New IRS Guidance Will Help Facilitate 403(b) Plan Terminations
With the publication of Revenue Ruling 2020-23, the IRS completed a cycle of helpful guidance regarding the termination of 403(b) plans that began with the publication of regulations under Code Section 403(b) in 2007. Revenue Ruling 2020-23, issued pursuant to a direction given to the Secretary of the Treasury under the SECURE Act, confirms that a plan administrator or custodian of a 403(b) plan may distribute individual custodial accounts in kind to participants as part of the termination process. This is the case even if the individual custodial account originated as part of a group contract. When combined with Revenue Ruling 2011-7, which blessed the distribution of individual annuity contracts as part of a termination process, this new guidance fills the final gap in the rules governing 403(b) plan terminations.
Prior to 2007, formal rules and guidance governing the termination of a 403(b) plan were scant. In fact, many professionals counseled against formal termination and instead recommended that employers simply freeze an unwanted plan and accept the administrative expenses associated with maintaining it rather than risking potential adverse tax consequences. Nevertheless, many employers chose to follow the longstanding rules that applied to the termination of tax-qualified retirement plans, by adopting an appropriate board resolution, amending the plan, seeking to distribute participant accounts (to the extent possible), and filing a final Form 5500 if a complete distribution of participant accounts was actually accomplished. Many will recall that in those days, non-ERISA 403(b) plans were not required to be maintained pursuant to a plan document and many 403(b) plans were funded with individual annuity contracts. These individual annuity contracts often did not allow lump sum distributions, and plan sponsors had little or no authority to initiate a distribution of benefits (except in cases of a termination of employment). So in many cases, a 403(b) plan could not be terminated simply because the employer lacked the authority to direct the annuity provider to distribute the account to the participant who “owned” the annuity contract.
IRS Regulations under Code Section 403(b) and Revenue Ruling 2011-7
In 2007, the IRS issued a comprehensive set of regulations governing 403(b) plans. Among other things, these regulations required all 403(b) plans – regardless of the funding vehicles and regardless of their status as non-ERISA retirement plans – to be established and maintained pursuant to a written plan document. (Many will recall that the IRS simultaneously amended the regulations under Code Section 414(c) to explain the application of the controlled group rules to tax-exempt organizations, which rules were previously developed through a series of Notices and Revenue Rulings.) The 2007 regulations also expressly authorized the termination of a 403(b) plan, so long as the written document pursuant to which the plan is maintained allows for the termination of the plan and the distribution of all benefits to participants. These rules generally amounted to an adaptation of the rules governing the termination of tax-qualified retirement plans, including the requirement of full vesting of account balances, limitations on making contributions to another 403(b) plan within 12 months after the distribution of assets from the terminated plan, and so on.
While the 403(b) regulations were enormously helpful, the nettlesome issue of dealing with individual annuity contracts remained, as did certain questions relating to the treatment of group annuity contracts that did not provide for lump sum distributions. To dispose of those questions, and address a few other practical plan termination problems, the IRS issued Revenue Ruling 2011-7. Revenue Ruling 2011-7 presents a series of scenarios involving the termination of both governmental and non-governmental 403(b) plans and holds that: (1) plans funded with individual annuity contracts may be terminated by distributing the individual annuity contracts to participants in kind as an alternative to making lump sum distributions; (2) payment obligations under a group annuity contract may be assumed by the issuer of the contract and the plan termination may be implemented by issuing to each participant a certificate evidencing a fully paid interest in his or her benefits under the group annuity contract; and (3) as long as the annuity contracts continue to comply with applicable rules under Code Section 403(b), no participants will be taxed on their benefits until the benefits are paid out. Although Revenue Ruling 2011-7 focused on the disposition of individual annuity contracts, the ruling also allows a terminating plan to make distributions in cash or in kind where the plan is funded with custodial accounts. Questions remained, however, regarding the effect of restrictive provisions that many vendors included in custodial account arrangements that could impede the complete implementation of a plan termination, and there was a desire for greater clarity regarding the treatment of individual custodial accounts maintained under a group contract.
Revenue Ruling 2020-23
Section 110 of the SECURE Act directed the Secretary of the Treasury to issue guidance providing that if an employer terminates a 403(b) plan funded with custodial accounts, the plan administrator or custodian may distribute an individual custodial account (“ICA”) in kind to a participant or beneficiary. The statute essentially directs the Secretary to confirm that if the distributed ICA is maintained by the custodian on a tax deferred basis – as required under Code Section 403(b)(7) – participants will not be taxed on their benefits until the benefits are actually distributed. In other words, the distribution of an ICA in connection with the termination of a 403(b) plan should be similar to the treatment of individual annuity contracts described under Revenue Ruling 2011-7. Revenue Ruling 2020-23 dutifully makes good on the directives contained in the SECURE Act.
Revenue Ruling 2020-23 addresses two scenarios involving the distribution of ICAs in connection with the termination of a 403(b) plan. In both scenarios, the employer: (1) maintains the 403(b) plan pursuant to a written document that complies with IRS regulations and contemplates the possibility of termination; (2) adopts a board resolution providing for the cessation of contributions, the termination of the plan, and the full vesting of all accounts; and (3) retains no material rights under any ICA after it has been distributed. In the first scenario, all participant accounts are funded through individual custodial contracts and benefits are distributed by lump sum payments to participants (who either accept the payments or roll them into IRAs) or by distribution of ICAs to the participants. Because the plan is funded with ICAs, no further action by the employer is necessary in order to implement the termination through the distribution of ICAs. Following the termination, a participant who holds an ICA is entitled to receive benefit payments in accordance with the terms of the contract.
In the second scenario, the facts are generally the same except the 403(b) plan is funded with custodial accounts maintained under a group agreement. In that case, the distribution of the ICAs is accomplished by providing to the participant a document that evidences the ICA. The document affirms the participant’s fully vested interest in the custodial account, as well as the related rights and respective responsibilities of the participant and the custodian. In that case, the distribution of the ICA will again constitute a complete distribution of the participant’s plan benefit upon termination of the 403(b) plan and the participant will not be taxed on underlying benefits until they are distributed by the custodian.
Because Revenue Ruling 2011-7 referenced the distribution of ICAs in connection with the termination of a 403(b) plan, Revenue Ruling 2020-23 is treated for regulatory purposes as a modification of the earlier ruling. Nevertheless, this new guidance closes what most professionals considered to be the final gap in the rules governing the termination of 403(b) plans. For that, we are grateful.