4.72.19  IRC 457 Examination Guidelines

Manual Transmittal

September 17, 2014

Purpose

(1) This transmits revised IRM 4.72.19, Employee Plans Technical Guidance - IRC 457 Examination Guidelines.

Background

Internal Revenue Code (IRC) 457, enacted in 1978 by the Revenue Act of 1978, Pub. L. 95-600, was designed to address the timing of inclusion in income of amounts deferred under governmental non-qualified deferred compensation plans. In 1986, the requirements under IRC 457 were extended to include non-qualified plans of most tax exempt employers.

This IRM covers audit techniques and guidelines that apply to the more common IRC 457(b) plans for state and local governments as well as for those of Exempt Organizations.

This IRM also covers IRC 457(f) plan audit techniques, but not in as much detail as IRC 457(b) plans. This IRM will be updated for additional IRC 457(f) plan audit guidelines after the proposed regulations are finalized.

Material Changes

(1) This IRM makes minor editorial changes to the June 11, 2012 published version of IRM 4.72.19.

(2) IRM 4.72.19.10.2 was revised to add the IRC 457(e)(15) limits for 2013 and 2014.

(3) IRM 4.72.19.10.4 was revised to add the IRC 414(v)(2) limits for 2013 and 2014.

(4) Links were added for internet sites in IRM 4.72.19.8.1(5).

Effect on Other Documents

This supersedes IRM 4.72.19 dated June 11, 2012.

Audience

TE/GE, Employee Plans

Effective Date

(09-17-2014)


Robert Choi
Director, Employee Plans
Tax Exempt and Government Entities Division

4.72.19.1  (09-17-2014)
General Overview of Responsibilities for EP Examiners

  1. The guidance contained in this IRM is designed primarily to assist Employee Plans examiners in identifying relevant issues relating to both Eligible and Ineligible plans under IRC 457 (referred herein as Eligible 457 Plans and Ineligible 457 Plans).

  2. This guidance reflects changes made to IRC 457 by the Tax Reform Act of 1986, Pub. L. 99-514 (TRA 86), the Small Business Job Protection Act of 1996, Pub. L.104-188 (SBJPA), the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. 107-16 (EGTRRA), the Job Creation and Worker Assistance Act of 2002, Pub. L. 107-147 (JCWAA), and Pension Protection Act of 2006, Pub. L. 109-280 (PPA).

  3. In examining Eligible Plans of state and local governments and tax exempt organizations, agents must ensure that the issues under consideration satisfy the applicable requirements of final Regulations under IRC 457 in both form and operation.

  4. In examining Ineligible Plans of state and local governments and tax exempt organizations, agents must ensure that benefits are subject to a substantial risk of forfeiture.

  5. Agents may need to consult the Internal Revenue Code and Treasury Regulations (Treas. Regs.) for further development of a particular issue. Accordingly, cites are provided where appropriate. Unless otherwise noted, all references are to final Regulations.

  6. All issues raised in this guideline may not be relevant for every examination.

  7. Examination Steps and techniques identified may be modified based on the actual examination issue encountered.

  8. Additional tools and resources supplementing these examination guidelines, including tax information, tax forms and publications are available at www.irs.gov/retirement.

  9. These guidelines cannot be, nor are they intended to be, a comprehensive statement of the legal position of the Internal Revenue Service (IRS).

  10. These guidelines are not to be relied on or cited as authority.

  11. These guidelines are subject to future change in accordance with developments in the law governing IRC 457.

4.72.19.1.1  (09-17-2014)
Technical Overview of IRC 457

  1. Final regulations under IRC 457 are applicable to taxable years beginning after December 31, 2001, subject to certain transitional rules.

  2. There is a transitional period for an Eligible 457 Plan to comply with EGTRRA. For taxable years beginning after December 31, 2001, and before January 1, 2004, a plan will not fail to be an Eligible 457 Plan if it is operated in accordance with a reasonable good faith interpretation of IRC 457(b).

  3. IRC 457 contains a special rule for options. Treas. Reg. 1.457-11(d) does not apply to an option without a readily ascertainable fair market value under IRC 83(e)(3) granted on or before May 8, 2002. See Treas. Reg. 1.457-12(d).

  4. IRC 457 contains a special rule for Qualified Domestic Relations Orders (QDRO). Treas. Reg. 1.457-10(c) provides that the special QDRO rule applies for distributions and payments made after December 31, 2001.

4.72.19.1.2  (09-17-2014)
Correction of Eligible 457 Plan Failures

  1. An Eligible 457 Plan administered in a manner inconsistent with the requirements of IRC 457(b) and Treas. Reg. 1.457-3 through 1.457-10 may become an Ineligible 457 Plan subject to the rules under IRC 457(f) and Treas. Reg. 1.457-11.

    1. Under IRC 457(b)(6), an Eligible Governmental Plan administered in a manner inconsistent with the requirements of IRC 457(b) and Treas. Regs. 1.457-3 through 1.457-10 will not be treated as an Ineligible 457 Plan until the beginning of the first plan year beginning more than 180 days after the date of notification by the Secretary of the inconsistency unless the employer corrects the inconsistency before the first day of such plan year.

    2. An Eligible 457 Plan of a tax exempt employer administered in a manner inconsistent with the requirements of IRC 457(b) and Treas. Regs. 1.457-3 through 1.457-10 ceases to be an Eligible 457 Plan on the first day that the plan fails to satisfy one or more of the requirements of the Internal Revenue Code (IRC) or the Regulations thereunder.

  2. Section 4.09 of Rev. Proc. 2008-50, 2008-35 IRB 464 provides that submissions relating to IRC 457(b) Eligible Governmental Plans will be accepted by the Service on a provisional basis outside of the Employee Plans Compliance Resolution System (EPCRS) through standards that are similar to EPCRS.

