Options for Employers not Eligible to Sponsor a 403(b)

December 2, 2011 (PLANSPONSOR (b)lines) - As with many employers, it is possible for a 403(b) plan sponsor’s tax status to change, or for the plan sponsor to be on either side of an acquisition or a merger.

Against that backdrop, one 403(b) question that seems to arise with some frequency is: what happens to the 403(b) plan if an employer was never eligible to contribute to the plan, or if a previously eligible employer ceases to be eligible?  Often when such questions arise, a first instinct may be to presume that the employer can no longer maintain the 403(b) plan.  Such a presumption would be incorrect.  

Consider the following scenarios:  

  • In reviewing employee benefits administration for a public hospital that does not enjoy dual tax exemption status (i.e., it is not also a 501(c)(3) organization) the head of the department discovers that the voluntary deferral plan sponsored for the hospital’s employees is a 403(b) plan.  The department head knows enough about plan rules to know that the hospital does not qualify either as a 501(c)(3) organization or as a public school, and thus cannot qualify for a 403(b) plan.  What should they do?  
  • Another public hospital previously enjoyed dual tax exemption status, both as a public hospital and as a 501(c)(3), but has ceased to qualify as a 501(c)(3) organization.  At a minimum, they will need to cease contributions to the 403(b) plan.  What else should they do? 


Interestingly, one alternative available under both of these scenarios is to keep the plan intact.  This generally involves two important steps: freeze the plan, cease all new contributions; and continue to administer the plan consistent with the relevant 403(b) withdrawal restrictions and related rules.  Although the answers overlap, the process for arriving at those answers follows two different paths.  Also, a previously eligible plan sponsor ceases to be eligible, whereas additional options are available in the second scenario.    

Let’s start with the first scenario. 

The hospital in the first scenario was ineligible to contribute to a 403(b) plan from the outset.  That means that contributions to the plan were improperly excluded from income taxes and income tax withholding.  There is also an additional concern for any employer contributions or non-elective employee contributions that were improperly excluded from FICA and FUTA withholding.    

Generally, all of these amounts can be collected by the IRS for any open tax year.  However, the IRS will agree to treat the plan, in effect, like a qualifying plan, if the above steps (freeze; continue to administer) are followed and if the hospital makes a submission for voluntary correction under IRS Revenue Procedure 2008-50.    

This entails completion of Appendix F (for streamlined correction submissions) and an associated Schedule 6 (a schedule for Appendix F that is specific to corrections for an ineligible employer).  The instructions for Appendix F also set forth a sliding scale correction fee based upon the number of plan participants.

The second scenario differs from the first in a very important way: the employer was an eligible employer at the time contributions were made.  If contributions ceased on or before the date when the employer became ineligible to contribute to a 403(b) plan, there is no defect.  The employer has two options: (1) freeze the plan and continue to maintain it as a 403(b) plan, subject to all of the 403(b) rules, as noted earlier; or (2) terminate the plan and timely distribute the accounts without regard to otherwise applicable withdrawal restrictions.    

The latter option, however, presents some additional questions, including:  

  • Does the employer have authority under the contracts or accounts to direct a distribution of cash, without obtaining the participant’s consent?  Some contracts and accounts, especially individual contracts and accounts, do not recognize such authority for the employer, and in certain other cases the investment arrangement might recognize such authority only if the plan clearly confers it upon the employer. 
  • Do the investment arrangements under the plan include one or more annuity contracts which can, for purposes of the 403(b) plan termination, be distributed in-kind to the participant?  If so, such a distribution satisfies the requirement for the plan termination distribution without a separate cash distribution. 


A plan termination also triggers additional important considerations.  For example, the employer generally cannot make 403(b) contributions to any plan for a full year after the plan termination.  This is not a concern for an employer that is currently ineligible to make 403(b) contributions, but could be very relevant for an employer seeking to terminate one 403(b) plan but continue contributing to another 403(b) plan.  Also, additional important concerns can arise if the 403(b) plan is subject to Title I of ERISA.  Such concerns should be discussed with knowledgeable ERISA counsel.  

Going back to the first scenario, it is reasonable to ask whether plan termination might be available there also.  If there is no IRS correction submission, the plan is not a 403(b) plan at all.  The good news is that a distribution of the accounts in that instance would not be subject to Code restrictions, though it may be subject to contractual or account restrictions. However, a failure to correct the employer eligibility defect leaves the hospital and the participants with a myriad of tax implications for open tax years.    

Alternatively, with the IRS correction submission the plan is treated as a 403(b) plan.  Schedule 6 to Appendix F expressly provides that the plan will be maintained, and is silent as to the availability of plan termination. Moreover, it does not appear that the IRS has addressed this question in other guidance.  It would seem reasonable to conclude that since a plan termination conducted in accordance with IRS guidance is not considered to violate the withdrawal restrictions under Code Section 403(b)(11) (for annuities) and 403(b)(7) (for custodial accounts), which are specifically referenced in Schedule 6, a plan termination should be permitted.    

Otherwise, the alternative reading is that since the referenced Code restrictions do not include an exception for plan termination, plan termination is not available following such an IRS-approved correction.  If such a plan termination is permitted, many of the same questions and issues noted above would apply to this scenario as well.  

Richard Turner serves as Vice President and Deputy General Counsel at VALIC. He was recently appointed to the U.S. Department of Labor ERISA Advisory Council and is a contributing author of the “403(b) Answer Book.”     

This article is for informational purposes only and should not be construed or used as legal or tax advice.