Update on Tax-sheltered 403(b) Retirement Plans

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1 In This Issue 1 Update on Tax-sheltered 403(b) Retirement Plans 3 Personal Loans Deductible as Bad Debts 5 ESOP Not Qualified Plan Where Contributions Exceeded Compensation 6 IRS Describes Requirements for QSEHRAs 7 Conversion of One Partnership to Another Did Not Result in Termination 8 Edward Jones Online Access to Tax Documents February 2018 Volume 11 Number 3 Update on Tax-sheltered 403(b) Retirement Plans A 403(b) plan or tax-sheltered annuity plan is a special type of retirement plan offered by public schools and certain tax-exempt 501(c)(3) organizations [Code Sec. 403(b)(1)]. If all 403(b) plan requirements are met, amounts contributed by a qualified employer to a 403(b) plan for an employee may be excluded from the employee s gross income [Code Sec. 403(b)(1), Reg (b)-3]. Elective contributions by employees to their 403(b) plans are also excludable from gross income. The amount excludable by the employee is the lesser of the employer s contributions, the annual employer contribution limit for the limitation year ending with the employee s tax year or the limit on elective deferrals for the employee s tax year [Code Sec. 403(b)(1)]. Earnings on contributions to a 403(b) plan are not taxed until they are distributed from the plan. Eligible Employers Tax-sheltered annuity programs may be established only by the following eligible employers: public school systems, tax-exempt Code Sec. 501(c)(3) organizations and certain ministers and chaplains or their employers [Reg (b)-2(b)(8)]. A state or local government is an eligible employer only with respect to an employee who performs services for the public school [Code Sec. 403(b)(1)(A) (ii)]. A school system is defined as one that ordinarily maintains a regular faculty and curriculum and has a regularly enrolled body of pupils or students in attendance where its educational activities occur [Code Secs. 403(b)(1)(A)(ii) and 170(b)(1)(A)(ii)]. Included in this category are public schools, state colleges and universities. A qualified tax-exempt employer could be a corporation, community chest, fund or foundation that is organized and operated exclusively for religious, charitable, scientific, literary, educational or public safety testing purposes, to encourage national or international amateur sports competition or for the prevention of cruelty to children or animals [Code Sec. 403(b)(1)(A)(i)]. Eligible Employees An individual who performs services as an employee for a public school is eligible [Reg (b)-2(b) (10)]. For example, the principal, clerks, custodians and teachers at a public elementary school are employees performing services directly for an For tax and legal professionals only. Not for use with the general public.

2 educational organization. Employees who do not work in a school but are involved in educational program operation or direction for public schools are employees performing services indirectly for public schools. An employee who participates in an in-home teaching program is also eligible. An elected or appointed official is not eligible unless a requirement of office is training or experience in the field of education [Reg (b)-2(b)(10)]. The following ministers are eligible: ministers employed by 501(c)(3) tax-exempt organizations, self-employed ministers employed by a tax-exempt organization that is a qualified employer, and ministers and chaplains who are employed by organizations that are not 501(c)(3) organizations and function as ministers in their day-to-day professional responsibilities with their employers. The limit on employee elective salary deferrals is $18,000 in Contribution Limit The limit on employee elective salary deferrals is $18,000 in Each 403(b) contract must provide that elective deferrals made under the contract may not exceed the annual limit. An employer may make deductible contributions to an employee s 403(b) plan up to a limit that, when combined with the employee s elective deferrals, does not exceed $54,000 in 2017 or 100% of the employee s compensation, whichever is less. Special Catch-up Election for Certain Employees of Qualified Organizations An employee with 15 years of service at a qualified organization (an educational organization, hospital, home health service agency, health and welfare service agency, church, or convention or association of churches) is entitled to make a special catch-up election [Code Sec. 402(g)(7)]. Under this election, the employee may make additional salary reduction contributions of whichever is least among the following: $3,000 $15,000 reduced by elective deferrals excluded from gross income in prior years under the catch-up rule $5,000 multiplied by the employee s number of years of service with the qualified employer, less all elective deferrals in prior years under all plans of the qualified organization In no event can the catch-up rule be used if an individual s elective deferrals exceed the lifetime limit. Catch-up contributions are authorized for employees who will attain at least age 50 before the close of the tax year and for whom no other elective deferrals may otherwise be made for the plan year because of the annual elective deferral limit or any comparable limit or restriction contained in the terms of the plan [Code Sec. 414(v); Reg (b)-4(c)(2)]. The additional amount of elective contributions that may be made is limited to the lesser of the applicable dollar amount or the participant s compensation for the year reduced by any other elective deferrals for the year. For 403(b) plans, the applicable dollar amount is $6,000 in Distributions Distributions from a 403(b) plan generally can only be made when the employee dies, attains age 59½, experiences a severance from employment, becomes permanently disabled or receives a qualified reservist distribution under Code Sec. 72(t)(2)(G). Distributions from 403(b) plans must be reported by the plan administrator on Form 1099-R and are subject to income tax withholding. A 403(b) plan may, but is not required to, allow hardship distributions. A distribution will be treated as a tax-free hardship distribution if it is made after an employee s hardship because of the employee s immediate and heavy financial need. The determination of immediate and heavy financial need and the amount necessary to meet the need must be made in accordance with non-discriminatory and objective standards set forth in the plan [Reg (b)-6(d)(2); Reg (k)-1(d)(3)(i)]. Rollovers An employee participating in a 403(b) annuity may roll over an eligible rollover distribution tax-free to another eligible retirement account, which could include a 401(k) plan or a governmental 457 plan, an IRA or another Code Sec. 403(b) annuity. 2