    Note:

    EPCRS is a comprehensive correction program, updated periodically, for sponsors of retirement plans intended to satisfy IRC requirements for tax favored treatment.

4.72.19.2  (09-17-2014)
General Characteristics of 457 Plans

  1. A plan under IRC 457 is either:

    1. An "Eligible 457 Plan" that satisfies the requirements under IRC 457(b) and Treas. Regs. 1.457-3 through 1.457-10, or

    2. An "Ineligible 457 Plan" which is subject to the rules under IRC 457(f) and Treas. Reg. 1.457-11.

  2. In general, an Eligible 457 Plan under IRC 457(b) is a written plan established by an Eligible Employer under IRC 457(e)(1) and Treas. Reg. 1.457-2(e) that covers employees and independent contractors performing service for the Eligible Employer.

  3. An Eligible 457 Plan must include, in writing, all the material terms and conditions for benefits under the plan.

  4. Annual Deferrals under an Eligible 457 Plan include both employee and employer contributions.

  5. An Eligible 457 Plan may also include certain optional features, such as:

    • The right to determine when payments will begin

    • Directed investments

    • Additional catch-up and age 50 contributions

    • Distributions for unforeseeable emergency

    • Loans (Governmental Plans)

    • Provisions for plan termination

    • Provisions for transfers to and from another Eligible 457 Plan

  6. Optional features must meet, in form and operation, the relevant provisions of Treas. Regs. 1.457-3 through 1.457-10.

  7. An Eligible 457 Plan maintained by state or local governments (Eligible Governmental 457 Plan) is a funded arrangement and generally covers a broad base of employees and independent contractors.

  8. Annual deferrals under an Eligible Governmental 457 Plan and income on those amounts are taxed when paid.

  9. An Eligible 457 Plan maintained by a tax exempt employer (Eligible Tax Exempt 457 Plan) is an unfunded arrangement that covers a select group of management or highly compensated employees (Top Hat Group).

  10. Annual deferrals under an Eligible Tax Exempt 457 Plan and income on those amounts are taxed when paid or made available.

  11. In general, an Ineligible 457 Plan is described in IRC 457(f).

    1. In essence, an Ineligible 457 Plan is any plan of deferred compensation maintained by an Eligible Employer that is not an Eligible 457 Plan under IRC 457(b) and Treas. Regs. 1.457-3 through 1.457-10.

    2. Annual deferrals and income on those amounts are taxed under an Ineligible 457 Plan when earned or, if later, when no longer subject to a substantial risk of forfeiture.

  12. The following plans are excluded from IRC 457:

    1. Qualified plans under IRC 401(a) or IRC 403(b).

    2. Bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, or death benefit plans under IRC 457(e)(11)(A)(i).

    3. Any plan paying length of service awards to bona fide volunteers (and their beneficiaries) under IRC 457(e)(11)(A)(ii).

    4. Any "nonelective" deferred compensation that is attributable to services performed as an independent contractor under IRC 457(e)(12).

      Note:

      Deferred compensation is treated as "nonelective" if all individuals (other than those who have not satisfied initial service requirements) with the same relationship to the Eligible Employer are covered under the same plan with no individual variations or options.

4.72.19.3  (09-17-2014)
Focused Examinations

  1. The focused examination methodology is the standard approach to conducting 457 examinations.

  2. Focused examinations require the examiner to review a variety of information to determine the scope of the examination and which specific issues will be examined.

  3. Under focused examinations for Eligible 457 Plans, three issues will be identified by EP Classification that the examiner must address in the examination. Based on the pre-audit review, the examiner will normally determine additional issues to be addressed. The examiner may address up to two additional issues without managerial approval. Managerial approval is required if the total number of issues exceeds five.

  4. Focused examinations for Ineligible 457 Plans are generally restricted to a determination that a substantial risk of forfeiture exists.

  5. See IRM 4.71.1.5, Overview of Form 5500 Examination Procedures, Scope of the Examination, for a more detailed description of the focused examination methodology.

4.72.19.4  (09-17-2014)
Pre-Audit Analysis

  1. A comprehensive pre-audit analysis is important to organize your examination and to identify potential issues prior to sending out your appointment letter. See IRM 4.71.1.6, Overview of Form 5500 Examination Procedures, Pre-Audit Analysis, for a discussion of pre-audit responsibilities.

  2. IRC 457 plans file no annual return; therefore, other sources should be reviewed in order to identify potentially significant issues. These sources may include, but are not limited to:

    • The Internet

    • Form 990, Return of Organization Exempt From Income Tax (if the sponsoring employer is tax exempt)

    • Top Hat Plan data

    • Form 5500, Annual Return/Report of Employee Benefit Plan, for related plans

  3. The pre-audit analysis could indicate the need for assistance from specialists such as Computer Audit Specialists (CAS), Exempt Organizations (EO), and Federal State and Local Governments (FSLG).

    Note:

    See IRM 4.71.6.11, Employee Plans Referrals, EP Group Procedures – Specialist Referral System (SRS), for a discussion of the procedures to request specialized assistance through the Specialist Referral System.

  4. Upon completion of the pre-audit analysis, prepare Letter 1346-C, IRC 457 Plan Field Examination Appointment (for Eligible 457 Plans) or Letter 1346-G, Non-Return Unit Examination Appointment Letter, for (Ineligible 457 Plans) and attach a request for the various types of records needed to conduct the examination.

  5. A copy of the written plan and trust (if applicable), should be requested prior to the initial appointment. The review of the plan and trust will provide valuable information on how plan terms should be operating.

