SERVICE CORRECTS NOTICE PROVIDING SAFE HARBORS FOR SECTION 403(b) ANNUITY CONTRACTS.

Notice 89-23

Editor's Note: According to Rev. Rul. 2009-18, Notice 89-23 is obsolete except to the extend described in the last paragraph of the “Treatment of Controlled Groups that Include Tax-Exempt Entities” section of the preamble to Treasury Decision 9340. That paragraph in T.D. 9340 reads as follows:

"These controlled group rules for tax-exempt entities generally do not apply to certain church entities under section 3121(w)(3). These rules also do not apply to a State or local government or a federal government entity. Until further guidance is issued, church entities under section 3121(w)(3)(A) and (B) and State or local government public schools that sponsor section 403(b) plans can continue to rely on the rules in Notice 89-23 for determining the controlled group."

I. BACKGROUND

Section 1120 of the Tax Reform Act of 1986 (TRA '86) amended the rules applicable to annuities qualifying for favorable tax treatment under section 403(b) of the Internal Revenue Code of 1986 to require that such annuities generally must be purchased under a plan that is nondiscriminatory within the meaning of section 403(b)(12) (the Technical and Miscellaneous Revenue Act of 1988 (TAMRA '88) redesignated section 403(b)(10), which was added by TRA '86, as section 403(b)(12)). The term "annuities" refers to annuity contracts, custodial accounts and retirement income accounts purchased under plans eligible for favorable tax treatment under section 403(b) (403(b) annuity plans). Section 403(b)(12) applies to all 403(b) annuity plans other than those contributed to or sponsored by churches or church-controlled organizations described in section 3121(w)(3). Thus, section 403(b)(12) is generally applicable to annuity contracts purchased for employees either by (1) an employer described in section 501(c)(3) that is exempt from tax under section 501(a) and (2) for employees (other than employees of an employer exempt under section 501(a) by reason of being described in section 501(c)(3)) who perform services for an educational organization described in section 170(b)(1)(A)(ii), an employer that is a State, political subdivision of a State, or an agency or instrumentality of any one or more of the foregoing that purchases such contract.

Section 403(b)(12)(ii) sets forth nondiscrimination rules for contributions made to 403(b) annuity plans pursuant to salary reduction agreements. Section 403(b)(12)(i) provides that certain nondiscrimination rules applicable to qualified plans apply to all contributions to 403(b) annuity plans other than those made pursuant to salary reduction agreements. If a 403(b) annuity plan provides for both salary reduction contributions and other contributions, such as matching contributions or employee contributions, the nondiscrimination rules of section 403(b)(12)(ii) apply to the plan with respect to assets attributable to the salary reduction contributions and the nondiscrimination rules of section 403(b)(12)(i) apply to the assets attributable to the other contributions.

This Notice provides that, until further guidance is published, section 403(b)(12) is satisfied if an employer operates its 403(b) annuity plan or plans in accordance with a reasonable, good faith interpretation of such section. Part II of this Notice describes some circumstances in which the Service will and will not consider an employer to be operating a 403(b) annuity plan in accordance with such an interpretation. Part V contains definitions of certain terms the Service will apply in determining whether an employer operates a 403(b) annuity plan in accordance with a reasonable, good faith interpretation of the statute.

The Service has determined that, because of the unique circumstances faced by many employers contributing to or sponsoring 403(b) annuity plans, transitional safe harbors are necessary to facilitate compliance with the nondiscrimination rules of section 403(b)(12). For the first time, an annuity contract purchased for one employee may be required to be considered together with annuity contracts covering other employees. In addition, changes to 403(b) annuity plans sponsored by public educational organizations sometimes require legislative approval and such approval often is delayed in the legislative process.

The safe harbors are set forth in Parts III and IV of this Notice and the definitions of significant terms used in the safe harbors are in Part V. Although section 6052(b) of TAMRA '88 permits an employer to use a statistically valid random sample of employees when applying the nondiscrimination rules of section 403(b)(12), an employer must take into account all of its employees in applying the safe harbors.

The safe harbors are designed to provide reasonable transition rules and are intended to be less restrictive than the permanent rules which will be set forth in regulations or other guidance. Thus, the Service cautions taxpayers not to draw any inferences regarding the provisions of future guidance from the contents of the transitional safe harbors.

