IRS Revenue Ruling
2000-35

 Code Sec. 403

<<FULL TEXT>>

26 CFR 1.403(b)-1: Taxability of beneficiary under annuity contract
purchased by a section 501(c)(3) organization or public school.

Section 403(b) plans; elective deferrals. This revenue ruling specifies
the criteria to be met in order to automatically reduce an employee's
compensation by a certain amount and have that amount contributed as an
elective deferral to an employer's section 403(b) plan.


REV. RUL. 2000-35

ISSUE

Will employer contributions to an annuity contract described in section
403(b) of the Internal Revenue Code (the "Code") fail to be considered to
be made under a salary reduction agreement merely because they are made
pursuant to an arrangement under which a fixed percentage of an employee's
compensation is contributed to the annuity contract unless the employee
affirmatively elects to receive the amount in cash?


FACTS

Employer X, an organization described in section 501(c)(3) which is
exempt from tax under section 501(a), maintains Plan A, a plan described
in section 403(b) of the Code and section 3(2) of the Employee Retirement
Income Security Act of 1974 ("ERISA"). Under Plan A, any employee of
Employer X, including a newly hired employee, may elect to have Employer X
make contributions on the employee's behalf towards the purchase of an
annuity contract in lieu of receiving that amount as cash compensation
that would otherwise be payable to the employee. The employee may
designate the amount of these compensation reduction contributions as a
percentage of the employee's compensation, subject to certain limitations
set forth in the plan. These compensation reduction contributions satisfy
the section 403(b) requirements applicable to contributions made pursuant
to a salary reduction agreement, and are treated for all purposes as made
pursuant to a salary reduction agreement under the plan.

Plan A also provides that Employer X will make matching contributions
on account of an employee's compensation reduction contributions up to a
specified percentage of the employee's compensation. Plan A does not
permit any other contributions.

Plan A is amended, effective the next January 1, to add an automatic
compensation reduction election feature. Under this feature, each
employee's compensation will automatically be reduced by 4 percent and
this amount will be contributed towards the purchase of an annuity
contract under Plan A unless the employee affirmatively elects to receive
cash or have a different percentage contributed. Both before and after the
amendment, the employee is not able to receive, prior to a distributable
event described in section 403(b)(11), amounts contributed towards the
purchase of an annuity contract. Both before and after the amendment, Plan
A and the annuity contracts purchased thereunder satisfy the requirements
of section 403(b). An election not to make compensation reduction
contributions or to contribute a different percentage of compensation can
be made at any time.

Under Plan A as amended, in the case of a newly hired employee, an
election not to make compensation reduction contributions or to contribute
a different percentage is effective for the first pay period and for
subsequent pay periods (until superseded by a subsequent election) if
filed when the employee is hired or if filed within a reasonable period
thereafter ending before the compensation for the first pay period is
currently available. Thus, if a newly hired employee files an election to
receive cash in lieu of compensation reduction contributions and the
election is filed when the employee is hired or within a reasonable period
thereafter ending before the compensation is currently available, then no
compensation reduction contributions for the first pay period or
subsequent pay period are made on the employee's behalf to Plan A until
the employee makes a subsequent affirmative election to reduce his or her
compensation. Elections filed at a later date are effective for payroll
periods beginning in the month next following the date the election is
filed.

At the time an employee is hired, the employee will receive a notice
that explains the automatic compensation reduction election and the
employee's right to elect to have no such compensation reduction
contributions made to the plan or to alter the amount of those
contributions, including the procedure for exercising that right and the
timing for implementation of any such election.

In the case of an employee hired before the January 1 effective date
who has not elected compensation reduction contributions of at least 4
percent, Plan A as amended provides that the automatic election will
become effective on the first pay period beginning on or after January 1
unless the employee elects during a specified reasonable period ending on
January 1 to receive cash or have a different amount contributed to Plan
A. Thus, if a current employee files an election to receive cash in lieu
of compensation reduction contributions and the election is filed during
the reasonable period ending on the January 1 effective date, then no
compensation reduction contributions for the first pay period beginning on
or after the January 1 effective date or for subsequent pay periods are
made on the employee's behalf to Plan A until the employee makes a
subsequent affirmative election to reduce his or her compensation. In the
case of a current employee who has a compensation reduction contribution
election in effect for less than 4 percent, who does not make a new
compensation reduction contribution election during the reasonable period
ending on the January 1 effective date, and whose compensation is
therefore automatically reduced by 4 percent, if that employee thereafter
makes an affirmative election to reduce his or her compensation by another
amount (or no amount), then that affirmative election will continue in
effect until the employee makes a subsequent affirmative election for a
different amount.

At the beginning of the reasonable period ending on the January 1
effective date, each current employee receives a notice that explains the
new automatic compensation reduction election and the employee's right to
elect to have no such compensation reduction contributions made to the
plan or to alter the amount of those contributions, including the
procedure for exercising that right and the timing for implementation of
any such election.