4.72.19.5  (09-17-2014)
Package Audits

  1. Package audits include an assessment of the plan sponsor’s various filing requirements.

  2. Examples of the types of returns that fall within the package audit requirements include:

    • Related EP returns (Form 5500, and Form 5330, Return of Excise Taxes Related to Employee Benefit Plans)

    • Employment tax returns (Form 940,Employer’s Annual Federal Unemployment Tax Return, Form 941, Employer's Quarterly Federal Tax Return, and Form W-2, Wage and Tax Statement)

    • Plan sponsor's return (e.g., Form 990)

  3. IDRS research should be conducted to determine filing requirements and whether returns have been timely filed.

  4. See IRM 4.71.1.14, Overview of Form 5500 Examination Procedures, Package Audit Requirements, for a discussion of Package Audit requirements.

4.72.19.6  (09-17-2014)
Initial Interview

  1. The initial interview is an essential part of the examination process and provides a productive forum to gather information. It is important to hold the initial interview with persons who are familiar with the organization of the employer, the various deferred compensation plans maintained, and the day to day operation of the plan under examination.

  2. Detailed questions should be prepared in advance covering the structure of the employer and the types of deferred compensation plans maintained. In addition, detailed questions should be asked concerning the day to day operation of each aspect of the plan being examined. This is an important step in the preparation of a focused audit plan.

  3. Some important things to consider when preparing for an initial interview:

    1. Know what you want to accomplish.

    2. Develop a strategy.

    3. Utilize a questionnaire as an aid, but remain flexible.

    4. Conduct interviews with persons who can best answer your questions.

    5. Listen to answers.

    6. Follow up immediately if responses are ambiguous.

    7. Document responses.

  4. See IRM 4.71.1.11, Overview of Form 5500 Examination Procedures, Taxpayer Confidentiality Privilege, for a discussion of the importance of the initial interview.

4.72.19.7  (09-17-2014)
Evaluation of Internal Controls

  1. Internal controls for EP examination purposes is a series of procedures designed to promote and protect sound practices in plan administration.

  2. The evaluation of internal controls is a continuous process beginning with the pre-audit analysis.

  3. Most of the information regarding the plan’s internal controls will likely be obtained during the initial interview.

  4. Adequacy of internal controls will determine the sample size utilized and will set parameters for the depth of review required.

  5. For this reason, it is important to evaluate internal controls for each aspect of plan administration.

  6. A well designed questionnaire will assist in the evaluation of internal controls and provide an understanding of the administrative and accounting systems that pertains to retirement plans. The questionnaire should be directed to those employees who are directly responsible for the administration of the plan and may be combined with initial interview questionnaires for simplicity.

  7. Plan records and persons responsible for maintaining them are usually located at the employer’s place of business; therefore, the initial interview and the assessment of internal controls should be conducted at the employer’s place of business (see Treas. Reg. 301.7605-1(d)).

  8. For general information regarding the evaluation of internal controls see IRM 4.10.3.4, Examination Techniques, Evaluating the Taxpayer’s Internal Controls.

4.72.19.8  (09-17-2014)
Eligible Employer

  1. IRC 457 Plans are restricted to Eligible Employers under IRC 457(e)(1) and Treas. Reg. 1.457-2(e).

  2. In general an Eligible Employer is:

    1. A state and local government and the agencies and instrumentalities thereof, or

    2. A tax exempt entity other than a church, a church controlled organization and the Federal Government including the agencies and instrumentalities thereof.

      Note:

      See IRC 3121(w)(3)(a) and IRC 3121(w)(3)(b) and parallel section 3(32) of ERISA for the definition of church and church controlled organizations.

  3. Under Treas. Reg. 1.457-2(l) the term "state" includes the District of Columbia.

  4. There is an unresolved question regarding whether Federal Credit Unions are Eligible Employers for purposes of IRC 457.

    1. Notice 2005-58, 2005-33 IRB 295 provides transition relief allowing Federal Credit Unions to continue to maintain Eligible 457(b) Plans that were in effect on August 15, 2005.

    2. To qualify for this transition relief, the Federal Credit Union must demonstrate that it has consistently claimed the status of a non-governmental tax exempt organization for all employee benefit plan purposes, including IRC 414(d) and the parallel definition of a governmental plan in section 3(32) of ERISA.

  5. Under Treas. Reg. 1.457-10(a), an employer that ceases to be an Eligible Employer may no longer maintain an Eligible 457 Plan and must either terminate the plan or, in the case of a governmental entity, transfer assets to another Eligible Plan of the state.

4.72.19.8.1  (09-17-2014)
Examination Steps

  1. For an Eligible Governmental 457 Plan, determine whether the sponsoring organization is a state or local government, or an agency or instrumentality thereof. In most cases it will be obvious whether an organization is an Eligible Governmental Employer since they will be organized pursuant to a State constitution or State statute. Agencies and instrumentalities may require a more careful analysis.

  2. If the organization has received a private letter ruling that it is a governmental organization, no further inquiry is necessary.

  3. If it is not apparent that the sponsoring organization is an Eligible Governmental Employer, consider the factors for governmental status under Rev. Rul. 65-196, 1965-2 CB 388. Factors to consider include:

    1. Whether it is used for a governmental purpose and performs a governmental function.

    2. Whether performance of its functions is on behalf of one or more states or political subdivisions.

    3. Whether any private interests are involved, or whether the states or political subdivisions involved have the powers and interests of an owner.

    4. Whether control and supervision of the organization is vested in public authority or authorities

    5. Whether express or implied statutory or other authority is necessary or exists for the creation and use of the organization.

    6. The degree of financial autonomy and the source of its operating funds.

  4. If a determination cannot be made that the sponsoring organization is an Eligible Governmental Employer, consider referring the issue of Eligible Employer status to Federal State and Local Governments (FSLG) Division.