II. REASONABLE INTERPRETATION

The Service will deem a 403(b) annuity plan to be in compliance with section 403(b)(12) if the employer operates the plan in accordance with a reasonable, good faith interpretation of section 403(b), as amended by TRA '86 and TAMRA '88, taking into account their legislative histories. This Notice provides certain definitions to aid the employer in interpreting section 403(b).

If contributions to a 403(b) annuity plan may be made pursuant to a salary reduction agreement within the meaning of section 3121(a)(5)(D), the plan meets the nondiscrimination requirements applicable to such contributions only if each participant who elects to make salary reduction contributions may elect to reduce annually his or her salary by more than $200 and the opportunity to make such contributions is available to all employees on a basis that does not discriminate in favor of highly compensated employees.

The Service will not consider it to be a reasonable, good faith interpretation of the statute and its legislative history if the employer treats contributions made pursuant to an employee's one-time, irrevocable election to reduce salary, made at the time of initial eligibility to participate in the plan, as salary reduction contributions subject to the nondiscrimination rules of section 403(b)(12)(ii). Such contributions are considered employer contributions and, thus, are subject to the nondiscrimination rules of section 403(b)(12)(i). If an employee upon initial eligibility to participate in a plan elects to make contributions pursuant to a salary reduction agreement and may subsequently elect to make contributions on an after-tax basis rather than a pre-tax basis or may elect not to participate, then the employee's initial election is not considered to be a one-time, irrevocable election.

In the case of all employer and employee contributions other than salary reduction contributions, a 403(b) annuity plan must satisfy the nondiscrimination requirements of sections 401(a)(4), (5), (17) and (26), 401(m) and 410(b) in the same manner as if the plan were described in section 401(a). The Service will not consider it to be a reasonable, good faith interpretation of the statute and its legislative history unless the employer, whether an organization described in section 501(c)(3) and exempt from federal income tax under section 501(a) or an educational organization described in section 170(b)(l)(A)(ii), operates the plan in accordance with a reasonable, good faith interpretation of these sections, as amended by TRA '86 and TAMRA '88, taking into account their legislative histories.

III. SECTION 403(b)(12)(ii) SAFE HARBOR

A 403(b) annuity plan is deemed to satisfy the nondiscrimination requirements of section 403(b)(12)(ii) for a plan year only if each employee of the common law employer sponsoring or maintaining the plan is eligible to defer annually more than $200 pursuant to a salary reduction agreement within the meaning of section 3121(a)(5)(D) and the opportunity to make such contributions is available to all employees on the same basis. Contributions made pursuant to an employee's one-time, irrevocable election to reduce salary, made at the time of initial eligibility to participate in the plan, are not treated as deferrals made pursuant to a salary reduction agreement within the meaning of section 3121(a)(5)(D). Individuals, who are excludable employees (see Part V for definition of excludable employees), may be excluded in determining whether a 403(b) annuity plan satisfies this safe harbor. If a common law employer historically has treated its various geographically distinct units as separate for employee benefit purposes, then each unit, rather than the common law employer, may be considered a separate organization for purposes of this safe harbor, so long as the units are, on a day-to-day basis, operated independently. In general, for purposes of this rule, units of the same common law employer are not geographically distinct if such units are located within the same Standard Metropolitan Statistical Area (SMSA).

Examples. 1. The University of State X, a common law employer, has campuses in City A, City B and City C. Each campus is independently responsible for its day-to-day operations and has its own administrative staff. For many years, the University has maintained a separate health plan and a separate 403(b) annuity plan for employees performing services at each of its campuses. Since 1978, the University has contributed to a 403(b) annuity plan for eligible employees at each campus according to their elections made pursuant to salary reduction agreements. Those eligible to participate in the City A campus's 403(b) annuity plan are all of the full-time professors teaching at such campus. All employees at the City B campus are eligible to participate in the City B campus's 403(b) annuity plan. All employees at the City C campus are eligible to participate in the City C campus's 403(b) annuity plan. Each eligible employee has a one-time election to participate in the State X Retirement Plan, which is a profit sharing plan with a cash or deferred arrangement, rather than in the 403(b) annuity plan maintained for employees performing services at the same campus as the electing employee. The employees at each campus are as follows:

