Taxpayers conduct their operations via a variety of entities, including limited liability companies (LLCs). Even tax-exempt organizations are using the limited liability form to provide protection for their operations. Most organizations also try to offer retirement benefits to their employees. The interaction of these three issues—limited liability, tax-exempt status, and employee retirement plans—are addressed in IRS Chief Counsel Advice (CCA) 201634021, released on August 19, 2016 (https://www.irs.gov/pub/irs-wd/201634021.pdf). CPAs who become familiar with this guidance can better aid tax-exempt organizations wishing to offer retirement plans to employees.
Internal Revenue Code (IRC) section 501(c)(3) organizations are organized and operated exclusively for charitable, religions, educational, or certain other purposes. Under IRC section 501(a), these organizations are exempt from income tax when no part of their net earnings inures to the benefit of a private shareholder or individual and they do not engage in certain political activities. Donations to such nonprofits generally result in a charitable-contribution deduction under IRC section 170.
IRC section 403(b) covers the taxability of retirement benefits purchased for an employee of an IRC section 501(c)(3) organization. As with IRC section 401(k) benefits, contributions and other additions to the retirement plan are not included in an employee’s current income. Employees and independent contractors of tax-exempt entities, as well as of state and local governments, can also participate in deferred-compensation plans under IRC section 457(b). With these plans, they can defer a portion of their current salary to their retirement years and not pay a current tax on the deferrals or the earnings on the amounts deferred. IRC section 457(b) also allows such individuals to exclude from income any employer contributions made for them to these plans.
IRC section 403(b) plans are covered by the universal availability requirement under Treasury Regulations section 1.403(b)-(b). This means that if any of the organization’s employees are allowed to make elective deferrals under IRC section 403(b), the organization must permit all employees to make them. IRC section 457(b) plans, on the other hand, have no universal availability requirement; consequently, employees are allowed but not required to make elective deferrals under this type of plan.
Retirement Plans for Tax-Exempt Entities
A tax-exempt entity faces the same challenges as any other employer—recruiting and retaining exceptional employees. Job seekers also consider not only the offered salary, but also how the company is willing to contribute to their quality of life after their productive years of employment. Of course, 401(k) plans are the most common and well-known retirement plans, established by for-profit businesses.
An IRC section 501(c)(3) organization and other tax-exempt filers, such as state and local entities, are also often interested in providing post-employment benefits for employees and their families. Retirement plans under IRC sections 403(b) and 457 have been established to encourage and reward employees who plan and prepare for life after gainful employment. These plans are somewhat similar investment vehicles, yet they are unique in their own ways. Although each has different repercussions for early withdrawals and varying criteria for accessing funds, they are both tax-deferred retirement investments comparable to the 401(k) plans prevalent today. Many schools, churches, public hospitals, and tax-exempt charitable entities have adopted IRC section 403(b) plans. IRC section 457 retirement plans are more commonly used by state and local governments, as well as certain nongovernmental entities that are tax-exempt under IRC section 501.
From an employer’s perspective, the difference between IRC sections 403(b) and 457 retirement plans is significant. As previously mentioned, the universal availability rule applies only to the former; thus, employers who sponsor such a plan must allow all eligible employees to participate in a retirement plan offered to any other employee of the company. In a company-sponsored IRC section 457 plan, however, the tax-exempt business is allowed to choose only a select group of individuals to participate in the plan. Quite often, this means that only executives and upper management can participate.
IRS Chief Counsel Advice
This question recently arose in a tax case: should employees of a company be allowed to participate in an associated entity’s employer-sponsored retirement plan? To be more specific, should an employee of a single-member limited liability company (SMLLC)—where the sole member is a tax-exempt IRC section 501(c)(3) organization—be allowed to participate in the organization’s company-sponsored retirement plan? Should the employees of the tax-exempt organization have the same retirement opportunities and privileges as other employees, despite being employed by two different entities?
Although this SMLLC was considered a “disregarded entity” for income tax purposes, CCA 201634201 states that its employees must be allowed to participate in the company-sponsored plan in accordance with the universal availability requirement under IRC section 403(b). Because IRC section 457(b) plans sponsored by tax-exempt organizations have no such universal availability requirements, the CCA concluded that those employees may be eligible to participate but are not required to. As a result, this recently released memo could have far-reaching implications for tax-exempt entities associated with other organizations. If a tax-exempt organization is the sole member of a disregarded entity, then it is expected to treat the employees of that entity the same as the employees of the organization when it comes to company-sponsored retirement plans.
To illustrate, assume that the First Church of XYZ has a thriving congregation in a small city in the Midwest. For years, the church has funded a retreat in the nearby secluded mountains. The retreat is operating as an LLC, with the First Church of XYZ listed as the sole member. Newly hired retreat employees were informed that their only compensation would be their salary and the peaceful, serene surroundings. The camp director, groundskeeper, activities director, and several others all signed an agreement stating as much and looked forward to a fulfilling career making a difference in others’ lives.
Should employees of a company be allowed to participate in an associated entity’s employer-sponsored retirement plan?
Back at the First Church of XYZ, the senior pastor, music director, custodian, and others were all leading a rewarding and fulfilling life as well; however, those employees were also participating in the church-sponsored IRC section 403(b) retirement plan, under which the First Church of XYZ matched employee contributions up to 6% of their salary. The employees at the mountain retreat were not given the opportunity to save for their future because they were not considered employees of the First Church of XYZ.
CCA 201634201 will have a dramatic impact on such situations. The IRS has determined that, although the mountain retreat is a separate entity from the tax-exempt organization, the employees of the retreat should be treated no differently than the nonprofit’s employees with respect to retirement or investing opportunities. According to the IRS’s memo, a disregarded entity should be treated as a branch of the member organization; thus, given that determination, the universal availability rule of the IRC section 403(b) retirement plans would permit the employees of the mountain retreat to participate in the IRC section 403(b) plan sponsored by the First Church of XYZ.
The CCA is a good indication of the U.S. Treasury Department’s position on LLCs and retirement plans for tax-exempt entities. This clarification should be quite useful to such entities and the tax professionals who advise them. It is clear that, with careful planning, these entities can provide retirement benefits for their employees—but they must remember that if they have an IRC section 403(b) plan, they must provide coverage to all their own employees and the employees of their related LLC.