    Note:

    See IRM 4.71.6, Employee Plans Referrals, for a discussion of the referral process.

  5. Eligible Exempt Organizations require a letter from EO Rulings and Agreements as to their exempt status under IRC 501(a).

    1. Review the IDRS via command code BMFOL0 for information regarding the entity under audit.

    2. Review a copy of the organization’s ruling letter, if available.

    3. Review on-line Pub 78, Cumulative List of Organizations. Pub. 78 contains a list of organizations eligible to receive tax-deductible charitable contributions.

    4. Review the "Tax Stats" section of the IRS web site at http://www.irs.gov/uac/Tax-Stats-2 . "Tax Stats" contains statistical tables, articles, and other information on charities and other tax exempt organizations.

    5. The "GuideStar" site at http://www.guidestar.org/ provides a searchable database of IRC 501(c)(3) charitable organizations, including online copies of Forms 990, Forms 990-EZ or Forms 990-PF and other information.

4.72.19.8.2  (09-17-2014)
Issue Resolution and Correction

  1. Under Treas. Reg. 1.457-10, a governmental employer that ceases to be an Eligible Employer due to a change in status (no longer governmental) may either terminate the plan or transfer assets to another Eligible Governmental Plan within that same state.

  2. The tax consequences to participants of a previously Eligible Governmental 457 Plan that was not terminated nor transferred are determined under IRC 402(b), if the assets are held in a trust, or under IRC 403(c) if the assets are in annuity contracts, and the trust is no longer tax exempt under IRC 501(a).

  3. A Tax Exempt Employer that ceases to be an Eligible Employer due to a change in status (no longer tax exempt) may terminate the plan.

  4. The tax consequences to participants of a previously Eligible Tax Exempt 457 Plan that was not terminated are:

    1. Determined under IRC 451 if the employer becomes an entity other than a State

    2. Determined under Treas. Reg. 1.457-11 if the employer becomes a State.

4.72.19.9  (09-17-2014)
Employees Eligible to Participate

  1. Eligible 457 Plans may include any individual who performs services for an Eligible Employer as either a common law employee or an independent contractor.

4.72.19.9.1  (09-17-2014)
Participation in Eligible Tax Exempt 457 Plans

  1. Eligible Tax Exempt 457 Plans must restrict participation to a select group of management or highly compensated employees (Top Hat Group) defined under section 201(2) of ERISA.

  2. Failure to limit participation in an Eligible Tax Exempt 457 Plan subjects the plan to ERISA Title I funding requirements.

  3. Eligible Tax Exempt 457 Plans that must comply with ERISA funding requirements will fail to satisfy the requirement under IRC 457(b)(6), which provides that the plan must be unfunded or lose Eligible Plan status.

  4. Contributions to a funded Eligible Tax Exempt 457 Plan are immediately taxable.

4.72.19.9.2  (09-17-2014)
Participation in Eligible Governmental 457 Plans

  1. Eligible Governmental 457 Plans are not subject to ERISA Title I and have complete discretion about who may participate and may impose specific age and service requirements for participation. In general, however, participation in Eligible Governmental 457 Plans is broad based with little exclusion.

  2. Although exempt from ERISA Title I funding requirements, IRC 457(g) requires Eligible Governmental 457 Plans to hold assets in trust for the exclusive benefit of participants and beneficiaries. This requirement is effective August 20, 1996 for new plans and January 1, 1999, for existing plans. See also Notice 98-8, 1998-4 IRB 6.

  3. An Eligible Governmental employer can adopt a plan offered and administered by a union representing its collectively bargained employees under certain limited circumstances. See Rev. Rul. 2004-57, 2004-24 IRB 1048 and Announcement 2004-52, 2004-24 IRB 1071.

4.72.19.9.3  (09-17-2014)
Examination Steps

  1. For Eligible Tax Exempt 457 Plans, verify that the plan covers only a select group of management or highly compensated (Top Hat) employees.

  2. For Eligible Governmental 457 Plans, review plan participation requirements and confirm that each eligible employee is able to participate.

  3. In all cases verify that administration is consistent with the plan’s written terms and that the requirements Treas. Regs. 1.457-4 through 1.457-10 are satisfied.

4.72.19.9.4  (09-17-2014)
Issue Resolution and Correction

  1. Deferrals to an Eligible 457 Plan by an ineligible participant are taxable as wages under IRC 83 for the tax year in which the improper deferrals were made.

    1. Deferral amounts are subject to income tax withholding, social security taxes (if applicable), Medicare, and FUTA (except in the case of governmental and section 501(c)(3) employers).

    2. Discrepancy adjustments may be proposed or in the alternative, the employer would file corrected Form(s) W-2, and affected participants would be required to file amended Form(s) 1040 to include the deferral in income.

    3. In addition, the employer would be required to file applicable amended employment tax returns.

  2. Eligible Tax Exempt 457 Plans cease to be Eligible Tax Exempt 457 Plans on the first day that the plan fails to satisfy one or more of the requirements under Treas. Regs. 1.457-3 through 1.457-8 and 1.457-10.

  3. Under IRC 457(b), an Eligible Governmental 457 Plan ceases to be an Eligible Governmental 457 Plan on the first day of the first plan year beginning more that 180 days after the date the Commissioner notifies the plan in writing that the plan is being administered inconsistent with the requirements of Treas. Regs. 1.457-3 through 1.457-8, or 1.457-10.

    1. The Plan may correct the inconsistencies prior to the expiration of the 180 day period and retain Eligible status.

    2. If a plan ceases to be an Eligible Governmental Plan, amounts subsequently deferred by participants will be includible in income when deferred, or, if later, when the amounts deferred cease to be subject to a substantial risk of forfeiture, as provided at Treas. Reg. 1.457-11.