                Eligible to participate    Ineligible     Excludable

2. X, an organization described in section 501(c)(3) and exempt from federal income tax under section 501(a), has two offices, one in City D and another in Suburb E, which is within the SMSA of City D. For eligible employees performing services at each of these offices, X sponsors a health plan and a 403(b) annuity plan. Under the 403(b) annuity plan for employees performing services in City D (403(b) annuity plan D), all of X's employees performing services at the office located in City D are eligible to defer annually 5% of their compensation. Under the 403(b) annuity plan for employees performing services in Suburb E (403(b) annuity plan E), all of X's employees performing services at the office located in City E who are full-time employees are eligible to defer annually 5% of their compensation. There are three part-time employees performing services at the office located in City E who normally work 25 hours per week. Because the offices located in Cities D and E are not geographically distinct from one another, X must test 403(b) annuity plan D and 403(b) annuity plan E on an aggregate basis. The plans fail the 403(b)(12)(ii) safe harbor because three employees performing services at the office located in City E are ineligible to participate.

IV. SECTION 403(b)(12)(i) SAFE HARBORS

A. In general. The Service will deem all of an employer's 403(b) annuity plans included in the employer's aggregated 403(b) annuity program to satisfy section 403(b)(12)(i) only if the aggregated 403(b) annuity program satisfies one of the following three safe harbors with respect to all contributions, other than matching contributions and employee contributions within the meaning of section 401(m), that are not made pursuant to a salary reduction agreement within the meaning of section 3121(a)(5)(D). In addition, if a plan or plans included in an aggregated 403(b) annuity program provides for matching contributions or employee contributions, or both, such plan or plans must satisfy section 401(m) and the regulations thereunder. For purposes of applying the regulations under section 401(m), contributions made pursuant to a salary reduction agreement to a 403(b) annuity plan may not be considered. Furthermore, in determining whether an aggregated 403(b) annuity program meets any of the following safe harbors, an employer may not take into account any social security benefits or contributions which may be taken into account under section 401(a)(4) or 401(a)(5) or any permitted disparity under section 401(1).

1. Maximum disparity safe harbor. This safe harbor is satisfied only if (i) the highest percentage of compensation for a year contributed on behalf of any highly compensated employee who is currently accruing benefits under a plan or plans included in the program is not more than 180% of the lowest percentage of compensation for a year contributed on behalf of any nonhighly compensated employee who is currently accruing benefits, (ii) at least 50% of the nonhighly compensated employees are currently accruing benefits under the plans included in the program, and (iii) the percentage of employees who are currently accruing benefits under the plans included in the program who are nonhighly compensated employees is at least 70%.

2. Lesser disparity safe harbor. This safe harbor is satisfied only if (i) the highest percentage of compensation for a year contributed on behalf of a highly compensated employee who is currently accruing benefits under a plan or plans included in the program is not more than 140% of the lowest percentage of compensation for a year contributed on behalf of any nonhighly compensated employee who is currently accruing benefits, (ii) at least 30% of the nonhighly compensated employees are currently accruing benefits under the plans included in the program and (ii) the percentage of employees who are currently accruing benefits under a plan included in the program who are nonhighly compensated employees is at least 50%.

3. No disparity safe harbor. This safe harbor is satisfied only if the highest percentage of compensation for a year contributed on behalf of any highly compensated employee who is currently accruing benefits in a plan included in the program is not higher than the lowest percentage of compensation for a year contributed on behalf of any nonhighly compensated employee who is currently accruing benefits, and either one of the following two tests is satisfied. Under the first test, at least 20% of the nonhighly compensated employees must be currently accruing benefits under a plan or plans included in the program and the percentage of participants in the plans included in the program who are nonhighly compensated employees must be at least 70%. Under the second test, at least 80% of the nonhighly compensated employees must be currently accruing benefits under a plan or plans included in the program and the percentage of participants in the plans included in the program who are nonhighly compensated employees must be at least 30%.

