403(b) Plan Employer Eligibility Failures
A Trap For The Unwary Governmental Agency
One of the principal drivers of 403(b) Plans for governmental agencies is that when they are combined with a governmental 457(b) Plan, employees eligible for both plans may “double dip.” This is a common scenario for employees of public universities. The 2025 contribution limits for 403(b) and 457(b) plans are $23,500 for those under age 50 and $31,000 for those who have attained age 50. There are also enhanced catch-up contributions for employees aged 60-63. Employees eligible for both plans may make pre-tax contributions up to the combined maximum annual dollar amount for each plan. This can be a compelling reason to establish a 403(b) Plan. But, what is less well understood is that, unless a governmental agency operates a public school system, has received an IRS determination letter recognizing it as a tax-exempt organization under Section 501(c)(3) (or was grandfathered under rules that apply to governmental agencies formed before October 10, 1969), or is within one of the very narrow classifications of other eligible employers, it is not eligible to establish a 403(b) Plan.
It is not uncommon to find governmental agencies that do not operate a public school system, do not have an IRS determination letter and are not within any other classification of an eligible employer, having operated a Section 403(b) Plan for many years. They have been under the misconception that because they are exempt from federal income taxation as a “local government,” they are an eligible employer. However, the IRS considers a 403(b) plan maintained by an ineligible employer to have experienced a potentially disqualifying event, which it classifies as an “Employer Eligibility Failure,” starting from the plan's inception.
Why It Matters
Unless proactive steps are taken, an employer maintaining a Section 403(b) Plan with an Employer Eligibility Failure is subject to the retroactive revocation of all of the favorable Section 403(b) tax treatment since the plan’s inception. If an employer does not resolve this by utilizing the correction methods available under the IRS’s Employee Plans Compliance Resolution System (“EPCRS”), it will be forced to negotiate from a very weak position under the IRS’s Audit Closing Agreement Program (“Audit CAP”). Under Audit CAP, the employer is required to make up for all the unremitted income tax withholding and unpaid payroll taxes plus pay the late payment penalties, and pay a significant sanction for its failure to timely withhold and pay these amounts. The participants are also exposed to the retroactive loss of the pre-tax treatment of their employee contributions.
Under current IRS guidance, a governmental agency whose 403(b) Plan experienced an Employer Eligibility Failure may use the Self-Correction Procedure (“SCP”) to avoid retroactive revocation if, within six (6) months of discovering the failure, it freezes the plan by (1) ceasing all employee and employer contributions and (2) keeping the plan’s assets in the issued annuity contracts or custodial retirement income accounts and defers distribution until one of the plan’s distributable events occurs. If it does not complete these steps within the six-month period, it may not use SCP but may still utilize this correction method under the Voluntary Correction Program (“VCP”) by filing an application requesting written IRS approval of the correction and paying a user fee. In these circumstances, absent an application under VCP, the governmental agency faces the risk that the Employer Eligibility Failure will be spotted by the IRS in an audit context. This almost always occurs after a much longer period of noncompliance, causing the magnitude of the adverse tax consequences to increase significantly and leaving the governmental agency in the position of negotiating with the IRS under the more draconian Audit CAP.
How This Happens
The typical scenario involves a governmental agency that does not operate a public school system that was not well advised regarding the requirements of obtaining tax-exempt status under Section 501(c)(3). Governmental agencies that have regulatory or enforcement powers are not among the exhaustive list of entities that qualify for tax exemption under the statute. Such entities are limited to corporations, trusts, community chests, foundations, unincorporated associations, and, under very limited circumstances, LLCs. They must be organized and operated exclusively for at least one of the following purposes: religious, charitable, scientific, educational, literary, testing for public safety purposes, fostering or national or international amateur sports, or prevention of cruelty to animals and children. Outside of certain special districts, e.g. a Health Care District, it is rare that a governmental agency will satisfy these requirements.
Health Care Districts that operate public hospitals and/or clinics have a history of successfully obtaining IRS determination letters under Section 501(c)(3) in recognition of their “charitable” purpose. Frequently, districts form affiliate organizations in order to facilitate a dual status, i.e. they are both a governmental agency and a Section 501(c)(3) tax-exempt organization, which makes them eligible to maintain both a governmental 457(b) Plan and a 403(b) Plan, providing their employees with the advantages of making pre-tax contributions up to the combined deferral limits. Nonetheless, there are Health Care Districts that have operated 403(b) Plans for many years and either never requested an IRS determination letter or are unaware that their original determination letter was revoked by the IRS for one reason or another.
How BBK Can Help
Aside from governmental agencies that operate a public school system or have obtained an IRS determination letter that recognizes their tax-exempt status under Section 501(c)(3), almost every governmental agency that maintains a 403(b) Plan will benefit from a review of its tax filing position that it is an eligible employer. These reviews can also detect other compliance issues, e.g. plan documents and plan operational failures. Under EPCRS these other kinds of qualification failures can be packaged with the Employer Eligibility Failure and all of them can be corrected at the same time. In those cases where the governmental agency cannot qualify for an IRS determination letter, this would be an opportune time to consider establishing a governmental 401(a) plan in combination with the existing governmental 457(b) Plan. However, it should be noted that such an arrangement does not permit eligible employees to “double dip.” In those cases where the governmental agency may qualify for an IRS determination letter, the best approach will be to correct under EPCRS by freezing the existing plan and establishing a new 403(b) Plan for tax years after the date of the IRS determination letter.
For more information and assistance, contact Philip Koehler.
Disclaimer: BBK Legal Alerts are not intended as legal advice. Additional facts, facts specific to your situation, or future developments may affect subjects contained herein. Seek the advice of an attorney before acting or relying upon any information herein.