    3. Amounts deferred and related earning prior to the deadline set in the notice by the Commissioner are treated as if the plan continues to be an Eligible Governmental 457 Plan and will not be includible in taxable income until paid.

    4. Use Letter 1758-B, IRC 457 Notification of Potential Non-compliance Closing Letter, or Letter 1758-C, IRC 457 Notification of Potential Non-compliance Letter to notify the Eligible Governmental 457 Plan that correction is required.

4.72.19.10  (09-17-2014)
Deferral Agreements and Taxation of Annual Deferrals Under Eligible 457 Plans

  1. Deferral agreements for currently eligible employees must be entered into before the first day of the calendar month in which the deferred compensation would be paid or made available.

  2. Deferral agreements for new employees may be entered into during the month provided the agreement is entered into on or before the first day service is performed.

  3. Deferral agreements may remain in effect until the participant revokes or alters the terms of the agreement. A deferral agreement that carries over from year to year until revoked or altered is commonly referred to as an "Evergreen Election" .

  4. Nonelective employer contributions are treated as being made under an agreement entered into before the first day of the calendar month.

  5. Annual deferrals under IRC 457 that satisfy the deferral election timing requirements and the maximum deferral limits described below are excluded from income in the year deferred.

  6. Annual deferrals are not includible in income until paid (Governmental) or until paid or made available (Tax Exempt) to the participant. See Treas. Reg. 1.457-4(a).

4.72.19.10.1  (09-17-2014)
Maximum Deferral Limitations

  1. The annual deferral limit applies on both an individual and plan basis. See Treas. Regs. 1.457-4 and 1.457-5.

  2. Annual deferrals cannot exceed the sum of the Basic Annual Limit plus any applicable Special Catch-up or Age 50 Catch-Up contribution.

  3. All Eligible 457 Plans with a single employer in which an individual participates are treated as a single plan for purposes of the Maximum Deferral Limitation.

  4. Contributions within the Maximum Deferral Limitations are required in both form and operation.

  5. Combined Annual Deferrals that exceed the individual limits due to multiple plan participation are treated as excess deferrals. See Treas. Reg. 1.457-4(e).

  6. Employer nonelective contributions are not taken into account as Annual Deferrals until the year they become vested. Generally, Annual Deferrals do not include earnings; however Annual Deferrals subject to a vesting schedule are adjusted to include earnings on nonelective contributions in the year vested. See Treas. Reg. 1.457-2(b)(2).

  7. In certain rare circumstances an Eligible 457 Plan may be a defined benefit plan under IRC 414(j).

    1. Annual Deferrals under a defined benefit Plan are the present value of the increase in accrued benefits during the taxable year of the participant's accrued benefit that is not subject to a substantial risk of forfeiture (disregarding any such increase attributable to prior annual deferrals).

    2. For this purpose, present value must be determined using actuarial assumptions and methods that are reasonable (both individually and in the aggregate), as determined by the IRS. See Treas. Reg. 1.457-2(b)(3).

4.72.19.10.2  (09-17-2014)
Basic Annual Limitation (Plan Ceiling)

  1. Annual deferrals are limited to the lesser of the applicable dollar amount or 100% of participant’s taxable year Includible Compensation. See Treas. Reg. 1.457-4(c)(1).

  2. The applicable dollar amount under IRC 457(e)(15) is as follows:

    1. 2002: $11,000

    2. 2003: $12,000

    3. 2004: $13,000

    4. 2005: $14,000

    5. 2006: $15,000

    6. 2007: $15,500

    7. 2008: $15,500

    8. 2009: $16,500

    9. 2010: $16,500

    10. 2011: $16,500

    11. 2012: $17,000

    12. 2013: $17,500

    13. 2014: $17,500

      Note:

      The applicable dollar amount is adjusted for cost-of-living increases in increments of $500 at the same time and same manner as under IRC 415(d).

  3. Includible Compensation under IRC 457(e)(5) is defined as compensation under IRC 415(c)(3) for services performed for the Eligible Employer.

    1. Includible Compensation may include amounts includible in income under IRC 409A, IRC 457(f), or the constructive receipt doctrine if already scheduled for payment without regard to severance. See Treas. Reg. 1.415(c)-2(b) (7).

    2. Includible Compensation may include amounts that would have been compensation under IRC 415(c)(3) if paid prior to severance of employment if paid within 2 ½ months after the later of severance from employment or the end of the limitation year. See Treas. Regs. 1.415(c)(2) and 1.457-4(d).

    3. Includible Compensation may include payment for unused bona fide sick, vacation or other leave if the Plan specifically includes such amounts and the employee would have been able to use the leave if employment had continued. See Treas. Regs. 1.415(c)-2 and 1.457-4(d).

    4. Includible Compensation does not include severance pay or parachute payments under IRC 280G(b)(2).

4.72.19.10.3  (09-17-2014)
Special IRC 457 Catch-up Contributions

  1. An Eligible 457 Plan may provide for an increased deferral ceiling during one or more of the last three taxable years prior to normal retirement age. See Treas. Reg. 1.457-4(c)(3).

  2. Normal retirement age may be any age that is on or after the earlier of (i) age 65, or (ii) the age at which participants have a right to retire and receive, under the basic defined benefit pension plan of the governmental or tax exempt entity, a benefit without actuarial or similar reduction for early retirement.

    1. In no event may the normal retirement age be later than 70½.

    2. The plan must either designate a normal retirement age or permit the participant to designate a normal retirement age. See Treas. Reg. 1.457-4(c)(2)(v).

    3. Entities that sponsor multiple Eligible 457 Plans may not permit more than one normal retirement age under all the plans it sponsors.

    4. Qualified police and firefighters may use an earlier age but not earlier than age 40. See Treas. Reg. 1.457-4(c)(2)(v)(B).