4. Example. The employer contribution disparity safe harbors are illustrated in the chart below. The numbers in the blocks represent the benefit disparity (i.e., the ratio of the highest percentage of compensation contributed on behalf of any highly compensated employee who is currently accruing benefits under a plan or plans included in an employer's aggregated 403(b) annuity program to the lowest percentage of compensation contributed on behalf of any nonhighly compensated employee who is currently accruing benefits) permitted under the safe harbors.

[Chart omitted]

For example, if 55% of an employer's nonhighly compensated employees are currently accruing benefits under the program, and 50% of the employees currently accruing benefits under such program are nonhighly compensated employees, the program satisfies the lesser disparity safe harbor in subpart A.2. as long as the highest percentage of compensation for a year contributed on behalf of any highly compensated employee who is currently accruing benefits is not more than 140% of the lowest percentage of compensation for a year contributed on behalf of any nonhighly compensated employee who is currently accruing benefits.

B. Applications. In applying any of the safe harbors, the employer must apply the following principles and interpretations.

1. Testing date. The safe harbors in part IV.A. are to be applied as of the last day of the plan year, taking into account employees who are employed by the employer on such day. However, highly compensated employees of the employer who accrue benefits under the employer's aggregated 403(b) annuity program during the plan year but terminate from employment with the employer during the last quarter of such year must be considered to be currently accruing benefits and included for purposes of determining the highly compensated employee with the highest percentage of contributions in applying the disparity limitation in these safe harbors. Employees who are excludable employees may be excluded, as provided in Part V.B.

2. "Pick-up" contributions. If a government "picks-up" contributions (within the meaning of section 414(h)) to a plan included in an aggregated 403(b) annuity program, such contributions are deemed to be employer contributions.

3. Valuation. a. Vesting schedules. (i). Adjustment. If an employer chooses to include one or more plans described in sections 401(a), 403(a), 414(d) or 414(e) in its aggregated 403(b) annuity program, then, for the purpose of the section 403(b)(12)(i) safe harbors, the value of the benefits under each such plan must be adjusted to take into account the difference between the vesting schedules of such plan and the 403(b) annuity plan or plans. In the case of an included defined benefit plan, this adjustment is made by calculating each participant's benefit by projecting the participant's age and service to the earlier of the participant's attainment of age 65 or the normal retirement age under the plan and multiplying such benefit by the average vested percentage differential. The resultant amount is subtracted from the participant's benefit. In the case of an included defined contribution plan, the adjustment is made by multiplying the percentage of compensation contributed by or on behalf of any highly compensated employee for the plan year by the average vested percentage differential. The resultant amount is subtracted from the amount contributed for the plan year for or on behalf of the participant. This adjustment is based on the principles of Rev. Rul. 74-166, 1974-1 C.B. 97.

(ii). Average vested percentage. The average vested percentage is determined by dividing the sum of the vested percentage at the end of each year of service under the plan by the maximum years of service under the plan. The maximum years of service under the plan are the years of service during the period beginning at the later of age 18 or the earliest entry age under the plan and ending on the later of the normal retirement age under the plan and age 65.

(iii). Average vested percentage differential. The average vested percentage differential is 50% of the difference between the average vested percentage and 100%.

(iv). Vesting valuation example. An employer chooses to include a governmental plan in its aggregated 403(b) annuity program. The governmental plan provides for 0% vesting for the first 9 years of service and 100% vesting for each year thereafter. The earliest entry age under the plan is age 21 and the normal retirement age under the plan is age 65. Assume there are three participants in the governmental plan, participant A with 15 years of service and a projected annual benefit of $50,000, participant B with 2 years of service and a projected annual benefit of $45,000, and participant C with 5 years of service and a projected annual benefit of $30,000. The sum of the vested percentages for each year of service is 3500 [9(0) + 35(100)]. The average vested percentage is 79.55% (3500/44). The average vested percentage differential is 10.23% [(100% - 79.55%)/2]. Participant A's benefit must be adjusted by subtracting $5115 (10.23% times $50,000) from his projected benefit of $50,000. Participant B's benefit must be adjusted by subtracting $4603.50 from her projected benefit of $45,000. Participant C's benefit must be adjusted by subtracting $3069 from his projected benefit of $30,000.

b. Defined benefit plans. If the aggregated 403(b) annuity program includes one or more defined benefit plans, then the value of the contributions to such plan or plans with respect to any employee must be determined on a contribution basis under the rules contained in Treasury Regulation section 1.403(b)-1(d)(4). The rules contained in such regulation are to be applied after any adjustment for differences in vesting schedules required by subparagraph a of this paragraph 3.

