By Mark G. Kmiecik
Public sector and tax-exempt employers in Wisconsin should be aware that the IRS appears to be targeting section 403(b) plans for examination. Prior to and during recent IRS examinations of 403(b) plans in the state, we have learned that the audit trigger more than once was the IRS’s review of the employers’ websites for 403(b)-related communications. Unfortunately, the information revealed that the employers’ respective 403(b) plans were not being operated in compliance with IRS requirements. The posted documents ultimately led to the IRS selecting the employers’ plan for examination.
As the IRS has emphasized in two recent newsletters targeted to federal, state, and local government employers, the “constructive receipt” rules under the Internal Revenue Code require that individuals recognize income as soon as they have effective control over it; that is, when the funds are made available without substantial limitations. When an employee or retiree has an option to receive the income without restriction, such as an option to elect a cash payout in lieu of a 403(b) contribution, it is recognized as taxable income under the law, regardless of whether the employee actually receives it at that time. Narrow exemptions (including the use of a Cafeteria Plan) exist to circumvent the normal “constructive receipt” rules. The Cafeteria Plan exemption applies, for example, when an employee chooses to contribute his or her income on a pre-tax basis for health insurance premiums, rather than receiving taxable wages.
Certain benefits, however, including 403(b) and Health Reimbursement Arrangement (HRA) benefits, are not permitted to be offered under a Cafeteria plan. For instance, an employer may not allow an employee or retiree to choose whether to receive a payment in the form of cash or as an employer contribution to a 403(b) or HRA account, respectively. The employer who offers such a choice inadvertently compromises the tax-qualified status of either the entire 403(b) plan or the individual’s HRA account. This results in negative tax consequences to the employer and/or employees.
IRS auditors perceive, sometimes correctly so, that there is a low level of awareness among public sector employers, that certain benefit choices are not permitted. See, for example, our prior article outlining the IRS’s focus on impermissible choices in unused sick leave benefit plans, “Risky Choices in Unused Sick Leave Benefit Plans.” (https://www.dkattorneys.com/publications.cfm?id=359). That the IRS holds this perception is further confirmed by our experience that the IRS is actively looking for these issues in connection with 403(b) plans – and commencing audits on such plans upon discovery of possible plan or operational failures.
In each case of which we are aware, the IRS discovered the audit trigger after review of content on the employers’ website. Documents on each employer’s website showed that they offered employees and retirees the impermissible option to elect to receive either a cash payment, a 403(b) contribution, or other form of tax favored benefit. Consequently, each employer subjected itself to an unwanted examination by publishing its 403(b) plan documents, statements and other correspondences on its website.
To protect the tax qualified status of 403(b) plans and avoid the burden and costs of a potential audit, it is recommended that you consult with an employee benefits or tax attorney before publishing 403(b) plan documents. If you have any questions, please contact your Davis & Kuelthau attorney or the author, Mark G. Kmiecik at 414.225.1406 / firstname.lastname@example.org.