  3. The increased deferral ceiling is the lesser of twice the annual dollar limit or the "Underutilized Limitation."

    1. The "Underutilized Limitation" is the sum of the applicable plan ceiling for each year of participation less the amount of deferrals made, disregarding any deferrals made under age 50 catch-up elections.

    2. For purposes of determining the "Underutilized Limitation" for years prior to 2002, Eligible 457 Plan deferrals must be coordinated with deferrals to other plans (e.g., 403(b), 401(k), SEP, SIMPLE, plans). See Treas. Reg. 1.457-(c) (3)(ii), (iii), & (iv).

  4. Under IRC 414(v)(6)(C) and IRC 457(e)(18) the age 50 catch-up does not apply in any year in which the Special IRC 457 catch-up is greater. Thus participants are not permitted simultaneous use of the Special IRC 457 and age 50 catch-up contribution.

4.72.19.10.4  (09-17-2014)
Age 50 Catch-up Contributions

  1. Under 1.457-4(c)(2)(ii), an Eligible Governmental 457 Plan may permit additional annual deferrals for participants who are age 50 by the end of the year. The maximum additional deferral under IRC 414(v)(2) is:

    1. $1,000 for 2002

    2. $2,000 for 2003

    3. $3,000 for 2004

    4. $4,000 for 2005

    5. $5,000 for 2006

    6. $5,000 for 2007

    7. $5,000 for 2008

    8. $5,500 for 2009

    9. $5,500 for 2010

    10. $5,500 for 2011

    11. $5,500 for 2012

    12. $5,500 for 2013

    13. $5,500 for 2014

  2. For additional guidance on the age 50 catch-up, see Regulations under IRC 414(v).

  3. Under Treas. Reg. 1.457-4(c)(ii), where an Eligible Governmental 457 Plan permits both the Special IRC 457 and the Age 50 catch-up contributions, participants’ eligible for both must use the option which yields the largest deferral.

4.72.19.10.5  (09-17-2014)
Examination Steps

  1. Sample and cross check amounts shown of Form W-2 with the plan allocation report. Verify that both elective and nonelective contributions are reflected on Form W-2. Discrepancies should be explained, and if significant, investigated further.

  2. Sample contributions allocated and compare with the amounts required by the terms of the plan and any salary reduction agreements in effect.

  3. Review deferral agreements to insure timeliness of execution and the type of compensation to be deferred.

    1. A separate agreement may be necessary for various forms of compensation, such as unused sick or vacation pay.

    2. Verify agreements to defer compensation were entered into in the month prior to the first day of the month in which compensation was deferred.

  4. Analyze participants with annual deferrals in excess of the basic limit to determine whether they are entitled to either special or age 50 catch-up contributions.

    1. Personnel records, prior year allocation reports, and related plan documents may be used to establish the facts necessary to determine entitlement for catch-up contributions and the proper amount.

    2. Review employer calculations and appropriate back up documentation to verify deferrals made prior to 2002 were properly included in the calculation of a participant’s "underutilized" amount.

  5. Determine whether excess deferrals were timely distributed.

    1. Excess Deferrals are includible in income for the year in which the excess occurred.

    2. Earnings should be reported in the year distributed.

    3. In the absence of timely corrective distributions, consider appropriate enforcement and corrective action.

4.72.19.10.6  (09-17-2014)
Issue Resolution and Correction

  1. If it is determined that annual deferrals exceeded the annual plan limitations set forth in Treas. Reg. 1.457-4(c), the plan is not an Eligible 457 Plan unless correction is permitted and is made in a timely manner.

  2. In the absence of correction, in the case of a tax exempt organization’s plan, annual deferrals are taxable to participants under IRC 457(f) for the year allocated.

  3. In the absence of correction, in the case of an Eligible Governmental 457 Plan, annual deferrals are taxable to participants under IRC 457(f) for years beginning on and after the deadline set in the Commissioner’s correction letter. In addition, the earnings would become taxable to the trust in the case of a governmental plan for years beginning on and after the deadline set in the Commissioner’s correction letter.

  4. Where the plan limitations have not been exceeded, but it is determined that participant deferrals exceeded the individual limitation due to participation in multiple unrelated Eligible 457 Plans, the plan will retain its eligible status but the excess contributions will be taxable to the participant in the year allocated. Earnings are taxed in the year in which they accrue.

4.72.19.11  (09-17-2014)
Deferrals of Sick, Vacation, and Back Pay

  1. Under revised Treas. Reg. 1.457-4(d) and Treas. Reg. 1.415(c)-2(e)(3), Eligible 457 Plan compensation may include accumulated sick, vacation and back pay paid after severance from employment. Accordingly, an Eligible 457 Plan may provide that a participant may elect to defer accumulated sick pay, vacation pay, or back pay if the requirements outlined below are satisfied:

    1. An Eligible 457 Plan may provide that a participant who has not had a severance may elect to defer accumulated sick, vacation, and back pay if the election to defer is entered into prior to the first day of the month in which the amount would otherwise be paid or made available and the participant is an employee on the date the amounts would otherwise be paid or made available.

    2. Former employees may elect to defer accumulated sick, vacation and back pay if payable by the later of 2 ½ months following severance from employment or the end of the limitation year that includes the severance (calendar year substitution permitted for governmental employers) and the election is made prior to the beginning of the month the amounts are paid or made available.

    3. The employee would have been able to use the leave if employment had continued.

    4. Severance pay or parachute payments under IRC 280G(b)(2) are not eligible for deferral.

    5. Post severance non-qualified deferred compensation is not eligible for deferral unless payment would have been made at that time without regard to severance.

