457(b) Plan of Tax Exempt Entity - Tax Consequences of Noncompliance

 

IRC Section 457 provides rules for nonqualified deferred compensation plans established by eligible employers.  State and local governments and tax exempt organizations are eligible to maintain a 457 plan.  There are two types of 457 plans, eligible plans that satisfy IRC Section 457(b) requirements, and ineligible plans that are subject to IRC Section 457(f). 

An eligible 457(b) deferred compensation plan sponsored by a non-governmental tax-exempt entity (“457(b) tax exempt plan”) that fails one or more of the requirements of IRC Section 457(b) becomes an ineligible plan subject to IRC Section 457(f).  This Issue Snapshot explores the tax consequences to the participants and employer when a 457(b) tax exempt plan becomes an ineligible plan governed by IRC Section 457(f). 

IRC Sections and Treas. Regulations

Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)

Analysis

Background

Reg. Section 1.457-2(b)(1) defines the term “annual deferrals” as the amount of compensation deferred under an eligible plan, whether by salary reduction or by nonelective employer contributions, made during the taxable year.  In an eligible 457(b) plan, contributions are counted as “annual deferrals” in the taxable year of the deferral or, if later, the year in which the amount contributed is no longer subject to a substantial risk of forfeiture.

Reg.  Section 1.457-3 provides that an eligible plan is a written plan established and maintained by an eligible employer that is maintained, in both form and operation, in accordance with the requirements of Reg. Sections 1.457-4 through 1.457-10.

Reg.  Section 1.457-4(a) provides that, in the case of an eligible plan maintained by a tax exempt entity, annual deferrals that satisfy the requirements of paragraph (b) (relating to the deferral agreement) and paragraph (c) (relating to the maximum deferral limitations) are excluded from the gross income of a participant in the year deferred and are not includible in gross income until paid or made available to the participant.

Reg.  Section 1.457-9(b) provides that a plan of a tax exempt entity ceases to be an eligible plan on the first day that the plan fails to satisfy one or more of the requirements of Reg. Sections 1.457-3 through 1.457-8 and 1.457-10.  These requirements relate to form, annual deferral limitations, the timing and taxability of distributions, and funding.

IRC Section 457(f) and Reg. Section 1.457-11 provide the tax treatment of participants if the plan is not an eligible plan.  Specifically, IRC Section 457(f)(1) provides that:

In the case of a plan of an eligible employer providing for a deferral of compensation, if such a plan is not an eligible deferred compensation plan, then—

(A) the compensation shall be included in the gross income of the participant or beneficiary for the 1st taxable year in which there is no substantial risk of forfeiture of the rights to such compensation, and
(B) the tax treatment of any amount made available under the plan to a participant or beneficiary shall be determined under section 72 (relating to annuities, etc.).

Tax Consequences to the Employee

As indicated above, when an eligible 457(b) plan of a tax exempt organization fails to meet the requirements of IRC Section 457(b), amounts deferred under the plan become subject to IRC Section 457(f) and Reg. Section 1.457-11 beginning on the first day of the failure.  Such amounts are includible in the participant’s or beneficiary’s gross income in the first taxable year in which there is no substantial risk of forfeiture.  Earnings on the deferred amounts are includible in gross income in the first taxable year in which there is no substantial risk of forfeiture and determined as of that date.  See Reg. Section 1.457-11(a)(2).  All other amounts are includible in gross income when paid or made available to the participant under IRC Section 72 relating to annuities.  See Reg. Section 1.457-11(a)(3) and (a)(4). 

The following example illustrates the taxability of nonvested, nonelective contributions made to an ineligible plan under IRC Section 457(f).

Example (1):  A tax exempt organization maintains a 457(b) plan.  In 2014, the plan fails to comply with the requirements of IRC Section 457(b) and becomes a 457(f) plan.  In 2015, a $3,000 nonelective contribution is made on behalf of a participant.  The $3,000 contribution is not vested.  In 2018, the $3,000 and $200 in earnings thereon become vested.  The $3,000 contribution and $200 in earnings are taxable to the participant in 2018.  Subsequent earnings on these amounts are includible in gross income when paid or made available (provided that the participant’s or beneficiary’s interest in the assets is not senior to that of the employer’s general creditors).

Example (1) shows that amounts deferred are taxable under the tax exempt 457(f) plan when they become vested and include earnings calculated through to the date of vesting.  Subsequent earnings are taxable when paid or made available.  This means that the earnings may be taxable before they are actually distributed.   

If the plan in Example (1) had remained an eligible tax exempt 457 plan, the $3,200 would be considered an annual deferral in 2018 due to the vesting schedule.  The deferral and earnings would not be includible in gross income until paid or made available to the participant.

