4.72.19  IRC 457 Examination Guidelines (Cont. 1)

4.72.19.15  (06-11-2012)
Qualified Domestic Relations Orders (QDROs)

  1. Treas. Reg. 1.457-10(c) provides that an Eligible 457 Plan will not violate the restrictions on distributions under IRC 457(d) due to payment to an alternate payee under a QDRO as defined in IRC 414(p).

  2. The alternate payee will be the distributee under IRC 402(e)(1)(A).

4.72.19.16  (06-11-2012)
Commencement of Distributions

  1. There are no requirements under IRC 457 that an Eligible 457 Plan must satisfy for establishing the date for the commencement of distributions, other than the requirements associated with required minimum distributions under IRC 401(a)(9). The conditions for distributions and the timing of distributions, however, are required plan provisions, and once established must be followed in operation pursuant to Treas. Reg. 1.457-3.

  2. Treas. Reg. 1.457-7(c)(2)(iv) provides that an Eligible Tax Exempt 457 Plan may provide a period for making an initial election by the participant or beneficiary, in accordance with the terms of the plan, to defer the payment of some or all of the amounts deferred to a fixed or determinable future time.

    1. The period for making this initial election must expire prior to the first time that any such amounts would be considered made available under the plan.

    2. The plan may provide for one additional election, after the initial election, to further defer the commencement of distributions.

    3. The additional election must be made before distributions have commenced in accordance with the initial deferral election.

    4. In no event can an election extend beyond the date on which distributions are required to be made under IRC 401(a)(9).

  3. An Eligible Tax Exempt 457 Plan may provide for a default payment schedule that would apply if no election is made under Treas. Reg. 1.457-7(c)(2)(iv). The amounts deferred under the default provision are includible in the gross income of the participant or beneficiary in the year the amounts deferred are first made available under the terms of the default payment schedule.

  4. An Eligible Tax Exempt 457 Plan may provide an election as to the method of payment to be made prior to the date the amounts are distributed in accordance with the initial or additional election to defer commencement of payment under Treas. Reg. 1.457-7(c)(2)(iv).

4.72.19.16.1  (06-11-2012)
Examination Steps

  1. Discuss the procedures followed and the type of records maintained with respect to plan distributions with individuals responsible for plan administration and record keeping.

    1. Document any information that may reveal substantial non-compliance.

    2. Seek written clarification for any statements that appear to reveal areas of substantial non-compliance.

    3. Examine relevant records to corroborate oral testimony.

  2. Inspect the language in the plan document to determine when and under what circumstances distributions are allowed under the plan. Ensure plan provisions comply with the distribution restrictions under IRC 457(d).

  3. Examine payroll and personnel records to determine the identity of individuals who terminated employment during the year under examination and to identify individuals who are age 70 ½ or older. Compare this with any report identifying the participants who received distributions in excess of the dollar amount in IRC 411(a)(11)(D) for small amounts for the year under examination.

  4. Document the work papers to reflect that the above steps were completed and identify the documents/reports examined.

    1. Document the identity of any participant who received a distribution where there is no corresponding date of termination reflected on the employer’s records.

    2. Also, document the identity of participants who were age 70 ½ or older, but who did not receive a distribution.

    3. A follow up inquiry may be needed to determine whether there were any violations of the IRC 457(d) distributions restrictions or the IRC 401(a)(9) minimum distribution requirements.

  5. Obtain and examine the records used to justify distributions made on account of unforeseeable emergencies, if any, and document the payments. Determine whether an unforeseeable emergency occurred and that appropriate steps were taken to ascertain whether the payment was necessary considering other financial resources available to the participant.

  6. Inspect the language in the plan document to determine whether the plan allows loans to participants. If the plan provides for loans, document whether the Plan is sponsored by an Eligible Governmental Employer. Verify and document that plan provisions comply with Treas. Reg. 1.457-6(f)(2).

  7. Obtain and examine the records used to justify plan loans, if any, and document the payments.

    1. Verify the interest rate was reasonable considering similar loans available through financial institutions.

    2. Document whether the safe harbor requirements in IRC 72(p)(2) were satisfied, document and explain the facts and circumstances of the loan, and determine whether the loan violates the distribution restrictions of IRC 457(d) and Treas. Reg. 1.457-6(f)(1), in the case of a plan of a tax exempt organization, or Treas. Reg. 1.457-6(f)(2) in the case of a plan of a state or local government entity.

  8. Document whether loans from IRC 457 plans of non-governmental tax exempt entities were treated as distributions.

  9. Document that provisions pertaining to the timing of distributions are contained in the plan and are being followed in operation.

4.72.19.17  (06-11-2012)
Taxation of Distributions

  1. The tax rules pertaining to distributions from IRC 457 plans vary depending on whether the Plan is sponsored by a Governmental employer or a tax exempt entity.

