Does this jeopardize
their tax-exempt status?
With the release of the Internal Revenue Service (IRS)
Revenue Ruling 2014-24 and the issuance of a Securities and Exchange Commission
(SEC) “no-action” letter last year, advisers and their clients are asking
whether plans established under Section 403(b) of the Internal Revenue Code of
1986 (IRC) can invest in group trusts or other pooled investment vehicles
without jeopardizing the tax-exempt status of the trusts or triggering federal
securities law registration requirements. This article intends to clarify the
extent to which group trusts or other “pooled” investment options are available
for 403(b) plans and to consider some other opportunities.
In its ruling, the IRS clarifies that certain 403(b) plans
may invest in a group trust without the trust losing its tax-exempt status.
These include 403(b) plans organized under IRC Section 403(b)(7), which are
custodial accounts that may invest only in mutual funds, and under IRC Section
403(b)(9), which are a type of church plan. However, the ruling does not apply
to 403(b) plans that are annuity arrangements under Section 403(b)(1).
Therefore, the trust may lose its tax-exempt status if it admits a 403(b)(1)
investor.
Importantly, even if a 403(b) plan can invest in a group
trust for tax purposes, the group trust may be subject to registration as an
investment company under the Investment Company Act of 1940 (’40 Act), and its
units may be subject to registration under the Securities Act of 1933 (’33
Act). To avoid registration, the trust sponsors most often intend to comply
with exemptions under Section 3(c)(11) of the ’40 Act and Section 3(a)(2) of
the ’33 Act in cases where 403(b) participants may direct the investment of
assets.
Unfortunately, the above ’40 and ’33 Act exemptions apply
only to a 403(b) plan that is a 403(b)(9) church plan. The exemptions are not
available if a participant-directed 403(b)(7) custodial account invests in a
group trust. Therefore, group trusts continue to be unavailable to 403(b)(7)s
unless the trust sponsor is willing to register the group trust under the ’40
and ’33 Acts.
Fortunately, however, 403(b) plans may have other options,
including the use of an investment management service or implementation of a
“generic investment option.” First, it is possible to structure an investment
management program or service to 403(b) plans that does not result in the
creation of an actual or “deemed” pooled fund subject to the ’40 Act. The SEC
issued SEC Rule 3a-4 several years ago, in which it provides for a nonexclusive
safe harbor from the definition of an investment company and registration under
the ’33 Act for programs that provide discretionary investment advisory
services to individuals, including 403(b) plan participants. Among other
things, the rule requires that the investment advice be individualized and that
the participant have the option to opt out of investments available under the
service.
The SEC has ruled on a number of occasions—including the
no-action letter issued to Benson White & Co., which became publicly
available June 14, 1995—that investment services, if structured in a specified
manner, may avoid ’40 and ’33 Act registration. The SEC does not always require
that the advice be “individualized” or that the participant be able to opt out
of an investment.
More recently, on April 8, 2014, the SEC issued a no-action
letter to Invesco Advisers Inc. In the letter, the SEC determined that a
“generic stable value investment option” under a 403(b) plan with both an
annuity and custodial component would not result in a deemed investment company
or require registration. The generic option appears to have been set up as a
managed account or a so-called “white label” fund, possibly in reliance upon
the Benson White model. The assets of the 403(b) were then invested in
insurance company pooled separate accounts. The participants were given the
option to invest only in the generic option and were not made aware of the
underlying account investments. The 403(b) plan sponsor, which is either a
fiduciary under the Employee Retirement Income Security Act (ERISA) or
contractually bound to comply with ERISA’s fiduciary standards, selected these
underlying investments. The SEC determined that the separate account
investments were exempt from registration under the ’40 and ’33 Acts.
In summary, while recent IRS rulings confirm that 403(b)(7)
and 403(b)(9) plans may be pooled for investment purposes, 403(b)(1) plans may
not. Further, the SEC has yet to catch up to the IRS with regard to 403(b)(7)
plans. However, sponsors of and advisers to these plans still have options.
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