Each employee is notified annually of his or her compensation reduction
percentage, and of his or her right to change the percentage, including
the procedure for exercising that right and the timing for implementation
of any such election.

Plan A provides that both matching contributions and compensation
reduction contributions will be invested in accordance with the
participant's election among a broad range of annuity contracts. If no
investment election is made by a participant, contributions are invested
in an annuity contract providing an investment return based on the return
on a balanced fund that includes both diversified equity and fixed-income
investments. <<ENDNOTE 1>>


LAW AND ANALYSIS

Section 403(b)(1) of the Code provides that amounts contributed by
certain employers, including an employer described in section 501(c)(3)
which is exempt from tax under section 501(a), for the purchase of an
annuity contract for an employee of such an employer are excluded from the
gross income of the employee if certain requirements are satisfied.
Contributions to purchase annuity contracts under section 403(b) may be
made either pursuant to a salary reduction agreement or not pursuant to a
salary reduction agreement. Contributions made pursuant to a salary
reduction agreement are subject to different requirements than are
contributions not made pursuant to a salary reduction agreement. (See, for
example, sections 403(b)(1)(E), 403(b)(7)(A)(ii), 403(b)-(11) and
403(b)(12).) In general, a contribution is not treated as made pursuant to
a salary reduction agreement if under the agreement it is made pursuant to
a one-time irrevocable election made by the employee at the time of
initial eligibility to participate in the agreement. See sections
402(g)(3)(C) and 403(b)(12).

Section 1.403(b)-1(b)(3)(i) of the regulations prescribes rules
applicable to contributions made pursuant to a salary reduction agreement,
including rules relating to the frequency and revocability of such
agreements and to the salary to which such agreements apply.

Section 1450(a) of the Small Business Job Protection Act of 1996
("SBJPA") provides that, for purposes of section 403(b) of the Code, the
frequency that an employee is permitted to make a salary reduction
agreement, the salary to which such an agreement may apply and the ability
to revoke such an agreement shall be determined under the rules applicable
to cash or deferred elections under section 401(k). Section 1450(a) of
SBJPA is effective for taxable years beginning after December 31, 1995.
Thus, section 1.403(b)-1(b)(3)(i) of the regulations does not reflect
current law, and the rules relating to these aspects of salary reduction
agreements are the same as those for cash or deferred elections under
section 401(k).

Section 401(k) provides that a profit-sharing or stock bonus plan, a
pre-ERISA money purchase plan, or a rural cooperative plan can meet the
requirements of section 401(a) even if it includes a qualified cash or
deferred arrangement. Section 401(k) also sets forth the requirements that
a cash or deferred arrangement must satisfy in order to be a qualified
cash or deferred arrangement.

Section 1.401(k)-1(a)(2)(i) defines a cash or deferred arrangement as
an arrangement under which an eligible employee may make a cash or
deferred election with respect to contributions to, or accruals or other
benefits under, a plan that is intended to satisfy the requirements of
section 401(a).

Section 1.401(k)-1(a)(3)(i) defines a cash or deferred election as any
election (or modification of an earlier election) by an employee to have
the employer either provide an amount to the employee in the form of cash
(or some other taxable benefit) that is not currently available or
contribute an amount to a trust (or provide an accrual or other benefit)
under a plan deferring the receipt of compensation. Section
1.401(k)-1(a)(3)(iv) provides that a cash or deferred election does not
include a one-time irrevocable election, made at the time an employee
commences employment with the employer or upon the employee's first
becoming eligible under any plan of the employer, to have contributions
made by the employer on the employee's behalf to the plan (or to any other
plan of the employer) equal to a specified amount or percentage of the
employee's compensation. Section 1.401(k)-1(g)(3) defines elective
contributions as employer contributions made to a plan that were subject
to a cash or deferred election under a cash or deferred arrangement.

Revenue Ruling 2000-8, 2000-7 I.R.B. 617 (February 14, 2000), holds
that where a newly hired or a current employee has an effective
opportunity to elect to receive an amount in cash or have that amount
contributed by the employer to a profit-sharing plan, those employer
contributions made on the employees' behalf to the plan in lieu of receipt
of cash compensation will not fail to be considered elective contributions
within the meaning of section 1.401(k)-1(g)(3) made under a qualified cash
or deferred arrangement within the meaning of section 401(k) merely
because they are made pursuant to an arrangement under which, in any case
in which an employee does not affirmatively elect to receive cash, the
employee's compensation is reduced by a fixed percentage and that amount
is contributed on the employee's behalf to the plan.

