4.72.19 IRC 457 Examination Guidelines

Manual Transmittal

November 27, 2020

Purpose

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

Material Changes

(1) Expanded IRM 4.72.19.1.1, Background, to provided historical perspective on the development of the rules governing IRC 457 plans.

(2) Expanded IRM 4.72.19.2, General Overview of Responsibilities for EP Examiners, to list resources agents may use to fully develop a particular issue.

(3) Updated IRM 4.72.19.2.1(9) to state that this IRM is divided into two sections, one addressing an eligible 457(b) plan of a governmental entity and the other the eligible 457(b) plan of a tax-exempt entity.

(4) Replaced IRM 4.72.19.3, Special Rules for 457 plans, with IRM 4.72.19.3, Risk Assessment Examinations, to state that a 457(b) examination should be conducted using the risk assessment approach.

(5) Replaced IRM 4.72.19.4, Focused Examinations, with IRM 4.72.19.4, Initial Taxpayer Contact.

(6) Renumbered IRM 4.72.19.5, Pre-Contact Analysis as IRM 4.72.19.3.1.

(7) Renumbered IRM 4.72.19.6, Package Examinations, as IRM 4.72.19.3.2.

(8) Renumbered IRM 4.72.19.7, Initial Interview, as IRM 4.72.19.3.3.

(9) Renumbered IRM 4.72.19.8, Evaluation of Internal Controls, as IRM 4.72.19.3.4.

(10) Renumbered IRM 4.72.19.9, Eligible Employer, as IRM 4.72.19.5.

(11) Added IRM 4.72.19.5.1, Eligible Employer - Governmental Entity, to list factors to consider in determining whether an entity is a governmental entity.

(12) Added IRM 4.72.19.5.2, Eligible Employer - Tax-Exempt Entity, to state that eligible tax-exempt organizations require a letter from EO Rulings and Agreements as to their exempt status under IRC 501(a).

(13) Renumbered and renamed IRM 4.72.19.9.2, Issue Resolution and Correction, as IRM 4.72.19.5.3, Correction - Ineligible Employer.

(14) Added IRM 4.72.19.6.1, Plan Document Compliance for Governmental Entities and IRM 4.72.19.7.2, Plan Document Compliance for Tax-Exempt Entities, to state that written plan requirements were part of the final IRC 457(b) regulations issued July 11, 2003, and to state other regulatory and statutory requirements applicable to 457 plans.

(15) Added IRM 4.72.19.6.1.1, Examination Steps - Plan Document Compliance - Governmental Entities, and IRM 4.72.19.7.2.1, Examination Steps - Plan Document Compliance - Tax-Exempt Entities.

(16) Added IRM 4.72.19.8.8.1, DO 8-3 Correction, to state that in the event of a top-hat plan failure, as an alternative to treating an eligible 457(b) plan as an ineligible 457(f) plan a closing agreement under Delegation Order 8-3 can be considered.

(17) With the updating of this IRM, sections 4.72.19.10 through IRM 4.72.19.29 have been deleted and the material incorporated into IRM sections 4.72.19.5 through IRM 4.72.19.9.

(18) Updated throughout to substitute the word, “examination” for the word “audit” and for plain language and current revenue rulings.

Effect on Other Documents

This supersedes IRM 4.72.19 dated September 30, 2019.

Audience

Tax Exempt and Government Entities.
Employee Plans

Effective Date

(11-27-2020)


Eric D. Slack
Director, Employee Plans
Tax Exempt and Government Entities

Program Scope and Objectives

  1. Purpose: IRM 4.72.19, Employee Plans Technical Guidelines - IRC 457 Plans, is designed to help Employee Plans (EP) agents conduct quality examinations of eligible and ineligible non-qualified deferred compensation plans under IRC 457 (referred to in this IRM as "eligible 457" plans and "ineligible 457 plans" ).

  2. Audience: This IRM lists procedures for agents, their group managers and support staff in EP Examinations.

  3. Policy Owner: Director, EP Examinations.

  4. Program Owner: EP Examinations.

  5. Program Authority: EP Examinations’ authority to resolve issues is derived from its authority to make determinations of tax liability under IRC 6201.

  6. Program Goals: The information in this IRM is:

    1. designed to promote quality examinations of eligible and ineligible 457 plans.

    2. to discuss the technical aspects of IRC 457 and the underlying final Treasury Regulations.

    3. to give examination steps for the agent to determine whether a plan complies with the provisions of the law.

    4. to explain procedures for initiating, working, and closing the examination case file.

Background

  1. EP Examinations determines whether eligible 457 plans and ineligible 457 plans comply with the requirements of IRC 457.

  2. The rules governing 457 plans were developed based on nonqualified deferred compensation plan concepts.

  3. IRC 457 was created by the Revenue Act of 1978 and originally applied only to state and local government. The Tax Reform Act of 1986 extended IRC 457 to apply to tax-exempt entities under Subtitle A of the Code.

  4. The final regulations for 457(b) were issued July 11, 2003 and apply to taxable years beginning after December 31, 2001. These regulations include the Tax Reform Act of 1986 (TRA ’86), the Small Business Job Protection Act of 1996, the Tax Reform Act of 1997, and the Economic Growth and Tax Reconciliation Relief Act of 2001 (EGTRRA) changes.

  5. Subsequent legislation that affects Section 457 include:

    • Job Creation and Worker’s Assistance Act of 2002

    • The Pension Protection Act of 2006 (PPA ‘06)

    • The Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART Act)

    • The Worker, Retiree & Employer Recovery Act of 2008 (WRERA)

    • The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act)

    • The Bipartisan American Miners Act of 2019 (Miners Act)

  6. Eligible 457(b) plans that become ineligible are subject to IRC 457(f). On June 22, 2016, the Department of the Treasury issued proposed IRC 457(f) regulations which haven’t yet been finalized.

Authority

  1. The authority for conducting an examination of eligible and ineligible 457 plans is primarily provided by IRC 457 and the underlying regulations.

Program Controls

  1. Tax Exempt Quality Measurement System (TEQMS) is the quality control system TE/GE uses to oversee the entire examination program. For more information on TEQMS, IRM 4.70.7, TE/GE Examinations, Special Review (SR) and Tax Exempt Quality Measurement System (TEQMS) Procedures.

  2. All examinations are done according to the Taxpayer Bill of Rights as listed in IRC 7803(a)(3). You can find more information on IRS.gov at: www.irs.gov/taxpayer-bill-of-rights.

Acronyms, Abbreviations and Forms

  1. This IRM uses the following acronyms and refers to the following forms.

    Acronyms and Abbreviations

    Acronym/Abbreviation Definition
    CAS Computer Examination Specialists
    CFR Code of Federal Regulations
    DOL Department of Labor
    EO Exempt Organizations
    EP Employee Plans
    EPCRS Employee Plans Compliance Resolution System
    ERISA Employee Retirement Income Security Act of 1974
    FICA Federal Insurance Contributions Act
    FSL/ET Federal State and Local Governments/ Employment Tax
    FUTA Federal Unemployment Tax Act
    IDRs Information Document Requests
    IDRS Integrated Data Retrieval System
    IRC Internal Revenue Code
    IRS Internal Revenue Service
    PPA ‘06 Pension Protection Act Of 2006
    RAR Revenue Agent Report
    RGS Report Generation Software
    SRS Specialist Referral System
    TE/GE Tax Exempt and Government Entities
    TEQMS Tax Exempt Quality Measurement System
    QDRO Qualified Domestic Relations Orders
    CP&C Classification, Planning and Compliance
     

    Forms and Schedules

    Form Name
    Form W-2 Wage and Tax Statement
    Form SS-10 Consent to Extend the Time to Assess Employment Taxes
    Form 940 Employer’s Annual Federal Unemployment Tax Return
    Form 941 Employer's Quarterly Federal Tax Return
    Form 945 Annual Return of Withheld Federal Income Tax
    Form 990 Return of Organization Exempt From Income Tax
    Form 1099-R Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
    Form 1040 U.S. Individual Income Tax Return
    Form 4564 Information Document Request
    Form 5329 Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts
    Form 5330 Return of Excise Taxes Related to Employee Benefit Plans
    Form 5500 Annual Return/Report of Employee Benefit Plan
     

General Overview of Responsibilities for EP Examiners

  1. EP examiners:

    1. identify issues for eligible and ineligible 457 plans and verify these plans satisfy the applicable requirements of IRC 457 and the regulations under IRC 457 in both form and operation.

    2. determine when compensation deferred under IRC 457 becomes taxable and verify that taxes were paid or ensure the collection of taxes owed.

    3. may need to use the IRC and regulations along with Revenue Procedures, Revenue Rulings, Notices, Private Letter Rulings, internal memos, and other sources to fully develop a particular issue. We provide cites where appropriate and available. Unless otherwise noted, all references are to the final regulations.

  2. All issues raised in these guidelines may not be relevant for every examination.

  3. Examination steps and techniques identified may be modified based on the actual examination issue encountered.

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

  5. These guidelines:

    1. Can’t be, nor are they intended to be, a comprehensive statement of the legal position of the IRS.

    2. Shouldn’t be relied on or cited as authority.

    3. Are subject to change according to developments in IRC 457 law.

Technical Overview of IRC 457

  1. A plan under IRC 457 is either:

    1. An eligible 457 plan that satisfies the requirements under IRC 457(b) and 26 CFR 1.457-3 through 26 CFR 1.457-10.

    2. An ineligible 457 plan that is subject to the rules under IRC 457(f) and 26 CFR 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 26 CFR 1.457-2(e) that covers employees and independent contractors performing service for the eligible employer.

  3. An eligible employer is either:

    1. A governmental entity including a State, political subdivision of a State and any agency or instrumentality of a state or political subdivision of a State, IRC 457(e)(1)(A).

    2. Any other organization (that is not a governmental unit) that is exempt from tax (tax-exempt organizations), IRC 457(e)(1)(B).

  4. An eligible 457 plan must:

    1. Include, in writing, all the material terms and conditions for benefits under the plan.

    2. Satisfy the requirements of 26 CFR 1.457-4 through 26 CFR 1.457-10 in form and operation along with applicable law changes enacted after the final regulations.

  5. An eligible 457 plan may also include certain optional features of which the type and availability depends on the type of eligible entity sponsoring the plan.

    Note:

    Optional features must meet, in form and operation, the relevant provisions of 26 CFR 1.457-3 through 26 CFR 1.457-10 along with applicable law changes enacted after the final regulations.

  6. Annual deferrals under an eligible 457 plan include both employee and employer contributions.

  7. In general, an ineligible 457 plan is described in IRC 457(f).

    1. 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 26 CFR 1.457-3 through 26 CFR 1.457-10.

    2. Under an ineligible 457, plan contributions, and the income earned on these amounts, are taxed when earned or when there is no longer a substantial risk of forfeiture.

  8. 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 (certain voluntary early retirement incentive plans are treated as bona fide severance pay plans), disability pay, or death benefit plans under IRC 457(e)(11)(A)(i).

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

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

  9. While some IRC 457(b) rules apply to the plans of both a governmental entity and a tax-exempt entity (such as those listed above), many rules are specific to only one type of entity. Therefore, this IRM is divided into two sections:

    1. IRM 4.74.19.6 addresses an eligible 457(b) plan of a governmental entity.

    2. IRM 4.74.19.7 addresses an eligible 457(b) plan of a tax-exempt entity.

Risk Assessment Examinations

  1. IRC 457(b) examinations should be conducted using the Risk Assessment approach.

  2. Risk Assessment examinations require you, as the examiner, to scan all key compliance areas of an IRC 457(b) examination, that apply to the eligible entity sponsoring the plan, to determine the highest areas of risk which in turn, determines the exam scope and focus.

  3. In an IRC 457(b) exam, use the individual Information Document Request (IDR) model which includes a set of IDRs issued with the opening letter. The IDRs allow you to:

    • Quickly identify the areas that have the highest potential for failure.

    • Set the scope and focus of the examination.

  4. The Risk Assessment process includes:

    • pre-contact analysis per IRM 4.72.19.3.1

    • package examination analysis per IRM 4.72.19.3.2

    • response to the initial IDRs issued

    • initial interview per IRM 4.27.19.3.3

    • evaluation of internal controls per IRM 4.72.19.3.4

Pre-Contact Analysis

  1. Doing a comprehensive pre-contact analysis is important to organize your examination and identify potential issues before you send your appointment letter, IRM 4.71.1.6, Employee Plans Examination of Returns, Overview of Form 5500 Examination Procedures, for a discussion of pre-contact responsibilities.

  2. IRC 457 plans do not file an annual return; therefore, you have to review other sources to identify potentially significant issues, such as:

    1. The Internet

    2. Form 990 (if the sponsoring employer is tax-exempt)

    3. Comprehensive Annual Financial Report - CAFR (if the sponsoring employer is a government)

    4. Department of Labor (DOL) top-hat plan registration list

    5. Form 5500 (for other plans the employer has)

  3. You might realize during the pre-contact analysis that you need help from specialists such as CAS, EO, and FSL/ET, IRM 4.71.6.10, Employee Plans Examination of Returns, Employee Plans Referrals, for how to request specialized assistance through the SRS.

Package Examinations

  1. Package audits include assessing the plan sponsor’s various filing requirements.

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

    1. Related EP returns (Form 5500 and Form 5330)

    2. Employment tax returns (Form 940, Form 941, and Form W-2)

    3. Plan sponsor's return (such as Form 990)

  3. Research IDRS to determine filing requirements and whether the plan sponsor has filed the returns by their due dates.

  4. See IRM 4.71.1.14, Employee Plans Examination of Returns, Overview of Form 5500 Examination Procedures.

Initial Interview

  1. The initial interview is an essential part of the examination process and is a productive way to gather information. Hold the initial interview with people familiar with the employer’s organization, the various deferred compensation plans the company has, and the day-to-day operation of the plan under examination.

  2. Prepare detailed questions ahead of time; cover the employer’s structure and the types of deferred compensation plans they sponsor. Ask detailed questions about the day-to-day operation of each part of the plan. Preparing your interview questions is an important step to prepare a focused examination plan.

  3. Consider these important actions when you prepare for the initial interview:

    1. Know what you want to accomplish.

    2. Develop a strategy.

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

    4. Interview people who can best answer your questions.

    5. Listen to answers.

    6. Follow up immediately if responses are ambiguous.

    7. Document responses.

  4. See IRM 4.71.1.12, Employee Plans Examination of Returns, Overview of Form 5500 Examination Procedures. Also, see IRM 4.10.3.3, Examination of Returns - Examination Techniques.

  5. Use an internal control questionnaire to gain a perspective about the company and plan’s internal controls, but don’t use it in place of the interview.

Evaluation of Internal Controls

  1. Internal controls for EP examination purposes are a series of procedures the taxpayer uses to promote and protect sound practices in plan administration.

  2. Evaluating internal controls is part of the risk assessment process and continues throughout the examination beginning with the pre-contact analysis.

  3. Adequacy of internal controls determines the level of risk for the plan’s compliance with different requirements, the sample size you will use, and the depth of review required.

  4. For this reason, it’s important to evaluate internal controls for each aspect of plan administration.

  5. A well-designed questionnaire will help you evaluate internal controls and understand the administrative and accounting systems for the retirement plan. Direct the questionnaire to those employees who are directly responsible for administering of the plan. You may combine internal control questions with your initial interview questionnaires for simplicity.

  6. For general information on evaluating internal controls, see IRM 4.10.3.5, Examination of Returns - Examination Techniques.

Initial Taxpayer Contact

  1. Your initial contact with the taxpayer must be in writing using a 1346 series letter.

    1. Prepare Letter 1346-C, IRC 457 Plan Field Examination Appointment.

    2. Attach the appropriate Forms 4564 (IDRs) request for the records you need to do a risk assessment and standard examination procedures.