  2. Deferrals may also be made for a participant who has had a severance from employment, after the date of the severance from employment, if the agreement providing for the deferral is entered into prior to the first day of the month in which the amount would otherwise be paid or made available (as defined in regulations under IRC 401(k), provided the compensation is paid by the later of 2 ½ months after severance from employment with the employer maintaining the plan or the end of the limitation year that includes the date of severance from employment with the employer maintaining the plan. In the case of an Eligible Governmental 457 Plan, the limitation year is the calendar year.

  3. Under revised Treas. Reg. 1.457-4(d) and final Treas. Reg. 1.415(c)-2(e)(3) issued on April 5, 2007, the amounts must have otherwise been payable if employment had not terminated. In the case of unused leave, the participant must have been eligible to use the leave if employment had not terminated. The regulations apply to taxable years beginning on or after December 31, 2001.

4.72.19.11.1  (09-17-2014)
Examination Steps

  1. Verify agreements were entered into in the month prior to the month compensation was paid or made available.

  2. Verify amounts were paid by the later of 2 ½ months after severance from employment or the end of the limitation year that includes the date of severance from employment.

  3. Verify the participant would have been entitled to the amount deferred had a severance from employment not occurred.

4.72.19.12  (09-17-2014)
Excess Deferrals- Individual and Plan Limits

  1. Deferrals in excess of the Maximum Deferral Limitation are subject to income tax and withholding.

    1. These excess amounts are includible in income in the taxable year deferred, or if later, in the year in which there is no substantial risk of forfeiture. See Treas. Reg. 1.457-4(e)(1).

    2. See Notice 2003-20, 2003-19 IRB 894 for specific rules and examples.

  2. Deferrals in excess of the Maximum Dollar Amount are Plan Limitation Excess Deferrals.

    1. These excess amounts are taxable to the participant in the year of deferral.

    2. Eligible Governmental 457 Plans must distribute Plan Limitation Excess Deferrals and accumulated earnings as soon as administratively feasible in order to retain eligible status. See Treas. Reg. 1.457-4(e)(2).

  3. Eligible Tax Exempt 457 Plans must distribute Plan Limitation Excess Deferrals and accumulated earnings on or before April 15th of the year following the year in which the excess occurred. Failure to make timely distributions will result in loss of eligible status. See Treas. Reg. 1.457-4(e)(3).

  4. Pursuant to Treas. Reg. 1.457-4(e)(4), both Eligible Tax Exempt 457 Plans and Eligible Governmental 457 Plans may provide that an excess deferral resulting solely from a failure to comply with the individual limitation for combined annual deferrals under multiple Eligible Plans (under Treas. Reg. 1.457-5) for a taxable year may be distributed to the participant, with allocable net income, as soon as administratively practicable after the plan determines that the amount is an excess deferral.

    Note:

    Although a plan will still maintain eligible status if excess deferrals are not distributed under this rule, a participant must include the excess amounts in income.

4.72.19.13  (09-17-2014)
Timing of Distributions

  1. IRC 457(d) provides that plan amounts will not be made available to participants or beneficiaries earlier than the calendar year in which:

    1. The participant attains age 70 ½,

    2. The participant has a severance from employment with the employer maintaining the plan, or

    3. The participant is faced with an unforeseeable emergency.

    Note:

    However, see IRM 4.72.6.3.4.4, Section 415(b), QDROs and IRC 415, regarding payments to an alternate payee under a Qualified Domestic Relations Order (QDRO).

  2. Rev. Rul. 2004-12, 2004-7 IRB 478 provides that amounts received by a plan that are attributable to rollover contributions are not subject to the above timing of distribution restrictions if the rollover contributions are separately accounted for.

    1. IRC 402(c)(1) prohibits an Eligible 457 Plan from accepting a rollover from a plan that is not an IRC 457 plan unless it separately accounts for the rollover contributions.

    2. As such, amounts rolled into an Eligible 457 Plan from a plan that is not an IRC 457 plan will not be subject to the distribution restrictions.

  3. IRC 414(w), as added by PPA 2006, provides that for plan years beginning in 2008 or later, an Eligible Governmental 457 Plan which includes an automatic enrollment feature may allow a permissible withdrawal by an "automatically enrolled" employee to cash out his or her elective deferrals made as a result of the automatic enrollment.

    1. The election by the participant to make a permissible withdrawal must be made no later than 90 days from the date on which the first elective contribution was made on behalf of such employee as a result of the automatic enrollment.

    2. Distributions made pursuant to this provision will not cause the plan to violate the distribution restrictions in (1) above.

4.72.19.13.1  (09-17-2014)
Severance from Employment

  1. Treas. Reg. 1.457-6(b)(1) provides an employee has a severance from employment with the Eligible Employer if the employee dies, retires, or otherwise has a severance from employment with the Eligible Employer.

    1. Treas. Reg. 1.401(k)-1(d)(2) provides that an employee has a severance from employment when the employee ceases to be an employee of the employer maintaining the plan.

    2. An employee does not have a severance from employment if, in connection with a change of employment, the employee's new employer maintains such plan with respect to the employee.

      Example:

      A new employer maintains a plan by continuing or assuming sponsorship of the plan or by accepting a transfer of plan assets and liabilities (within the meaning of IRC 414(l)) with respect to the employee.

  2. Treas. Reg. 1.457-6(b)(2)(i) provides that an independent contractor has a severance from service upon the expiration of all contracts requiring services to be performed for the Eligible Employer provided the expiration of the contract(s) constitutes a good faith and complete termination of the contractual relationship. For additional guidance relating to good faith expiration of the contractual relationship see Treas. Reg. 1.457-6(b)(2)(i).