  2. Effective January 1, 2002 benefits under Eligible Governmental 457 Plans are generally taxable to participants or beneficiaries in the year paid under Treas. Reg. 1.457-7(b)(1).

    Note:

    EGTRRA repealed the "made available" rule for Eligible Governmental 457 Plans.

  3. Any payment made from an Eligible Governmental 457 Plan in the form of an "eligible rollover distribution" (as defined in IRC 402(c)(4)) is not includible in gross income in the year paid to the extent the payment is transferred to an "eligible retirement plan" (as defined in IRC 402(c)(8)(B)) within 60 days, including the transfer to the "eligible retirement plan" of any property distributed from the Eligible Governmental 457 Plan.

    1. For this purpose, the rules of IRC 402(c)(2) through (7) and (9) apply.

    2. Any trustee-to-trustee transfer under Treas. Reg. 1.457-7(b)(2) from an Eligible Governmental 457 Plan is a distribution that is subject to the distribution requirements of Treas. Reg. 1.457-6.

  4. Loans determined to be deemed distributions under IRC 72(p) are includible in gross income for the taxable year in which the deemed distribution occurred under Treas. Reg. 1.457-7(b)(3). This is true even though a deemed distribution is not an actual distribution.

  5. Benefits under Eligible Tax Exempt 457 Plans are taxable to participants or beneficiaries in the year amounts first become available under Treas. Reg. 1.457-7(c)(1).

  6. Amounts deferred under an Eligible Tax Exempt 457 Plan are includible in the gross income of the participant or beneficiary in the year the amounts are first made available under the terms of the plan, even if the plan has not distributed the amounts deferred under Treas. Reg. 1.457-7(c)(2).

4.72.19.18  (06-11-2012)
Amounts Made Available Under Eligible Tax Exempt 457 Plans

  1. The taxation of benefits under an Eligible Tax Exempt 457 Plan depends on the availability of benefits for distribution under the terms of the plan, and the availability and timing of any election that a participant may make to alter the method of distribution or the timing of distributions otherwise payable under the terms of the plan.

  2. Transfers between Eligible Tax Exempt 457 Plans are the only method to defer taxation under Treas. Reg. 1.457-10(b)(5).

    1. Such transfer must be elected before the onset of a distribution event under the plan.

    2. Rollovers may not occur into or from plans of tax exempt entities.

  3. Under Treas. Reg. 1.457-7(c)(2)(i) amounts are generally considered to be made available to a participant at the earliest date on or after severance from employment, on which the plan allows distributions to commence, but in no event later than the date on which distributions must commence pursuant to IRC 401(a)(9). Thus, in the absence of an election to defer the timing of distributions or the method of distributions, amounts payable under the terms of the plan will be includible in the gross income of the participant or beneficiary for the year in which amounts become payable regardless of whether there has been an actual distribution.

  4. An Eligible Tax Exempt 457 Plan may allow a participant or beneficiary an initial election to defer the payment of benefits to a future date under Treas. Reg. 1.457-7(c)(2)(ii) and (iii).

    1. A participant or beneficiary who has made an initial election to defer payment may make one additional election to defer commencement of distribution under the plan.

    2. Such elections must be made prior to the date the amounts become payable under the initial election.

  5. An election to defer commencement of benefits in an Eligible 457 Plan must not violate IRC 401(a)(9).

    1. The plan may also permit participants to choose among various payment options under Treas. Reg. 1.457-7(c)(2)(iv).

    2. Where such elections are permitted, the plan must state the timing and method of distribution that will be used in the absence of a timely election.

  6. Amounts will not be considered to be "made available" under the following circumstances:

    1. The participant or beneficiary is permitted to choose among various methods of payment offered by the plan.

    2. The availability of distributions satisfy the requirements for "unforeseeable emergencies" under Treas. Reg. 1.457-6(c).

    3. A distribution from an account for which the total amount deferred is not in excess of the dollar limit under IRC 411(a)(11)(A) to the extent the distribution is permitted under Treas. Reg. 1.457-6(e).

4.72.19.18.1  (06-11-2012)
Loans

  1. Deemed distributions occur when loans under Eligible Governmental 457 Plans fail to satisfy the requirements of Treas. Reg. 1.72(p)-1 Q&A 3.

  2. Deemed distributions are includible in the gross income of participants or beneficiaries in the year in which the loan first fails to satisfy one or more of those requirements under Treas. Reg. 1.72(p)-1 Q&A 4.

4.72.19.18.2  (06-11-2012)
Qualified Domestic Relations Orders

  1. A payment from an Eligible 457 Plan to an alternate payee who is the spouse or former spouse of a participant is includible in the gross income of the alternate payee if made pursuant to a Qualified Domestic Relations Order (QDRO) as defined in IRC 414(p).

  2. Payments made under IRC 414(p) to alternate payees other than the spouse or former spouse of the participant are includible in the gross income of the participant under IRC 402(e)(1), and Treas. Reg. 1.457-10(c).