    • Your IDR "respond by" date should give 14-days to initially respond and an additional 15 to 30 days for the taxpayer to fully respond to the IDRs.

    • Per IRC 7521, if a taxpayer asks for time to get someone to represent them, factor that into the IDR response date.

  2. After you send the letter and IDR(s), call the taxpayer by the time below to review the IDR(s), address their questions, verify the availability of books and records and verify a date for the initial appointment, IRM 4.71.1.7(8):

    1. No earlier than fourteen calendar days or ten business days (whichever is longer) after the Letter 1346 series letter is mailed, and

    2. No later than the 15th business day.

  3. The appointment date should allow you enough time to review the responses to the IDRs, set the initial examination focus, and prepare follow-up IDRs to give during your examination meeting.

  4. Refer to IRM 4.71.1.7, Employee Plans Examination of Returns, Overview of Form 5500 Examination Procedures.

Eligible Employer

  1. Only eligible employers under IRC 457(e)(1) and 26 CFR 1.457-2(e) can adopt IRC 457 plans.

  2. Generally, an eligible employer is:

    1. A state and local government, and the agencies and instrumentalities thereof and under 26 CFR 1.457-2(l) the term "state" includes the District of Columbia, or

    2. A tax-exempt entity other than a church, a church-controlled organization; however, a non-qualified church-controlled organization is an eligible employer.

      Note:

      See IRC 3121(w)(3)(A) and IRC 3121(w)(3)(B) for the definition of church and church-controlled organizations.

  3. The federal government or any agency of the federal government is not eligible to sponsor a 457(b) plan.

  4. Federal credit unions are a special category of tax-exempt employers deemed eligible to sponsor an eligible 457 plan. See Notice 2005-58, Announcement 2011-78, 2011-2 CB 874, and Announcement 2011-2.

  5. Notice 2005-58 provides transition relief allowing federal credit unions to continue to maintain eligible 457(b) plans in effect on August 15, 2005. Notice 2005-58.

    1. 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 ERISA Section 3(32).

    2. The rule in Notice 2005-58 only applies pending the issuance of regulations under IRC 414(d). Announcement 2011-78, 2011-2 C.B 874, anticipates that a federal credit union will be an eligible employer per IRC Section 457(e)(1)(B) based on the fact that federal credit unions are non-governmental tax-exempt organizations.

  6. An employer that ceases to be an eligible employer may no longer maintain an eligible 457 plan and must either terminate the plan, or, if a governmental entity, transfer assets to another eligible plan of the state, 26 CFR 1.457-10(a).

  7. For all 457(b) plans, first verify the type of entity sponsoring the plan. Determine if the entity is a state or local government, or an agency or instrumentality thereof, or if the entity is a tax-exempt entity under IRC 501. Clearly state how you determined the employer is an eligible employer (and the evidence you used to determine that) in your workpapers.

Eligible Employer – Governmental Entities

  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’s obvious whether an organization is an eligible governmental employer because it is organized under a state constitution or state statute. Agencies and instrumentalities’s eligibility may require a more careful analysis. If the organization has received a private letter ruling that it is a governmental organization, that is sufficient evidence.

  2. If it’s not apparent that the sponsoring organization is an eligible governmental employer, consider the following resources: Announcement 2011-78, 2011-2 C.B. 874; Rev. Rul. 89-49, 1989-1 C.B. 117; Rev. Rul. 65-196, 1965-2 C.B. 388; and Rev. Rul. 57-128, 1957-1 C.B. 311. Consider factors, such as:

    1. If its purpose is governmental and is performing a governmental function.

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

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

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

    5. If 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.

    7. The source of its operating funds.

  3. It’s common for a governmental entity to also have acquired a tax-exempt determination letter (a dual-status entity). For purposes of being an eligible 457 plan, the entity’s governmental status will always take precedence over the tax-exempt status. So, a governmental entity that also has tax-exempt status is treated as a governmental entity for IRC 457.

  4. If you can’t determine that the sponsoring organization is an eligible governmental employer, consider referring the issue of eligible employer status to FSL/ET.

    Note:

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

Eligible Employer – Tax-Exempt Entities

  1. Eligible tax-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 BMFOLO for information about the entity under examination.

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

    3. Review a list of organizations eligible to receive tax-deductible charitable contributions at Exempt Organizations Business Master File Extract (EO BMF).

    4. Review the Tax Statistics section of the IRS website. Tax Statistics has statistical tables, articles, and other information on charities and other tax-exempt organizations.

    5. Use the Guidestar website’s searchable database of IRC 501(c)(3) charitable organizations and online copies of Forms 990, Forms 990-EZ or Forms 990-PF and other information.

Correction – Ineligible Employer

  1. 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, 26 CFR 1.457-10.

  2. If the employer doesn’t terminate or transfer the plan assets, determine the tax consequences to participants under either IRC 402(b) (or under IRC 403(c) for annuity contracts). Also, 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 determined under:

    1. IRC 451, if the employer becomes an entity other than a state.

    2. 26 CFR 1.457-11, if the employer becomes a state.

Examination Fundamentals - Governmental Entities

  1. The IRC 457(b) rules differ significantly for an eligible 457 plan maintained by a governmental entity versus that of a tax-exempt entity. Therefore, this IRM separates the examination issues, steps, and correction according to the type of entity:

    1. IRM 4.72.19.6 addresses eligible governmental 457(b) plans.

    2. IRM 4.72.19.7 addresses eligible tax-exempt 457(b) plans.

  2. Governmental plans don’t have to comply with vesting rules, participation and nondiscrimination rules, reporting and disclosure requirements, funding requirements or fiduciary rules. However, they must:

    1. Hold assets in trust for the exclusive benefit of participants and beneficiaries.

    2. Provide definitely determinable benefits.

    3. Operate according to plan terms.

    4. Meet IRC 401(a)(17) compensation limits for contributions.

    5. Comply with the required minimum distribution rules.

    6. Follow the rules for contribution limits in most circumstances.

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

  4. A county, municipality or other type of governmental entity may either:

    1. Adopt an individual plan where they sponsor the plan.

    2. Become an adopting employer of a plan of the State.

      Note:

      There’s no way for you or CP&C to know this before assigning the case. You must therefore, determine whether the 457(b) plan is sponsored directly by the employer under examination or if the entity under examination is an adopting employer of a plan of the State.

  5. If the entity is the plan sponsor, all of the examination components that follow apply.

  6. If the entity is an adopting employer of a State sponsored plan, you may only examine those plan features under the adopting employer’s control, including:

    1. A properly executed adoption agreement to verify what optional provisions of the State plan this employer has adopted.

    2. Deferral limitations and proper taxation (and correction of failures).

    3. Proper reporting to the State for eligibility for a distributable event.

    4. Operational compliance with the State plan and adoption agreement terms over which the employer has control.

  7. Be careful when issuing any closing letter or 180-day notice to be clear that any findings are specific to the adopting employer and not to the entire State. Per IRS Counsel, include the following on the closing letter to avoid misrepresenting the scope of the examination:

    1. List the EIN of the entity under examination - Do not list State EIN on the closing letter.

    2. List the name of the plan as the State Plan followed by “as adopted by” and the name of the adopting employer.

      Example:

      "State of XXXX 457(b) Plan as adopted by the City of XXXX"

Plan Document Compliance for Governmental Entities

  1. A written plan requirement was part of the final 457(b) regulations issued July 11, 2003, and applies to taxable years beginning after December 31, 2001. The document must be maintained, in form and operation, according to the requirements of IRC 457(b) and 26 CFR 1.457-4 through 1.457-10 and contain all the material terms and conditions for benefits, 26 CFR 1.457-3(a).

    1. The plan must be adopted and exist before the first day of the month in which compensation is paid and a deferral can occur.

  2. IRS doesn’t have an IRC 457(b) opinion letter program in which the IRS confirms that the plan’s language meets the requirements of the IRC and regulations. However, the IRS issued Rev. Proc. 2004-56 to provide model language incorporating law requirements through EGTRRA that the governmental 457(b) plan sponsor may use.

    1. If an employer chose to adopt the model language of Rev. Proc 2004-56, the plan document had to be adopted no later than December 31, 2005, for the regulations effective December 31, 2001. Plan sponsor weren’t required to use the model language and were free to modify the language.

  3. Governmental 457(b) plans do not have a remedial amendment period for plan amendments. New laws may include a date by which amendments must be adopted which generally is the earlier of: i) a stated effective date or ii) within a certain time period tied to the entity’s time period for taking legislative action.

  4. In addition to the language requirements of 26 CFR 1.457-4 through 1.457-10, the following legislation affects 457(b) governmental plans and require plan language:

    Law Provision
    Uniform Services Employment and Re-employment Rights Act of 1994 (USERRA) - IRC 414(u) Treatment of contributions made on behalf of re-employed veterans. The plan may incorporate this language by reference.
    HEART Act Certain death benefits to beneficiaries if a participant dies while performing qualified military service applying to years beginning after December 31, 2008. See Notice 2010-15 for required adoption dates.
    The Small Business Jobs Act of 2010 Permitted Roth deferrals in a 457(b) governmental plan, if elected (optional provision). A plan sponsor could adopt an amendment to permit Roth deferrals at any time the plan wishes to permit Roth deferrals effective 2011 or later.
    Under Section 104, Division M of the Further Consolidated Appropriations Act, 2020, Governmental 457(b) plans may allow in-service distributions as early as age 59 ½ including rollovers to another plan, effective for plan years beginning on or after January 1, 2020. If permitted, the plan sponsor must adopt the amendment no later than the last day of the plan year beginning on or after January 1, 2024 (unless such distributions are not permitted until after that date).
    Notice 2014-19. Governmental 457(b) plans were required to remove any “husband/wife” language generally after the close of the first regular legislative session of the body with the authority to amend the plan that ends after December 31, 2014.
    The Tax Cuts and Jobs Act of 2017 If the plan permits loans, requires that governmental plans allow for an extended rollover period for loan offset amounts, effective January 1, 2018.

  5. The plan document must also contain language for any optional provisions the plan allows.

  6. The cumulative list doesn’t include law changes to 457(b) plans, so you must know current law changes and plan document requirements as they apply to 457(b) governmental plans.

Examination Steps - Plan Document Compliance – Governmental Entities
  1. Read and be familiar with Revenue Procedure 2004-56 model language, and the IRC and regulations language along with subsequent law changes to verify the plan document contains the proper language.

  2. If you find plan document deficiencies, issue Letter 1758-B -180 Day Notification 457(b) to the governmental entity, IRM 4.72.19.6.13 for more details on correction in a governmental 457(b) plan.

Eligibility - Governmental Entities

  1. Eligible 457 plans may allow any individual who performs services for an eligible employer as either a common law employee or an independent contractor to participate. The employer has discretion about which employees and independent contractors may participate in the plan and may have specific age and service requirements for participation. In general, however, participation in eligible governmental 457 plans is broad with few exclusions or requirements for whom can participate.

  2. Eligible governmental 457(b) plans aren’t required to meet any non-discrimination tests.

  3. Under certain limited circumstances an eligible governmental employer can adopt a plan offered and administered by a union representing its collectively bargained employees, Rul. 2004-57, 2004-24 IRB 1048, and Announcement 2004-52, 2004-24 IRB 1071.

Examination Steps – Eligibility – Governmental Entities
  1. Review plan participation requirements and confirm that each eligible employee is able to participate.

  2. Eligible governmental 457 plans aren’t subject to non-discrimination requirements, so you don’t need to test for discrimination.

  3. In all cases, verify that the plan’s administration is consistent with the plan’s written terms and that the plan satisfies the requirements under 26 CFR 1.457-4 through 26 CFR 1.457-10.

  4. If you find deficiencies, issue Letter 1758-B -180 Day Notification 457(b) to the governmental entity. See IRM 4.72.16.6.13 for more details on correction in a governmental 457(b) plan.

Annual Deferrals Overview and Taxation – Governmental Entities

  1. Annual deferrals include salary reduction and non-elective employer contributions. The amount deferred is considered an annual deferral in the later of:

    • the taxable year deferred or,

    • the year the deferral is no longer subject to a substantial risk of forfeiture.

    1. A substantial risk of forfeiture means that there is no vesting schedule applied to the deferral or non-elective employer contributions, IRM 4.72.19.9.1.

  2. In addition to regular deferrals (including any non-elective employer contributions), a governmental 457(b) plan can allow Roth deferrals, age 50 catch-up deferrals, and a special 3-year pre-retirement catch-up (outlined in IRM 4.72.19.6.5, Age 50 Catch-up Contributions and IRM 4.72.19.6.6, Special Catch-up Contributions).

  3. 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, IRC 3121(u).

  4. Governmental employers are exempt from FUTA tax, IRC 3306(c)(7).

  5. If annual deferrals under an eligible 457 plan are properly taken into account for FICA taxes, subsequent amounts paid or made available to a participant or beneficiary attributable to those deferrals are not subject to additional FICA taxes, IRC 3121(v)(2)(B), IRC 3306(r)(2)(B), 26 CFR 31.3121(v)(2)-1(a)(2)(iii) and 26 CFR 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.

  7. Annual deferrals, and income attributable to those deferrals are not taxable income for federal income tax purposes until paid to the participant, 26 CFR 1.457-4(a).

  8. Notice 2003-20, 2003-19 IRB 894, has guidance on the withholding and reporting requirements applicable to eligible governmental 457 plans for periods after December 31, 2001.

  9. Designated Roth contributions are includible for income tax purposes in the participant’s gross income when made.

  10. Deferrals in a single employer’s eligible 457 plan in excess of the IRC 457(b) contribution limits are not annual deferrals; thus, they’re subject to the income tax withholding rules under IRC 3402(a).

  11. Eligible employees’ deferral agreements must be entered into before the first day of the calendar month in which the deferred compensation would be paid or made available as required by IRC 457(b)(4).

    1. Deferral agreements for new employees may be entered into on or before the first day service is performed.

    2. Deferral agreements may remain in effect until the participant revokes or alters the terms of the agreement.

    3. Nonelective employer contributions are deemed made under an agreement entered into before the first day of the calendar month.

  12. Governmental 457(b) plans are specifically permitted to have automatic enrollment features per the PPA ‘06. Before PPA ‘06, Revenue Ruling 2000-33 stated that an automatic enrollment provision wouldn’t violate the conditions of IRC 457(b)(4) for the timing of the election to defer.

Examination Steps – Annual Deferrals – Governmental Entities
  1. Verify that plan language shows that participant deferral agreements were entered into before the first day of the month in which the deferred compensation would’ve been paid or made available as required by IRC 457(b)(4).

  2. Verify the plan allows the types of deferrals, including any employer non-elective contributions which are treated as deferrals, as those in operation.

  3. Verify that all deferrals are subject to FICA and Medicare taxation and are only excluded from federal income tax (except Roth deferrals, if permitted).

    1. If the plan has employer non-elective contributions, verify they were included in gross compensation before being treated as a deferral for federal income tax purposes.

    2. If there is no FICA withholding or if there are certain groups of employees who don’t have FICA being withheld, the plan may also be acting as a “FICA Replacement Plan,” IRM 4.72.19.6.14.

  4. Verify proper reporting as outlined in Notice 2003-20, 2003-19 IRB 894.

  5. If you find inconsistencies between the plan document and operations, issue Letter 1758-B -180 Day Notification 457(b) to the governmental entity. See IRM 4.72.19.6.13 for more details on correction in a governmental 457(b) plan.

  6. If deferrals are not being subject to FICA or Medicare taxation, including any employer non-elective contributions and the plan is not intended to be part of a FICA Replacement Plan, IRM 4.72.19.6.14, consult with FSL/ET.