    1. An Eligible 457 Plan will be considered to have satisfied the requirement for Independent Contractors if it provides that amounts deferred will not be paid or made available for at least 12 months following the expiration of all contracts with the employer; and

    2. No amount payable to the participant on that date will be paid to the participant if, after the expiration of the contract (or contracts) and before that date, the participant performs services for the Eligible Employer as an independent contractor or an employee.

4.72.19.13.2  (09-17-2014)
Unforeseeable Emergencies

  1. Treas. Reg. 1.457-6(c) provides an exception to the general rule barring distributions before the earlier of age 70 ½ or severance from employment where the participant or beneficiary is faced with an unforeseeable emergency resulting from an unanticipated event.

  2. An unforeseeable emergency must be defined in the plan as a severe financial hardship of the participant or beneficiary resulting from:

    1. An illness or accident of the participant or beneficiary, the participant's or beneficiary's spouse, or the participant's or beneficiary's dependent (as defined in IRC 152 and, for taxable years beginning on or after January 1, 2005, without regard to IRC 152(b)(1), IRC 152(b)(2), and IRC 152(d)(1)(B));

    2. Loss of the participant's or beneficiary's property due to casualty (including the need to rebuild a home following damage to a home not otherwise covered by homeowner's insurance as a result of a natural disaster); or

    3. Other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant or the beneficiary.

      Example:

      The imminent foreclosure of or eviction from a primary residence, the need to pay medical expenses, and funeral expenses of a spouse or dependent.

  3. The amount distributed to satisfy the emergency may be grossed up to include federal, state or local income taxes or penalties that can be reasonably anticipated to result from the distribution.

  4. The determination of whether a participant has an unforeseeable emergency is based on all of the relevant facts and circumstances.

  5. Distributions made on account of an unforeseeable emergency must be limited to the amount necessary to satisfy the emergency need and may not be made to the extent that the emergency is or may be relieved through:

    1. Reimbursement or compensation from insurance or otherwise,

    2. Liquidation of the participant's assets, to the extent the liquidation of such assets would not itself cause severe financial hardship, or

    3. The cessation of deferrals under the plan.

  6. Generally, the purchase of a home and the payment of college tuition do not qualify as an unforeseeable emergency.

4.72.19.13.3  (09-17-2014)
Required Distributions

  1. IRC 457(d)(2) provides that a plan must meet the minimum distribution requirements of IRC 401(a)(9).

  2. IRC 401(a)(9) requires that a plan begin lifetime distributions to a participant no later than April 1 of the calendar year following the later of the calendar year in which the participant attains age 70½ or the calendar year in which the participant retires. Refer to IRC 401(a)(9) and the regulations thereunder for additional guidance.

4.72.19.13.4  (09-17-2014)
Distributions of Smaller Accounts

  1. An Eligible 457 Plan may provide for a distribution of all or a portion of a participant's benefit if the following requirements are satisfied:

    1. The participant's total amount deferred (the participant's total account balance) which is not attributable to rollover contributions (as defined in IRC 411(a)(11)(D)) is not in excess of the dollar limit under IRC 411(a)(11)(A);

    2. No amount has been deferred under the plan by or for the participant during the two-year period ending on the date of the distribution; and

    3. There has been no prior distribution under the plan to the participant under this small account rule.

  2. An Eligible 457 Plan is not required to permit distributions of small accounts. If the plan so permits, and the above requirements are otherwise satisfied, small amounts may be limited to an amount less than the dollar limit under IRC 411(a)(11)(A).

  3. A Plan may provide that the distribution will be made automatically, at the election of the participant, or a combination thereof. See Treas. Reg. 1.457-6(e).

  4. In the event of a mandatory distribution greater than $1,000, if the participant does not elect to have such distribution paid directly to an eligible retirement plan specified by the participant in a direct rollover or to receive the distribution directly, then the plan administrator must pay the distribution in a direct rollover to an individual retirement plan designated by the plan administrator.

4.72.19.14  (09-17-2014)
Loans

  1. Treas. Reg. 1.457-6(f)(1) provides that an Eligible Tax Exempt 457 Plan may not allow for participant loans.

    1. If a participant or beneficiary receives (directly or indirectly) any amount deferred as a loan from an Eligible Tax Exempt 457 Plan, that amount will be treated as having been paid or made available to the individual as a distribution under the plan, in violation of the distribution requirements of IRC 457(d).

    2. A loan from an IRC 457(b) plan of a tax exempt entity would cause the plan to fail the requirements under IRC 457(b); thereby, causing it to become an Ineligible Plan subject to taxation under IRC 457(f) and Treas. Reg. 1.457-11.

  2. Treas. Reg. 1.457-6(f)(2) provides that Eligible 457 Plans of a governmental entity may provide for participant loans. A facts and circumstances test is used to determine whether the availability of loans, the making of a loan, or the failure to repay loans violate any requirement of IRC 457(b), or whether a violation of the plan distribution restrictions has occurred. Factors to consider include:

    1. The loan must bear a reasonable rate of interest in order to satisfy the exclusive benefit rule contained in IRC 457(g)(1) and Treas. Reg. 1.457-8(a)(1).

    2. There must be a fixed repayment schedule.

    3. Repayment safeguards must be in place to which a prudent lender would adhere.

    4. A loan from an Eligible Governmental 457 Plan which satisfies the requirements of Treas. Reg. 1.72(p)-1 Q&A 3 and deemed distributions as defined in Treas. Reg. 1.72(p)-1 Q&A 4, would not, in and of itself, violate IRC 457(d).

    5. Treas. Reg. 1.457-7(b)(3) provides that the amount of any loan from an Eligible Governmental 457 Plan to a participant or beneficiary that does not satisfy IRC 72(p)(2) is treated as having been received as a distribution from the plan under IRC 72(p) and is includible in the gross income of the participant or beneficiary for the taxable year in which the loan is made.


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