4.72.19.18.3  (06-11-2012)
Examination Steps

  1. Distributions from Eligible Governmental 457 Plans will usually be reported by a third party administrator on Form 1099-R.

    1. Examine distribution reports and, if available, the Form 1099-R records.

    2. Document whether the withholding and reporting requirements in Notice 2003-20, 2003-19 IRB 894 were complied with.

    3. IDRS research may be used to verify amounts paid were reported in gross income of the participant or beneficiary.

  2. Distributions from Eligible Tax Exempt 457 Plans will usually be reported by the employer and are reported on Form W-2 as wages.

    1. Document the distributable events, methods of distribution permitted by the plan, and any election available to participants.

    2. Determine whether amounts became available to any participant for the year(s) under examination.

    3. Examine the employers' payroll records to verify withholding and reporting obligations were met with respect to amounts paid or made available.

4.72.19.19  (06-11-2012)
Funding

  1. Contributions or annual deferrals can be made through a salary reduction agreement or employer nonelective contributions, and must be in accordance with the written terms of the plan.

  2. Salary reduction agreements must be entered into in the month prior to the first day of the month in which the compensation is paid or made available under Treas. Reg. 1.457-4(b).

  3. Plans may use automatic enrollment arrangements that satisfy Rev. Rul. 2000-33, 2000-31 IRB 142, IRC 414(w) and the regulations thereunder.

4.72.19.19.1  (06-11-2012)
Governmental Employers

  1. Eligible Governmental 457 Plans adopted on or after August 20, 1996 must satisfy the funding requirements of IRC 457(g).

  2. Sponsors of Eligible Governmental 457 Plans already in existence on August 20, 1996 need not establish a trust prior to January 1, 1999; although a trust may be established prior to that date if it wishes to do so.

  3. The trust must be established pursuant to a written agreement which establishes a valid trust under applicable State law. Notice 98-8, 1998-4 IRB 6 provides guidelines for satisfying the trust requirement of IRC 457(g).

  4. IRC 457(g)(3) provides that custodial accounts and contracts described in IRC 401(f) (annuity contracts) are to be treated as trusts under rules similar to those found in IRC 401(f).

  5. The terms of the trust must make it impossible for any part of the assets and income of the trust to be used for or diverted to, purposes other than for the exclusive benefit of participants and their beneficiaries, before the satisfaction of all liabilities with respect to such participants and their beneficiaries.

4.72.19.19.2  (06-11-2012)
Tax Exempt Employers

  1. By contrast, under IRC 457(b)(6) and Treas. Reg. 1.457-8(b), the assets of Eligible Tax Exempt 457 Plans must be unfunded. This is true for both employee and employer contributions.

  2. Plan assets may not be held in trust for the exclusive benefit of participants.

    1. The assets must remain the property of the employer subject to the claims of the employers' general creditors.

    2. So long as this requirement is satisfied, assets may be set aside in so called "Rabbi" trusts.

4.72.19.19.3  (06-11-2012)
Dual Status Employers

  1. Employers that are governmental organizations and have also received a determination letter from the Service that they satisfy the requirements for tax exemption under IRC 501(a) will be considered governmental for purposes of plan funding requirements.

4.72.19.19.4  (06-11-2012)
Examination Steps

  1. Review the plan document for Eligible Governmental 457 Plans to verify that assets are held in trust, custodial accounts, or annuity contracts.

  2. When examining Eligible Governmental 457 Plans, review and document whether trust documents, custodial account documents and annuity contracts contain the required exclusive benefit and anti-diversion language.

  3. With regard to IRC 457 plans sponsored by tax exempt employers, review the plan document and determine whether there are any other governing documents with respect to plan assets.

    1. If so, obtain copies of those documents.

    2. Review the relevant documents to verify that title to plan assets is in the name of the employer and are subject to the claims of the creditors of the employer.

    3. It may also be necessary to review financial statements and journals to verify that assets are the property of the employer.

  4. Review communications between the employer and employee with respect to plan deferrals or investment choices.

  5. Document all employee deferrals were taken into account and reported on Form W-2.

  6. A Governmental 457 Plan that has not established a trust, that satisfies Treas. Reg. 1.457-8(a), within their applicable 180 day correction period is not an Eligible 457 Plan; relief may be offered by the Service outside of EPCRS through standards similar to those found in Rev. Proc. 2008-50, 2008-35 IRB 464.

  7. A Tax Exempt 457 Plan that is funded is not an Eligible 457 Plan.

    1. There may be ERISA concerns if the plan covers employees that are not Top Hat group employees.

    2. A referral to DOL may be necessary.

4.72.19.20  (06-11-2012)
Plan Terminations and Frozen Plans

  1. A plan may contain provisions permitting plan termination whereupon amounts can be distributed without violating the distribution restrictions under IRC 457 and Treas. Reg. 1.457-10(a)(2)(ii).