Deferral Limitations and Excesses – Governmental Entities

  1. The annual deferral limit applies on both an individual and plan basis, 26 CFR 1.457-4 and 26 CFR 1.457-5.

  2. Annual deferrals can’t exceed the sum of the basic annual limit plus any applicable special catch-up or age 50 catch-up contribution.

    1. Annual deferrals are limited to the lesser of: i) the applicable annual dollar amount, or ii) 100% of a participant’s taxable year includible compensation, IRC 457(b)(2) and 26 CFR 1.457-4(c)(1).

    2. The applicable dollar amount is adjusted annually for cost-of-living increases under IRC 415(d). See https://www.irs.gov/retirement-plans/cola-increases-for-dollar-limitations-on-benefits-and-contributions for current and prior year IRC 457(e)(15) deferral limits.

  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, 26 CFR 1.415(c)-2(b)(7).

    2. Includible compensation may include amounts paid prior to severance of employment or paid within 2 ½ months after the later of severance from employment or the end of the calendar year that includes the date of severance, 26 CFR 1.415(c)-2(e) and 26 CFR 1.457-4(d

    3. Includible compensation may include payment for unused bona fide sick, vacation, or other leave, if the plan specifically includes these and the employee could’ve used the leave if they continued to be employed, 26 CFR 1.415(c)-2 and 26 CFR 1.457-4(d).

    4. Includible compensation doesn’t include severance pay or parachute payments under IRC 280G(b)(2).

    5. Before the final regulations, includable compensation was net of deferrals into other tax-deferred arrangements such as IRC 403(b) or IRC 125. The final regulations changed the definition to IRC 415(c)(3) compensation which does include deferrals in other tax-deferred arrangements.

  4. All of a single employer’s eligible 457 plans are treated as a single plan to determine the maximum deferral limitation for individual participants.

  5. An excess deferral is any amount deferred under an employer’s eligible 457 plans that exceeds the maximum deferral limitation.

  6. Also treat combined annual deferrals that exceed the participant’s individual limits due to participating in plans of different employers as excess deferrals, 26 CFR 1.457-5.

  7. Employer nonelective contributions are considered annual deferrals when they become vested. Generally, annual deferrals don’t include earnings; however, annual deferrals subject to a vesting schedule are adjusted to include earnings on nonelective contributions in the year vested, 26 CFR 1.457-2(b)(2).

    Example:

    Employer A contributes to an eligible 457 plan $4,000 per year for five years for an employee, and the amounts vest in year 5. The employee will be treated as having deferred $20,000 ($4,000 x 5 years) in year 5, which, for that year, exceeds the maximum deferral limitation. You’d include any earnings on the $20,000 and any salary reduction contributions to determine the amount of the deferral in year 5.

     

  8. In rare instances, 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 isn’t subject to a substantial risk of forfeiture (disregarding increases for 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, 26 CFR 1.457-2(b)(3).

  9. Participant contributions to a Roth IRA under the plan are subject to the dollar limitation in effect for the year contributed, limiting the amount that can be contributed pre-tax, IRM 4.72.19.6.12, Deemed IRAs - Eligible Governmental Entities.

Age 50 Catch-up Contributions – Governmental Entities

  1. An eligible governmental 457 plan may permit additional annual deferrals for participants who are age 50 by the end of the year, 26 CFR 1.457-4(c)(2)(i). The maximum additional deferral for current and prior years under IRC 414(v)(2) is listed in the COLA table, https://www.irs.gov/retirement-plans/cola-increases-for-dollar-limitations-on-benefits-and-contributions.

  2. For additional guidance on the age 50 catch-up, IRC 414(v) and 26 CFR 1.414(v)-1.

  3. If an eligible governmental 457 plan permits both age 50 catch-up contributions and special IRC 457 catch-up contributions, IRM 4.72.19.6.6, the catch-up that yields the larger deferral applies, 26 CFR 1.457-4(c)(2)(ii).

Special Catch-up Contributions – Governmental Entities

  1. An eligible 457 plan may provide for an increased deferral ceiling during one or more of the last three taxable years before normal retirement age under the special IRC 457 catch-up, 26 CFR 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 that participants have a right to retire and receive a benefit without actuarial or similar reduction for early retirement under the basic defined benefit pension plan of the governmental or tax-exempt entity (or money purchase pension plan).

    1. The normal retirement age can’t be later than 70½.

    2. The plan must either designate a normal retirement age or permit the participant to designate a normal retirement age, 26 CFR 1.457-4(c)(3)(v).

      Note:

      The normal retirement age is merely a date that is required for making the special catch-up election. It doesn’t require the participant actually retire at that age.

    3. An entity that sponsors 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, 26 CFR 1.457-4(c)(3)(v)(B).

  3. The increased deferral ceiling under the special IRC 457 catch-up is the lesser of twice the applicable annual dollar amount, or the "underutilized limitation."

    1. The "underutilized limitation" is the sum of the plan ceiling (in other words, the lesser of the applicable annual dollar amount or 100% of includible compensation) for each year of participation, less the amount of deferrals made in prior years, disregarding any age 50 catch-up deferrals. In other words, add up the limits for each year and subtract how much was deferred for each year (not counting age 50) and the difference is how much that person has available to defer under the special catch-up provision.

    2. To determine the "underutilized limitation" for years before 2002, coordinate eligible 457 plan deferrals with deferrals to other plans (such as 403(b), 401(k), SEP, and SIMPLE plans), 26 CFR 1.457-4(c)(3)(iv).

  4. The age 50 catch-up doesn’t apply in any year in which the special IRC 457 catch-up is greater, IRC 414(v)(6)(C), and IRC 457(e)(18). In other words, participants can’t make age 50 catch-ups and special catch-up contributions at the same time.

Examination Steps – Limitations and Excesses – Governmental Entities
  1. Review the plan document to verify the types of deferrals permitted and, if special catch-up deferrals are permitted, the designated normal retirement age. Verify that the normal retirement age in the 457(b) plan is consistent with the normal retirement age noted in the employer’s other plans.

  2. Don’t rely on an IRPTRR report (relating to information returns processing) to determine deferrals made under a 457(b) plan, because the IRS system consolidates IRC 457(b) and IRC 403(b) deferrals on the W-2. Therefore, the only way to accurately determine IRC 457(b) deferrals made is to request payroll and W-2 records directly from the employer.

  3. Request W-2 records from the employer showing the breakdown of deferrals by plan type.

  4. Request payroll records with a separate column for each employer plan and the deferrals made to each. Review payroll records for details on employer contributions made to each plan.

  5. Cross reference W-2 and payroll records to verify data. Verify that both elective and non-elective IRC 457(b) contributions are shown on the Form W-2 in the total amount of deferrals reported and that employer non-elective contributions are included in gross compensation before deferrals are deducted for federal income tax purposes.

  6. Determine if the employer has other 457(b) plans in which participants may also participate or may have participated in during the calendar year. Verify that deferrals under all plans of the employer are considered.

  7. Request account statements to compare deposits to payroll and W-2 records.

  8. Sample and review deferral agreements to ensure they’re executed in the month before and specify the type of compensation to be deferred.

    1. The plan may need a separate agreement for various forms of compensation, such as unused sick or vacation pay.

    2. Verify that agreements to defer compensation were entered into in the month before the first day of the month that compensation was deferred. This includes age 50 catch-up elections.

  9. A participant must make a written election to make special catch-up contributions, including designating the retirement age (unless the plan designates the age and doesn’t allow participants to designate).

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

    1. Verify that the limit calculations include only the years the employer maintained the plan and the years that the employee could’ve been a participant.

    2. Verify that deferrals made before 2002 were properly included in the calculation of a participant’s "underutilized" amount.

  11. For participants using the special catch-up provision, request and review the employer’s calculation of the underutilized amount.

  12. Excess deferrals must be corrected as soon as administratively practicable after the excess is identified, per 26 CFR 1.457-(e)(2). The excess must be included in their gross income in the year to which it applied or when it is distributed to them.

    1. Generally, the requirement to correct an excess as soon as administratively practicable after the excess is identified would be an exception to the 180-day rule, IRM 4.72.19.6.13, and is one of the few failures a 457(b) governmental plan is required to correct before the case is closed.

    2. Excess deferrals are includible in income for the year that the excess occurred, or the year distributed if the year the excess occurred is closed to statute expiration.

    3. Earnings should be reported in the year distributed.

  13. Verify that uncorrected excesses were not rolled over into an IRA at termination or other distributable event. Refer to IRM 4.71.27, Employee Plans Examination of Returns, Form 5329 Examination Procedures.

  14. If you are aware that participants also participated in another employer’s 457(b) plan, review IDRS to determine if the aggregated IRC 457(b) deferrals exceeded limits.

Correction – Excesses – Governmental Entities
  1. If you identify excess deferrals on examination, notify the plan sponsor immediately. The plan sponsor must distribute those excesses as soon as administratively practicable and demonstrate proof of correction and proper taxation.

    1. Work with the plan administrator to define a date that is administratively practicable. Document this date in your workpapers and proceed according to that agreement.

  2. If the plan sponsor can’t distribute excesses for whatever reason, consider a DO 8-3 and identify and document the reasons. Otherwise, if the plan sponsor doesn’t distribute excesses, the plan is an ineligible 457(f) plan per the 180-day rule outlined in IRM 4.72.19.6.13.

    1. If participants rolled over excesses into an IRA refer to IRM 4.71.27 Employee Plans Examination of Returns, Form 5329 Examination Procedures.

  3. 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 in the year in which there is no substantial risk of forfeiture if later, 26 CFR 1.457-4(e)(1).

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

  4. Deferrals in excess of the maximum deferral limitation that are made to a plan or plans of a single employer are plan limitation excess deferrals. These excess amounts are taxable to the participant in the year of deferral or in the year in which there is no substantial risk of forfeiture, if later.

  5. If the plan limitations haven’t been exceeded, but you determine that participant deferrals exceeded the individual limitation due to participation in multiple unrelated eligible 457 plans, the plan keeps its eligible status, but the excess deferrals are taxable to the participant in the later of: the year vested or deferred. Earnings are taxed in the year that they accrue.

    1. Eligible governmental 457 plans may permit excess deferrals resulting solely from a failure to comply with the individual limitation for combined annual deferrals under multiple eligible plans (under 26 CFR 1.457-5) for a taxable year to be distributed to the participant, with allocable net income, as soon as administratively practicable after the plan determines it is an excess deferral, 26 CFR 1.457-4(e)(4).

      Note:

      Although a plan keeps its eligible status if it doesn’t distribute excess deferrals under this rule, a participant must include the excess amounts in income.

Deferrals of Sick, Vacation, and Back Pay – Governmental Entities

  1. Eligible 457 plan compensation may include accumulated sick, vacation and back pay paid after severance from employment, 26 CFR 1.457-4(d) and 26 CFR 1.415(c)-2(e)(3). An eligible 457 plan, therefore may allow a participant to elect to defer accumulated sick pay, vacation pay, or back pay, if the following requirements are satisfied:

    1. A participant who hasn’t had a severance from employment may elect to defer accumulated sick, vacation, and back pay, if they elect to defer before the first day of the month 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 paid by the later of 2 ½ months following severance from employment or the end of the calendar year that includes the severance date, and they elect before the beginning of the month the amounts are paid or made available.

    3. The employee must have been able to use the leave if they continued to be employed.

    4. Post severance non-qualified deferred compensation is not eligible for deferral unless payment would’ve been made at that time not considering the employee’s severance.

      Note:

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

  2. Deferrals may also be made for a participant who severed employment, after the employment severance date, if both:

    1. they make the deferral agreement before the first day of the month in which the amount would otherwise be paid or made available.

    2. the compensation is paid by the later of 2 ½ months after severance from employment or the end of the calendar year that includes the date of severance from employment with the employer maintaining the plan.

  3. The amounts must have otherwise been payable if the employee’s employment hadn’t terminated (26 CFR 1.457-4(d) and 26 CFR 1.415(c)-2(e)(3) issued on April 5, 2007). For unused leave, the participant must have been eligible to use the leave if they hadn’t terminated employment.

Examination Steps – Sick, Vacation and Back Pay Deferrals – Governmental Entities
  1. Verify participants entered into agreements before the month compensation was paid or made available.

  2. Verify the participant’s compensation was paid by the later of 2 ½ months after severance from employment, or the end of the calendar year that includes the date of severance from employment.

  3. Verify the participant would have been entitled to the amount deferred if they didn’t have a severance from employment.

Distributions– Governmental Entities

  1. Plan amounts can’t be made available to participants or beneficiaries under IRC 457(d) earlier than:

    1. The calendar year in which the participant is age 70 ½ (or age 59 ½ for plans years beginning after December 31, 2019, for governmental 457(b) plans), Section 104

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

    3. When the participant is faced with an unforeseeable emergency.

      Exception:

      Plans may make distributions of small amounts, and distributions for plan terminations or qualified domestic relations orders.

  2. Amounts a plan receives from rollover contributions aren’t subject to the above timing of distribution restrictions if the plan accounts for the rollover contributions separately, Rev. Rul. 2004-12, 2004-7 IRB 478.

    1. An eligible governmental 457 plan is an eligible retirement plan for the rollover requirements, IRC 402(c)(8)(B)(v). An eligible 457 plan is prohibited from accepting a rollover from a plan that isn’t an IRC 457 plan unless it separately accounts for the rollover contributions, IRC 402(c)(10).

    2. As such, amounts rolled into an eligible governmental 457 plan from a plan that isn’t an IRC 457 plan aren’t subject to the IRC 457(d) distribution restrictions.

  3. For plan years beginning in 2008 or later, an eligible governmental 457 plan which includes an automatic enrollment feature may allow automatically enrolled employees to permissibly withdrawal their elective deferrals made as a result of the automatic enrollment, IRC 414(w), as added by PPA 2006.

    1. The participant must elect a permissible withdrawal by 90 days from the date on which the first elective contribution was made on their behalf in the automatic enrollment.

    2. Distributions made under this provision don’t cause the plan to violate the distribution restrictions in IRM 4.72.19.6.8 (1) above.

  4. An eligible governmental 457 plan may make distributions for disaster relief, as provided in notices, announcements and other guidance.

  5. IRC 457 contains a special rule for a QDRO. The special QDRO rule applies for transfers, distributions and payments made after December 31, 2001, 26 CFR 1.457-12(e).

Severance from Employment– Governmental Entities
  1. An employee has a severance from employment with the eligible employer if the employee dies, retires, or otherwise has a severance from employment (including leave for certain military service per IRC 414(u)(12)(B). See 26 CFR 1.457-6(b)(1) and the 401(k) regulations on severance from employment. An employee:

    1. Has a severance from employment when the employee ceases to be an employee of the employer maintaining the plan, 26 CFR 1.401(k)-1(d)(2).

    2. Doesn’t have a severance from employment if, in connection with a change of employment, the employee's new employer keeps the plan for 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, per IRC 414(l), for this employee.

  2. An independent contractor has a severance from service when all contracts requiring their services for the eligible employer expire, if the contract expiration constitutes a good faith and complete termination of the contractual relationship, 26 CFR 1.457-6(b)(2)(i). For more guidance on good faith expiration of the contractual relationship, 26 CFR 1.457-6(b)(2)(i). An eligible 457 plan is considered to have satisfied the requirement for independent contractors if it states:

    1. Amounts deferred won’t be paid or made available to the participant for at least 12 months after all contracts with the employer expire; and

    2. The plan won’t pay any amount payable to the participant on that date if, after the contract(s) expire and before that date, the participant performs services for the eligible employer as an independent contractor or an employee.

Unforeseeable Emergencies– Governmental Entities
  1. An eligible plan may permit a distribution for an unforeseeable emergency resulting from an unanticipated event, 26 CFR 1.457-6(c).

  2. The plan must define an unforeseeable emergency 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 (per IRC 152 and, for taxable years beginning on or after January 1, 2005, without considering 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 needing 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, medical expenses, and funeral expenses of a spouse or dependent may constitute unforeseeable emergencies.