3 Required Minimum Distributions Code Sec. 403(b) plans are subject to the required minimum distribution rules provided by Code Sec. 401(a)(9). According to Reg (b)-6(e): The required beginning date for distributions is April 1 of the calendar year following the later of the calendar year in which the employee attains age 70½ or in which the employee retires from employment with the employer maintaining the plan. The surviving spouse of an employee may not treat a section 403(b) contract as the spouse s own 403(b) contract. If the issuer of the 403(b) annuity has a record of the balance on Dec. 31, 1986, the minimum distribution rules only apply to benefits accruing after 1986 (including post-1986 earnings on pre-1987 contributions). Termination of 403(b) Plan An employer is permitted to amend a Code Sec. 403(b) plan to eliminate future contributions for existing participants or to limit participation to existing participants and employees. A Code Sec. 403(b) plan may contain provisions that provide for plan termination and allow accumulated benefits to be distributed on termination [Reg (b)-10(a)]. Personal Loans Deductible as Bad Debts In W.C. Owens [114 TCM 188, Dec. 60,988(M), TC Memo ], the Tax Court found that an individual who made loans from his personal funds continuously and regularly with the purpose of making a profit was in the trade or business of lending money. He therefore was entitled to claim a bad-debt deduction. Facts The taxpayer is in the business of lending money to investors who want to buy income-producing property and need immediate financing to close the deal. Typically, the loan is for 18 months and bears an interest rate of between 7% and 11%. In 2002, the taxpayer began making personal loans to a business owner who eventually filed for bankruptcy. The business owner recovered nothing from the bankruptcy and was unable to repay the money that the taxpayer had lent him. From 1999 through 2013, Owens personally (alone or acting as trustee of Owens Trust) made at least 66 loans exceeding $24 million, including the loans to the business owner who filed for bankruptcy. Bad-debt Deductions The taxpayer claimed a $9.5 million bad-debt deduction on his tax return because in his view these personal loans created bona fide debts that became worthless after the business owner was unable to pay him back. Code Sec. 166(a)(1) allows a deduction for a bona fide debt that becomes worthless within a taxable year. For a non-business bad debt held by a taxpayer other than a corporation, Code Sec. 166(a)(1) does not apply, and the taxpayer is allowed a short-term capital loss for the tax year in which the debt becomes completely worthless [Code Sec. 166(d)(1)]. Code Sec. 166(a)(1) allows a deduction for a bona fide debt that becomes worthless within a taxable year. A business debt is defined in Code Sec. 166(d)(2) as a debt created or acquired... in connection with a trade or business of the taxpayer or a debt the loss from the worthlessness of which is incurred in the taxpayer s trade or business. A business debt is fully deductible without the limitations imposed on short-term capital losses. To be eligible to deduct a loss as a business bad debt, an individual taxpayer must show that the debt was created or acquired in connection with 3