    1. An Eligible 457 Plan is considered terminated only if all amounts deferred under the plan are paid to participants as soon as administratively practicable following termination.

    2. The plan is treated as a frozen plan if amounts are not timely distributed.

    3. The plan must continue to comply with all of the applicable statutory requirements necessary for plan eligibility until all amounts deferred into the plan are paid out.

  2. Employers that cease to be Eligible Employers under IRC 457(e)(1) and Treas. Reg. 1.457-2(e) may no longer maintain an Eligible 457 Plan.

    1. If the employer is tax exempt and the plan is not terminated, the tax consequences to participants and beneficiaries are determined in accordance with IRC 451 if the employer becomes an entity other than a State, and Treas. Reg. 1.457-11 if the employer becomes a State entity.

    2. If employer is a State entity and the plan is not terminated or transferred to another eligible plan the tax consequences to participants are determined in accordance with IRC 402(b) (in the case of a trust) or IRC 403(c) (in the case of an annuity contract) and the trust is no longer exempt from tax under IRC 501(a).

4.72.19.20.1  (06-11-2012)
Examination Steps

  1. Review the plan document.

    1. Determine whether it contains provisions allowing for termination of the 457 Plan.

    2. Review all amendments to determine if an amendment terminating the plan has been adopted.

  2. Document whether distributions have been made to all participants as soon as administratively practicable (generally within one year) following the date of termination.

  3. Document whether the employer continues to be an Eligible Employer under IRC 457(e)(1) or Treas. Reg. 1.457-2(e).

  4. In the case of a former tax exempt employer who is no longer eligible to maintain an IRC 457(b) Plan, but the plan has not been terminated, document whether the tax consequences to participants and beneficiaries was determined in accordance with either IRC 451 (if the employer becomes an entity other than a State) or Treas. Reg. 1.457-11 (if the employer becomes a State entity).

  5. In the case of a former state employer that is no longer eligible to maintain an IRC 457(b) Plan, and in which case the plan has not been terminated or transferred to another Eligible Governmental 457 Plan within the same state, document whether the tax consequences to participants and beneficiaries has been determined under IRC 402(b) for amounts held in trust or IRC 403(c) for amounts held in annuity contracts. Consider the trust no longer exempt from tax under IRC 501(a).

  6. Verify whether Eligible Governmental 457 Plan assets of a State have been transferred to another Eligible Governmental 457 Plan within the same State as permitted under Treas. Reg. 1.457-10(b).

4.72.19.21  (06-11-2012)
Rollovers and Plan to Plan Transfers

  1. Within certain limits, funds may be moved by transfer or rollover from an Eligible 457 Plan without being included in gross income in the taxable year of the transaction.

4.72.19.21.1  (06-11-2012)
Rollovers to Eligible Governmental 457 Plans

  1. Treas. Reg. 1.457-10(e) permits an Eligible Governmental 457 Plan to receive contributions that are eligible rollover distributions from qualified retirement plans, 403(b) annuities, traditional IRAs, and Governmental 457(b) plans.

  2. Such amounts are not subject to the annual deferral limits but are otherwise treated in the same manner as amounts deferred under IRC 457 for purposes of Treas. Regs. 1.457-3 through 1.457-9.

  3. Contributions received as eligible rollover distributions must be accounted for separately.

  4. Eligible Governmental 457 Plans are not required to accept eligible rollover distributions; however, such plans must comply in form and operation with requirements similar to those set forth in IRC 401(a)(31) with respect to direct transfer of eligible rollover distributions under IRC 457(d)(1)(C).

  5. An eligible retirement plan includes an Eligible Governmental 457 Plan for purposes of IRC 401(a)(31) and IRC 402(c)(8)(B).

4.72.19.21.2  (06-11-2012)
Purchase of Permissive Service Credit

  1. Under Treas. Reg. 1.457-10(b)(8) an Eligible Governmental 457 Plan of a State may provide for the transfer of amounts deferred by a participant or beneficiary to a defined benefit governmental plan (as defined in IRC 414(d)), and no amount shall be includible in gross income by reason of the transfer, if the transfer is for either of the following reasons:

    1. The purchase of permissive service credit (as defined in IRC 415(n)(3)(A)) under the receiving defined benefit governmental plan; or

    2. To repay a cash out from the governmental plan in accordance with IRC 415(k)(3).

  2. A transfer under Treas. Reg. 1.457-10(b)(8) is not treated as a distribution for purposes of Treas. Reg. 1.457-6. Therefore, such a transfer may be made before severance from employment.

  3. Treas. Reg. 1.457-10(b)(8) was revised to coincide with the Final Treas. Reg. 1.415 issued on April 5, 2007, which deleted the word "past" from permissive service credit. The final 415 regulations and corresponding changes to the 457 regulations are effective for plan years beginning on or after July 1, 2007.