  3. The amount distributed to satisfy a participant’s emergency may be grossed up to include federal, state or local income taxes or penalties due from the distribution.

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

    Example:

    Medical expenses for cosmetic surgery or cosmetic dental work generally wouldn’t qualify unless due to an unforeseeable event.

  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. Reimbursing or compensating the participant from insurance or otherwise.

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

    3. Stopping plan deferrals.

  6. Generally, purchasing a home or the paying college tuition don’t qualify as an unforeseeable emergency.

Required Minimum Distributions– Governmental Entities
  1. A plan must meet the minimum distribution requirements of IRC 401(a)(9), IRC 457(d)(2).

  2. A plan must 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 retires. Refer to IRC 401(a)(9) and its regulations.

    Note:

    The SECURE Act changed the age to 72 for employees who reach age 70 ½ after December 31, 2019.

Distributions of Smaller Accounts – Governmental Entities
  1. An eligible 457 plan may distribute all, or a portion, of a participant's benefit if the following requirements are satisfied:

    1. For a governmental eligible 457(b) plan that allows rollovers into the plan, the participant's total amount deferred (the participant's total account balance) which is not attributable to rollover contributions, per IRC 411(a)(11)(D), doesn’t exceed 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-years ending on the distribution date; and

    3. The plan hasn’t distributed to the participant before under this small account rule.

  2. An eligible 457 plan isn’t required to permit distributions of small accounts. However, if the plan permits, and the above requirements are otherwise satisfied, small accounts may be an amount less than the dollar limit under IRC 411(a)(11)(A).

  3. A plan may automatically make the distribution, at the election of the participant, or a combination thereof, 26 CFR 1.457-6(e).

  4. If the participant doesn’t elect to have a mandatory distribution greater than $1,000 in an eligible governmental 457 plan paid directly to an eligible retirement plan they specify in a direct rollover or receive it directly, then the plan administrator must pay the distribution in a direct rollover to an individual retirement plan the plan administrator designates.

Loans– Governmental Entities
  1. Eligible governmental 457 plans may permit participant loans, 26 CFR 1.457-6(f)(2). Use a facts and circumstances test to determine whether the availability of loans, the making of loans, or the failure to repay loans violates any requirement of IRC 457(b), or whether the plan violated the plan distribution restrictions. Consider these factors:

    1. Whether the loan bears a reasonable rate of interest. A loan must bear a reasonable rate of interest to satisfy the exclusive benefit rule contained in IRC 457(g)(1) and 26 CFR 1.457-8(a)(1).

    2. Whether the loan has a fixed repayment schedule.

    3. Whether there are repayment safeguards to which a prudent lender would adhere.

  2. A loan from an eligible governmental 457 plan which satisfies the requirements of 26 CFR 1.72(p)-1 Q&A 3 is not treated as a distribution, 1.457-7(b)(3). A deemed distribution in 26 CFR 1.72(p)-1 Q&A 4 doesn’t necessarily violate IRC 457(d).

  3. Any loan amount from an eligible governmental 457 plan to a participant or beneficiary that doesn’t satisfy IRC 72(p)(2) is treated as though the participant received it as a distribution from the plan under IRC 72(p) and is includible in the their or their beneficiary’s gross income for the taxable year in which the loan is made, 26 CFR 1.457-7(b)(3). Disaster relief as provided in Notices, Announcements and other guidance may expand the availability of loans.

Qualified Domestic Relations Orders (QDROs) – Governmental Entities
  1. An eligible 457 plan doesn’t violate the restrictions on distributions under IRC 457(d) due to paying an alternate payee under a QDRO, as defined in IRC 414(p), 26 CFR 1.457-10(c).

  2. The alternate payee is the distributee per IRC 402(e)(1)(A). A payment from an eligible 457 plan to an alternate payee

    1. who is the participant’s spouse or former spouse is includible in the alternate payee’s gross income if made under a QDRO as defined in IRC 414(p).

    2. who is someone other than the participant’s spouse or former spouse is includible in the participant’s gross income under IRC 402(e)(1) and 26 CFR 1.457-10(c).

Commencement of Distributions – Governmental Entities
  1. An eligible 457 plan doesn’t have any requirements to set the date for the distribution commencement, other than the dates in IRC 401(a)(9) for required minimum distributions. Plan distribution conditions and timing, however, are required plan provisions, and once established must be followed in operation per 26 CFR 1.457-3.

Rollovers– Governmental Entities
  1. An eligible governmental 457 plan may accept contributions that are eligible rollover distributions (but aren’t required to accept them) from qualified retirement plans, 403(b) annuities, traditional IRAs, and governmental 457(b) plans, 26 CFR 1.457-10(e).

  2. Contributions received as eligible rollover distributions:

    1. Aren’t subject to the annual deferral limits, but treat them in the same way you would treat amounts deferred under IRC 457 for purposes of 26 CFR 1.457-3 through 26 CFR 1.457-9.

    2. Must be accounted for separately.

  3. Eligible governmental 457 plans that accept eligible rollover distributions must comply in form and operation with requirements similar to those in IRC 401(a)(31) for direct transfer of eligible rollover distributions under IRC 457(d)(1)(C).

  4. Eligible governmental 457 plans, effective in 2010, may allow in-plan Roth rollovers.

    1. The plan must separately account for any in-plan Roth rollovers of otherwise nondistributable amounts.

    2. The amounts rolled over remain subject to the distribution restrictions that applied to them before the in-plan Roth rollover.

    3. The rollover must be direct; 60-day rollovers are not permitted if the amount was otherwise non-distributable, Notice 2013-74.

    4. Tax withholding does not apply.

    5. A plan may also discontinue the availability of in-plan Roth rollovers. An employee’s ability to make in-plan Roth rollovers is not protected by the anti-cutback rules in IRC 411(d)(6). See IRM 4.72.19.6.12, Deemed IRAs - Governmental Entities, for additional information.

Direct Plan to Plan Transfers – Governmental Entities
  1. An eligible governmental 457(b) plan’s assets can’t be transferred to an eligible tax-exempt 457(b) plan nor can a 457(b) tax-exempt entity’s plan assets be transferred to a governmental entity 457(b) plan.

    1. Transfers between eligible 457 plans can only take place between eligible governmental 457 plans, or between eligible tax-exempt 457 plans.

  2. Eligible governmental 457 plans may permit a participant’s assets to be transferred post-severance to another eligible governmental 457 plan subject to the following:

    1. Both the transferring plan and the receiving plan must contain provisions allowing the plan transfers.

    2. Amounts received in a transfer must be at least equal to the dollar value of the transfer immediately before the transfer occurred.

    3. If assets are transferred to a different employer’s eligible 457 plan, the affected participants must: i) have had a severance from employment with the transferring employer and ii) be performing services for the recipient employer.

      Exception:

      This rule doesn’t apply if all of the assets of an eligible governmental 457 plan are being transferred to another eligible governmental 457 plan within the same state.

Purchase of Permissive Service Credit – Governmental Entities
  1. An eligible governmental 457 plan of a state may, under 26 CFR 1.457-10(b)(8), permit the transfer of amounts deferred by a participant or beneficiary to a defined benefit governmental plan, as defined in IRC 414(d), and neither the participant or beneficiary includes the transfer in gross income, if the transfer is for either of the following reasons:

    1. To purchase 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 per IRC 415(k)(3).

  2. A transfer under 26 CFR 1.457-10(b)(8) is not treated as a distribution for purposes of 26 CFR 1.457-6. Therefore, transfers may be made before a participant has a severance from employment.

Distributions - Income Tax Withholding and Reporting – Governmental Entities
  1. Benefits under eligible governmental 457 plans are generally taxable to participants or beneficiaries in the year paid under 26 CFR 1.457-7(b)(1).

  2. Distributions from eligible governmental 457 plans are subject to income tax withholding rules under IRC 3405.

    1. Any trustee-to-trustee transfer that is a direct rollover under IRC 401(a)(31) from an eligible governmental 457 plan is a distribution subject to the distribution requirements of 26 CFR 1.457-6. See 26 CFR 1.457-7(b)(2).

  3. Eligible rollover distributions, as defined in IRC 402(c)(4)), aren’t includible in participants’ gross income in the year paid if the participant or plan transfers the payment to an eligible retirement plan, as defined in IRC 402(c)(8)(B), within 60 days. This transfer includes transferring any property distributed from the eligible governmental 457 plan to the eligible retirement plan.

    1. For these transfers, the rules of IRC 402(c)(2) through (7), (9) and (11) apply.

  4. For distributions that aren’t eligible rollover distributions under IRC 402(c)(4), the elective withholding rules under IRC 3405(a) and (b) apply.

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

  6. Find more information on the withholding rules under IRC 3405 in 26 CFR 31.3405(c)-1, 26 CFR 35.3405-1T, 26 CFR 1.401(a)(31)-1, 26 CFR 1.402(c)- 2, and 26 CFR 1.402(f)-1.

  7. Distributions from an eligible governmental 457 plan are reported on Form 1099-R according to the instructions for that form.

  8. The regulations require that the plan administrator or payor deposit and report tax withholding on deferred compensation under IRC 3405 separately from payroll taxes.

    1. Taxes withheld under IRC 3405 are reported annually on Form 945.

    2. Payroll taxes are reported on Form 941.

    3. Check IDRS BMFOLI for list of filed returns (MFT 88 for Form 945 and MFT 01 for Form 941).

  9. Distributions to beneficiaries are reported on Forms 1099-R, but income tax isn’t required to be withheld.

  10. Loan offset amounts are considered actual distributions and participants can roll them over if otherwise eligible, 1.402(c)-2, Q&A -9(b). Effective January 1, 2018, the 60-day rollover period is extended for a plan loan offset that is due to plan termination or severance from employment. The participant has until the due date, including extensions, for filing their federal income tax return for the taxable year in which the offset occurs, IRC 402(c)(3)(C).

  11. Loans determined to be deemed distributions under IRC 72(p) are includible in the participant’s gross income for the taxable year in which the deemed distribution occurred under 26 CFR 1.457-7(b)(3) even though a deemed distribution is not an actual distribution.

  12. Distributions from an eligible governmental 457(b) plan used to pay qualified health insurance premiums for an eligible public safety officer are excluded from income per IRC 402(l).

Examination Steps for Distributions– Governmental Entities
  1. Review the plan document to determine when and under what circumstances the plan permits:

    Type of Distribution Examination Steps per Type of Distribution
    • Regular distributions

    • Transfers

    • Rollovers

    • The purchase of service credits

    • Loans

    • Unforeseeable emergencies

    1. Verify that the plan’s form doesn’t conflict with the type and form of distributions allowed in operation.

    2. Ensure that the plan language complies with the distribution restrictions under IRC 457(d) and IRC 401(a)(9).

    3. Verify the plan has the language for optional provisions.

      Example:

      If the plan permits unforeseeable emergency distributions, the plan language must state the conditions under which an unforeseeable emergency distribution can be made.

  2. Request a list of plan distributions, including loans and unforeseeable emergency requests.

  3. Review procedures and the type of records maintained for plan distributions during the interview with the employer.

  4. Examine payroll/census records to:

    1. Identify individuals who:

      • terminated employment during the calendar year under examination

      • are at least age 70 ½ (or age 72 for plan years beginning after December 31, 2019 for eligible governmental 457 plans).

    2. Compare individuals in 1 above with any report identifying the participants who received distributions in excess of the dollar amount in IRC 411(a)(11)(A) for small accounts, IRM 4.72.19.8.4, Distributions of Smaller Accounts - Governmental Entities.

    3. Confirm the plan complied in operation with the minimum distribution requirements of IRC 401(a)(9).

  5. Document your work papers to show you completed the above steps and list the documents/reports you examined. Determine if there are any obvious failures or concerns for each of the different types of distributions.

  6. Ask for and examine additional records you need to verify that each type of distribution was properly administered per the plan document and the applicable Code and regulations.

  7. Use the examination steps for reviewing required minimum distributions under IRC 401(a)(9) for an eligible governmental 457 plan as you’d use for a 401(a) plan.

  8. Use the examination steps for reviewing loans from an eligible governmental 457 plan as you’d use for a 401(a) plan for IRC 72(p) compliance.

    1. A loan which satisfies the requirements of 26 CFR 1.72(p)-(1) Q&A 3 is not treated as a distribution, 26 CFR 1.457-7(b)(3).

    2. Deemed distributions occur when loans under eligible governmental 457 plans fail to satisfy the requirements of 26 CFR 1.72(p)-1 Q&A 3.

    3. 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 26 CFR 1.72(p)-1 Q&A 4.

      Note:

      Because a governmental entity has no owners, the prohibited transactions rules don’t apply for a failed plan loan to a disqualified person.

  9. Verify and document that unforeseeable emergency distributions comply with the rules in IRM 4.72.19.8.2, Unforeseeable Emergencies - Governmental Entities.

  10. Document that rollover and transfer amounts an eligible governmental 457 plan receives are accounted for separately.

  11. Verify that transactions for transferring funds to purchase permissive service credits under a governmental employer’s qualified defined benefit plan aren’t more than the amount needed to purchase the service credit.

  12. Verify that distributions were properly reported and taxed.

    1. Request and analyze distribution reports and, if available, the Forms 1099-R.

    2. Review Forms 1099-R for distributions to beneficiaries (income tax withholding is not required).

    3. Document whether the plan administrator or payor followed the withholding and reporting requirements in Notice 2003-20, 2003-19 IRB 894.

    4. Use IDRS research to verify amounts paid were reported in gross income of the participant or beneficiary.

Issue Resolution and Correction – Governmental Entities
  1. When government entities correct their distribution failures, correction is limited to proper taxation. So, for any failure that results in taxes owed but not paid, you’re required to secure delinquent or required income or excise taxes as applicable.

  2. Other failures like the ones below are treated as inconsistencies subject to the 180-day rule discussed in IRM 4.72.19.6.13 below:

    • Failing to follow the plan document in operation.

    • Making an improper regular distribution, loan, or unforeseeable emergency distribution.

Funding – Governmental Entities

  1. An eligible governmental 457 plan is a funded plan. The assets must be held in a 457(g) trust, custodial account, or annuity contract for the exclusive benefit of the participants and beneficiaries.

  2. Eligible governmental 457 plans adopted on or after August 20, 1996, must satisfy the funding requirements of IRC 457(g).

  3. Sponsors of eligible governmental 457 plans already in existence on August 20, 1996, don’t need to establish a trust before January 1, 1999, although they may have established one before that date.

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

  5. Custodial accounts and contracts described in IRC 401(f) (annuity contracts) are treated as trusts under rules similar to IRC 401(f), IRC 457(g)(3).

  6. 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 for those participants and their beneficiaries.

  7. An eligible governmental 457 plan must meet the requirements of IRC 401(a)(37) - If a participant dies while performing qualified military service, the plan states that the survivors of the participant are entitled to any additional benefits (other than benefit accruals relating to the period of qualified military service) had the participant resumed and then terminated employment on account of death (IRC 457(g)(4)).

  8. The trusts of governmental entities aren’t subject to ERISA nor the fiduciary requirements outlined under ERISA.

    Note:

    "Dual-status entities" - Entities that are governmental organizations and have also received an IRS determination letter that they satisfy the requirements for tax exemption under IRC 501(a) are considered governmental for purposes of plan funding requirements.

Examination Steps – Funding – Governmental Entities
  1. Review the plan document for eligible governmental 457 plans to verify that assets are held in trust, custodial accounts, or annuity contracts.

  2. Review and document whether eligible governmental 457 plans’ trust documents, custodial account documents and annuity contracts contain the required exclusive benefit and anti-diversion language.

