Successfully Surviving the IRS 403(b) Compliance Check

Perhaps – but you should be aware that the IRS is vigilant about making sure that 403(b) plan sponsors also ensure that all of their eligible employees know they have the opportunity to participate in the 403(b) plan, and the IRS has a method to monitor just that – the Compliance Check Questionnaire mailing.

Background about the IRS Compliance Check

In 2006, the IRS began a pilot mailing of a Compliance Check questionnaire to public school districts in New Jersey, Missouri, and the state of Washington to determine if schools were appropriately extending the opportunity to participate in their 403(b) plans to all eligible employees.  In 2007 and 2008, the IRS took the Compliance Check initiative nationwide, mailing the questionnaire to a representative sampling of K-12 public school districts.

While that sampling is now complete, the IRS has stated that it intends to expand the scope of the Compliance Check to private college and universities.  In addition, based on information from the K-12 compliance check initiative, the IRS plans to follow up with those K-12 school districts whose completed questionnaires indicated eligibility defects to determine whether and how those defects were resolved. 

What Is the IRS Compliance Check Questionnaire?

The Compliance Check Questionnaire mailing seems innocuous enough.  An employer who sponsors a 403(b) plan receives a questionnaire from the IRS that solicits information about who can participate in that 403(b) plan.  The questionnaire essentially has four themes:

• Who cannot participate in the 403(b) plan?
• What are the requirements for participating in the 403(b) plan?
• How are employees informed about the chance to participate in the 403(b) plan?
• Does the employer maintain any other plans that permit employees to make elective deferrals?

The accompanying cover letter notes that this Compliance Check is “not an audit” and that the employer should return the completed questionnaire within 15 days of the date of the letter.

Working Without a Safety Net

While the IRS questionnaire appears simple, actually it is precisely focused on whether an employer’s 403(b) plan violates the Internal Revenue Code by not allowing all eligible employees to participate.  Under the federal tax laws, an employer must generally give all employees (with very few, limited exceptions) the opportunity to participate in its 403(b) plan if at least one employee has the ability to defer at least $200 a year, either as pre-tax or Roth 403(b) contributions, to the plan.  This requirement, known among tax practitioners as the “universal availability rule,” ensures that employee contributions made to an employer’s 403(b) plan are nondiscriminatory in accordance with the Internal Revenue Code.

However, the employee who is the point of contact for the 403(b) plan may not appreciate the IRS’ mission in sending this questionnaire.  After all, the Compliance Check is a brief questionnaire.  What could go wrong?

Plenty.  For example, the K-12 Compliance Check included a question on whether substitute or part-time teachers, janitors, bus drivers, or cafeteria workers are excluded from participating in the employer’s 403(b) plan.  The IRS rationale behind this question was to determine whether the 403(b) plan is indeed being offered to all eligible employees.

The employer may not understand that underlying assumption and this then becomes a trap for the unwary.  Suppose that an employer outsources its custodial services to a third party.  The employer receiving the Compliance Check in turn answers that janitors are excluded from participating in its 403(b) plan – they aren’t participating, of course, because those individuals are not employees of the employer.

However, the IRS doesn’t know this – from an IRS perspective, the sponsor responded that not all of its employees are told about the 403(b) plan and, as a result, the IRS thinks the 403(b) plan is defective.

Do not assume that the IRS knows each 403(b) sponsor’s specific employee and independent contract arrangements.  Be sure that your response to an IRS Compliance Check Questionnaire identifies any classifications that are outsourced and thus are not considered your employees.

The Cost of Noncompliance

What if all individuals providing services to the employer are in fact employees?  What would be the downside if an employer inadvertently has not been including all of its eligible employees and responds accordingly on the IRS Compliance Check?  The IRS will issue a form letter warning to the employer that its 403(b) plan is "at risk of losing its tax-favored status, resulting in the loss of the retirement savings and tax benefits provided to its participants." To remedy this violation of the universal availability rule, the IRS will require that the employer make a non-forfeitable contribution to an account for each employee who was inappropriately excluded from the 403(b) plan for each year he or she was excluded. 

For each year that an employee was excluded from participating in the employer’s 403(b) plan, the employer must contribute an amount determined to be the "lost opportunity cost," calculated as follows:

• 50% of the average deferral percentage for that year of the group of employees to which the excluded employee belongs (non-highly or highly compensated employees); or
• 1.5% of the excluded employee’s annual compensation for that year; or
• an alternate means of correcting this defect, after discussion with and approval by the IRS.

If the employer’s 403(b) plan has matching contributions, the employer must also contribute the full matching contribution on the "lost opportunity cost" amount.

Follow-up after Fixing the Defect

Suppose that the employer’s responses to the questionnaire indicate that employees were improperly excluded and the employer makes this "lost opportunity" contribution.   There is the possibility that the IRS will contact the employer again.  Part of the Compliance Check initiative includes the IRS issuing a follow-up letter to those 403(b) sponsors that had eligibility defects in the initial compliance check to determine whether and how those defects were resolved

Don’t Go it Alone

So, what should an employer do if it receives a Compliance Check letter from the IRS?  Most importantly, proceed with caution.  Do not assume that the point of contact in the organization understands the precise context of the IRS terminology or that the IRS knows how the organization operates.  Seek help in responding to the Compliance Check from legal counsel or a tax adviser. 

Employers should get their 403(b) plans in order now.  The cost of "wait and see" is too high.

- Linda Segal Blinn, JD, Vice President of Technical Services, ING

NOTE: This feature is to provide general information only, does not constitute legal advice and cannot be used or substituted for legal or tax advice.