4.72.19.21.3  (06-11-2012)
Direct Plan to Plan Transfers Between Eligible 457 Plans

  1. The assets of an Eligible Governmental 457 Plan cannot be transferred to an Eligible Tax Exempt 457 Plan.

  2. The assets of an Eligible Tax Exempt 457 Plan cannot be transferred to an Eligible 457 Plan of a State.

  3. Eligible 457 Plans cannot provide for the receipt of such transfers.

  4. Transfers can only take place between Eligible Governmental 457 Plans, or between Eligible Tax Exempt 457 Plans.

  5. Eligible Governmental 457 Plans may provide for post-severance transfer of a participant’s assets to another Eligible Governmental 457 Plan subject to the following rules:

    1. Both the transferor plan and the receiving plan must contain provisions allowing for the transfer of said assets.

    2. In all cases involving the transfer of assets between Eligible 457 Plans, each participant or beneficiary whose amounts deferred are being transferred must have an amount deferred immediately after the transfer that is at least equal to the amount deferred with respect to that participant or beneficiary immediately before the transfer.

    3. In the case of a transfer for a participant, the participant must have had a severance from employment with the transferring employer and is performing services for the entity maintaining the receiving plan.

    4. Where assets are transferred to an Eligible 457 Plan of a different employer, the affected participants must have had a severance from employment with the transferring employer and must be performing services for the recipient employer. This rule does not apply where all of the assets of an Eligible Governmental 457 Plan are being transferred to another Eligible Governmental 457 Plan within the same State.

  6. Eligible Tax Exempt 457 Plans may provide for post-severance plan-to-plan transfers of participant amounts to other Eligible Tax Exempt 457 Plans subject to the following rules:

    1. Both the transferor plan and the receiving plan must contain provisions allowing for the transfer.

    2. In all cases involving the transfer of amounts between Eligible 457 Plans, each participant or beneficiary whose amounts deferred are being transferred must have an amount deferred immediately after the transfer at least equal to the amount deferred with respect to that participant or beneficiary immediately before the transfer.

    3. In the case of a transfer for a participant, the participant must have had a severance from employment with the transferring employer and be performing services for the entity maintaining the receiving plan.

4.72.19.21.4  (06-11-2012)
Examination Steps

  1. Verify and document that Eligible Governmental 457 Plan documents contain provisions similar to the requirements under IRC 401(a)(31) relating to direct rollovers.

  2. Document amounts received into an Eligible Governmental 457 Plan as rollover contributions are accounted for separately.

  3. Verify transactions involving the transfer of funds for the purchase of permissible service credits under a qualified defined benefit plan of a governmental employer are not more than the amount needed to purchase the service credit.

  4. Document post severance transfer of a participant’s assets to another Eligible 457 Plan meet the requirements listed above for governmental and tax exempt employers.

4.72.19.22  (06-11-2012)
Death Benefit and Life Insurance

  1. A "death benefit only" plan under IRC 457(e)(11) is not an Eligible 457 Plan.

  2. A "death benefit only" plan is a plan that:

    1. Has no provision for payments to the decedent during his or her life;

    2. Provides that payments can only be made to the surviving spouse or other designated surviving beneficiary; and

    3. The employee has no power to designate or change the beneficiary.

  3. No amount paid as death benefits or life insurance proceeds under an Eligible Governmental 457 Plan or made available under an Eligible Tax Exempt 457 Plan is excludable from gross income under IRC 101(a) and Treas. Reg. 1.457-10(d).

  4. The cost of life insurance protection purchased by a tax exempt employer with amounts deferred under an Eligible 457 Plan is not taxed to the participant, as long as the employer:

    1. Retains all the incidents of ownership in the policy;

    2. Is the sole beneficiary under the policy; and

    3. Is under no obligation to transfer the policy or pass through the proceeds of the policy under Treas. Reg. 1.457-8(b)(1).

4.72.19.23  (06-11-2012)
Deemed IRAs under Eligible Governmental Plans

  1. For tax years beginning after 2002, Eligible Governmental 457 Plans may contain provisions that permit a deemed IRA under IRC 408(q) that meets the applicable requirement under IRC 408A.

  2. A deemed IRA includes voluntary employee contributions to a separate account or annuity established under the Eligible 457 Plan in the form of a traditional or Roth IRA.

  3. The plan document must contain provisions permitting deemed IRAs prior to accepting IRA contributions.

  4. An employee must designate contributions as IRC 408(q) deemed IRA contributions.

  5. A deemed IRA is treated as a separate entity from the Eligible 457 Plan subject to applicable rules for traditional (IRC 408) or Roth (IRC 408A) IRAs, and is not subject to the Eligible 457 Plan rules.

  6. See regulations under IRC 408(q) for guidance regarding the treatment of separate accounts or annuities as IRAs.

4.72.19.23.1  (06-11-2012)
Examination Steps

  1. Review the Eligible 457 Plan document and all amendments to determine if the plan has been amended to include a deemed IRA. See Rev. Proc. 2003-13, 2003-4 IRB 317 for guidance regarding amendments to Eligible Governmental 457 Plans to include a deemed IRA.