  3. Verify, by reviewing trust statements that plan contributions went to the trust.

    Reminder:

    A governmental 457(b) plan isn’t required to transfer plan contributions to the trust within a certain time frame as in a 401(k) or other 401(a) plan but you should still check to make sure the company transferred them.

  4. Verify that all employee deferrals were taken into account and reported on Form W-2.

  5. Treat a governmental 457(b) plan that hasn’t established a trust per 26 CFR 1.457-8(a) as an inconsistency subject to the 180-day rule discussed in IRM 4.72.19.6.13.

Plan Terminations and Frozen Plans – Governmental Entities

  1. A plan may be written to say that the plan may terminate. When a plan terminates, it may distribute amounts without violating the distribution restrictions under IRC 457 and 26 CFR 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 it only distributes amounts upon the occurrence of a distributable event under the plan.

    3. The plan must continue to comply with all of the applicable statutory requirements needed for plan eligibility until it pays out all amounts deferred into the plan.

Examination Steps – Terminations and Frozen Plans – Governmental Entities
  1. Review the plan document to verify it has language allowing for the 457(b) plan termination. Verify that the plan sponsor adopted an amendment terminating (or freezing) the plan.

  2. Document whether the plan made distributions 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 26 CFR 1.457-2(e).

    1. If not, verify if the plan sponsor transferred assets to another eligible governmental 457 plan within the same state as permitted under 26 CFR 1.457-10(b).

    2. If the plan has not been terminated or its assets transferred to another eligible governmental 457 plan within the same state, document whether the plan sponsor has determined the tax consequences to participants and beneficiaries 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).

  4. Verify, if the plan has been frozen, that neither the participants nor the employer is making deferrals or employer contributions and that the plan is making distributions according to the plan document.

Death Benefit and Life Insurance– Governmental Entities

  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. Doesn’t pay the deceased person during their life;

    2. Requires that the plan can only pay the surviving spouse or other designated surviving beneficiary; and

    3. The employee can’t change designate or change the beneficiary.

  3. Payees can’t exclude any amount paid as death benefits or life insurance proceeds under an eligible governmental 457 plan from their gross income under IRC 101(a) or 26 CFR 1.457-10(d).

Deemed IRAs – Governmental Entities

  1. For tax years beginning after 2002, eligible governmental 457 plans may contain language that permits a deemed IRA under IRC 408(q) that meets the requirements under:

    • IRC 408

    • IRC 408A

  2. A deemed IRA includes voluntary employee contributions to a separate account or annuity in the eligible governmental 457 plan as a traditional or Roth IRA.

  3. The plan document must contain language permitting deemed IRAs before 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 rules for traditional (IRC 408) or Roth (IRC 408A) IRAs.

    • not subject to the eligible 457 plan rules.

  6. See the regulations under IRC 408(q) for how to treat separate accounts or annuities as IRAs.

  7. Amounts participants contribute to a Roth IRA are subject to the annual dollar limitation for the year contributed. The annual dollar limit is the maximum a participant can contribute to traditional and Roth IRAs.

Examination Steps– Deemed IRAs – Governmental Entities
  1. Review the eligible governmental 457 plan document and all amendments to determine if the plan sponsor amended the plan to include a deemed IRA.

  2. Confirm that participants haven’t designated voluntary contributions as deemed IRA contributions before the plan sponsor adopted the amendment permitting these contributions.

  3. Sample selected deemed IRA accounts to confirm that they satisfy requirements for a traditional IRA under IRC 408 or Roth IRA under IRC 408A requirements.

  4. Confirm the plan keeps separate accounts with allocable gains and losses if deemed IRAs are commingled with the eligible governmental 457 plan’s other assets.

Correction of Eligible 457 Plan Failures – Governmental Entities

  1. An eligible 457 plan administered inconsistent with the requirements of IRC 457(b) and 26 CFR 1.457-3 through 26 CFR 1.457-10 may become an ineligible 457 plan subject to the rules under IRC 457(f) and 26 CFR 1.457-11.

    1. Treat an eligible governmental plan as an ineligible 457 plan at the beginning of the first plan year which begins more than 180 days after the date of notification by the Commissioner of the inconsistency unless the employer corrects the inconsistency before the first day of that plan year, IRC 457(b), and 26 CFR 1.457-9(a).

  2. IRS accepts IRC 457(b) eligible governmental plan submissions on a provisional basis outside of the EPCRS through standards similar to EPCRS (Rev. Proc. 2019-19 Section 4.09).

    Note:

    EPCRS is a comprehensive correction program, updated periodically, for retirement plan sponsors intending to satisfy IRC requirements for tax-favored treatment.

Examination Steps – Correction – Governmental Entities
  1. Most errors in an eligible 457(b) governmental plan don’t require correction; rather, the plan administrator can’t operate the plan any longer in a manner that’s inconsistent with the requirements of IRC 457(b) and 26 CFR 1.457-3 through 26 CFR 1.457-10.

    Exception:

    Plan sponsors may operate the plan when they correct excesses, which must occur as soon as administratively practicable after the error is identified, IRM 4.72.19.6.6.2

  2. Calculate the date by which the plan would become ineligible based on the 180-day rule. Issue the 1758-B, 180-Day Notification Letter, as soon as you note a deficiency. You can issue multiple 1758-B letters and aren’t required to have completed the examination to issue the letter.

    Note:

    If the error is an excess deferral amount, your letter should explain that correction is required as soon as administratively practicable but no later than the date of the 180-day deadline.

  3. The plan sponsor is not required to make any other corrections under the 180-day rule. They are only required to operate correctly by the deadline you calculated under the 180-day rule and going forward.

    1. Example 1: If you identify a plan document form failure, the plan sponsor isn’t required to retroactively amend the plan, nor is the plan subject to a Closing Agreement to remain eligible. Rather, the plan sponsor would need to have a plan document that has corrected the identified form failure by the date of the 180-day deadline.

    2. Example 2: You determine that, in operation, the plan is permitting Roth deferrals but the plan document doesn’t allow them. The plan sponsor isn’t required to retroactively amend the plan under a closing agreement to allow Roth deferrals, or treat them as excesses. Rather, the plan sponsor can either amend the plan to allow Roth deferrals or stop allowing participants to elect to make Roth deferrals as of the date you calculated under the 180-day notice rule (and assuming proper notification).

    3. Example 3: You determine that certain employees are eligible to participate but in operation, the plan excluded them. The plan sponsor is not required to retroactively amend the plan to make the employees plan participants. Rather, as of the date calculated under the 180-day notice rule (and assuming proper notification), the plan sponsor can either begin to properly include the employees or amend the plan to prospectively exclude the employees.

  4. Under the 180-day rule, you don’t have to hold the case open to verify that the inconsistency identified stops by the calculated date in the notification letter. However, if the case is still open for other issues, verify that you addressed the inconsistency as of that date.

    Note:

    Although governmental 457(b) plans are not covered by EPCRS, the agent will still use Code 14 - SCP correction in the absence of a closing code specific to the 180-day rule for governmental 457(b) plans.

  5. Address failures involving proper taxation of certain failures.

    Example:

    If the plan doesn’t make required minimum distributions, the plan has no consequences, but the participant is required to catch-up on missed distributions and is still liable for the IRC 4974 excise tax.

  6. In the rare instance that a governmental 457(b) plan can’t correct inconsistencies by the 180-day deadline date, the plan is deemed an ineligible plan and treated under the rules in IRC 457(f), IRM 4.72.19.9, Ineligible 457(f) Plans.

  7. Sometimes, a governmental entity may wish to make corrections, even if not required to do so and may choose to make those corrections following EPCRS principles working with the agent. The governmental entity is not obligated to make corrections and follow EPCRS principles and you may not lead the plan sponsor to believe these actions are required. However, if the plan sponsor believes this approach is in their best interest, you may help the plan sponsor to self-correct.

Eligible Governmental 457 Plan as Social Security Replacement

  1. Governmental employers are not required to participate in the Federal Insurance Contributions Act program (Social Security) and may choose instead to provide membership in a public retirement system under IRC 3121(b)(7)(F) that meets the minimum benefit requirements under 26 CFR 31.3121(b)(7)-2(e) and Rev. Proc. 91-40, 1991-2 CB 694. These plans are commonly referred to as FICA Replacement Plans or Social Security Replacement Plans.

  2. An eligible governmental 457 plan that provides an annual minimum allocation of at least 7.5% of compensation, including employer and employee contributions and satisfies the other requirements may be used as a Social Security Replacement Plan, 26 CFR 31.3121(b)(7)-2.

  3. An eligible governmental 457 plan intended as a FICA Replacement Plan that doesn’t satisfy the minimum allocation or improperly excludes eligible employees is an exception to the 180-day rule discussed in IRM 4.72.19.6.13 because the benefit is required under IRC 3121 as noted in paragraph (1) above. Depending on the case’s facts and circumstances, you may need to make a referral to FSL/ET, per IRM 4.71.6.1.6, Employee Plans Examination of Returns - Employee Plans Referrals. However, securing a plan benefit, even if intended to be in lieu of FICA, is in Employee Plans’ jurisdiction.

Examination Fundamentals – Tax-Exempt Entities

  1. The application of 457(b) rules differ significantly for a governmental entity versus a tax-exempt entity. Therefore, this IRM separates the examination issues, steps, and correction according to the type of entity:

    • IRM 4.72.19.6 addresses eligible 457 plans for governmental entities.

    • IRM 4.72.19.7 addresses eligible 457(b) plans for tax-exempt entities.

  2. Eligible 457(b) plans of tax-exempt entities are also called "top-hat" plans because they’re intended to only cover a select group of employees. Unless otherwise indicated, the term "top-hat plan" refers to an eligible 457(b) plan maintained by a tax-exempt entity and in this IRM, "top-hat plan" and "eligible 457(b) plan" may be used interchangeably.

  3. ERISA has a limited Title 29 exemption for top-hat plans which means they’re generally not subject to most ERISA conditions. This means these plans don’t have to comply with vesting and nondiscrimination rules; nor are they required to file a Form 5500. However, they must meet the following conditions:

    1. Maintain a written plan document.

    2. Operate according to the plan terms.

    3. Be an "unfunded" plan.

    4. Follow the contribution limitations under 457(b)(2) and (3).

    5. Follow the required minimum distribution rules of 401(a)(9).

  4. A tax-exempt plan sponsor of a 457(b) eligible plan is required to notify the Department of Labor of the plan’s existence to take advantage of ERISA exemptions.

  5. A top-hat plan is not intended to be a retirement plan. It’s a non-qualified deferred compensation plan that was created under ERISA in 1974 to allow additional benefits (those over and above the benefits provided under qualified plans) to a select group of management or highly compensated employees. This select group was presumed to have sufficient leverage within, and knowledge of, the employer to not need complete ERISA and IRC protection. For top-hat plans, you are:

    1. verifying that the plan meets the requirements that allow the select group of individuals to take advantage of this tax benefit.

    2. ensuring the government’s interests are protected regarding the proper payment of income tax rather than protecting an individual’s retirement benefits.

Department of Labor (DOL) Plan Registration – Tax-Exempt Entities

  1. The sponsor of a 457(b) top-hat plan must notify the DOL of the plan’s existence within 120 days of adopting the plan which grants them an exception from filing the Form 5500 (DOL Regs. section 2520.104-23).

    1. Until August 16, 2019, organizations could register via paper letter or via electronic submission.

    2. After August 16, 2019, all registrations must be submitted electronically.

  2. An employer must register each individual top-hat plan with the DOL and must update the DOL on the plan’s status if it is terminated or affected by a merger or change of ownership, changing the sponsor of the plan.

  3. The DOL has a list of all registered 457(b) top-hat plans that you can search to verify the plan under exam is properly registered with the DOL at https://www.askebsa.dol.gov/tophatplansearch.

  4. If the plan sponsor fails to register the plan with the DOL, the plan is required to file a Form 5500.

    1. Note:

      Failure to file the annual Form 5500 includes IRS penalties of $250 per day up to $150,000 (for returns required to be filed after December 31, 2019) and DOL penalties of $1,000 per day with no limit. However, the IRS will generally waive failure to file penalties if the plan sponsor registers the plan under the DOL Delinquent Filer Voluntary Compliance Program (DFVCP) as outlined in IRM 4.72.19.7.1.1 below.

Correction – DOL Plan Registration – Tax-Exempt Entities
  1. Verify the plan under examination is registered with the DOL via the link above. If the sponsor has other plans, consider them in your Risk Assessment per IRM 4.72.19.3.

  2. If the plan is not listed, determine via interview and/or IDR, if the plan sponsor has evidence of registration or a required update. If the plan sponsor can’t demonstrate registration, seek correction via the DFVCP.

  3. The plan sponsor can access instructions and information on the DFVCP program via the DOL website.

  4. Get proof of correction and include the proof in the RCCMS case file before you close the case. Use Closing Code 14 – SCP correction.

  5. If the plan sponsor chooses not to register the plan with the DOL via the DFVCP program, secure a Form 5500 and assess all penalties.

Plan Document Compliance – Tax-Exempt Entities

  1. A written plan requirement was part of the final IRC 457 regulations issued July 11, 2003, and applies to taxable years beginning after December 31, 2001. The document must be maintained, in form and operation, per the requirements of IRC 457(b) and 26 CFR 1.457-4 through 26 CFR 1.457-10 and contain all the material terms and conditions for benefits, 26 CFR 1.457-3(a).

    1. The plan must be adopted and exist before the first day of the month in which compensation is paid and a deferral can occur.

  2. IRS doesn’t have an opinion letter program for 457(b) plans in which the IRS confirms that the plan’s language meets the requirements of the IRC and regulations. Nor has the IRS provided model language for a top-hat plan. A tax-exempt 457(b) plan sponsor is required to apply for a private letter ruling if they want the IRS to review and approve their plan language.

  3. Top-hat plans don’t have a remedial amendment period for plan amendments. If the new law does not state a date by which the tax-exempt entity’s 457(b) plan must adopt an amendment, it’s assumed that the sponsor must adopt the amendment in the year the law change takes effect.

  4. In addition to the language requirements of 26 CFR 1.457-4 through 26 CFR 1.47-10, the following legislation affects top-hat plans and is required plan language:

    1. IRC 414(u) provisions via USERRA on the treatment of contributions made on behalf of re-employed veterans. The language may be incorporated by reference.

    2. All plans, including 457(b) plans, were required to remove any "husband/wife" language generally after the close of the first regular legislative session of the body with the authority to amend the plan that ends after December 31, 2014, Notice 2014-19.

  5. The plan document must also contain language for any optional provisions allowed under the plan.

  6. The cumulative list doesn’t include law changes to 457(b) plans and as such, you, as the examining agent must know current law changes and plan document requirements as they apply to 457(b) top-hat plans.

Examination Steps – Plan Document Compliance – Tax-Exempt Entities
  1. Be familiar with IRC 457(b) and regulations as they define the majority of the language that must be in a 457(b) plan. Review the language of the Code and the Treasury Regulations along with subsequent law changes to verify the plan document contains the proper language.

  2. Verify that the plan document was properly signed and dated or adopted per the minutes of a board meeting.

  3. Verify, if this was a recently adopted plan, that the plan sponsor adopted the document before participants made deferrals into the plan. Review payroll records or participant account statements and compare the date deferrals started with the date the plan was adopted.

  4. The plan document doesn’t have to identify the select group. The group can be identified via employment contracts, board minutes or other internal communications. The plan document merely needs to state that the plan will only cover a select group.

  5. A plan document must state that excesses will be removed by April 15 of the year following the year the excess occurred. The plan document can’t state that the excess will be treated as an ineligible IRC 457(f) contribution.

  6. Per the IRC and regulations, any deficiency in plan language causes the plan to become an ineligible 457(f) plan on the first day of the tax year of the plan document deficiency or failure to satisfy the IRC and regulations. However, given the lack of IRS guidance on plan language, consider if the failures are significant and if they extend into failures in operation. One or two minor oversights where there are no other failures in form or operation may warrant allowing the plan sponsor to amend the plan. In this case, close the plan SCP with a detailed explanation in the workpapers of why you didn’t deem the plan an ineligible 457(f) plan.