4 the taxpayer s trade or business, a bona fide debt existed between the taxpayer and his debtor, and the debt became worthless in the year that the bad-debt deduction was claimed. Analysis and Conclusion The court first considered whether the taxpayer s moneylending activity was a trade or business. To determine whether the taxpayer was in the business of lending money, the court considered the following non-exhaustive list of facts and circumstances: Total number of loans made Period over which the loans were made Adequacy and nature of the taxpayer s records Whether the loan activities were kept separate and apart from the taxpayer s other activities Whether the taxpayer sought out the lending business Amount of time and effort expended in the lending activity Relationship between the taxpayer and his debtors The court first considered whether the taxpayer s moneylending activity was a trade or business. After pointing out the taxpayer made approximately 33 loans totaling over $21 million during the relevant tax years, including $17 million in loans to the business owner who eventually filed for bankruptcy, the court found that the taxpayer lent from his personal funds continuously and regularly with the primary purpose of earning income or making a profit. He was therefore found to be in the trade or business of lending money. The court rejected the IRS arguments that the taxpayer was not in the moneylending business because he did not maintain a separate office, spend enough time in the activity or advertise his business. The court explained that requiring the taxpayer to maintain a separate office under these circumstances would be a needless expense which a prudent businessman would not incur. The court also found that the taxpayer was well known for lending money out of his own funds, and his reputation brought customers to him without the need to advertise. The court then addressed whether the purposed loans constituted bona fide debt. A bona fide debt is one that arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. Whether a purported loan is a bona fide debt is determined by the facts and circumstances of each case. The court considered the following factors to determine whether the purported loan constituted bona fide debt for tax purposes: Names given to the certificates evidencing the indebtedness Presence or absence of a maturity date Source of the payments Right to enforce the payment of principal and interest Participation and management Status equal to or inferior to that of regular corporate creditors Intent of the parties Thin or adequate capitalization Identity of interest between creditor and stock holder Payment of interest only out of dividend money Ability of the corporation to obtain loans from outside lending institutions The court found that each of the taxpayer s purported loans was evidenced by promissory notes that showed a general intent between the parties to form a genuine debt. The court found further that the promissory notes showed the intent of the parties and made the taxpayer s investments look like loans. The court concluded that the taxpayer was involved in the trade or business of lending money and that his personal advances to a business owner constituted bona fide debt that became worthless. The taxpayer was therefore entitled to claim a bad-debt deduction. 4

5 ESOP Not Qualified Plan Where Contributions Exceeded Compensation In DNA Pro Ventures, Inc. [CA-8, USTC 50,221, aff g, 110 TCM 346, Dec. 60,421(M), TC Memo ], the Court of Appeals for the Eighth Circuit affirmed the Tax Court to hold that the IRS did not abuse its discretion in disqualifying an employee stock ownership plan (ESOP) because it exceeded the Code Sec. 415 contribution limits by allocating class B stock to an employee for a year when he did not receive any compensation, and because it violated its plan document by failing to have the contributed stock appraised annually. Thus, the ESOP was not a Code Sec. 401 qualified plan and was not exempt from tax pursuant to Code Sec. 501(a) for any tax year. Background An ESOP trust does not qualify for tax-exempt status if the ESOP makes annual contributions for a plan participant above the lesser of either a specific dollar amount or the participant s annual compensation [Code Sec. 415(c)]. An employer transferring property other than cash for less than fair market value constitutes an annual contribution in the amount of the property s fair market value [Reg (c)-1(b)(5)]. Annual additions are the sum of employer contributions, employee contributions and forfeitures. An allocation of stock to a participant s account is an employer contribution [Reg (c)-1(b) (5)]. Participant s compensation is defined as the compensation of the participant from the employer for the year. Facts In 2008, Daniel Prohaska and his wife became involved with the taxpayer, DNA Pro Ventures, Inc., which was incorporated on Nov. 12, The same day, DNA created an ESOP for the benefit of its employees. DNA was the employer, plan sponsor and plan administrator of the ESOP. Prohaska and his wife were directors of DNA at the time of its incorporation. Prohaska acted as DNA s chairman and served as its president and treasurer. The Prohaskas were DNA s only employees. On Nov. 12, 2008, DNA issued 50 shares of class A common stock to Prohaska and 50 to his wife with a par value of $10 per share, in exchange for $500 in contributions. The plan directed the plan trustee (Prohaska) to determine the fair market value of the trust fund assets on each valuation date. On Dec. 31, 2008, DNA issued 1,150 shares of class B common stock to the trust with a par value of $10 per share. The trust then allocated the 1,150 shares of DNA stock to Prohaska s ESOP account in Neither Prohaska nor his wife received any compensation for services as a DNA officer or employee during Accordingly, their contribution limits were zero. Because DNA improperly transferred 1,150 shares of DNA s class B common stock to Dr. Prohaska s ESOP account in 2008 with a $10 par value per share, the annual addition to his account was $11,500 more than his contribution limit. For 2009, DNA issued separate Forms W-2, Wage and Tax Statement, to Prohaska and his wife, reporting respective amounts of $4,500. DNA issued Forms W-2 for 2010 to Prohaska and his wife reporting respective amounts of $3,000. DNA deducted a $1,350 retirement plan contribution for 2009 on its Form 1120, U.S. Corporation Income Tax Return. Although DNA was the sponsor of the ESOP, it did not file any Forms 5500, Annual Return/Report of Employee Benefit Plan, for plan years 2008, 2009 and IRS Challenge After an investigation, the IRS issued a Notice of Deficiency to the ESOP s trust based on a final determination that the trust was not a qualified plan under Code Sec. 401 and therefore the trust s income was not exempt from taxation under Code Sec. 501(a) in calendar years

