4.72.19 IRC 457 Examination Guidelines

Manual Transmittal

August 17, 2017

Purpose

(1) This transmits revised IRM 4.72.19, Employee Plans Technical Guidance - IRC 457 (Deferred Compensation Plans of State and Local Governments and Tax-exempt Organizations) Examination Guidelines.

Material Changes

(1) IRM 4.72.19.1, Program, Scope and Objectives, and the subsections thereunder, were added to meet the new internal controls requirements.

(2) Minor editorial changes were made throughout the document, including the annual updates to the catch up contributions tables at IRM 4.72.19.11.3 and IRM 4.72.19.11.4.

Effect on Other Documents

This supersedes IRM 4.72.19 dated July 18, 2016.

Audience

Tax Exempt and Government Entities
Employee Plans

Effective Date

(08-17-2017)


Robert S.Choi
Director, Employee Plans
Tax Exempt and Government Entities

Program Scope and Objectives

  1. Purpose: IRM 4.72.19, Employee Plans Technical Guidance - IRC 457 (Deferred Compensation Plans of State and Local Governments and Tax-exempt Organizations) Examination Guidelines, is designed primarily to assist Employee Plans (EP) agents conduct quality examinations of Eligible and Ineligible Plans under IRC 457 (referred herein as Eligible 457 Plans and Ineligible 457 Plans).

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

  3. Policy Owner: Director, EP Examination.

  4. Program Owner: EP Examination.

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

  6. Program Goals: The information contained in this IRM is designed to promote quality examinations of Eligible and Ineligible 457 Plans. To achieve this goal, this IRM discusses the technical aspects of IRC section 457, the underlying regulations, and provides examination steps for the agent to take to determine whether a Plan is in compliance with the provisions of the law. This IRM also provides procedural guidance on initiating, working and closing the examination case file.

Background

  1. EP Examination is the division designated to determine whether Eligible 457 Plans and Ineligible 457 Plans are in compliance with IRC 457 and the underlying regulations.

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 used to oversee the entire examination program. For more information on TEQMS, see IRM 4.71.15.1.3, Program Controls and Program Reports - TEQMS.

  2. All examinations will be done in accordance with the Taxpayer Bill of Rights as listed in IRC 7803(a)(3).

    Note:

    Additional information may be found on the irs.gov website at www.irs.gov/taxpayer-bill-of-rights.

Acronyms, Abbreviations and Forms

  1. This manual uses the following acronyms and references the following forms.

    Acronyms and Abbreviations

    Acronym/Abbreviation Definition
    CAS Computer Audit Specialists
    CRF Code of Federal Regulations
    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
    FSLG Federal State and Local Governments
    FUTA Federal Unemployment Tax Act
    IDR Information Document Request
    IDRS Integrated Data Retrieval System
    IRC Internal Revenue Code
    IRS Internal Revenue Service
    PPA 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


    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 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. The guidance contained in this IRM is designed primarily to assist E P examiners in identifying relevant issues relating to Eligible 457 Plans and Ineligible 457 Plans.

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

  3. In examining Ineligible Plans of state and local governments and tax exempt organizations, agents must determine when deferred compensation becomes taxable.

  4. Agents may need to consult the IRC and Regulations for further development of a particular issue. Accordingly, cites are provided where appropriate. Unless otherwise noted, all references are to the final Regulations.

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

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

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

  8. These guidelines cannot be, nor are they intended to be, a comprehensive statement of the legal position of the IRS.

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

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

Technical Overview of IRC 457

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

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

  3. IRC 457 contains a special rule for options. 26 CFR 1.457-11(d) does not apply to an option without a readily ascertainable fair market value under IRC 83(e)(3) granted on or before May 8, 2002. See 26 CFR 1.457-12(d).

  4. IRC 457 contains a special rule for QDRO). 26 CFR 1.457-10(c) provides that the special QDRO rule applies for distributions and payments made after December 31, 2001.

Correction of Eligible 457 Plan Failures

  1. An Eligible 457 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 may become an Ineligible 457 Plan subject to the rules under IRC 457(f) and 26 CFR 1.457-11.