    1. Example 1: You note the original plan document adopted March 1, 2004 didn’t include the required language for IRC 401(a)(9) required minimum distributions. You also noted a plan amendment dated June 1, 2005, adding that language to the plan document. Technically, the plan was never an eligible 457(b) plan because the document didn’t contain the material terms and conditions as required in IRC 457(b) and 26 CFR 1.457-4 through 26 CFR 1.457-10. However, the plan sponsor made a good faith effort to identify and correct the plan document deficiency and you didn’t find other plan document errors or operational errors.

    2. Example 2: You note the plan document doesn’t include language stating excess contributions will be corrected by April 15 of the year following the year in which the excess occurred and instead, has language stating that any excesses will be treated as ineligible IRC 457(f) contributions. You determine that there has never been an excess contribution failure in operation to which the plan language would’ve applied. Likewise, you didn’t find other plan document failures or operational failures.

  7. Plan document failures generally will mean the plan was administered in a manner that is inconsistent with 26 CFR 1.457-3 requiring a written plan maintained in form, to contain the requirements of 26 CFR 1.457-4 through 26 CFR 1.457-10 and requiring the plan contain all the material terms and conditions for benefits under the plan. See IRM 4.72.19.9 for eligible plan failures for top-hat plans.

Eligibility – Tax-Exempt Entities

  1. Eligible tax-exempt 457 plans must restrict participation to a select group of management or highly compensated employees (top-hat group) defined under ERISA Section 201(2).

  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 must comply with ERISA funding requirements under IRC 457(b)(6), which requires this type of plan to be unfunded or lose eligible status.

  4. Contributions to a funded eligible tax-exempt 457 plan generally are immediately taxable.

Examination Steps – Eligibility – Tax-Exempt Entities

  1. Verify the plan document has the proper language limiting eligibility to a select group and stating the plan is unfunded and subject to creditors.

    Note:

    You don’t have to verify that all those eligible are participating. Rather, you’re merely verifying that there is no rank and file covered by the plan in form or in operation.

  2. Verify via payroll records/W2s the plan doesn’t benefit rank and file employees.

  3. Commonly, third-party administrators sell tax-exempt entities a governmental plan structure which covers rank and file employees. If you find that the rank and file employees are included, this is one of the rare instances in which a DO 8-3 Closing Agreement may be appropriate.

    1. A 401(a), 401(k) or 403(b) plan can be substituted for the 457(b) plan where only rank and file are permitted to transfer assets with no tax consequences under the DO 8-3 agreement. Highly paid employees, executives, and other select group employees shouldn’t be considered eligible for this type of conversion and should remain in the 457(b) plan which is then treated as an ineligible 457(f) plan, IRM 4.72.19.9.

Deferrals – Overview and Taxation - Tax-Exempt Entities

  1. Annual deferrals include salary reduction and non-elective employer contributions. The amount deferred is considered an annual deferral in the later of the taxable year deferred or the year the deferral is no longer subject to a substantial risk of forfeiture.

    1. Substantial risk of forfeiture means that there’s no vesting schedule applied to the deferral or non-elective employer contributions, IRM 4.72.19.8.1.

  2. In addition to regular deferrals (including any non-elective employer contributions) a top-hat plan can allow a special 3-year pre-retirement catch-up, IRM 4.72.19.8.3.2.

  3. If annual deferrals under an eligible 457(b) plan are properly taken into account for FICA and 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, IRC 3121(v)(2)(B), IRC 3306(r)(2)(B), 26 CFR 31.3121(v)(2)-1(a)(2)(iii) and 26 CFR 31.3121(v)(2)-1(d)(1)(ii)(B).

  4. Annual deferrals, and income attributable to those deferrals are not taxable income for federal income tax purposes until paid or made available to the participant, 26 CFR 1.457-4(a).

  5. See Notice 2003-20, 2003-19 IRB 894, for guidance on the withholding and reporting requirements that apply to eligible tax exempt 457(b) plans for periods after December 31, 2001.

  6. Annual deferrals under an eligible tax-exempt 457(b) plan and any income attributable to the amounts deferred aren’t 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).

  7. Deferrals in a single employer’s eligible 457(b) plan in excess of the IRC 457(b) contribution limits are not annual deferrals so they’re subject to the income tax withholding rules under IRC 3402(a).

  8. Deferral agreements for 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 as required by IRC 457(b)(4).

  9. Deferral agreements for new employees may be entered into on or before the first day service is performed.

  10. Deferral agreements may remain in effect until the participant revokes or alters the terms of the agreement.

  11. Nonelective employer contributions are deemed to be made under an agreement entered into before the first day of the calendar month.

  12. Automatic enrollment features aren’t permitted in a top-hat plan.

Examination Steps– Deferrals and Taxation – Tax Exempt Entities
  1. Verify that plan language reflects that participants entered into deferral agreements before the first day of the month in which the deferred compensation would’ve been paid or made available as required by IRC 457(b)(4).

  2. Verify that the types of deferrals the plan language describes (including any employer non-elective contributions which are treated as deferrals) are the same as those in operation.

  3. Verify that all deferrals are subject to FICA and Medicare taxation and are only excluded from federal income tax.

    1. If the plan has employer non-elective contributions, verify they were included in gross compensation amounts before being treated as a deferral for federal income tax purposes.

    2. If deferrals, including any employer non-elective contributions, are not being treated as subject to FICA or Medicare taxation, consult with EO.

  4. Verify proper reporting as outlined in Notice 2003-20, 2003-19 IRB 894.

  5. If a plan/sponsor has taxation failures, they aren’t considered plan eligibility failures. Handle taxation failures via either a referral to EO or a discrepancy adjustment.

  6. Failure to properly limit the ability to begin deferrals per IRC 457(b)(4) is considered an eligibility failure, IRM 4.72.19.8.8.

  7. Both eligible tax-exempt 457(b) plans and eligible governmental 457 plans may state that an excess deferral resulting solely from a failure to comply with the individual limitation for combined annual deferrals under multiple eligible plans (under 26 CFR 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 (26 CFR 1.457-4(e)(4)).

    Note:

    Although a plan still maintains its eligible status if it doesn’t distribute deferrals in excess of the individual limitation under this rule, a participant must include the excess amounts in income.

Deferral Limitations and Excesses – Tax Exempt Entities

  1. The annual deferral limit applies on both an individual and plan basis, 26 CFR 1.457-4 and 26 CFR 1.457-5.

  2. Annual deferrals can’t exceed the sum of the basic annual limit plus any applicable special catch-up contribution.

    1. Annual deferrals are limited to the lesser of the applicable annual dollar amount, or 100% of a participant’s taxable year includible compensation, IRC 457(b)(2) and 26 CFR 1.457-4(c)(1).

    2. The applicable dollar amount is adjusted annually for cost-of-living increases under IRC 415(d), https://www.irs.gov/retirement-plans/cola-increases-for-dollar-limitations-on-benefits-and-contributions for current and prior year IRC 457(e)(15) deferral limits.

  3. Includible compensation under IRC 457(e)(5) is defined as compensation under IRC 415(c)(3) for services performed for the eligible employer. Includible compensation may include:

    1. Amounts includible in income under IRC 409A, IRC 457(f), or the constructive receipt doctrine if already scheduled for payment without regard to severance, 26 CFR 1.415(c)-2(b)(7).

    2. Amounts paid before severance of employment or paid within 2 ½ months after the later of severance from employment or the end of the calendar year that includes the date of severance, 26 CFR 1.415(c)-2(e) and 26 CFR 1.457-4(d).

    3. Payment for unused bona fide sick, vacation, or other leave, if the plan specifically includes these amounts and the employee would have been able to use the leave if they remained employed, 26 CFR 1.415(c)-2 and 26 CFR 1.457-4(d).

  4. Compensation under the final regulations to IRC 415(c)(3) includes deferrals in other tax-deferred arrangements.

    Reminder:

    Before the final regulations, includible compensation was net of deferrals into other tax-deferred arrangements such as 403(b) plans or section 125 deferrals.

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

  6. All eligible 457(b) plans of a single employer are treated as a single plan to determine the maximum deferral limitation for individual participants.

  7. Any amount deferred under an employer’s eligible 457(b) plans that exceeds the maximum deferral limitation is an excess deferral.

  8. Combined annual deferrals that exceed the individual limits due to participation in plans of different employers are treated as excess deferrals, 26 CFR 1.457-5.

  9. Employer nonelective contributions are considered annual deferrals when they become vested. Generally, annual deferrals don’t include earnings; however, annual deferrals subject to a vesting schedule are adjusted to include earnings on nonelective contributions in the year vested, 26 CFR 1.457-2(b)(2).

    Example 1: Employer A contributes to an eligible 457(b) plan $4,000 per year for five years for Employee B, and the amounts vest in year 5. Employee B will be treated as having deferred $20,000 ($4,000 x 5 years) in year 5, which, for that year, exceeds the maximum deferral limitation. B must include any earnings on the $20,000 and any salary reduction contributions when determining the amount of her deferrals in year 5.

  10. In rare instances, an eligible 457(b) 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 (not considering any 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, 26 CFR 1.457-2(b)(3).

Age 50 Catch-up Contributions and Roth Contributions – Tax-Exempt Entities
  1. Certain contributions are not permitted in a tax-exempt entity’s eligible plan:

    • Age 50 catch-up contributions

    • Roth contributions

Special Catch-up Contributions – Tax-Exempt Entities
  1. An eligible 457(b) plan may permit an increased deferral ceiling during one or more of the last three taxable years before normal retirement age under the special IRC 457 catch-up, 26 CFR 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 that participants have a right to retire and receive a benefit without actuarial or similar reduction for early retirement under the tax-exempt entity’s basic defined benefit pension plan or money purchase pension plan.

    1. Normal retirement age can’t be later than 70½.

    2. The plan must either designate a normal retirement age or permit the participant to designate a normal retirement age, 26 CFR 1.457-4(c)(3)(v).

      Note:

      The normal retirement age is merely a date that is required for purposes of making the special catch-up election. It does not require the participant to actually retire at that age.

    3. An entity that sponsors multiple eligible 457(b) plans may not permit more than one normal retirement age under all the plans it sponsors.

  3. The increased deferral ceiling under the special IRC 457 catch-up is the lesser of twice the applicable annual dollar amount, or the "underutilized limitation."

    1. The "underutilized limitation" is the sum of the plan ceiling (e.g., the lesser of the applicable annual dollar amount or 100% of includible compensation) for each year of participation, less the amount of deferrals the participant made in prior years. In other words, add up the limits for each year and subtract how much was deferred for each year and the difference is how much that person has available to defer under the special catch-up provisions.

    2. For purposes of determining the "underutilized limitation" for years before 2002, eligible 457(b) plan deferrals must be coordinated with deferrals to other plans (e.g., 403(b), 401(k), SEP, and SIMPLE plans), 26 CFR 1.457-4(c)(3)(iv).

Examination Steps – Limitations and Excesses – Tax-Exempt Entities
  1. Review the plan document to verify the types of deferrals permitted and if special catch-up contributions are permitted, the designated normal retirement age. Verify that the normal retirement age in the 457(b) plan is consistent with the normal retirement age noted in other plans of the employer.

  2. Request payroll records from the employer to accurately determine 457(b) deferrals made. You can’t rely on an IRPTRR report (for information returns processing) to determine deferrals made in a 457(b) plan. This is because the IRS system consolidates IRC 457(b) and IRC 403(b) deferrals on the Form W-2.

  3. Request payroll records with a separate column for each plan of the employer and the deferrals made to these plans. Payroll records should also include details on employer contributions made to each plan as applicable.

  4. Request W-2 records from the employer showing the breakdown of deferrals by plan type.

  5. Cross reference W-2 and payroll records to verify data. Verify that both elective and non-elective IRC 457(b) contributions are on the Form W-2 in the total amount of deferrals reported and that employer non-elective contributions are included in gross compensation before deferrals are deducted for federal income tax purposes.

  6. Ask the employer if they had additional 457(b) plans in which participants may also participate or may have participated in during the calendar year. Verify that deferrals under all plans of the employer are accounted for.

  7. Request participant account statements to show credited amounts under the unfunded trust.

  8. Sample and review deferral agreements to ensure timeliness of execution and the type of compensation to be deferred. A participant:

    1. May need separate agreements for various forms of compensation, such as unused sick or vacation pay.

    2. Must have entered into agreements to defer compensation in the month before the first day of the month that compensation was deferred.

    3. Must have made a written election to make special catch-up contributions, including designating the retirement age unless the plan designates the age and doesn’t allow the participant to designate.

  9. Analyze participants with annual deferrals in excess of the basic limit to determine whether they are entitled to the special catch up deferrals. For participants using the special catch-up provision:

    1. Request and review the employer’s calculation of the underutilized amount.

    2. Verify that only the years the employer maintained the plan and the years that the employee could have been a participant, are used in the calculation.

    3. Verify that deferrals made before 2002 were properly included in the calculation of a participant’s underutilized amount.

  10. If you become aware of participants who may have also participated in another employer’s 457(b) plan for the plan year under examination, review IDRS to determine if the participant’s combined 457(b) deferrals exceeded limits.

  11. Excess deferrals must be corrected by April 15 of the year following the year in which the excess occurred per 26 CFR 1.457-4(e)(3). The excess deferral is included in gross income in the year in which the excess occurred. If deferrals in excess of the plan limitation are not distributed timely, the plan is deemed an ineligible 457(f) plan, IRM 4.72.19.9.

    1. Note there is no mechanism in the code or regulations for removing excesses after the April 15 deadline, nor is the method of excess correction under Rev. Proc. 2009-19 EPCRS applicable. To remove excesses after the deadline creates another failure in that a distribution has now occurred without a permissible distributable event.

    2. If the deadline is passed, the participant must pay taxes on the excess but can’t remove the excess.

    3. If the participant: i) pays taxes, the excess will have basis at distribution but the earnings will be taxable when the participant receives their account as a plan distribution. If the participant: ii) doesn’t pay income taxes within the time period allowed by statute, the full amount, including earnings is taxed upon a distributable event.

Correction – Excess Deferrals – Tax-Exempt Entities
  1. If you identify excess deferrals on examination, determine if the plan sponsor corrected them by April 15 of the year following the year in which the excess occurred. If the sponsor didn’t timely correct the excesses or removed them after the deadline, the plan is no longer an eligible 457(b) plan as of the first day of the plan year in which the failure occurred, IRM 4.72.19.9.

    1. If excesses have been rolled over into an IRA refer to IRM 4.71.27, Employee Plans Examination of Returns, Form 5329 Examination Procedures. Also, note that rollovers are not permitted so this is a plan eligibility failure.

  2. 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 in the year in which there is no substantial risk of forfeiture if later, 26 CFR 1.457-4(e)(1).

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

  3. If the participant’s total deferrals don’t exceed plan limitations but do exceed the individual limitation due to participation in multiple unrelated eligible 457(b) plans, the plan keeps its eligible status, but the excess deferrals will be taxable to the participant in the later of the year vested or deferred. Earnings are taxed in the year that they accrue.

  4. Eligible 457(b) plans may permit an excess deferral resulting solely from a failure to comply with the individual limitation for combined annual deferrals under multiple eligible plans (under 26 CFR 1.457-5) for a taxable year to 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, 26 CFR 1.457-4(e)(4).

    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.

