rr-11-07.pdf

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Section 403(b) – Taxability of Certain Annuity Contracts

26 CFR 1.403(b)-10 Tax Sheltered Annuity Contracts

Rev. Rul. 2011 –7

ISSUE

Whether a retirement plan that takes the actions described below has been
terminated in accordance with the rules of § 1.403(b)-10(a) of the Income Tax
Regulations and whether distributions made to participants or beneficiaries in
connection with termination of the plan are included in gross income.

FACTS

Situation 1

Plan A is a defined contribution plan that includes both nonelective employer
contributions and elective deferrals. Prior to the action taken to terminate the
plan as described below, Plan A satisfies the requirements of § 403(b) and §§
1.403(b)-2 through § 1.403(b)-9. Plan A only permits benefit payments to be
made after termination from employment or upon plan termination. Plan A is
funded solely through the use of fully paid individual annuity contracts issued by
an insurance company. Plan A is not subject to ERISA (because it is a
governmental plan, within the meaning of section 3(32) of ERISA). All amounts
held under Plan A are a result of employer contributions, including elective
deferrals as defined in §1.403(b)-2(b)(7), and no amounts are held there as a
result of designated Roth contributions or after-tax contributions. Neither the
sponsoring employer nor any other entity that is treated as the same employer
under § 414(b), (c), (m), or (o) on the date of the termination makes contributions
to any § 403(b) contract that is not part of Plan A, including during the period
beginning on January 1, 2012 and ending on the date that is 12 months after
distribution of all assets from Plan A.

On or before January 1, 2012, the employer sponsoring Plan A takes action to
terminate Plan A. That action includes a binding resolution of the employer to
cease future purchases of annuity contracts under Plan A and to terminate Plan
A, effective January 1, 2012. The resolution also provides that all benefits held
under Plan A are fully vested and nonforfeitable as of January 1, 2012, and
directs that all benefits be distributed as soon as practicable thereafter.
Participants and beneficiaries in Plan A are notified of the plan termination.

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Distributions pursuant to the terms of Plan A and the termination resolution are
made as soon as administratively practicable after the termination date and are
effectuated by distribution of fully paid individual insurance annuities to all
participants, beneficiaries who are alternate payees, and beneficiaries of
deceased participants.

Some of the contracts permit single-sum payments as a form of liquidating
distribution in connection with plan termination and such single-sum payments
are made as soon as administratively practicable after January 1, 2012. Each
insurance carrier permits any such payment that is an eligible rollover distribution
(as described in §402(c)(4)) to be paid by a direct transfer to an individual
retirement account or annuity under § 408 (IRA) or other eligible retirement plan
(as defined in §401(a)(31)(E)) in a manner that satisfies § 401(a)(31). The plan
administrator provides a notice to employees describing their rollover rights, as
required by § 402(f).

Situation 2

The facts are the same as in Situation 1
, except that Plan A is funded not only by
individual annuity contracts, but also by a group annuity contract. Distribution of
amounts from the group annuity contract is effectuated by issuing individual
certificates to each participant, beneficiary who is an alternate payee, and
beneficiary of a deceased participant in the group annuity contract evidencing a
fully paid interest in his or her benefits under the contract as soon as
administratively practicable after January 1, 2012. Some participants and
beneficiaries receive a single-sum payment as a liquidating distribution from the
contract in accordance with the terms of the contract.

Situation 3

The facts are the same as in Situation 2
, except that Plan A is funded not only by
individual annuity contracts and a group annuity contract, but also by amounts
held by one or more regulated investment companies (as defined in § 851(a)
relating to mutual funds) in custodial accounts that are treated as annuity
contracts for purposes of § 403(b). Custodial accounts are maintained either
under individual or group agreements.

The distribution of amounts held in the custodial accounts is made as soon as
administratively practical after January 1, 2012. Depending on the elections
made by the participant or beneficiary, distributions equal to recipient’s account
balance under the custodial account are made (in cash or in kind) either to the
participant or beneficiary or to an IRA established for the participant or
beneficiary or another eligible retirement plan, in accordance with the rules of
§1.403(b)-7(b)(1) under which an eligible rollover distribution may be made to an
IRA established for the participant or beneficiary or to another eligible retirement
plan. Each custodial account provider permits an eligible rollover distribution (as

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described in §402(c)(4)) to be paid by a direct transfer to an individual retirement
account or annuity under § 408 (IRA) or other eligible retirement plan (as defined
in §401(a)(31)(E)) in a manner that satisfies § 401(a)(31), including an IRA
established by the same provider that permits investment in the same mutual
fund in which the participant’s or beneficiary’s custodial account is invested.