  2. Confirm that voluntary contributions designated by participants as deemed IRA contributions have not been made prior to the adoption of plan provisions permitting such contributions.

  3. Test sample selected deemed IRA accounts to confirm satisfaction of applicable requirements for a traditional or Roth IRA under IRC 408 and IRC 408A.

  4. Confirm separate accounts are maintained with allocable gains and losses if deemed IRAs are commingled with other assets of the Eligible 457 Plan.

4.72.19.24  (06-11-2012)
Ineligible Plans

  1. IRC 457(f)(1)(A) generally provides that, in the case of an agreement or arrangement for the deferral of compensation the deferred compensation is included in gross income when deferred or if later when the rights to payment of the deferred compensation ceases to be subject to a "substantial risk of forfeiture" .

  2. Facts and circumstances determine whether a risk of forfeiture is substantial.

4.72.19.24.1  (06-11-2012)
Substantial Risk of Forfeiture

  1. A "substantial risk of forfeiture" exists where rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a condition related to a purpose of a transfer, and the possibility of forfeiture is "substantial" if such condition is not satisfied.

    1. In order for the risk of forfeiture to be considered "substantial" the risk must be real and serve a significant business purpose apart from the tax laws.

    2. The requirement that an employee perform services in the future must have real economic consequences for the parties and thus can be said to possess the economic substance that is the essence of the business purpose doctrine.

    3. Where conditions are imposed other than the performance of substantial future services, the question of whether there is a "substantial risk of forfeiture" depends upon the facts and circumstances.

  2. Following are several methods that are presumed to not create a "substantial risk of forfeiture" unless supported by additional fact and circumstances:

    1. Covenants not to Compete - An enforceable requirement that the property be returned to the employer if the employee accepts a job with a competing firm. "Covenants not to Compete" will not ordinarily be considered to result in a substantial risk of forfeiture unless the particular facts and circumstances indicate to the contrary. Factors which may be taken into account in determining whether a "Covenant not to Compete" constitutes a substantial risk of forfeiture are: the age of the employee, availability of alternative employment opportunities, the likelihood of the employee obtaining such other employment, the degree of skill possessed by the employee, the employee’s health, and the practices of the employer to enforce such covenants.

    2. Consulting Service Agreements - Rights to property transferred to a retiring employee subject to the sole requirement that it be returned unless he or she renders consulting services upon the request of the former employer. "Consulting Service Agreements" will not be considered subject to a substantial risk of forfeiture unless the parties in fact anticipate the performance of substantial services. Refer to Richardson v. Comr. 64 T.C. 621 (1975).

    3. Rolling Risk of Forfeiture - As the risk of forfeiture approaches its end, executives unilaterally further extend the period of the risk and thereby delay taxation. In a typical rolling risk situation an employee has a unilateral right to extend a risk of forfeiture for a period of time, usually two or more years. The election to roll the risk to a future date typically is made six to twelve months before the risk would otherwise expire.

    4. Elective Deferrals - Unilateral imposition of a risk of forfeiture by an employee on salary or bonuses that have already been earned to delay taxation until the risk of forfeiture lapses. Willingness to subject compensation that you are about to receive free and clear of any restrictions to a real and meaningful risk of forfeiture that you know will be enforced for a significant period of time could be viewed as suspect.

  3. IRC 409A was added to the Code by section 885 of the American Jobs Creation Act of 2004, Pub. L. 108-357.

    1. IRC 409A applies to Ineligible Non-qualified Deferred Compensation Plans of tax exempt and governmental employers separately and are in addition to the rules under IRC 457(f).

    2. If a plan fails to conform with IRC 409A in form or operation, all compensation deferred under the plan is immediately taxable to participants to whom the failure relates.

    3. In addition, interest will be owed at the income tax underpayment rate plus one percent, as well as a penalty tax equal to twenty percent of the amount required to be included in income.

    4. Final regulations under IRC 409A were published on April 10, 2007, and generally became effective January 1, 2008.

    5. Regulation 1.409A-1(d) does not consider "Covenants not to Compete" , "Rolling Risk of Forfeitures" , and "Elective Deferrals" , described in paragraph (2) above, to be "substantial risks of forfeiture."

    6. The Treasury and Service anticipate issuing guidance regarding "substantial risk of forfeiture" for purposes of IRC 457(f)(3)(B) similar to those under 1.409A-1(d).

4.72.19.24.2  (06-11-2012)
Examination Steps

  1. Review employment contracts for executives, highly paid employees, head coaches, and endorsement contracts for deferred compensation provisions.