    1. Under IRC 457(b)(6), an Eligible Governmental Plan administered in a manner inconsistent with the requirements of IRC 457(b) and 26 CFR 1.457-3 through 26 CFR 1.457-10 will not be treated as an Ineligible 457 Plan until the beginning of the first plan year beginning more than 180 days after the date of notification by the Secretary of the inconsistency unless the employer corrects the inconsistency before the first day of such plan year.

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

  2. Section 4.09 of Rev. Proc. 2013-12, 2013-4 IRB 313, as modified by Rev. Proc. 2015-27, 2015-16 IRB 914, and Rev. Proc. 2015-28, 2015-16 IRB 920, provides that submissions relating to IRC 457(b) Eligible Governmental Plans will be accepted by the Service on a provisional basis outside of the EPCRS through standards that are similar to EPCRS.

    Note:

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

General Characteristics of 457 Plans

  1. A plan under IRC 457 is either:

    1. An "Eligible 457 Plan" that satisfies the requirements under IRC 457(b) and 26 CFR 1.457-3 through 26 CFR 1.457-10 , or

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

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

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

    • The right to determine when payments will begin

    • Directed investments

    • Additional catch-up contributions

    • Age 50 catch-up contributions (Governmental Plans)

    • Distributions for unforeseeable emergency

    • Loans (Governmental Plans)

    • Provisions for plan termination

    • Provisions for transfers to and from another Eligible 457 Plan

    • Qualified Roth contribution program (Governmental Plans)

  6. Optional features must meet, in form and operation, the relevant provisions of 26 CFR 1.457-3 through 26 CFR 1.457-10.

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

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

    Exception:

    Designated Roth contributions are included in income in the year of deferral.

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

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

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

    1. In essence, an Ineligible 457 Plan is any plan of deferred compensation maintained by an Eligible Employer that is not an Eligible 457 Plan under IRC 457(b) and 26 CFR 1.457-3 through 26 CFR 1.457-10.

    2. Under an Ineligible 457 Plan, annual deferrals, and the income earned on those amounts that are not subject to a substantial risk of forfeiture, are taxed when earned. If a substantial risk of forfeiture exists, the amounts become taxable when the risk no longer exists.

  12. The following plans are excluded from IRC 457:

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

    2. Bona fide vacation leave, sick leave, compensatory time, severance pay (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. Any plan paying length of service awards to bona fide volunteers (and their beneficiaries) under IRC 457(e)(11)(A)(ii).

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

      Note:

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

Focused Examinations

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

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

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

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

Pre-Audit Analysis

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

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

    • The Internet

    • Form 990 (if the sponsoring employer is tax exempt)

    • Top Hat Plan data

    • Form 5500

  3. The pre-audit analysis could indicate the need for assistance from specialists such as CAS, EO, and FSLG.

    Note:

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

  4. 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, for Eligible 457 Plans.

    2. Prepare Letter 1346-G, Non-Return Unit Examination Appointment Letter, for Ineligible 457 Plans.

    3. Attach a request for the various types of records needed to conduct the examination. Separate Form 4564s (IDRs) for each area of examination are recommended.

  5. After you mail the letter, call the taxpayer to discuss the availability of books and records, the scope of the audit and the date for the initial appointment.

  6. The agent’s phone call should be:

    1. No earlier than fourteen calendar days after the 1346 series letter is mailed, and

    2. No later than twenty one calendar days after the letter is mailed.

    Note:

    The taxpayer must be given ample time to receive the letter before the agent calls to schedule the audit appointment.

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

Package Audits

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

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

    • Related EP returns (Form 5500 and Form 5330)

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

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

  3. Conduct IDRS research to determine filing requirements and whether returns have been timely filed.

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

Initial Interview

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

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

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

    1. Know what you want to accomplish.

    2. Develop a strategy.

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

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

    5. Listen to answers.

    6. Follow up immediately if responses are ambiguous.

    7. Document responses.

  4. See IRM 4.71.1.12, Initial Interview, for a discussion of the importance of the initial interview.

  5. Use of an internal control questionnaire can be helpful, but should not be used in lieu of the interview.

Evaluation of Internal Controls

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

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

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

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

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

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

  7. Plan records and persons responsible for maintaining them are usually located at the employer’s place of business; therefore, the initial interview and the assessment of internal controls should be conducted at the employer’s place of business (see 26 CFR 301.7605-1(d)).