Deferrals of Sick, Vacation, and Back Pay -Tax-Exempt Entities

  1. Eligible 457(b) plan compensation may include accumulated sick, vacation and back pay paid after severance from employment, 26 CFR 1.457-4(d) and 26 CFR 1.415(c)-2(e)(3). So, an eligible 457(b) plan may permit a participant to elect to defer accumulated sick pay, vacation pay, or back pay, if the requirements outlined below are satisfied:

    1. An eligible 457(b) plan may permit a participant who has not had a severance from employment to elect to defer accumulated sick, vacation, and back pay, if they enter into the election to defer before the first day of the month that 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 calendar year that includes their severance date and they make the election before the beginning of the month the amounts are paid or made available.

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

    4. Post severance non-qualified deferred compensation is not eligible for deferral unless payment would’ve been made at that time without the severance.

      Note:

      Severance pay or parachute payments under IRC 280G(2)(b) aren’t eligible for deferral.

  2. Eligible 457(b) plans may also make deferrals for a participant who severed employment, after their date of the severance from employment, if the participant entered into the deferral agreement before the first day of the month in which the amount would otherwise be paid or made available, as long as 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 calendar year that includes the severance from employment date.

  3. The amounts must have otherwise been payable if employment had not terminated (26 CFR 1.457-4(d) and 26 CFR 1.415(c)-2(e)(3) issued on April 5, 2007). For unused leave, the participant must have been eligible to use the leave if employment had not terminated.

Examination Steps– Sick, Vacation, and Back Pay – Tax-Exempt Entities
  1. Verify agreements were entered into in the month before 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 calendar year that includes the date of severance from employment.

  3. Verify the participant would’ve been entitled to the amount deferred had they not had a severance from employment.

Distributions – Tax-Exempt Entities

  1. Plan amounts aren’t available to participants or beneficiaries, under IRC 457(d), earlier than:

    1. The calendar year in which the participant attains age 70 ½.

    2. The participant’s severance from employment with the employer maintaining the plan, or

    3. The participant’s unforeseeable emergency.

      Exception:

      The plan may distribute small amounts, and distributions for plan terminations or qualified domestic relations orders.

  2. Rollovers are not permitted from a top-hat plan. Plan language permitting rollovers or actual rollovers will cause the plan to become ineligible. Any amounts rolled over into an IRA are considered an excess to the IRA and subject to IRC 4973 excise taxes. Refer to IRM 4.71.27, Employee Plans Examination of Returns, Form 5329 Examination Procedures.

  3. An eligible tax-exempt 457(b) plan may have a period for the participant or beneficiary to make an initial election to defer commencement of plan distributions, per plan terms, of some or all of the amounts deferred, to a fixed or determinable future time, 26 CFR 1.457-7(c)(2)(ii).

    1. The period the participant or beneficiary must make this initial election must expire before the first time that any of these amounts would be considered available under the plan.

    2. After the initial election, the plan may have one additional election to further defer the commencement of distributions.

    3. The participant or beneficiary must make the additional election before distributions have commenced under the initial deferral election.

    4. Elections can’t extend beyond the date on which distributions are required to be made under IRC 401(a)(9).

  4. An eligible tax-exempt 457(b) plan may have a default payment schedule that would apply if no election is made under 26 CFR 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.

  5. An eligible tax-exempt 457(b) plan may permit participants to elect the method of payment to be made before the date the amounts are distributed under the initial or additional election to defer commencement of payment under 26 CFR 1.457-7(c)(2)(iv).

  6. Distributions from eligible tax-exempt 457(b) plans are considered to be wages under IRC 3401(a), are subject to income tax withholding rules under IRC 3402(a), and are reported on Form W-2 per the Form W-2 instructions.

  7. Income tax withheld must be deposited, per 26 CFR 31.6302, and reported on Form 941.

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

  9. 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.

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

Paid or Made Available Conditions– Tax-Exempt Entities
  1. The taxation of benefits from an eligible plan of a tax exempt entity depends on the availability of benefits for distribution under the plan terms.

  2. Availability is determined by taking into account the plan’s default conditions for distributions, the availability and timing of any election that a participant may make to alter the default method of distribution or the default timing of distributions otherwise payable under the terms of the plan.

  3. If there is a severance of employment, a participant can defer taxation via a transfer to a new employer’s eligible tax-exempt 457(b) plan, per 26 CFR 1.457-10(b)(5). However, both plans must allow for the transfer.

    1. The participant must elect this transfer before the severance of employment occurs.

    2. Transfers are not synonymous with rollovers. Rollovers between eligible tax-exempt 457(b) plans are not permitted.

  4. 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 per IRC 401(a)(9), 26 CFR 1.457-7(c)(2)(i).

  5. If the plan allows participants to elect to a future date or to elect the method of payment, and the participant properly executes the election, amounts are considered to be made available based on the elections made. Therefore, if the participant doesn’t elect to defer the timing of distributions or the method of distributions, amounts payable under the terms of the plan are includible in the participant’s or beneficiary’s gross income for the year in which amounts become payable regardless of whether there has been an actual distribution.

  6. An eligible tax-exempt 457(b) plan may allow a participant or beneficiary an initial election to defer the payment of benefits to a future date under 26 CFR 1.457-7(c)(2)(ii) and 26 CFR 1.457-7(c)(2)(iii).

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

    2. The participant or beneficiary must make these elections before the date the amounts become payable under the initial election.

  7. An election to defer commencement of benefits in an eligible 457(b) plan must not violate IRC 401(a)(9).

    1. The plan may also permit participants to choose among various payment options under 26 CFR 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.

  8. Amounts aren’t considered "made available" under the following circumstances:

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

    2. The availability of distributions satisfies the requirements for "unforeseeable emergencies" under 26 CFR 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 26 CFR 1.457-6(e).

  9. IRC 457 has a special rule for a QDRO. The special QDRO rule applies for transfers, distributions and payments made after December 31, 2001, 26 CFR 1.457-12(e).

Severance from Employment– Tax-Exempt Entities
  1. An employee has a severance from employment with the eligible employer if the employee dies, retires, or otherwise has a severance from employment (including leave for certain military service as described in IRC 414(u)(12)(B)), 26 CFR 1.457-6(b)(1). Also refer to the IRC 401(k) regulations for additional guidance on severance from employment.

    1. An employee has a severance from employment when the employee ceases to be an employee of the employer maintaining the plan, 26 CFR 1.401(k)-1(d)(2).

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

      Example:

      A new employer maintains a plan by continuing or assuming plan sponsorship, or by accepting a transfer of plan assets and liabilities, per IRC 414(l) for the employee.

  2. An independent contractor has a severance from service when all contracts requiring services to be performed for the eligible employer expire, if the contracts expiration constitutes a good faith and complete termination of the contractual relationship, 26 CFR 1.457-6(b)(2)(i). For more on good faith expiration of the contractual relationship, 26 CFR 1.457-6(b)(2)(i). An eligible 457(b) plan is considered to have satisfied the requirement for independent contractors if it requires that amounts:

    1. Won’t be paid or made available for at least 12 months after all contracts with the employer expire; and

    2. Payable to the participant on that date aren’t paid to the participant if, after the contracts expire and before that date, the participant performs services for the eligible employer as an independent contractor or an employee.

Unforeseeable Emergencies – Tax-Exempt Entities
  1. A tax exempt entity’s eligible plan may make a distribution for an unforeseeable emergency resulting from an unanticipated event, 26 CFR 1.457-6(c).

  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 (per IRC 152 and, for taxable years beginning on or after January 1, 2005, not considering 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, medical expenses, and a spouse’s or dependent’s funeral expenses may constitute unforeseeable emergencies.

  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.

    Example:

    Medical expenses for cosmetic surgery or cosmetic dental work generally wouldn’t qualify unless due to an unforeseeable event.

  5. Plan 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 if the emergency is or may be relieved through:

    1. Insurance (or other) reimbursement or compensation,

    2. Liquidation of the participant's assets, if the liquidation doesn’t itself cause severe financial hardship, or

    3. Stopping plan deferrals.

  6. Generally, the purchase of a home or the payment of college tuition don’t qualify as an unforeseeable emergency.

Required Minimum Distributions – Tax-Exempt Entities
  1. A plan must meet the minimum distribution requirements of IRC 401(a)(9), IRC 457(d)(2).

  2. A plan, under IRC 401(a)(9) must 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 reaches age 70½ or retires. Refer to IRC 401(a)(9) and its regulations for additional guidance.

    Note:

    The SECURE Act substituted “age 70 ½” with age 72 effective for individuals reaching age 70 ½ after December 31, 2019.

Distributions of Smaller Accounts– Tax-Exempt Entities
  1. An eligible 457(b) plan may permit a distribution of all, or a portion, of a participant's benefit if the participant hasn’t had either:

    1. Amounts deferred under the plan on their behalf during the two-year period ending on the date of the distribution; and

    2. Prior distribution under the plan under the small account rule.

  2. An eligible 457(b) plan isn’t required to permit distributions of small accounts. However, if it does, and the above requirements are otherwise satisfied, the plan may limit small accounts to an amount less than the dollar limit under IRC 411(a)(11)(A).

  3. A plan may state that the distribution will be made automatically, at the participant’s election, or a combination of both, 26 CFR 1.457-6(e).

Qualified Domestic Relations Orders (QDROs)– Tax-Exempt Entities
  1. An eligible 457(b) plan doesn’t violate the restrictions on distributions under IRC 457(d) if it pays an alternate payee under a QDRO, as defined in IRC 414(p),CFR 26 CFR 1.457-10(c).

  2. The alternate payee is the distributee per IRC 402(e)(1)(A).

  3. A payment from an eligible 457(b) plan to an alternate payee who is the participant’s spouse or former spouse is includible in the gross income of the alternate payee if made per a QDRO as defined in IRC 414(p).

  4. 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 26 CFR 1.457-10(c).

Loans– Tax-Exempt Entities
  1. An eligible tax-exempt 457(b) plan may not allow participant loans, 26 CFR 1.457-6(f)(1):

    1. If a participant or beneficiary receives (directly or indirectly) any amount they deferred as a loan from an eligible tax-exempt 457(b) plan, it’s treated as having been paid, or made available, to the individual as a distribution under the plan and violates the distribution requirements of IRC 457(d).

    2. A loan from a tax-exempt entity’s IRC 457(b) plan fails the requirements under IRC 457(b), causing it to become an ineligible plan subject to taxation under IRC 457(f) and 26 CFR 1.457-11.

Plan to Plan Transfers – Tax-Exempt Entities
  1. A tax-exempt employer’s eligible plan assets can’t be transferred to a governmental 457(b) plan and vice versa and a plan document can’t have language allowing a transfer.

  2. A tax-exempt employer’s eligible plan may permit a post-severance transfer of a participant’s assets to another top-hat plan subject to the following rules:

    1. Both the transferring plan and the receiving plan must have language allowing plan-to-plan transfers.

    2. Amounts received in a transfer must be at least equal to the dollar value of the transfer immediately before the transfer occurred.

    3. If assets are transferred to a different employer’s eligible 457(b) plan, the affected participants must have had a severance from employment with the transferring employer and must be performing services for the recipient employer.

Examination Steps– Distributions Paid or Made Available – Tax-Exempt Entities
  1. Review the plan document to determine the distributable events, the permitted methods of payments, and any elections available to participants.

    1. Verify that the plan in form does not conflict with the type and form of distributions allowed in operation.

    2. Ensure plan language complies with all applicable requirements for distribution restrictions under IRC 457(d) and IRC 401(a)(9).

    3. Verify, for any optional provisions, that the plan has language for that optional provision.

      Example:

      If the plan permits unforeseeable emergency distributions, the plan language must state the conditions under which an unforeseeable emergency distribution can be made.

  2. Request a list of plan distributions and type of distribution (termination, transfer, rollover, etc.) including any loans and unforeseeable emergency requests.

    Note:

    The plan shouldn’t permit loans or rollovers and asking to include any on the list is simply verifying that none occurred.

  3. Request a list of all participants, the amount of their account balances, and termination date, if any.

  4. Review procedures and the type of records the employer keeps for plan distributions during your interview.

  5. Examine payroll/census records to determine participants who terminated employment during the year under examination and to identify individuals who are age 70 ½ (72 for individuals turning 70 1/1 after December 31, 2019) or older. Compare this with any report identifying the participants who received distributions in excess of the dollar amount in IRC 411(a)(11)(A) for small accounts, IRM 4.72.19.6.8.4, Distribution of Smaller Accounts. Also check for operational compliance with IRC 401(a)(9).

  6. Document your work papers to show you completed the above steps were completed and identify the documents/reports you examined. Determine if there are any obvious failures or concerns for each of the different types of distributions.

  7. Use the examination steps for reviewing required minimum distributions under 401(a)(9) as you would for those in a 401(a) plan.

  8. Verify and document, for unforeseeable emergency distributions, that they comply with the rules in IRM 4.72.19.8.5.3 Unforeseeable Emergencies.

  9. Document that the transferred amounts the top-hat plan received are accounted for separately and were transferred from another top-hat plan.

  10. For any participant that has terminated and still has an account balance, verify when their accounts were made available based on the provisions of the plan document.

    1. Note:

      If the plan permits the participant to elect to defer distributions to a later date or to select a method of payment (such as installments or lump sum) request and review election forms and verify that the participant made the election timely.

  11. For any amounts that were paid or made available in the current year, request and examine W-2s to verify proper reporting and withholding. Plan sponsors often report top-hat distributions, in error, on Form 1099. If they do - it’s not a plan eligibility failure, however, verify taxes were withheld/paid and educate the plan sponsor about properly reporting distributions on a Form W-2.

  12. Testing is intended to verify that account balances were taxed when made available. This may be at the same time they were paid but, it may not be. Amounts deferred under an eligible tax-exempt 457(b) 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 26 CFR 1.457-7(c)(2).

  13. For participants who should’ve had amounts distributed but didn’t, review to determine if the amounts were taxed when they were available for distribution, regardless of whether or not the amounts were actually distributed.

  14. Failure to tax and distribute amounts per the terms of the plan document, IRC and regulations is a plan eligibility failure. However, the IRS’s focus in a top-hat plan is not on whether the participants received their account balances but whether the amounts were properly taxed when paid or made available.

Funding– Tax-Exempt Entities

  1. An eligible tax-exempt 457(b) plan’s assets must be unfunded, IRC 457(b)(6) and 26 CFR 1.457-8(b), for both employee and employer contributions.

  2. "Unfunded" means that plan assets may not be held in trust for the exclusive benefit of participants. The assets must remain the employer’s property subject to the claims of the employer’s general creditors.

    Note:

    Unfunded does not mean that the plan sponsor can’t set assets aside to pay future benefits. It simply means that those assets must be subject to creditors and can’t be in the name of the benefitting employee/participant.

  3. Review the plan document and determine whether there are any other governing documents for plan assets. An eligible 457(b) plan of a tax-exempt entity may hold plan assets in a "Rabbi Trust" , IRM 4.72.19.8.6.1, Rabbi Trusts.

Rabbi Trusts– Tax-Exempt Entities
  1. Rabbi Trusts are a way in which a top-hat plan sponsor can set aside assets to provide a source of funds for future benefits. The trust, however, must still remain subject to creditors.

    1. The name stems from a 1980 IRS Private Letter Ruling that involved a rabbi whose congregation had made contributions to a trust for the rabbi’s benefit.

    2. Eventually, the IRS issued Revenue Ruling 92-64 that provided specific guidance on how a trust can properly be used in a non-qualified deferred compensation plan such as an eligible 457(b) plan of a tax-exempt entity.

  2. The trust must be set up as an irrevocable trust that can’t be terminated by the plan sponsor. The trust is considered a "grantor trust" with the earnings from the trust being taxed to the plan sponsor. However, a tax-exempt entity is not required to pay taxes on trust earnings, nor are they required to file a Form 1041.

Examination Steps – Funding – Tax-Exempt Entities
  1. Review the plan document and determine whether there are any other governing documents for plan assets.

