Publications: Recent IRS Developments for Tax-Exempt Employers

To read the original Client Update in PDF format, please click the Related Files link.

This client update summarizes two important recent developments at the IRS affecting tax-exempt employers.

I. Executive Compensation Audits

The IRS has recently launched a new enforcement initiative regarding executive compensation practices at tax-exempt employers. The initiative focuses on the employer’s compliance with the “intermediate sanction” rules of Code Section 4958. In short, these rules (i) prohibit unreasonable executive compensation, and (ii) require that strict internal protocols be developed and followed in approving executive compensation. The IRS is currently auditing executive compensation reported on Form 990 for the 2002 tax year. The IRS is focusing on four primary concerns:

• Was the total economic benefit received by the executive reported on Form 990?
• Was the total compensation package reasonable for each executive?
• Were compensation levels based on appropriate and reliable comparability studies regarding similar positions?
• Did the organization establish and follow the required internal protocols in approving the executive compensation?

Failure to answer all of these questions to the IRS’ satisfaction may trigger excise taxes for both the executives and the persons who approved the executives’ compensation packages. In light of the foregoing, we recommmend that all tax-exempt employers review their executive compensation practices in this regard. If you receive an audit letter from the IRS before undertaking this review, you should contact us immediately.

II. New Section 403(b) Regulations

The IRS has issued proposed regulations for Section 403(b) retirement arrangements which are effective January 1, 2006. These regulations represent the first comprehensive guidance issued by the IRS under Code Section 403(b) in almost 40 years. The new regulations continue many provisions of current law, but also make several important changes. In light of this new guidance, all Section 403(b) programs, including “salary deferral-only” arrangements with minimal employer involvement, will need to be reviewed and brought into compliance with the new regulations. Some of the more important changes included in the new regulations are the following:

A. Written Plan Document. Under the new regulations, all Section 403(b) programs, including “salary deferral-only” arrangements, must be maintained pursuant to a written plan document. In particular, salary deferral-only 403(b) programs will need to be reviewed to determine if the existing investment contract documentation provided by the investment vendor meets all of the new “plan document” requirements. This additional documentation could cause some salary deferral only programs to become subject to ERISA, which would trigger Form 5500 annual reporting and other new compliance requirements.

B. Universal Availability. The new regulations generally retain the “universal availability” requirement that currently applies to Section 403(b) salary deferral features. However, the regulations “fine tune” these rules in some respects. As a result, all salary deferral features will need to be carefully reviewed and modified as appropriate to ensure continued compliance with this open eligibility requirement.

C. Nondiscrimination. The new regulations repeal the “good faith” nondiscrimination standard that applies to employer contributions under current law, including the nondiscrimination “safe harbors” in IRS Notice 89-23. As a result, all matching contributions will have to satisfy the same nondiscrimination test that applies to matching contributions under a 401(k) plan. Similarly, other employer contributions will have to satisfy the same nondiscrimination rules that apply to employer contributions under Section 401(a) qualified plans. These rules are generally less flexible than the current Section 403(b) nondiscrimination standards. All employer contributions need to be reviewed to assure compliance with these new standards.

D. Deadline for Remitting Employee Contributions. The new regulations will require employers to remit employee contributions to the investment provider or custodian as soon as administratively practicable after they are withheld from paychecks (and never later than 15 business days after the end of the month in which the amounts are withheld). In most cases, weekly, bi-weekly or semi-monthly deposits will be required. This new rule will apply to all 403(b) programs, regardless of whether they are subject to ERISA.

E. Controlled Group Rules. The new regulations formalize the controlled group rules for tax-exempt organizations as set forth in IRS Notice 89-23. These rules generally provide that entities linked by 80% or more common board control will be treated as a single employer for benefit plan purposes. However, the new regulations also provide that multiple exempt organizations that maintain a single plan for their employees may treat themselves as a controlled group if they regularly coordinate their day-to-day activities, even if they lack 80% common board control.

F. Plan Termination. The proposed regulations will generally permit employers to terminate their 403(b) arrangements and make distributions to employees (which is impermissible under current law). This provision will give tax-exempt employers additional flexibility in dealing with their 403(b) programs.

G. Transfers and Exchanges. Under current law, employees have wide latitude to transfer their 403(b) annuities or custodial accounts to other vendors or exchange their 403(b) annuity (or custodial account) for another 403(b) product on a non-taxable basis (but only if the underlying 403(b) program so permits). The new regulations generally prohibit such transfers or exchanges with “outside” vendors.

H. Defined Contribution Only. The new regulations take the position that Section 403(b) programs generally must be based on a “defined contribution” model, with individual participant account balances. Defined benefit 403(b) programs are relatively rare, but any such programs will need to be modified.

The proposed regulations are scheduled to take effect on January 1, 2006 (later effective dates apply to certain church plans and collectively bargained plans). Thus, sponsors of 403(b)programs should begin reviewing their programs immediately to (i) develop compliance strategies and evaluate plan design alternatives without unnecessary time constraints, (ii) authorize counsel to prepare or amend applicable plan documents, and (iii) start considering appropriate communications to affected employees, all to be completed prior to January 1, 2006.