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

Eligible Employer

  1. IRC 457 Plans are restricted to Eligible Employers under IRC 457(e)(1) and 26 CFR 1.457-2(e).

  2. Generally, an Eligible Employer is:

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

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

      Note:

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

  3. Under 26 CFR 1.457-2(l) the term "state" includes the District of Columbia.

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

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

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

  5. Under 26 CFR 1.457-10(a), an employer that ceases to be an Eligible Employer may no longer maintain an Eligible 457 Plan and must either terminate the plan, or, in the case of a governmental entity, transfer assets to another Eligible Plan of the state.

Examination Steps

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

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

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

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

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

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

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

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

    6. The degree of financial autonomy.

    7. The source of its operating funds.

  4. If a determination cannot be made that the sponsoring organization is an Eligible Governmental Employer, consider referring the issue of Eligible Employer status to FSLG .

    Note:

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

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

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

    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 web site. Tax Statistics contains statistical tables, articles, and other information on charities and other tax exempt organizations.

    5. The GuideStar web site provides a searchable database of IRC 501(c)(3) charitable organizations, including online copies of Forms 990, Forms 990-EZ or Forms 990-PF, and other information.

    6. Forms 990 can easily be obtained at the Foundation Center - 990 Finder.

Issue Resolution and Correction

  1. Under 26 CFR 1.457-10, a governmental employer that ceases to be an Eligible Employer due to a change in status (no longer governmental), may either terminate the plan, or transfer assets to another Eligible Governmental Plan within that same state.

  2. The tax consequences to participants of a previously Eligible Governmental 457 Plan that was neither terminated nor transferred assets, are determined under either IRC 402(b), if the assets are held in a trust, or under IRC 403(c), if the assets are in annuity contracts and the trust is no longer tax exempt under IRC 501(a).

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

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

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

    2. Determined under 26 CFR 1.457-11, if the employer becomes a State.

  5. See IRM 4.71.17.7, Procedures for Correction of Eligible IRC 457 Plan Failures for procedures to correct failures in an Eligible IRC 457 Plan.

Employees Eligible to Participate

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

Participation in Eligible Tax Exempt 457 Plans

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

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

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

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

Participation in Eligible Governmental 457 Plans

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

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

  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.

Examination Steps

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

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

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

Issue Resolution and Correction

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

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

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

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

  2. Eligible Tax Exempt 457 Plans cease to be Eligible Tax Exempt 457 Plans on the first day that the plan fails to satisfy one or more of the requirements under 26 CFR 1.457-3 through 26 CFR 1.457-8 and 26 CFR 1.457-10.

  3. Under IRC 457(b), an Eligible Governmental 457 Plan ceases to be an Eligible Governmental 457 Plan on the first day of the first plan year beginning more than 180 days after the date the Commissioner notifies the plan in writing that the plan is being administered inconsistent with the requirements of 26 CFR 1.457-3 through 26 CFR 1.457-8, or 26 CFR 1.457-10.

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

    2. If a plan ceases to be an Eligible Governmental Plan, amounts subsequently deferred by participants must be included in income when deferred, or, if later, when the amounts deferred cease to be subject to a substantial risk of forfeiture, as provided at 26 CFR 1.457-11.

    3. Any amounts deferred, and the related earnings, made prior to the deadline provided by the Commissioner in the notice (from the Letter 1758 series), are treated as if the plan continues to be an Eligible Governmental 457 Plan and will not be includible in taxable income until paid.

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

      Note:

      Mail the applicable Letter 1758 when you are ready to close your examination.

Deferral Agreements and Taxation of Annual Deferrals Under Eligible 457 Plans

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

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

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

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

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

  6. Annual deferrals are not taxable income until paid (Governmental) or until paid or made available (Tax Exempt) to the participant. See 26 CFR 1.457-4(a).

    Exception:

    Designated Roth contributions to a qualified Roth contribution program are includible in income in the year of deferral.

Maximum Deferral Limitations

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

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

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

  4. Compliance with the Maximum Deferral Limitation is required both in form and in operation.

  5. Combined Annual Deferrals that exceed the individual limits due to multiple plan participation, are treated as excess deferrals. See 26 CFR 1.457-4(e).

