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A recent call with a financial advisor in Utah is representative of a common question on governmental entities.
Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans, and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security, and Medicare. This is where we highlight the most relevant topics affecting your business.
“Can an organization with governmental ties establish a 401(k) plan?”
At the heart of the question is the fact that state and local governments, political subdivisions, and their agencies or instrumentalities generally may not maintain a 401(k) arrangement unless the arrangement was adopted before May 6, 1986. Certain grandfathered plans, rural cooperatives, and Indian tribal governmental entities are subject to different rules.
IRC §414(d) defines a governmental plan as a plan established and maintained for employees by:
the United States,
a state,
a political subdivision of a state, or
an agency or instrumentality of any of the foregoing.
ERISA §3(32) contains a parallel definition, although it refers to a plan “established or maintained” by the governmental employer. A governmental plan is excluded from Title I of ERISA under ERISA §4(b)(1).
The IRS has stated that a plan will not be considered a governmental plan merely because its sponsoring organization has a relationship with a governmental unit or possesses some quasi-governmental authority. According to the IRS, determining whether an organization is an agency or instrumentality depends on several factors, including:
The degree of governmental control over daily operations.
Whether specific legislation created the organization.
The source of the organization's funding.
How the governing board is selected.
Whether workers are treated as government employees.
The IRS has also made clear that no single factor listed previously is determinative for identifying whether an entity should be treated as “governmental.”
In Revenue Ruling 89-49, the IRS reiterated that governmental control over everyday operations is one of the most important considerations, although no factor is necessarily controlling. In the case examined, the IRS ruled that a retirement plan maintained by a nonprofit volunteer fire company was not a governmental plan because the company was not sufficiently controlled by or affiliated with the municipalities it served to be treated as their agency or instrumentality.
Although the company performed the public function of providing fire protection and receiving payments from municipalities, the municipalities exercised minimal control over their daily operations. The company was formed under the state’s general nonprofit corporation law rather than specific enabling legislation, volunteer firefighters elected its board, part of its funding came from private donations, and its employees were not treated as state or municipal employees.
Rev. Rul. 89-49 did not address the company’s eligibility to maintain a 401(k) plan. Under current law, however, if an organization is not a state or local government, political subdivision, or governmental agency or instrumentality, the governmental-employer restriction would not, by itself, prevent the organization from adopting a 401(k) plan. The organization would still need to satisfy all other applicable qualification and operational requirements.
The determination of whether an entity with governmental ties should be treated as a governmental entity is based on several facts and circumstances. Therefore, having employee-benefits counsel experienced in governmental-plan classification perform a thorough evaluation of the entity’s governance and control, funding sources, employee status, statutory creation, and governmental oversight is highly recommended. Proper classification is important because it affects the types of retirement plans the organization may establish, the Internal Revenue Code requirements applicable to those plans, and whether the plan is subject to Title I of ERISA.