Anyone who has had the pleasure of dealing with the 403(b) annuity recognizes that it is truly an “odd duck” – especially when looking at it through the lens of the 401(a) experience.  So it should come as no surprise that this “odd-duckiness” shows up in settlements under the EPCRS’s Closing Agreement Program” (or CAP).

The CAP is the portion of EPCRS which is used when the IRS discovers uncorrected plan errors on audit. Ultimately, it involves the plan sponsor negotiating a final settlement with the IRS. This inevitably also involves the agreeing to pay a CAP sanction which, under current guidance, cannot be less than the fee that would be payable had the sponsor corrected under the IRS’s Voluntary Compliance Program.

There are formally 10 different factors under EPCRS which the IRS takes into account when proposing the sanction amount. One of those elements (and what used to be the most significant factor before the 2106 modifications to the program under 2016-51) is the “Maximum Payment Amount” (the MPA). The IRS agent is required to calculate the MPA as part of the CAP process, which is the tax which the IRS could collect because of the failure of the plan to meet the tax compliance rules. This includes the:

  • tax on the “trust;”
  • additional income tax on the employer from the loss of employer deductions (plus interest and penalties arising from the loss);additional income tax on the individual from the failure (including taxability of a loan);and
  • any other tax which may result from the failure that would apply but for the CAP settlement.

This number in the 401(a) world can be a very large number, even for a small plan, especially when taken over a number of years.

But it’s interesting to see the effect on a 403(b) plan going through this process:

  • There is no tax exempt trust here that is enjoying 501(a) tax exempt treatment. An annuity contract or a custodial account are not, themselves, taxpayers-or entities which can be taxed. The individual who owns the contacts can be taxed (so, the third bullet point applies), but that’s it. This number should be zero.
  • The employer is a tax-exempt entity. This means there should be no loss of deduction, except in the very rare case where a tax exempt might have been taxed under the UBIT rules.
  • The individual will suffer taxation, the amount of which should be included in the MPA. But there are a couple of important factors which come into play here:
    • “Inside buildup.” The tax rules which apply to “non-qualified” annuities (which is the terms we use to describe annuities sold outside of 401(a) and 403(b) plans) defer the taxation of earnings of the investments inside that contract (including the “separate account” investments) until those amounts are distributed-and even then, those earnings might only be taxed (if it’s considered a “distribution as an annuity”) using something called the “exclusion ratio.” The exclusion ratio has the effect of back loading the tax into much later years. Because most 403(b) annuity contracts will qualify as annuities for “inside buildup” purposes-even if they fail 403(b) treatment- the earnings should be excluded from the MPA. Note this treatment will not apply to custodial accounts.
    • Finally, virtually all of the operational errors (except for non-discrimination) will only impact the contracts against which the error occurred. So, for example, a 415 violation will only impact the particular contract to which the excess was made, and only to the extent of the excess. It does NOT “blow up” the entire plan. So, the MPA should only include the tax on portion of the excess in the account of the affected individual.

Though the MPA has a much more limited impact on the sanction amount than prior to 2016, it still can affect the ultimate sanction by showing that many errors may not really be all that egregious (especially when compared to a 401(a) sanction amount on the same type of error).