Situation 4

The facts are the same as in Situation 3
, except that the plan is a money
purchase pension plan (i.e. a defined contribution plan that is neither a profit
sharing nor a stock bonus plan) that is subject to the requirements of part 2 of
subtitle B of Title I of the Employee Retirement Income Security Act of 1974
(ERISA) and section 302 of ERISA. Therefore, distributions are made in
accordance with section 205 of ERISA (relating to qualified joint and survivor
annuities and qualified preretirement survivor annuities). If amounts held in the
custodial accounts for a participant are to be paid in the form of an annuity under
section 205 of ERISA, the distribution is made by purchase and distribution of a
fully paid individual insurance annuity. Prior to termination, the plan otherwise
complies with all the requirements of part 2 of subtitle B of Title I of ERISA. For
the plan year that includes the final distribution, the plan files a final return/report
(Form 5500).

LAW

Section 403(b) applies to contributions made for employees who are performing
services for a public school of a State or a local government or for employees of
employers that are tax-exempt organizations under § 501(c)(3). Section 403(b)
also applies to contributions made for certain ministers. Under § 403(b),
contributions are excluded from gross income only if made to certain funding
arrangements: (1) contracts issued by an insurance company qualified to issue
annuities in a State that includes payment in the form of an annuity; (2) custodial
accounts that are exclusively invested in stock of a regulated investment
company (as defined in § 851(a) relating to mutual funds); or (3) a retirement
income account for employees of a church-related organization (as defined in
§1.403(b)-2).

Final regulations under § 403(b) (TD 9340) were published in the Federal
Register (72 FR 41128) on July 26, 2007 (2007 Regulations). Subject to a
number of special effective date rules, the 2007 Regulations are generally
effective for taxable years beginning after December 31, 2008.

Section 1.403(b)-10(a) of the 2007 Regulations provides that an employer is
permitted to amend its § 403(b) plan to eliminate future contributions for existing
participants or to limit participation to existing participants and employees (to the
extent consistent with §1.403(b)-5). A § 403(b) plan is permitted to contain

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provisions that provide for plan termination and that allow accumulated benefits
to be distributed on termination.

However, in the case of a § 403(b) contract that is subject to the distribution
restrictions in §1.403(b)-6(c) or (d) (relating to custodial accounts and § 403(b)
elective deferrals), under §1.403(b)-10(a), termination of the plan and the
distribution of accumulated benefits is permitted only if the employer (taking into
account all entities that are treated as the same employer under § 414(b), (c),
(m), or (o) on the date of the termination) does not make contributions to any §
403(b) contract that is not part of the plan (any such contract is referred to below
as “another § 403(b) plan”). For rules relating to entities that are treated as the
same employer under § 414(c), see §1.414(c)-5 and, for controlled group rules
relating to governmental entities, see Notice 89-23 (1989-1 CB 654), as modified
by Rev. Rul. 2009-18, 2009-2 CB 1.

For purposes of the requirement that, after plan termination, the employer make
no contributions to any other § 403(b) plan, contributions are made to “another §
403(b) plan” if and only if contributions are made to a § 403(b) contract during the
period beginning on the date of plan termination and ending 12 months after
distribution of all assets from the terminated plan. However, if at all times during
the period beginning 12 months before the termination and ending 12 months
after distribution of all assets from the terminated plan, fewer than 2 percent of
the employees who were eligible under the terminating § 403(b) plan as of the
date of plan termination are eligible under another § 403(b) plan, that § 403(b)
plan is disregarded. To the extent a contract fails to satisfy the nonforfeitability
requirement of §1.403(b)-3(a)(2) of the 2007 Regulations at the date of plan
termination, the contract is not, and cannot later become, a § 403(b) contract.

In order for a § 403(b) plan to be considered terminated under §1.403(b)-10(a),
all accumulated benefits under the plan must be distributed to all participants and
beneficiaries as soon as administratively practicable after termination of the plan.
(For rules relating to when distributions to all participants and beneficiaries are
made as soon as administratively practicable after plan termination in the case of
a plan qualified under § 401(a), see Rev. Rul. 89-87, 1989–2 C.B. 2, and Internal
Revenue Manual 7.12.1.2.3, paragraph 5.) For this purpose, delivery of a fully
paid individual insurance annuity contract is treated as a distribution. The mere
provision for, and making of, benefit distributions to participants or beneficiaries
upon plan termination does not cause a contract to cease to be a § 403(b)
contract. Section 1.403(b)-7 provides rules regarding the tax treatment of benefit
distributions, including §1.403(b)-7(b)(1) under which an eligible rollover
distribution is not included in gross income if paid in a direct rollover to an eligible
retirement plan or if transferred to an eligible retirement plan within 60 days.