C. Examples. 1. Employer A, an organization described in section 501(c)(3) and exempt from federal income tax under section 501(a), has a headquarters office in State W and branch offices in States X, Y and Z. A sponsors a separate 403(b) annuity plan, which is a defined contribution plan, for its salaried employees performing services at each of its offices. Under each plan, an employee becomes a participant upon completion of one year of service. A contributes annually 8% of participants' compensation to the 403(b) annuity plan for its employees performing services at the State W office. To each other plan, A contributes annually 5% of participants' compensation. There are no 5% owners. The number of participants in each plan, the significant compensation levels of such participants and the number of nonexcludable employees who are ineligible because they are nonsalaried are set forth below.

                          highly         nonhighly       ineligible,

Employer A is required to include all of its 403(b) annuity plans in its aggregated 403(b) annuity program for purposes of this safe harbor. The aggregated 403(b) annuity program sponsored by A satisfies the maximum disparity safe harbor because the highest percentage of compensation contributed on behalf of any highly compensated employee is not more than 180% of that contributed on behalf of any nonhighly compensated employee currently accruing benefits (8%/5% = 160%); at least 50% of the nonhighly compensated employees are currently accruing benefits (103/203 = 50.74%); and the percentage of participants who are nonhighly compensated employees is at least 70% (103/130 = 79.23%).

2. Assume the same facts as in Example 1, and, in addition, that A pays an annual premium for a 403(b) annuity contract for one of its highly compensated employees at the State W office, the Executive Director, who is not eligible to participate in the group annuity plan. The annual premium for the contract is equal to 15% of the Executive Director's annual compensation. Employer A's aggregated 403(b) annuity program must include all of the 403(b) annuity plans for its employees in States W, X, Y and Z and the individual annuity contract purchased for its Executive Director. The aggregated 403(b) annuity program does not satisfy any of the safe harbors because the contribution rate for the Executive Director is 300% of the contribution rate for participants in the 403(b) annuity plans for employees in States X, Y and Z.

3. School-District No. 125 operates two schools, located in Boone County in State X, an elementary school for grades kindergarten through six, and a junior high for grades seven and eight. The District has the power to levy tax to provide funds for the elementary and junior high school. The District contributes for its administrative staff and the teachers employed at the schools to the State X Teachers' Retirement Plan, a 403(b) annuity plan which is a defined contribution plan, an amount equal to a percentage of each such employee's annual compensation. The percentage is determined by state statute. The current contribution percentage is 5%. The District contributes to a governmental plan, which is a defined benefit plan, for its janitors and cafeteria personnel in an amount that, after the required adjustments for vesting and plan type (see paragraph B. 3. of this Part IV), is the actuarial equivalent of 3% of each such employee's annual compensation. In addition, the District annually purchases a deferred annuity contract for its superintendent, who also participates in the 403(b) annuity plan. The premium paid each year, and thus the face amount of the annuity, varies from year to year as the school board of District No. 125 may determine. The contribution percentage for the current year is 15%. The District makes contributions either to the 403(b) annuity plan or the governmental plan on behalf of all of its employees. No employee is in both the 403(b) plan and the governmental plan. The number of employees currently accruing benefits under each plan and the number of highly compensated and nonhighly compensated employees in each are set forth below.

                                         highly         nonhighly

4. Assume the same facts as in Example 3, except that 40 of the teachers eligible to participate in the 403(b) annuity plan who are not highly compensated employees elect not to participate and the District does not purchase a deferred annuity contract for its superintendent. If the District decides to include the governmental plan in its aggregated 403(b) annuity program, the program satisfies the maximum disparity safe harbor because the highest percentage of compensation contributed on behalf of any highly compensated employee is not more than 180% of the lowest percentage of compensation contributed on behalf of any nonhighly compensated employee (5%/3% = 166.67%); at least 50% of the nonhighly compensated employees are currently accruing benefits (70/110 = 63.64%); and the percentage of participants who are nonhighly compensated employees is at least 70% (70/88 = 79.55%).