  6. Employer nonelective contributions are not taken into account as Annual Deferrals until the year they become vested. Generally, Annual Deferrals do not include earnings; however Annual Deferrals subject to a vesting schedule are adjusted to include earnings on nonelective contributions in the year vested. See 26 CFR 1.457-2(b)(2).

    Example 1: An employer sets aside $4,000 per year for five years for a certain employee, and the employee’s rights to these amounts vests only in year 5. The employee will be treated as having deferred $20,000 ($4,000 x 5 years) in year 5, when the amount vests. This will exceed the deferral limits, and would be further complicated if the employee has also elected to defer compensation.

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

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

    2. For this purpose, present value must be determined using actuarial assumptions and methods that are reasonable (both individually and in the aggregate), as determined by the IRS. See 26 CFR 1.457-2(b)(3).

  8. Amounts contributed 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. See IRM 4.72.19.24, Deemed IRAs under Eligible Governmental Plans.

Basic Annual Limitation (Plan Ceiling)

  1. Annual deferrals are limited to the lesser of the applicable dollar amount, or 100% of participant’s taxable year Includible Compensation. See 26 CFR 1.457-4(c)(1).

  2. The following table lists the applicable dollar amount under IRC 457(e)(15) for each year:

    Year IRC 457(e)(15) Limit
    2002 $11,000
    2003 $12,000
    2004 $13,000
    2005 $14,000
    2006 $15,000
    2007 $15,500
    2008 $15,500
    2009 $16,500
    2010 $16,500
    2011 $16,500
    2012 $17,000
    2013 $17,500
    2014 $17,500
    2015 $18,000
    2016 $18,000
    2017 $18,000

    Note:

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

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

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

    2. Includible Compensation may include amounts that would have been compensation under IRC 415(c)(3), if paid prior to severance of employment, if paid within 2 ½ months after the later of severance from employment, or the end of the limitation year. See 26 CFR 1.415(c)(2) 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 such amounts and the employee would have been able to use the leave if employment had continued. See 26 CFR 1.415(c)-2 and 1.457-4(d).

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

Special IRC 457 Catch-up Contributions

  1. An Eligible 457 Plan may provide for an increased deferral ceiling during one or more of the last three taxable years prior to normal retirement age. See 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).

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

    2. The plan must either designate a normal retirement age or permit the participant to designate a normal retirement age. See 26 CFR 1.457-4(c)(2)(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. Entities that sponsor multiple Eligible 457 Plans may not permit more than one normal retirement age under all the plans it sponsors.

    4. Qualified police and firefighters may use an earlier age, but not earlier than age 40. See 26 CFR 1.457-4(c)(2)(v)(B).

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

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

    2. For purposes of determining the "Underutilized Limitation" for years prior to 2002, Eligible 457 Plan deferrals must be coordinated with deferrals to other plans (e.g., 403(b), 401(k), SEP, SIMPLE, plans). See 26 CFR 1.457-(c)(3)(ii), (iii), & (iv).

  4. Under IRC 414(v)(6)(C) and IRC 457(e)(18) the age 50 catch-up does not apply in any year in which the Special IRC 457 catch-up is greater.

    1. Participants are not permitted simultaneous use of the Special IRC 457 and age 50 catch-up contribution.

    2. Only a Governmental Plan may permit the use of the age 50 catch-up.

Age 50 Catch-up Contributions

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

    Year IRC 414(v)(2) Limit
    2002 $1,000
    2003 $2,000
    2004 $3,000
    2005 $4,000
    2006 $5,000
    2007 $5,000
    2008 $5,000
    2009 $5,500
    2010 $5,500
    2011 $5,500
    2012 $5,500
    2013 $5,500
    2014 $5,500
    2015 $6,000
    2016 $6,000
  2. For additional guidance on the age 50 catch-up, see the Regulations under IRC 414(v).

  3. Under 26 CFR 1.457-4(c)(ii), where an Eligible Governmental 457 Plan permits both the Special IRC 457 and the Age 50 catch-up contributions, participants eligible for both must use the option that yields the largest deferral.

Examination Steps

  1. Request W-2 data through the CAS or through the IRPTRR command code in IDRS.

    Note:

    If you are unable to obtain W-2 data internally, you may request Forms W-2 from the employer.

