What is the IRS Looking For – and What Should 403(b) Sponsors Do to Prepare?

March 31, 2009 (PLANSPONSOR (b)lines) - On top of the challenges associated with complying with new IRS 403(b) regulations, sponsors can look forward to increased audit activity by the IRS.

How do we know?    First, because they have said so at numerous conferences around the country; and when top IRS officials talk publicly about enforcement, they really mean it.   Second, it makes sense.   It took them 40 years to put out the new guidance.   You can bet that they’ll want to make sure people are following the rules.

We’ve already seen one of the first steps – the letter sent out by the Employee Plans Compliance Unit to school districts asking about their compliance with the universal availability requirement.   But there are many other issues the IRS is concerned about.   In this column, we’ve provided a list of the issues the IRS will most likely want to review on audit.   (Keep in mind that this is not an exhaustive list, just the more likely items.)


Now, it’s clear that the IRS will not audit every 403(b) arrangement in the country.   In fact, the chance of being audited is probably less than 2%.   So what’s the point of having a list of audit items?   It’s this:   the rules are numerous and fairly complex.   Most of us want to comply with the rules – especially when we’re dealing with other people’s retirement savings.   This list provides 403(b) sponsors an opportunity to do a “self-audit,” to make sure they are satisfying the requirements and to fix problems where they exist.   And remember that if you do find problems, the IRS has voluntary correction programs that let you fix them with a lot less pain than if they are discovered on audit.

The list also gives sponsors the opportunity to verify who is responsible (between the sponsor and various service providers) for each element of the requirements.

The Audit List 

align="center"> AUDIT TOPIC

align="center"> COMMENTS

Are you an eligible employer?

Only public educational institutions and 501(c)(3) organizations (basically charitable or religious entities) may establish a 403(b) plan.   Other types of tax-exempt entities may not offer 403(b) arrangements.

Are you meeting the universal availability rule?

All employees who normally work 20 hours or more per week must have the opportunity to make salary deferrals.

Failure to meet this rule is often due to excluding part-time employees who would otherwise be eligible to participate.   Also, keep in mind that the final regulations changed the rules in this area.

Are you meeting the non-discrimination rules for employer contributions?

The arrangement must satisfy a number of rules regarding availability of benefits to ensure that the plan does not improperly favor the highly compensated employees versus the non-highly compensated.

Have you properly limited elective deferrals?

An employee is eligible to defer up to 100% of pay or $16,500 (for 2009), whichever is less.

Have you returned excess deferrals on a timely basis?

If an employee defers too much, the excess must be returned promptly in order to avoid serious tax consequences.

Have you properly applied the catch-up rules?

If your plan permits it, participants age 50+ may defer an additional $5,500 to the 403(b) plan for 2009.   There are also special catchup rules that require detailed records to ensure compliance.

Have you properly and timely withheld deferrals - and properly reported wages and tax/FICA withholding?

You must withhold the proper amount as requested by the employee and remit the funds to the provider on a timely basis.   And if there have been excess deferrals that need to be returned, you have to make sure that there has been proper reporting of the employee's income and proper withholding for income and other employment taxes.

Have you handled participant loans properly?

The plan must provide for loans and there are limits on the amount and terms of participant loans.   Failure to comply leads to significant tax issues.

Have you properly reported defaulted loans?

If a participant fails to repay a loan in accordance with its terms, the loan is taxable.   This must be reported to the IRS so that the employee pays the proper amount of income tax.

Have you handled your hardship distribution program properly?

Like loans, the plan must provide for hardship distributions and there are rules that must be followed in order to make hardship distributions.   Failure to comply leads to significant adverse tax consequences.

Have you properly followed the rollover rules?

Participants are entitled to rollover their distributions to other tax-deferred vehicles.   These need to be handled properly in order to avoid adverse tax consequences.

The following are some items the IRS has said it will not audit for currently, but will do so starting in tax years after 2010 (again, this is not an exhaustive list):

align="center"> AUDIT TOPIC

align="center"> COMMENTS

Do you have a written plan?

This is required under the 403(b) regulations.   The written plan must be in place by the end of 2009 - though plans must comply with the requirements of the regulations and must comply with the terms of the written document (as finally adopted) during 2009.  

Are you properly handling transfers and exchanges?

The regulations created new rules for exchanges among investments and transfers between plans that require employer involvement.   Failure to comply leads to adverse income tax consequences.

Have you properly taken into account all affiliated entities in administering the plan?

The IRS expanded its rules on controlled groups of entities when it adopted the 403(b) regulations.   These require compliance with the requirements for 403(b) arrangements by all members of the group.

- Bruce Ashton, Reish Luftman Reicher & Cohen

NOTE: This feature is to provide general information only, does not constitute legal advice as part of an attorney-client relationship, and cannot be used or substituted for legal or tax advice.