6 Tax Court Conclusion The Tax Court concluded that the IRS did not abuse its discretion in disqualifying the ESOP because the plan exceeded the Code Sec. 415 contribution limit by allocating class B shares to Prohaska s ESOP account in 2008, a year when he received no compensation from DNA, and violated its plan document by failing to have the value of DNA stock annually appraised in 2008 and later years. Eighth Circuit Analysis and Conclusion The appellate court limited its review to the violation of the Code Sec. 415 contribution limitation in The court found that the stipulated record showed the stock was issued to the ESOP in the tax year at issue, the stock was all allocated to the employee and the employee received no compensation for that year. The court found these facts established that the employer s contribution to the employee s ESOP account substantially exceeded the Code Sec. 415 contribution limit for that year. Therefore, the ESOP was not a Code Sec. 401(a) qualified plan. The court concluded that the IRS did not abuse its discretion in disqualifying the ESOP for 2008 and the subsequent plan years in question. IRS Describes Requirements for QSEHRAs The IRS has issued guidance, in Q&A format, on qualified small employer health reimbursement arrangements (QSEHRAs). The guidance describes dollar limits, who may participate and who may receive reimbursements. Background Only qualified small employers, generally with less than 50 employees, may offer QSEHRAs. Additionally, a QSEHRA must be funded solely by the employer. No salary reduction contributions may be made. Only qualified small employers, generally with less than 50 employees, may offer QSEHRAs. Eligible Employees Notice describes which employees may not participate in a QSEHRA. These include employees who have not completed 90 days of service with the employer, employees who have not attained age 25 before the beginning of the plan year, part-time or seasonal employees, and employees covered by a collective bargaining agreement. An eligible employee may not waive participation in a QSEHRA. The statute requires that the eligible employer provide, rather than offer, a QSEHRA on the same terms to all eligible employees. Minimum Essential Coverage An employee may receive reimbursements from a QSEHRA only if he or she has minimum essential health coverage. Otherwise, the reimbursements would be included in the employee s gross income. The employee must demonstrate minimum essential coverage (for example, an insurance card or an explanation of benefits). A QSEHRA may not reimburse medical expenses incurred before the arrangement is provided. Dollar Amounts QSEHRAs are subject to dollar limits, adjusted for inflation. For 2017, the dollar limits are $4,950 for self-only coverage and $10,050 for family coverage. For 2018, these amounts increase to $5,050 for self-only coverage and $10,250 for family coverage. If a QSEHRA permits carryover amounts, an employee s total permitted benefit, considering both carryover and newly available amounts, may not exceed the applicable statutory dollar limit. 6

7 Conversion of One Partnership to Another Did Not Result in Termination A state limited partnership that was formed as the result of converting a limited liability company classified as a partnership for federal tax purposes was a continuation of the existing partnership, and the conversion did not cause the partners in either the existing or continued partnership to recognize taxable income, gain or loss. In IRS Letter Ruling (Nov. 13, 2017), the IRS concluded that the state limited partnership would be considered as a continuation of the converting partnership, and the conversion did not cause the converting partnership to be treated as an association taxable as a corporation. Building a Team of Professionals to Help Provide Solutions for Our Clients At Edward Jones, we believe that when it comes to financial matters, the value of professional advice cannot be overestimated. In fact, in most situations we recommend that clients assemble a team of professionals to provide guidance regarding their financial affairs: an attorney, a tax professional and a financial advisor. We want to work together as a team and offer value for your practice and clients. Using complementary skills and philosophies, we can help save time, money and resources while assisting mutual clients in planning for today s financial and tax challenges. The Connection journal content is provided by Wolters Kluwer and Edward Jones and published by Edward D. Jones & Co., L.P., d/b/a Edward Jones, Manchester Road, St. Louis, MO Opinions and positions stated in this material are those of the authors and do not necessarily represent the opinions or positions of Edward Jones. This publication is for educational and informational purposes only. It is not intended, and should not be construed, as a specific recommendation or legal, tax or investment advice. The information provided is for tax and legal professionals only; it is not for use with the general public. Edward Jones, its financial advisors and its employees cannot provide tax or legal advice; before acting upon any information herein, individuals should consult a qualified tax advisor or attorney regarding their circumstances. Reprinted by Edward Jones with permission from Wolters Kluwer. All rights reserved. 7

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