  2. Review employee handbooks. Don’t stop at what the employer defines as the benefit.

  3. Review union contracts for negotiated benefits. Ensure benefits are not in the nature of deferred compensation.

  4. Analyze sick, vacation, and severance payouts that occur over an extended period of time and confirm benefits provided are not in the nature of deferred compensation. Refer to IRC 457(e)(11) and Notice 88-68, 1988-1 CB 556.

  5. Confirm that IRC 457(f) amounts are not set aside for the benefit of participants (funded). Compare gross to net payroll.

  6. Be aware that IRC 457(f) non-qualified deferred compensation may not flow through general payroll and may be managed by other departments; such as, Human Resource, Compensation, or Legal.

  7. Review Forms W-2 for entries in Box 11 for reference codes indicating the existence of IRC 457(f) or 409A arrangements.

  8. Review the Form 990 tax return and accompanying notes to audited financial statements for and disclosures regarding executive benefits.

  9. Review any rabbi trust agreements, memorandum accounts, or annuity contracts to ensure that IRC 457(f) assets have not been set aside for the exclusive benefit of participants (funded) and that assets are subject to the general creditors of the employer.

4.72.19.25  (06-11-2012)
Reporting and Withholding Requirements for Eligible 457 Plans

  1. Notice 2003-20, 2003-19 IRB 894 provides guidance with regard to the withholding and reporting requirements applicable to Eligible Governmental 457 Plans and Eligible Tax Exempt 457 Plans for periods after December 31, 2001.

4.72.19.25.1  (06-11-2012)
Withholding and Reporting on Annual Deferrals

  1. Annual deferrals under an Eligible Governmental 457 Plan and any income attributable to the amounts so deferred are not includible in a participant’s gross income until the amount is paid to the participant or beneficiary under IRC 457(a)(1)(A).

  2. Annual deferrals under an Eligible Tax Exempt 457 Plan and any income attributable to the amounts deferred are not includible in a participant’s gross income until that amount is paid or made available to the participant or beneficiary under IRC 457(a)(1)(B).

  3. Annual deferrals under an Eligible 457 Plan are generally not subject to income tax withholding at the time of the deferral.

  4. Annual deferrals are the amount of compensation deferred under the plan in accordance with IRC 457(b) and in compliance with the annual maximum deferral limitations under the plan, whether by elective deferral or nonelective employer contributions during the taxable year.

  5. Annual deferrals under an Eligible 457 Plan are reported on Form W-2, in the manner described in the instructions to that form.

  6. Deferrals in a single employer’s Eligible 457 Plan in excess of the IRC 457(b) contribution limits are not annual deferrals and thus are subject to the income tax withholding rules under IRC 3402(a).

  7. See Notice 2003-20, 2003-19 IRB 894 for additional guidance.

4.72.19.25.2  (06-11-2012)
Income Tax Withholding and Reporting on Eligible Tax Exempt 457 Plan Distributions

  1. Distributions from Eligible Tax Exempt 457 Plans are considered to be wages under IRC 3401(a) and are subject to income tax withholding rules under IRC 3402(a).

  2. Pension withholding rules of IRC 3405 do not apply.

  3. The tax exempt employer or other person having control of the payment under IRC 3401(d)(1) is responsible for income tax withholding on distributions.

  4. Distributions from an Eligible Tax Exempt 457 Plan are reported on Form W-2 in a manner described in the instructions to that form.

  5. Income tax withheld is required to be deposited in accordance with Treas. Reg. 31.6302 and reported on Form 941.

  6. Distributions to beneficiaries are reported on Form 1099-R, but no income tax withholding is required.

4.72.19.25.3  (06-11-2012)
Income Tax Withholding and Reporting on Eligible Governmental 457 Plan Distributions

  1. Distributions from Eligible Governmental 457 Plans are subject to income tax withholding rules under IRC 3405.

  2. Direct rollover and mandatory 20 percent withholding rules under IRC 3405(c) apply to distributions from Eligible Governmental 457 Plans that qualify as eligible rollover distributions under IRC 402(c)(4).

  3. For distributions that are not eligible rollover distributions under IRC 402(c)(4), the elective withholding rules under IRC 3405(a) and (b) apply.

  4. Plan administrators are generally liable for withholding on distributions under IRC 3405, but may delegate such liability to the payor under IRC 3405(d)(2)(A).

  5. Additional information regarding the withholding rules under IRC 3405 can be found in Treas. Reg. 31.3405(c)-1, Treas. Reg. 35.3405-1T, Treas. Reg. 1.401(a)(31)-1, Treas. Reg. 1.402(c)-2 and Treas. Reg. 1.402(f)-1.

  6. Distributions from an Eligible Governmental 457 Plan are reported on Form 1099-R in a manner described in the instructions to that form.

  7. The regulations require that tax withholding on deferred compensation under IRC 3405 be deposited and reported separately from payroll taxes.