5. Employer X maintains a section 403(b) plan. X requires all employees other than Executive Director, A, a highly compensated employee, to make a salary reduction contribution equal to at least 2% of compensation to the plan in order to receive a matching 10% contribution. A 10% employer contribution to A's account is made regardless of whether A makes any salary reduction contribution. There are no other contributions to the plan. All employer contributions, other than those for A, are treated as matching contributions. A is treated as receiving no matching contributions. This plan will satisfy section 401(m) for matching contributions (because only nonhighly compensated employees are eligible for the match); but it will fail the safe harbor for employer contributions because only A has employer contributions.

V. DEFINITIONS

A. In general. The definitions contained in this subpart A of Part V apply for all purposes under this Notice.

1. Highly compensated employees. Generally, the determination of which individuals are highly compensated employees is made under section 414(q) and the regulations thereunder. An employer may elect to include in its class of highly compensated employees only those employees who, during the plan year, are 5% owners of any entity within the same controlled group as the employer or receive compensation in excess of $50,000 (adjusted at the same time and in the same manner as under section 415(d), $54,450 in 1989).

2. Compensation. "Compensation" means compensation as defined in section 414(s) and the regulations thereunder and as limited under section 401(a)(17), ($200,000 for 1989) except that compensation includes only the amount of compensation received for services performed for an organization described in section 501(c)(3) which is exempt from tax under section 501(a) or for an educational organization described in section 170(b)(l)(A)(ii) of a state, political subdivision of a state, or an agency or instrumentality of a state or political subdivision.

3. Plan year. If a plan document (e.g., an annuity contract) specifies a plan year, the plan year for purposes of this Notice is the plan year specified in the document. If no plan year is specified in the plan document, the plan year is the calendar year unless the employer designates in writing by December 31, 1989, that the plan year is a fiscal year of the employer. If an aggregated 403(b) annuity program has plans with plan years that end on different dates, the calendar year in which the plan years end will be the plan year for all of the plans for purposes of the transitional safe harbors unless the employer designates in writing by December 31, 1989, that the plan year of all of the plans in the program is either (i) the plan year specified in one of the plan documents or (ii) a fiscal year of the employer.

B. Safe harbor definitions. The definitions contained in this subpart B of Part V apply to the safe harbors contained in this Notice, as specified in each definition.

1. Aggregated 403(b) annuity program. For purposes of the section safe harbors set forth in part IV.A., the term "aggregated 403(b) annuity program" means all of the annuity contracts described in section 403(b)(1), all of the custodial accounts described in section 403(b)(7), and all of the retirement income accounts described in section 403(b)(9) to which an employer makes contributions. In addition, an employer may decide, in testing its aggregated 403(b) annuity program to include any one or more of the employer's plans described in section 401(a), annuity plans described in 403(a), governmental plans described in section 414(d) and church plans described in section 414(e) to which the employer contributes, to the extent that any such plan covers the employer's employees, so long as each plan that the employer decides to include in the program satisfies sections 410(b) and 401(a)(4). A plan that satisfies sections 410(b) and 401(a)(4) only when considered together with one or more comparable plans may be included in an employer's aggregated 403(b) annuity program only if the employer also includes the comparable plans such plan relied on in satisfying sections 410(b) and 401(a)(4) in the aggregated 403(b) annuity program.

Each non-403(b) plan that an employer decides to include in its aggregated 403(b) annuity program continues to be subject to the nondiscrimination rules applicable to such plans as if they were not included in the aggregated 403(b) annuity program. If an employer makes contributions only to one annuity contract described in section 403(b)(1), one custodial account described in section 403(b)(7), or one retirement income account described in 403(b)(9), then the employer's aggregated 403(b) annuity program is such contract or account and any of the employer's plans described in section 401(a), annuity plans described in 403(a), governmental plans described in section 414(d) and church plans described in section 414(e) that the employer includes in the program pursuant to the first sentence of this definition.