The definition of a cash or deferred election in section
1.401(k)-1(a)(3)(i) requires that the employee have an election between
the employer paying cash (or some other taxable benefit) to the employee
or making a contribution to a trust on behalf of the employee. The
regulation does not require that the employee receive an amount in cash in
any case in which the employee does not make an affirmative election to
have that amount contributed to the trust. Similarly, under section
403(b), there is no requirement that an employee receive an amount in cash
in any case in which the employee does not make an affirmative election to
have that amount contributed to an annuity contract. Thus, a contribution
to purchase an annuity contract under section 403(b) will not fail to be
made under a salary reduction agreement merely because, when an employee
fails to make an affirmative election with respect to an amount of
compensation, that amount is contributed on the employee's behalf to an
annuity contract, provided that the employee had an effective opportunity
to elect to receive that amount in cash. The employee has an effective
opportunity to elect to receive an amount in cash as required under
section 1.401(k)-1(a)(3)(i) if the employee receives notice of the
availability of the election and the employee has a reasonable period
before the cash is currently available to make the election.

In this case, compensation reduction contributions made by Employer X
to Plan A, including those made on behalf of a newly hired employee who
has not filed an election to the contrary and those made on behalf of a
current employee who has elected less than 4-percent compensation
reduction contributions, are amounts contributed pursuant to a procedure
under which the employee receives a notice explaining his or her rights to
have no compensation reduction contributions made and, after receiving the
notice, the employee has a reasonable period before the cash is currently
available to elect to receive the cash in lieu of having it contributed
towards the purchase of an annuity contract. Thus, an employee has an
effective opportunity to elect to receive cash or have a contribution made
towards the purchase of an annuity contract. In addition, the employee is
not able to receive, prior to a distributable event described in section
403(b)(11), amounts contributed towards the purchase of an annuity
contract. Finally, compensation reduction contributions made under the
plan are not contributions made pursuant to a one-time irrevocable
election because the employee can change the election in the future.
Consequently, the compensation reduction contributions under Plan A as
amended are contributions made pursuant to a salary reduction agreement
described in section 403(b).


HOLDING

Where, as in this case, a newly hired or current employee has an
effective opportunity to elect to receive an amount in cash or have that
amount contributed by the employer to an annuity contract described in
section 403(b), those contributions made on the employee's behalf to the
annuity contract in lieu of receipt of cash compensation will not fail to
be considered to be made under a salary reduction agreement merely because
they are made pursuant to an arrangement under which, in any case in which
an employee does not affirmatively elect to receive cash, the employee's
compensation is reduced by a fixed percentage and that amount is
contributed on the employee's behalf to the annuity contract. This holding
would be the same if (1) Plan A were described in section 403(b)(1)(A)(ii)
(relating to arrangements maintained by State and local school systems),
or (2) the funding vehicles under Plan A were custodial accounts described
in section 403(b)(7) or retirement income accounts described in section
403(b)(9), provided the requirements of such respective Code sections are
otherwise satisfied.


PAPERWORK REDUCTION ACT

The collection of information contained in this revenue ruling has been
reviewed and approved by the Office of Management and Budget (OMB) in
accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control
number 1545-1694.

An agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless the collection of
information displays a valid OMB control number.

The collections of information in this revenue ruling are in the third,
fifth, seventh and eighth paragraphs in the section headed "FACTS" and in
the tenth paragraph in the section headed "LAW AND ANALYSIS." The
collections of information are required to enable personnel in the Tax
Exempt and Government Entities Division of the Internal Revenue Service to
determine if an employer's retirement plan satisfies the requirements to
obtain favorable tax treatment and to enable certain employee elections to
meet the requirements of section 403(b). The collections of information
are required to obtain a benefit. The likely respondents are State and
local government entities and not-for-profit institutions.

The estimated total annual reporting burden is 175 hours. The estimated
annual burden per respondent is 1 hour and 45 minutes. The estimated
number of respondents is 100. The estimated annual frequency of responses
is on occasion.

Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any Internal Revenue law. Generally, tax returns and tax
return information are confidential, as required by 26 U.S.C. 6103.


DRAFTING INFORMATION

The principal author of this revenue ruling is Roger Kuehnle of the Tax
Exempt and Government Entities Division. For further information regarding
this revenue ruling, call the Employee Plans' taxpayer assistance
telephone service at (202) 622-6074/6075 (not toll-free numbers) between
1:30 and 3:30 p.m. Eastern Time, Monday through Thursday.


<<ENDNOTES>>

1/ The Department of Labor has advised Treasury and the Service that,
under Title I of the Employee Retirement Income Security Act of 1974
(ERISA), fiduciaries of a plan must ensure that the plan is administered
prudently and solely in the interest of plan participants and
beneficiaries. While ERISA section 404(c) may serve to relieve certain
fiduciaries from liability when participants or beneficiaries exercise
control over the assets in their individual accounts, the Department of
Labor has taken the position that a participant or beneficiary will not be
considered to have exercised control when the participant or beneficiary
is merely apprised of investments that will be made on his or her behalf
in the absence of instructions to the contrary. See 29 CFR section
2550.404c-1 and 57 F.R. 46924.

<<END RULING>>
 

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