Annual deferrals made through salary reduction are vested when made; therefore, by definition there is no substantial risk of forfeiture at the time they are contributed.  Thus, if the deferrals in Example (1) were made by salary reduction to a plan that was determined to be a tax exempt 457(f) plan, these amounts would be taxable in the year deferred.  Subsequent earnings on the deferrals would be taxable when paid or made available if the participant’s interest is not senior to the interests of the employer’s general creditors.  Under IRC Section 72, the distributions from the 457(f) plan are treated as having “basis” only to the extent the deferred compensation has been included in gross income of the participant.  See Reg. Section 1.457-11(c).

When an agent discovers a failure causing an eligible tax exempt plan to become an ineligible tax exempt plan under IRC Section 457(f), the participants’ Form 1040 returns that are not closed by the statute of limitations should be adjusted.  The statute of limitations on assessments relating to a participant’s Form 1040 is generally three years from the later of the due date of the return (including extensions) or the date the return is filed.  Generally, the relevant year for determining the statute is the later of the date of the deferral or the date the amount is no longer subject to a substantial risk of forfeiture.  A participant’s Form 1040 for open years should be adjusted by all amounts deferred under the plan, plus any earnings through to the date the substantial risk of forfeiture lapses.  If the statute of limitations has expired, no tax adjustment can be made and no basis would be earned.  Any remaining amounts would be taxable when made available or distributed.  Distributions from ineligible plans (and eligible plans) maintained by a tax exempt entity cannot be rolled over.  See Reg. Sections 1.457-7(b) and 1.457-11.  Any attempted rollovers from such a plan to an eligible retirement plan are considered excess contributions and are subject to the excise tax under IRC Section 4973.

Tax Consequences to the Employer

Annual deferrals (elective and non-elective) made to a 457(b) tax exempt plan are taxed as of the later of when the services are performed or when there is no substantial risk of forfeiture of the rights to such amounts.  See IRC Section 3121(v)(2).  Salary deferrals that are immediately vested are subject to FICA when the services are performed.  Annual deferrals under a 457(b) plan are not subject to income tax withholding at the time of the deferral.  Rather, the employer is responsible for income tax withholding when amounts are paid or made available.

Similar to a tax exempt 457(b) plan, FICA taxes apply to deferrals made to a tax exempt 457(f) plan as of the later of when the services are performed or when the amount is no longer subject to a substantial risk of forfeiture.  See IRC Section 3121(v)(2).  Thus, if the deferrals became vested when the plan was eligible, they should already have been taxed under FICA.  If FICA was paid at the time of deferral, there are no tax consequences to the employer and the Form 941 need not be adjusted.  Deferrals under a 457(f) plan must be reported as income taxable wages in the first year in which there is no substantial risk of forfeiture.

Summary of Tax Consequences

Any vested deferrals made in years the plan is a 457(f) plan that have an open statute are taxable to the participant which may require a discrepancy adjustment to the Form 1040.  The individual will have a tax basis in the taxed amount.

If deferrals become vested in a year in which the plan is a 457(f) plan, earnings on the deferrals should be calculated through to the date of vesting to determine the amount includible in gross income for the year.

Other amounts, such as earnings subsequently earned, are includible in gross income when paid or made available.

Any attempted rollovers to an IRA of amounts distributed from a 457(f) plan (or a tax exempt 457(b) plan) are excess contributions that are subject to IRC Section 4973 excise taxes.

Under a 457(f) tax exempt plan, amounts are subject to federal income tax withholding when they are no longer subject to a substantial risk of forfeiture.

Issue Indicators or Audit Tips

  • Under the most recent Revenue Procedure 2019-19 update to the Employee Plans Compliance Resolution System ("EPCRS"), the Service generally will accept on a provisional basis - generally for plans that are sponsored by governmental entities described in IRC Section 457(e)(1)(A) - submissions relating to 457(b) plans outside of EPCRS but using standards that are similar to those that apply with respect to Voluntary Correction Program filings under sections 10 and 11 of the revenue procedure.  By contrast, 457(b) plans that are sponsored by a tax exempt entity described in IRC Section 457(e)(1)(B) and that provide an unfunded deferred compensation plan established for the benefit of top hat employees of the tax exempt entity generally are not subject to correction under EPCRS unless, for example, the plan was erroneously established to benefit the entity's nonhighly compensated employees and the plan has been operated in a manner that is similar to a qualified retirement plan.
  • The plan document may state when amounts deferred become vested.  Many 457(b) plans are silent on vesting because deferrals are fully vested when made.
  • A tax exempt employer that maintains a 457 plan files a W-2 rather than a Form 1099-R.