SunGard Relius

One of the more long awaited provisions of the final 403(b)regulations was the provision permitting an employer to terminate its 403(b) plan. More importantly, the new regulations recognized plan termination as a distributable event. Prior to the final regulations, the 403(b) rules did not contain a provision permitting plan termination nor did they permit it as a distributable event. Therefore, while an employer could cease making contributions or permitting deferrals, the employer was required to continue maintaining the plan until each participant incurred a distribution event (e.g., separation from service). If the plan were subject to Title I of ERISA, the employer would need to continue filing 5500s until the last participant incurred a distribution event and the plan distributed the final dollar from the plan.

When the IRS included a plan termination provision in the proposed regulations, sponsors wishing to terminate their 403(b) plans anxiously anticipated awaited the issuance of the final 403(b) regulations. However, the excitement over the new provision was short-lived as subsequent and inconsistent statements by IRS officials regarding plan termination caused 403(b) practitioners to wonder if the plan termination provision was an illusion. In applying the IRS’s interpretation of the provision, 403(b) sponsors, in many circumstances, will determine that they are not able to effect plan termination unless they have the cooperation of 100% of their plan participants.

In order to terminate a 403(b) plan and have that termination be a distributable event, the regulations provide that a plan must satisfy the following requirements: (1) the written plan must contain provisions authorizing the termination, (2) the employer (including all related employers) may not make contributions to any 403(b) plan for a 12-month period following the distribution of all assets from the terminated plan¹, and (3) the plan must distribute all accumulated benefits under the plan as soon as administratively practicable after termination of the plan. For purposes of the distribution requirement, “delivery of a fully paid individual insurance annuity contract is treated as a distribution.” Generally, when the regulations reference annuity contracts, the rule also applies to custodial accounts. However, IRS officials have stated that the inclusion of the word “insurance” before “annuity contract” limits its application to annuity contracts. Such an interpretation makes plan termination almost impossible for a 403(b) plan with individual custodial accounts unless it obtains the cooperation of all of its participants, because the employer is not a party to the custodial account.

After weaving through various interpretations of the plan termination provision, IRS officials seem to have settled on an interpretation of the termination provision. A 403(b) plan with a group annuity contract could effect plan termination by liquidating the contract or by converting the contract to individual contracts and distributing the contracts. If the plan contains individual annuity contracts or is completely made up of individual contracts, the employer probably has insufficient legal control over the contracts to effect distribution (i.e., the contract is between the employee and the insurance company). However, the employer may effectively distribute the contract by simply treating the contract as distributed. The IRS seems to accept this approach as long as the contract assumes the distribution responsibilities (e.g., Code §401(a)(9), joint and survivor annuity) in the same manner as annuity contracts distributed from a terminated defined benefit plan (see Rev. Rul. 89-87). The regulations do not provide any guidance on how a terminating 403(b) plan considers an annuity contract distributed but we recommend that after adopting a resolution to terminate the plan, the employer notify each participant with an individual annuity contract that it has terminated the plan and that pursuant to the regulations it is treating the contract as distributed (i.e., future questions regarding benefits and distributions should be directed to the insurance company). The fact that the plan considers the contract as distributed does not trigger taxation. The participant is not subject to taxation until the insurance company distributes benefits from the contract.

A 403(b) plan in which some or all investments are individual custodial accounts probably will find plan termination beyond its capability. As with individual annuity contracts, the employer probably has insufficient legal control over the accounts to effect distribution. Furthermore, the employer cannot satisfy the distribution requirements by distributing individual accounts (or treat the accounts as distributed) because the IRS has indicated that the regulations limit that option to annuity contracts. An IRS official uses the following example to illustrate the difficulty in terminating a 403(b) plan with individual custodial accounts: Assume a 403(b) plan includes a group annuity contract covering 99 participants and an individual custodial account covering one participant. If the participant in the custodial account will not agree to liquidate the account, the employer cannot terminate the plan and utilize plan termination as an event to distribute to the other participants. As the example illustrates, 403(b) plans with individual custodial accounts probably will find plan termination unattainable. In explaining the inconsistency of basing the ability to terminate a 403(b) plan on the plan investment, the IRS states that the regulations did not intend to create a mechanism for terminating a plan but were merely recognizing the ability to terminate in certain fact patterns. In effect, they have said: “We weren’t trying to empower you, just to tell you the consequences of your actions.”

While in future 403(b) custodial account arrangements will probably include mechanisms to allow termination, we can only hope that Congress or the IRS will revisit thie situation and provide a mechanism whereby an employer can terminate its plan regardless of the investment arrangements available under the plan in order to address the circumstances of existing investment products.

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