because it avoids having to run the Actual Deferral Percentage or “ADP” nondiscrimination test of 401(k) plans, and one of the most common pitfalls, because it is easy to inadvertently exclude someone who should be eligible, resulting in the need for make-up contributions.

Probably the most common exclusion from the universal availability rule is for all employees normally working fewer than 20 hours per week, The 20 hour rule is particularly tricky because it requires either actually counting hours accurately, or applying the “hour equivalency” rules of the service-counting regulations for 401(a) plans, which are fairly generous in how much service they count.

The IRS also recently issued some temporary relief in a Notice for plans that had applied the 20 hour rule on the basis of the employee's service each year, so that they might move in and out of eligible status, as opposed to a “once in, always in” rule, which is how the IRS interpreted the regulation.  This transition relief ends in 2019.

Some plans simply allow all employees to make elective deferrals, in order to avoid inadvertent but potentially costly violations.

Other exemptions from the universal availability rule include nonresident aliens, certain students performing services described in IRC 3121(b)(10) of the employment tax rules, and employees eligible to make elective deferrals under another 401(k), 403(b) or 457(b) plan of the same employer.

On the other hand, the plan cannot exclude employees merely because they are part-time, temporary, seasonal, a substitute teacher, an adjunct professor or a collectively bargained employee, unless they fall under the 20 hour rule.

Due to these complicated rules, it is important to carefully monitor compliance with any exceptions applied.

Governmental plan litigation – are you an “agency or instrumentality” of a governmental entity?

As mentioned above, the plaintiffs' bar has been attacking whether church-related entities meet the terms of the church plan definition.  In at least one case so far, a government-related hospital has been challenged on whether it is an “agency or instrumentality” of a political subdivision (in this case, the county).

Allegations discuss the control of the entity, daily operations and funding, among other factors.

The main goal of the litigation appears to be the claim that the defined benefit plan should be subject to ERISA, including its funding requirements, and subject to PBGC insurance.

However, as with the church plan litigation, it should be kept in mind that if the employer is not eligible to have plans exempt from ERISA, that has follow on effects on all the other plans of the employer.

For example, 403(b0 plans would have been subject to ERISA fiduciary duties and required to file 5500s, have plan audits, and provide summary plan descriptions.

A 457(b) plan, if structured for a governmental employer that turned out to be non-governmental, would have failed many of the requirements of 457(b), 457(f) and 409A, with potentially significant adverse tax consequences.  Health plans may have also failed to provide required disclosures and filed 5500s.

Of course, there are also proposed regulations on the definition of governmental plan on the horizon.

Many agencies and instrumentalities of political subdivisions have been waiting on those to consider their status for maintaining governmental plans, but this new litigation may suggest reviewing such status sooner rather than later.

Staying on top of distribution rules for 457(b) plans of tax-exempt employers

Section 457(b) plans of tax-exempt entities have some unusual distribution rules that are more based on the constructive receipt principles than the 401(k)/403(b) distribution rules.

For example, they generally require a distribution on a specific date (for example, 90 days after separation from service), and permit a one-time irrevocable election to be made before that date to defer the payment until a later date.

On the other hand, the same rules allow an irrevocable election to choose between a lump sum distribution or installments to be made separately, up to the date distributions are supposed to commence.

In large part, this complication serves as a trap for the unwary – it can happen that a distribution may not be timely commenced after termination, an election be lost, or a payment be impermissibly accelerated.

Tax-exempt 457(b) plan sponsors should carefully monitor that distributions to participants are timely made.  Fixes to any issues can be difficult to make, particularly if a 409A violation also results.

 Is your tax-exempt 457(b) plan limited to a true “top hat” group?

To be exempt from ERISA – which is critical for a 457(b) plan – tax-exempt employers must limit participation in a 457(b) plan to “a select group of management or highly compensated employees.”

This is not a bright line test, and may be a higher threshold, for example, than the “highly compensated employee” threshold under Code section 401(a) plans for nondiscrimination testing.

The DOL has described the test as whether “individuals, by virtue of their position or compensation level, have the ability to affect or substantially influence, through negotiation or otherwise, the design and operation of their deferred compensation plan, taking into consideration any risks attendant thereto, and, therefore, would not need the substantive rights and protections of Title I.”  (Not all courts agree with that approach, however.)

While there may be some individuals who fall into a grey area, sometimes plans inadvertently let in employees who are clearly not eligible.

Notably, this is one of the few errors that the Employee Plans Compliance Resolution System (EPCRS) indicates might be fixed on a provisional basis under that program.

Watch out for the final 457(b) regulations and related 409A regulations

New regulations under 457(f) and 409a were proposed in 2016.  Particular provisions include restriction on use of noncompete agreements to provide a substantial risk of forfeiture, and definitions of bona fide severance, death, disability, and leave and vacation pay plans that may be exempt from 457.

Generally, the new rules as proposed would be fairly limiting.  This is particularly true in the case of vacation and leave plans that do not forfeit unused leave, which is a common feature of some governmental plans.

Tax-exempt and governmental employers should review their nonqualified and leave and vacation pay plans to confirm that they are not adversely affected by the proposed regulations, which might be finalized this year.

Implications of the new 4960 excise tax

New Code Section 4960 imposes a 21% (i.e., the top corporate income tax rate) excise tax on compensation paid by a tax-exempt organization (or by any related person or government entity) to a “covered employee” in excess of $1 million for a tax year.

A “covered employee” includes any of the five highest compensated employees (including former employees) of the organization for the tax year, as well as any individual who was a covered employee in any preceding tax year beginning after December 31, 2016.

Compensation for these purposes includes “wages” as defined for income tax withholding purposes, except that compensation does not include designated Roth contributions to an employer's qualified defined contribution plan.

In addition, compensation generally includes amounts includible in income under a Code Section 457(f) deferred compensation plan, and such amounts are treated as paid when there is no substantial risk of forfeiture as defined in Code section 457(f)(3)(B).

Thus, the excise tax will apply to vested amounts under a Code section 457(f) plan even if those amounts have not yet been paid. Compensation does not include amounts paid to licensed medical or veterinary professionals for the performance of medical or veterinary services.

Code Section 4960 also imposes a 21% excise tax on “excess parachute payments” paid by an applicable tax-exempt organization to a covered employee. An excess parachute payment is generally an amount contingent on the employee's separation from service with the organization that exceeds three times the employee's “base amount.”

The employee's base amount is generally his or her average annual compensation over the previous five tax years, determined in accordance with Code Section 280G.

Amounts paid under qualified retirement plans, 403(b) and 457(b) plans, and amounts paid to licensed medical or veterinary professionals for the performance of medical or veterinary services, or amounts paid to individuals who are not considered “highly compensated employees” under Code Section 414(q) (generally relating to qualified retirement plans), are not taken into account for purposes of calculating an individual's excess parachute payment.

If a tax-exempt or governmental employer has any highly paid employees or plans providing large deferred compensation or severance amounts, they will want to carefully consider whether the 4960 excise tax may apply.

Next steps

Now is a good time for tax exempt and governmental employers to take stock of their 403(b) and 457(b) plans and consider whether there are any changes to make in light of recent developments.

In particular, it is not too early to start working on amending and restating 403(b) plans – and entities that are related to churches or governments and that maintain non-ERISA plans based on that relationship should consider how strongly they can claim that treatment.

David W. Powell is a Principal with Groom Law Group.

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