Of California’s more than 75 public healthcare districts, a significant number of them maintain Internal Revenue Code (IRC) section 403(b) plans. The question is: of those that have them, are they “eligible” to have them? We raise this issue because we have become aware of a significant number of public healthcare districts with 403(b) plans that cannot demonstrate they are properly eligible to sponsor such plans.
According to IRC section 403(b) and the related regulations, the only employers that can maintain a 403(b) plan are public schools and IRC section 501(c)(3) tax-exempt organizations. Since most healthcare districts would not be considered public schools, they must be basing their 403(b) plan sponsorship on their status as a section 501(c)(3) organization. Furthermore, unless an organization is “grandfathered” under specific rules relating to certain organizations organized before October 10, 1969, it generally is required to apply to the IRS for formal recognition of its tax exempt status using Form 1023. There is a parallel application process that applies for California State Franchise Tax Board purposes.
In many of the cases we have seen involving public healthcare districts with a 403(b) plan – but without a section 501(c)(3) exemption, the usual explanation is that the adviser or consultant who helped to set up the 403(b) plan asked if the district was “tax-exempt,” and was told that it was. Of course, the fact that a particular entity is exempt from federal and state income taxes can be based either on an exemption under IRC section 501(c), such as section 501(c)(3) status, or it simply can be based on the fact that the district is a “local government” agency that is also exempt from taxes. Unfortunately, many retirement plan advisers and consultants often “assume” that “tax-exempt” status means section 501(c)(3) status; they proceed to recommend and set-up a 403(b) when the client-entity involved does not have the right type of tax-exempt status.
What should you do if you find that you’re maintaining a 403(b) plan without the appropriate credentials? First, you need to understand that this problem is serious and could potentially lead to the loss of your plan’s tax-favored status. With that said, there are a number of ways to fix or correct the situation:
- One option would be to analyze whether your district hospital operation would or could qualify for tax exemption under IRC section 501(c)(3). You can get a good feel for what qualifies by looking at IRS Publication 557. Several of our public healthcare districts hold dual status as both “governmental” entities and 501(c)(3) tax-exempt organizations – something we have previously referred to as “bitaxual.” As such, they are eligible to maintain both a 403(b) plan and a governmental 457(b) plan – and obtain the advantages of the combined deferral limits. Although 501(c)(3) status generally cannot be obtained on a retroactive basis for most mature entities, it might be possible to utilize newly-obtained 501(c)(3) status as the basis for maintaining an active 403(b) plan as part of an EPCRS correction submission.
- The other option is to recognize that dual tax status is not appropriate for you and to correct the situation through the Employee Plans Compliance Resolutions System by: applying to the IRS under the Voluntary Corrections Program (within EPCRS); and entering into a voluntary closing agreement with respect to the plan that acknowledges the “employer eligibility” failure, causes the plan to be frozen to new contributions and participants, and allows the frozen plan to retain its tax-favored status so that participants will not be currently taxed and will be able to make tax-free rollovers of future distributions.
If you have this problem/situation, it does not go away by itself or over time – it just gets worse because the amounts of money at risk of immediate taxation just keep growing.
Jeff Chang is a partner at Best Best & Krieger LLP. He has four decades of experience skillfully evaluating benefit and retirement plan compliance to achieve maximum outcomes for public agency clients throughout California. He can be reached at firstname.lastname@example.org or (916) 329-3685.