    1. Taxes withheld under IRC 3405 are reported annually on Form 945, Annual Return of Withheld Federal Income Tax.

    2. Payroll taxes are reported on Form 941, Employer's Quarterly Federal Tax Return.

  8. Distributions to beneficiaries are reported on Forms 1099-R, but no income tax withholding is required.

4.72.19.26  (06-11-2012)
Income Tax Withholding and Reporting on Ineligible 457 Plan Distributions

  1. Generally deferrals under an Ineligible 457 Plan under IRC 457(f) are not taken into account as wages for income tax purposes until the later of:

    1. The date on which the employee performs the services that create the right to the deferral, or

    2. The date on which the amount deferred is no longer subject to a "substantial risk of forfeiture" . See IRC 457(f)(3)(B).

      Note:

      See Treas. Reg. 1.457-11 for additional guidance.

  2. These amounts are taxable and are reported on Form W-2 in the manner described in the instructions to that form.

4.72.19.27  (06-11-2012)
Eligible Governmental 457 Plan as Social Security Replacement

  1. Governmental employers can avoid mandatory social security coverage by providing membership in a public retirement system under IRC 3121(b)(7)(F) that meets the minimum benefit requirements under Treas. Reg. 31.3121(b)(7)-2(e) and Rev. Proc. 91-40, 1991-2 CB 694. Such plans are commonly referred to as Social Security Replacement Plans.

  2. An Eligible Governmental 457 Plan that provides an annual minimum allocation of at least 7.5 percent of compensation, including employer and employee contributions and satisfies the other requirements may be used as a Social Security Replacement Plan. See Treas. Reg. 31.3121(b)(7)-2.

  3. An Eligible Governmental 457 Plan intended as a Social Security Replacement Plan that fails to satisfy the minimum allocation should be referred to Federal, State, and Local Governments Division (FSLG) in accordance with IRM 4.71.6.1, Employee Plans Referral, Overview Employee Plans Referrals.

4.72.19.28  (06-11-2012)
FICA and FUTA Taxes and Reporting on Eligible 457 Plan Contributions

  1. Contributions to Eligible Governmental 457 Plans are subject to FICA tax if:

    1. Required by a Social Security Act Section 218 Agreement (IRC 3121(b)(7)(E)),

    2. An employee is not covered under a Social Security Replacement Plan (IRC 3121(b)(7)(F)), or

    3. The employee is subject to the Hospital Insurance tax portion of the FICA tax. See IRC 3121(u).

  2. IRC 3306(c)(7) exempts governmental employers from FUTA tax.

  3. An amount deferred under a non-qualified deferred compensation plan under IRC 457(f) is required to be taken into account as wages for FICA tax purposes under IRC 3121(v) as of the later of:

    1. The date on which the services creating the right to that amount are performed; or

    2. The date on which the right to that amount is no longer subject to a "substantial risk of forfeiture" under Treas. Reg. 31.3121(v)(2)-1(e)(1).

  4. If Eligible Tax Exempt 457 Plan contributions are subject to FICA or FUTA taxes:

    1. Vested annual deferrals, including employer contributions, are subject to FICA and FUTA taxes at the time of deferral.

    2. Unvested annual deferrals, including employer contributions, plus earnings, are taken into account for purposes of FICA or FUTA taxes, at the time of vesting.

  5. If annual deferrals under an Eligible 457 Plan are properly taken into account for FICA or FUTA taxes, subsequent amounts paid or made available to a participant or beneficiary attributable to those deferrals are not subject to additional FICA or FUTA taxes. See IRC 3121(v)(2)(B), IRC 3306(r)(2)(B), Treas. Reg. 31.3121(v)(2)-1(a)(2)(iii) and Treas. Reg. 31.3121(v)(2)-1(d)(1)(ii)(B).

  6. If an amount deferred for a period is not properly accounted for, distributions attributable to that amount, including income on the amount deferred may be wages for FICA tax purposes when paid or made available.

4.72.19.28.1  (06-11-2012)
Examination Steps

  1. Review payroll records & Forms W-2 to determine whether amounts deferred were excluded from gross income and were not subject to income tax withholding at the time of deferral.

  2. Review Forms W-2 to verify annual deferrals were properly reported.

  3. Review Forms 1099-R for distributions from Eligible Governmental 457 Plans. Ensure income taxes were properly withheld.

  4. Review Forms W-2 for distributions from Eligible Tax Exempt 457 Plans. Ensure income taxes were properly withheld.

  5. Review Forms 1099-R for distributions to beneficiaries.

    Note:

    Income tax withholding is not required.

  6. Determine whether governmental entities are subject to FICA taxes. Review Section 218 Agreements (under the Social Security Act).

  7. Review Social Security Replacement Plans of governmental employers to ensure they meet the minimum benefit requirements.

  8. Review payroll records and Forms W-2 to ensure FICA taxes were properly withheld, if applicable.

  9. Review IDRS to ensure Forms 941 and/or 945 were filed, if applicable.


More Internal Revenue Manual