  2. If the plan sponsor is using a Rabbi Trust:

    1. Review the trust documents to verify the trust complies with Revenue Ruling 92-64.

    2. Verify that the assets are in the name of the Rabbi Trust.

  3. Obtain account statements and verify that title to plan assets is in the employer’s name and the assets are subject to the employer’s creditor’s claims.

    1. In a Rabbi Trust, verify that the name of the trust is that of an independent trustee and not the employer.

  4. Consider reviewing financial statements and accounting ledgers to verify that assets are the employer’s property. The plan sponsor should be reporting the amounts attributable to the 457(b) plan as both an asset and a liability.

  5. A tax-exempt entity’s funded 457(b) plan is not an eligible 457(b) plan, IRM 4.72.19.9, Ineligible 457(f) Plans.

Plan Terminations and Frozen Plans– Tax-Exempt Entities

  1. A plan may contain provisions permitting plan termination and subsequent distributions without violating the distribution restrictions under IRC 457 and 26 CFR 1.457-10(a)(2)(ii).

    1. An eligible 457(b) 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 distributed until the occurrence of a distributable event under the plan.

    3. The plan must continue to comply with all of the applicable statutory requirements needed 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 26 CFR 1.457-2(e) may no longer maintain an eligible 457(b) plan. If the employer is tax-exempt and the plan is not terminated, the tax consequences to participants and beneficiaries are determined per 26 CFR 1.457-11 (if the employer becomes a state entity).

Examination Steps – Terminated or Frozen Plan – Tax-Exempt Entities
  1. Review the plan document to verify it has language allowing termination of the eligible 457(b) plan and that the plan sponsor adopted an amendment terminating (or freezing) the plan.

  2. Document whether distributions have been made and taxed to all participants as soon as administratively practicable (generally within one year) following the date of termination. Verify that no distributions were permitted to be treated as a rollover.

  3. Document whether the employer continues to be an eligible employer under IRC 457(e)(1) or 26 CFR 1.457-2(e).

  4. For a former tax-exempt employer no longer eligible to have an IRC 457(b) plan, but the plan hasn’t been terminated, document whether the tax consequences to participants and beneficiaries were determined per:

    1. 26 CFR 1.457-11 (if the employer becomes a state entity), or

    2. IRC 451 if the employer becomes an entity other than a state or another type of tax-exempt entity.

  5. If the plan has been frozen, verify that no deferrals or employer contributions have been made and that distributions continue to occur according to the plan document.

Grandfathered Plans – Tax-Exempt Entities
  1. Non-qualified deferred compensations plans sponsored by tax-exempt entities are required to comply with IRC 457 for taxable years beginning after December 31, 1986. (TRA ’86 amended 457 to include non-governmental tax-exempt organizations.)

  2. IRC 457(b) under Section 1107(c)(3)(B) doesn’t apply to deferrals under a deferred compensation plan of a tax-exempt entity for amounts that:

    1. were deferred for taxable years beginning before January 1, 1987, or

    2. are deferred for taxable years beginning after December 31, 1986, per an agreement that, was in writing on August 16, 1986, and on such date, provides for a deferral for each taxable year covered by the agreement of a fixed amount or of an amount determined by a fixed formula.

  3. Any modification to the fixed amount or fixed formula means that IRC 457 applies to any taxable year ending after the date on which the modification is effective. This includes individual participant modification or plan modification.

    1. This means that the amounts deferred under the old formula may exceed the limits established by 457(e)(15).

    2. Notice 87-13 gives Q & A guidance on this.

  4. Grandfathered 457(b) arrangements are only available to individuals covered under the plan on August 16, 1986. If new participants are allowed after this date, the plan loses its grandfathered status.

  5. Treasury Regulation 1.457-2(k)(4) included language that allowed non-qualified deferred compensation arrangements in existence before January 1, 1987, to be treated as a grandfathered 457(b) plan in existence before January 1, 1987, if it meets the requirements stated above.

  6. 26 CFR 1.457-2(b)(4) reduces the amount that can be deferred to a non-grandfathered 457(b) plan (a current eligible 457(b) plan) by amounts that are deferred to a grandfathered 457(b) pan.

  7. A grandfathered plan can make changes that do not affect the contribution.

    Example:

    The plan can change the benefit commencement date or modify or clarify a plan’s other definitions.

  8. If a violation occurs in a grandfathered plan, amounts deferred under the plan are included in gross income of the participants in the year the failure occurs and every year thereafter if deferrals continue.

  9. If you identify a grandfathered 457(b) arrangement, review Notice 87-13 for more detailed guidance and request the plan document. Verify that there have been no changes to the contribution formula, no participants have been allowed to change their elections, any contributions to an eligible 457(b) plan are netted against the grandfathered plan’s deferrals and no new participants have been allowed in. If any of these conditions aren’t met, make sure deferrals in all open statute years have been taxed or make discrepancy adjustments.

Top Hat Plan Failures

  1. An eligible 457(b) plan administered in a manner inconsistent with the requirements of IRC 457(b) and 26 CFR 1.457-3 through 26 CFR 1.457-10 is an ineligible 457 plan subject to the rules under IRC 457(f) and 26 CFR 1.457-11.

  2. An eligible 457(b) plan of a tax-exempt employer administered in a manner inconsistent with the requirements of IRC 457(b) and 26 CFR 1.457-3 through 26 CFR 1.457-10 ceases to be an eligible 457(b) plan on the first day that the plan fails to satisfy one or more of the requirements of the IRC and related regulations, 26 CFR 1.457-9(b).

  3. For unfunded deferred compensation plan established for the benefit of top-hat employees of a tax-exempt entity, the IRS generally won’t enter into an agreement to address plan failures, Section 4.09, Rev. Proc. 2019-19.

    Exception:

    However, the IRS may consider a submission, where, for example, the plan was erroneously established to benefit the entity’s non-highly compensated employees and the plan has been operated in a manner that is similar to a qualified plan.

  4. In practice, this means that in most cases, if you find failures in a top-hat plan, treat the plan as an ineligible 457(f) plan and the correction principles of EPCRS do not apply. Non-qualified deferred compensation plans are not considered retirement plans and, therefore, the goal is not the protection of retirement benefits but the protection of taxes owed.

    Reminder:

    The "top-hat" exemption was created under ERISA 1974, not under the IRC. The IRS accommodated that exemption in 1986 when it included unfunded plans of tax-exempt employers in TRA 1986. The top-hat exemption was created to allow additional benefits (i.e., over and above those permitted under qualified plans) to a select group of management or highly compensated employees. This select group was presumed to have sufficient knowledge and leverage with the employer to not need complete ERISA and IRC protections.

DO 8-3 Correction
  1. If the facts and circumstances of a top-hat plan failure lead you to seek an alternative to treating an eligible 457(b) top-hat plan as an ineligible 457(f) plan, you can consider a closing agreement under Delegation Order 8-3 as a way in which to address the eligibility failures for a taxable period or periods ended before the date of the agreement.

  2. DO 8-3 closing agreements allow the taxpayer and the Commissioner to formally agree that the plan under examination won’t be treated as an ineligible 457(b) plan. When a DO 8-3 closing agreement is fully executed by the taxpayer and the Commissioner’s delegated representative, the case becomes an agreed case in every respect, just like a case resolved under EPCRS. The taxpayer is legally forgoing their right to an Appeals hearing and their right to petition the Tax Court.

  3. Only offer or discuss resolutions using a DO 8-3 Closing Agreement with the tax-exempt organization when steps (4) through(10) are completed.

  4. As with EPCRS closing agreements, you must closely coordinate DO 8-3 closing agreements with your Area CAP Coordinator.

  5. When doing a DO 8-3 closing agreement, follow the closing agreement procedures in IRM 4.71.3.5.2, Employee Plans Examination of Returns, Unagreed Form 5500 Examination Procedures and EP Examinations Closing Procedures. They are similar to the procedures for EPCRS except that:

    1. You must get approval from the group manager, Area Manager, and Director, EP Examinations before you propose a DO 8-3 agreement.

    2. You must prepare an Executive Summary which includes Form 886-A, Revenue Agent Report (or the equivalent) and tax consequence calculations.

    3. The Director, EP Examinations signs the closing agreement for the Commissioner.

  6. Before you propose the DO 8-3 closing agreement to the taxpayer, prepare the following documents and send them via secure email to your group manager for review.

    1. DO 8-3 Transmittal Checksheet.

    2. Executive Summary which includes Form 886-A (or the equivalent) and tax consequence calculations.

    3. Draft DO 8-3 Closing Agreement.

  7. If the group manager determines that the above documents are acceptable, the documents will be forwarded by secure email to the Area CAP Coordinator. If the documents are unacceptable, the group manager will contact the agent for the appropriate revisions.

  8. If the Area CAP Coordinator determines that the documents the group manager sent are acceptable, they’ll secure email them to the Area Manager for review. If the documents are unacceptable, the Area CAP Coordinator will contact the group manager and the agent for the appropriate revisions.

  9. If the Area Manager determines that the documents the Area CAP Coordinator sent are acceptable, the documents will be forwarded the Director, EP Examinations for review using secure email. If these documents are not acceptable, then the Area Manager will contact the Area CAP Coordinator for the appropriate revisions.

  10. If the Director, EP Examinations determines that the documents the Area Manager sent are acceptable, then the Director, EP Examinations will approve and return them to the Area Manager and/or Area CAP Coordinator to forward to the group manager and agent. If the documents are unacceptable, then the Director, EP Examinations will contact the Area Manager and/or the Area CAP Coordinator for the appropriate revisions.

  11. When you receive approval from the Director, EP Examinations, send the draft closing agreement to the taxpayer using Letter 1595.

  12. If the taxpayer or Power of Attorney (POA) requests changes to the closing agreement language, secure approval from the EP Examinations Director.

  13. Secure documentation that the plan sponsor has corrected the issue(s) before you send the final closing agreement to the taxpayer/POA.

  14. Send three copies of the final closing agreement to the taxpayer/POA using Letter 1595-A along with execution and payment instructions (if appropriate).

  15. As soon as you receive the signed DO 8-3 closing agreements and payment, prepare the documents described in IRM 4.71.3.5.1(5) and forward to the Area CAP Coordinator.

  16. Upon receipt, the Area CAP Coordinator will send the signed closing agreements to the Director, EP Examinations for signature.

  17. After securing the fully executed closing agreements, the Area CAP Coordinator will mail fully executed closing agreement with the items listed in IRM 4.71.3.5.1, paragraphs (5)(c) through (g) to the Kansas Service Center "Next Day Air."

  18. The Area CAP Coordinator will mail a fully executed closing agreement to the:

    • Agent,

    • Taxpayer with Letter 1595-D,

    • POA with Letter 1595-D and coverLetter Letter 937-A, if applicable.

  19. When you receive the fully executed closing agreement:

    • Close the case as an agreed case per IRM 4.71.1.22, Employee Plans Examination of Returns, Overview of Form 5500 Examination Procedures.

    • Close the case disposal code 15 (disposal code 106 on RCCMS).

    • Use the applicable closing letter per IRM 4.71.1.22.1, Employee Plans Examination of Returns, Overview of Form 5500 Examination Procedures.

Ineligible 457(f) Plans

  1. For agreements or arrangements for the deferral of compensation, if the plan is not an eligible deferred compensation plan, the deferred compensation is included in gross income when the rights to payment of the deferred compensation cease to be subject to a "substantial risk of forfeiture" (IRC 457(f)(1)(A)).

  2. For an eligible 457(b) top-hat plan, deferrals are generally 100% vested at the time of deferral. Vested means the individual has no substantial risk of forfeiture. If the plan has a vesting schedule, any amounts not 100% vested are considered to have a substantial risk of forfeiture.

  3. When an eligible 457(b) top-hat plan is deemed ineligible, all deferrals that are 100% vested are taxable as income to the participant for all years open to statute. IRS can collect tax on the deferrals via:

    • discrepancy adjustments, IRM 4.71.4.

    • an employment tax adjustment for larger cases which would require a referral to EO’s Employment Tax specialists, IRM 4.71.6.

  4. Although taxes are assessed on deferrals open to statute, plans can’t distribute accounts until there is a distributable event (made available).

  5. When account balances are made available, the tax treatment on any previously untaxed portion is determined under IRC 72 relating to annuities.

  6. An ineligible 457(f) plan doesn’t allow elections delaying payment or forms of payment. Therefore, when a distributable event occurs such as termination or reaching age 701/1, amounts are deemed to have been made available for income tax purposes.

  7. An employer can elect to terminate the plan thereby making all balances available and taxable but then the participants are not required to wait for a distributable event to receive their balances.

  8. It is common to find issues with tax-exempt employers’ IRC 457(b) plans and IRC 457(f) arrangements that don’t satisfy the substantial risk of forfeiture requirement for tax deferral. Take these steps when you see these issues:

    1. Determine the amount of deferred compensation for each open year.

    2. Assess taxes through the RGS Discrepancy Adjustment program, or if the amounts are significant enough, ask EO to handle employment tax issues.

    3. Secure consents to extend the statute of limitations on Forms 1040 as necessary.

    4. Secure consent to extend the statute of limitations on employment taxes using Forms SS-10 as necessary.

  9. 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 26 CFR 31.3121(v)(2)-1(e)(1).

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

    Note:

    Under 26 CFR 1.457-11, amounts paid or made available are includible in gross income under IRC 72.

  11. For any amounts previously taxed, but not distributed from a 457(b) or 457(f) plan, the participant will have basis on that amount and is not required to pay tax again at the time of distribution. The individual is responsible for reporting this on Form 1040 for the year distributed, IRC 72 for additional guidance on basis, Pub 575, Pension and Annuity Income, and Pub 525, Taxable and Nontaxable Income.

Substantial Risk of Forfeiture

  1. A "substantial risk of forfeiture" exists where rights in property that are transferred are conditioned, directly or indirectly, upon any person’s future performance (or refraining from performance) of substantial services. A substantial risk of forfeiture can also exist where a condition must be satisfied and the possibility of forfeiture is "substantial" if that condition is not satisfied.

    1. 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.

    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 facts and circumstances:

    1. Covenants not to compete – This is an enforceable requirement where an employee would return compensation to the employer if they accept a job with a competing firm. "Covenants not to compete" are not ordinarily considered to result in a substantial risk of forfeiture unless the particular facts and circumstances indicate to the contrary. Consider these factors to determine whether a "covenant not to compete" is a substantial risk of forfeiture: the employee’s age, the availability of alternative employment opportunities, the likelihood the employee will get other employment, the degree of skill the employee has, the employee’s health, and the employer’s practices to enforce these covenants.

    2. Consulting service agreements - Rights to property (compensation) 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 subject the rights to property to a substantial risk of forfeiture unless the parties anticipate the performance of substantial services. Refer to Richardson v. Commissioner, 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.

      Note:

      A willingness to subject compensation that is about to be received free and clear of any restrictions to a real and meaningful risk of forfeiture that will be enforced for a significant period of time, could be viewed as suspect.

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

    1. The current policy is that EP plans agents will not pursue failures of 409A and any related penalties.

Examination Steps for 457(f) Arrangements
  1. Request and review employment contracts for executives, highly paid employees, head coaches, and endorsement contracts for deferred compensation provisions.

  2. Request and review employee handbooks. Don’t simply accept what the employer defines as the benefit.

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

  4. If you identify a deferred compensation arrangement, verify there is a valid definition of a substantial risk of forfeiture and that employees are properly taxed upon the expiration of that substantial risk of forfeiture.

  5. 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.

  6. Confirm that IRC 457(f) amounts are not set aside for the benefit of participants (funded).

  7. 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 resources, legal, or a special paymaster.

  8. Request and review Forms W-2 for entries in Box 11 for reference codes indicating the existence of IRC 457(f) or 409A arrangements. Compare gross to net payroll.

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

  10. Request and 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.