ANALYSIS

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The employer in Situation 1
adopted a resolution to cease contributions and
terminate the plan at a specified date, including full vesting for all benefits at that
date. Since the employer took action to fully vest any participants with respect to
amounts not otherwise fully vested at the date of plan termination, all contracts
under the plan will be § 403(b) contracts upon plan termination. See §§
1.403(b)-3(d)(2) and 1.403(b)-10(a)(1). Such contracts may permit benefits to
begin immediately upon plan termination, or may permit the participant to begin
benefits at a later date to the extent provided in the plan document and the
termination resolution, subject to applicable Code (and ERISA rules where
applicable.)

Distribution in Situation 1
was made by delivery of a fully paid individual annuity
contract or a single-sum payment to each participant or beneficiary as soon as
administratively practicable after the termination date. Because the plan is
funded solely through fully paid individual insurance annuity contracts, no further
action is required to be taken in order to distribute the contracts. In addition,
neither the sponsoring employer nor any other entity that is treated as the same
employer under § 414(b), (c), (m), or (o) on the date of the termination makes
contributions to any § 403(b) contract that is not part of Plan A, including during
the period beginning on the date of plan termination and ending 12 months after
distribution of all assets from the terminated plan. Accordingly, the actions taken
by the employer to terminate the plan and distribute accumulated benefits satisfy
the requirements of § 403(b) and § 1.403(b)-10(a) of the 2007 Regulations for
plan termination. Following termination of the plan, participants and beneficiaries
who hold fully paid insurance annuity contracts are entitled to payments in
accordance with the terms of the contracts (which may permit single-sum
payments in connection with plan termination).

In Situation 2, the same actions were taken, except that the employer provided
an individual certificate evidencing fully paid benefits under the contract to each
participant or beneficiary whose accumulated benefits are funded by a group
annuity contract. The issuance of this certificate to each participant or
beneficiary constitutes a distribution of the participant’s or beneficiary’s
accumulated benefit in the group annuity contract for purposes of §1.403(b)-
10(a) of the 2007 Regulations (but no amount is included in gross income until
amounts are paid out of the policy).

In Situations 3 and 4
, the employer also distributed all amounts in the individual
and group custodial accounts by payment either to the participant or beneficiary
or to an IRA established by the participant or beneficiary or another eligible
retirement plan, in accordance with §1.403(b)-7(b) of the 2007 Regulations, or by
delivery of a fully paid individual annuity contract. The actions taken by the
employer satisfy the requirements of § 403(b) and § 1.403(b)-10(a) of the 2007
Regulations for plan termination. The amounts paid to a participant or beneficiary
from custodial accounts in connection with the termination are not included in

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gross income to the extent those amounts are rolled over to an IRA or other
eligible retirement plan.

With respect to Situations 1 through 4
, the delivery of a fully paid individual
annuity contract to participants or beneficiaries, or of an individual certificate
evidencing fully paid benefits under a group annuity contract, is not included in
gross income until amounts are actually paid to the participant or beneficiary out
of the contract, so long as the contract maintains its status as a § 403(b)
contract. The § 403(b) status of any such contract is generally maintained if the
contract thereafter adheres to the requirements of § 403(b) that are in effect at
the time of the delivery of such contract. Any other amount paid to a participant
or beneficiary, such as a single-sum payment, is included in the gross income of
the participant or beneficiary, except to the extent the amount is rolled over to an
IRA or other eligible retirement plan by a direct rollover or by a transfer made
within 60 days after the distribution.

HOLDING

In each of Situations 1 through 4, Plan A has been terminated in accordance with
the rules of § 1.403(b)-10(a). Delivery of a fully paid individual annuity contract to
participants or beneficiaries, or of an individual certificate evidencing fully paid
benefits under a group annuity contract, is not included in gross income until
amounts are actually paid to the participant or beneficiary out of the contract, so
long as the contract maintains its status as a § 403(b) contract. Any other
distributions to a participant or beneficiary to effectuate plan termination, whether
from an insurance annuity contract, an individual certificate evidencing fully paid
benefits under a group annuity contract, or a custodial account, are included in
gross income, except to the extent the amount is rolled over to an IRA or other
eligible retirement plan by a direct rollover or by a transfer made within 60 days
after the distribution.

DRAFTING INFORMATION

The principal authors of this revenue ruling are Kathleen Herrmann and Sherri
Edelman of the Employee Plans, Tax Exempt and Government Entities Division.
Ms. Herrmann and Edelman may be reached by e-mail at
RetirementPlanQuestions@irs.gov.