2. Employer. a. In general. For purposes of the section 403(b)(12)(i) safe harbors, the employer as defined in section 414(b), (c), (m) and (o) is deemed to be the entity contributing to or maintaining the 403(b) annuity plan (contributing employer) and each entity in the same controlled group as the contributing employer which, under section 403(b), may contribute to or maintain a 403(b) annuity plan. The controlled group includes each entity of which at least 80% of the directors, trustees or other individual members of the entity's governing body are either representatives of or directly or indirectly control, or are controlled by, the contributing employer. In addition, an entity is included in the same controlled group as the contributing employer if such entity provides directly or indirectly at least 80% of the contributing employer's operating funds and there is a degree of common management or supervision between the entities. A degree of common management or supervision exists if the entity providing the funds has the power to appoint or nominate officers, senior management or members of the board of directors (or other governing board) of the entity receiving the funds. A degree of common management or supervision also exists if the entity providing the funds is involved in the day-to-day operations of the entity.

b. Governmental entities. In addition to the entities described in paragraph a. of this definition, in the case of an educational organization described in section 170(b)(l)(A)(ii) of an employer which is a state, a political subdivision of a state, or an agency or instrumentality of any one or more of such entities (governmental entity), the term "employer" includes any other educational organization described in section 170(b)(l)(A)(ii) that has the power to levy tax to provide funds to the contributing employer or to set or review the contributing employer's budget (involvement in the budgetary process must consist of more than mere approval of a previously developed budget), and all other educational organizations described in section 170(b)(l)(A)(ii) that receive tax disbursements pursuant to the same tax levy of an educational organization. If the contributing employer receives a majority of its tax disbursements pursuant to a tax levy of one governmental entity, each other educational organization described in section 170(b)(l)(A)(ii) receiving at least 80% of its tax disbursements pursuant to the same levy is included in the term "employer" so long as its budget is set or reviewed by the same educational organization that sets or reviews the contributing employer's budget. Thus, for example, if a two-year college and a university each receive 80% or more of their tax disbursements pursuant to a tax or taxes levied by a state and each of their budgets is reviewed by an educational organization, then both educational organizations are one employer for purposes of the safe harbors provided in part IV.A. For the purposes of this definition, an entity that is organized under a state statute and qualifies for an exemption under section 501(c)(3) is treated as described in section 170(b)(1)(A)(ii).

3. Excludable employees. a. In general. For purposes of applying any of the safe harbors contained in this Notice to a 403(b) annuity plan, the following individuals and employees of an employer are excludable employees: (i) employees who are nonresident aliens described in section 410(b)(3)(C); (ii) employees who are students performing services described in section 3121(b)(10); (iii) employees who normally work less than 20 hours per week; (iv) employees who make a one-time election to participate in a governmental plan described in 414(d) instead of a 403(b) annuity plan; (v) professors employed by an educational organization described in section 170(b)(1)(A)(ii) (original employer) who are providing services on a temporary basis to another educational organization described in section 170(b)(1)(A)(ii) and for whom a contribution to a 403(b) annuity plan or other tax-favored plan is being made at a rate no greater than the rate such professors would receive under the aggregated 403(b) annuity program of the original employer, provided that such professors are not excluded for this reason for more than one year; and (vi) employees who are affiliated with a religious order who have taken a vow of poverty and the religious order provides for such employees in their retirement. If an individual is eligible to participate in a 403(b) annuity plan even though the individual is included in a class of employees specified in the previous sentence, then the other individuals in such class may not be excluded for purposes of applying the safe harbors contained in this Notice.

b. Employees covered by collective bargaining agreements. For purposes of applying any of the safe harbors contained in this Notice to a 403(b) annuity plan, an employer may exclude employees whose retirement benefits were the subject of good faith bargaining between a representative of such employees and the employer (collectively bargained employees) in determining whether the safe harbor is satisfied with respect to employees whose retirement benefits were not the subject of such bargaining. Moreover, in determining whether any of the safe harbors is satisfied with respect to collectively bargained employees, an employer may exclude employees who are not collectively bargained employees and collectively bargained employees covered under an agreement that does not provide for benefits under the plan being tested.

c. Governmental employees. For purposes of applying any of the safe harbors contained in this Notice to a 403(b) annuity plan, an employer who is a state or a political subdivision, agency or instrumentality thereof may exclude the following individuals in addition to the excludable employees set forth in paragraphs a and b of this definition: (i) those individuals who were initially employed for the principal purpose of relieving unemployment and who have not become a part of the employer's regular workforce; (ii) inmates and patients of prisons, hospitals, homes and other institutions who perform services therein; and (iii) those individuals performing services on a temporary basis in case of fire, storm, snow, earthquake, flood or similar emergency.

d. Section 403(b)(12)(ii) safe harbor. In addition to those who are excludable employees under paragraphs a, b and c of this definition of excludable employees, the following employees of an employer are excludable employees for purposes of applying the 403(b)(12)(ii) safe harbor to a 403(b) annuity plan: (i) employees who are participants in an eligible deferred compensation plan within the meaning of section 457; (ii) employees who are eligible to participate in a qualified cash or deferred arrangement within the meaning of section 401(k)(2) or another 403(b) annuity plan sponsored or maintained by the employer which provides for contributions pursuant to a salary reduction agreement; and (iii) each employee whose contribution to the plan under its maximum deferral percentage would be $200 or less. If an employee is eligible to participate in a 403(b) annuity plan even though the employee is included in one of the classes of employers specified in the previous sentence, then all employees within that same class must be eligible to participate in the plan.

e. Section 403(b)(12)(i) safe harbors. (i) General age and service exclusion rule. In addition to those who are excludable employees under paragraphs a, b and c of this definition of excludable employees, for purposes of applying the 403(b)(12)(i) safe harbor to a 403(b) annuity plan, employees who have not satisfied the minimum age and service requirements set forth in the plan are excludable employees, so long as such requirements are permissible under section 410(a)(1) (assume plans not subject to section 410(a)(1) are subject to such section in determining those who are excludable employees) and all employees not meeting such requirements are excluded from participating in the plan.

(ii) Separate testing alternative to age and service exclusion rule. Employees who would be excludable under subparagraph (i) of this paragraph (e), but for the fact that they (or other employees with the same or lower age and service) are not excluded from coverage under the plan (otherwise excludable employees), may nevertheless be treated as an excludable employee if the employer provided benefits provided under such plan would satisfy the section 403(b)(12)(i) safe harbor by reference only to such employees and the benefits provided to such employees (expressed as percentages of compensation) are not greater than the benefits provided to the employees who are not otherwise excludable under the plan.

VI. EFFECTIVE DATE

Except as provided in the following sentence, section 403(b)(12) is effective for plan years beginning after December 31, 1988. In the case of a 403(b) annuity plan maintained pursuant to one or more collective bargaining agreements between employee representatives and one or more employers (a collectively bargained 403(b) annuity plan) that is ratified before March 1, 1986, section 403(b)(12) does not apply to plan years beginning before the earlier of (i) January 1, 1991, or (ii) the later of January 1, 1989, or the date on which the last of such collective bargaining agreements terminates (determined without regard to any extension thereof after February 28, 1986). Of course, if a collectively bargained 403(b) annuity plan is aggregated with other plans in an aggregated 403(b) annuity program, the delayed effective date applies only with respect to the collectively bargained 403(b) annuity plan.

The safe harbors set forth in this Notice apply for plan years commencing in the 1989 or 1990 calendar year.

VII. RELIANCE

Until additional guidance is published, this Notice may be relied upon by taxpayers to design and administer section 403(b) annuity plans and to determine the tax treatment of contributions. If such guidance is more restrictive than this Notice, then such guidance will be applied without retroactive effect.

This document serves as an "administrative pronouncement" as that term is described in Treasury Regulation section 1.6661-3(b)(2) and may be relied upon to the same extent as a revenue ruling or revenue procedure.

VIII. DRAFTING INFORMATION

The principal author of this Notice is Julie Jensen of the Employee Plans Technical and Actuarial Division. For further information regarding this Notice, please contact the Employee Plans Technical and Actuarial Division's telephone assistance service between the hours of 1:30 p.m. and 4:00 p.m., Eastern Standard Time, Monday through Friday at (202) 566-6783 or (202) 566-6784 (not a toll-free call). Ms. Jensen may be contacted at (202) 343-0729 (not a toll-free call). Mr. Richard Lent of the Employee Benefits and Exempt Organization Division of the Office of Chief Counsel will be the principal draftsman of the regulations in areas covered by this notice and may be contacted at (202) 377-9372 (not a toll-free call).