  2. Request reports from employer showing amounts deposited for each participant.

  3. Request reports from each vendor showing amounts received and credited to each participant's account.

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

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

  6. Sample and review deferral agreements to insure timeliness of execution and the type of compensation to be deferred.

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

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

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

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

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

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

  8. Determine whether excess deferrals were timely distributed.

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

    2. Earnings should be reported in the year distributed.

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

Issue Resolution and Correction

  1. If annual deferrals exceed the annual plan limitations set forth in 26 CFR 1.457-4(c), the plan is not an Eligible 457 Plan, unless correction is permitted and actually made in a timely manner.

  2. If the plan is sponsored by a tax exempt organization and correction isn’t made, the plan ceases to be an Eligible 457(b) plan, and annual deferrals are taxable to participants under IRC 457(f) for the year allocated.

  3. If the plan is an Eligible Governmental 457 Plan and correction isn’t made, annual deferrals are taxable to participants under IRC 457(f) for years beginning on and after the deadline set in the Commissioner’s correction letter. Additionally, trust earnings for a governmental plan are taxable for years beginning on and after the deadline set in the Commissioner’s correction letter.

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

Deferrals of Sick, Vacation, and Back Pay

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

    1. An Eligible 457 Plan may provide that a participant who has not had a severance from employment may elect to defer accumulated sick, vacation, and back pay, if the election to defer is entered into prior to the first day of the month 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 limitation year that includes the severance date (calendar year substitution permitted for governmental employers), and the election is made prior to the beginning of the month the amounts are paid or made available.

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

    4. Post severance non-qualified deferred compensation is not eligible for deferral unless payment would have been made at that time without regard to 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 date of the severance from employment, if the agreement providing for the deferral is entered into prior to the first day of the month in which the amount would otherwise be paid or made available (as defined in regulations under IRC 401(k), provided the compensation is paid by the later of 2 ½ months after severance from employment with the employer maintaining the plan or the end of the limitation year that includes the date of severance from employment with the employer maintaining the plan. In the case of an Eligible Governmental 457 Plan, the limitation year is the calendar year.

  3. Under revised 26 CFR 1.457-4(d) and final 26 CFR 1.415(c)-2(e)(3) issued on April 5, 2007, the amounts must have otherwise been payable if employment had not terminated. In the case of unused leave, the participant must have been eligible to use the leave if employment had not terminated. The regulations apply to taxable years beginning on or after December 31, 2001.

Examination Steps

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

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

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

Excess Deferrals- Individual and Plan Limits

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

    1. These excess amounts are includible in income in the taxable year deferred, or in the year in which there is no substantial risk of forfeiture if later. See 26 CFR 1.457-4(e)(1).

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

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

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

    2. Eligible Governmental 457 Plans must distribute Plan Limitation Excess Deferrals and accumulated earnings as soon as administratively feasible in order to retain eligible status. See 26 CFR 1.457-4(e)(2).

  3. Eligible Tax Exempt 457 Plans must distribute Plan Limitation Excess Deferrals and accumulated earnings on or before April 15th of the year following the year in which the excess occurred. Failure to make timely distributions will result in loss of eligible status. See 26 CFR 1.457-4(e)(3).

    Note:

    Excess deferrals not corrected by April 15 of the following year cause the 457(b) plan of an EO to become subject to 457(f). Discrepancy adjustments should be made for the open years on the entire amount of the deferral. The participant cannot receive a distribution from his account, except to pay taxes, until a distributable event occurs. When the participant's account balance is paid, he will have basis in amounts that were taxed. Amounts not previously taxed will still be taxable upon distribution. See paragraph (4) IRM 4.72.19.20.1, Governmental Employers, for additional guidance on taxation under IRC 457(f).

  4. Pursuant to 26 CFR 1.457-4(e)(4), both Eligible Tax Exempt 457 Plans and Eligible Governmental 457 Plans may provide that an excess deferral resulting solely from a failure to comply with the individual limitation for combined annual deferrals under multiple Eligible Plans (under 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.

    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.

Timing of Distributions

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

    1. The participant attains age 70 ½,

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

    3. The participant is faced with an unforeseeable emergency.

    Note:

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

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

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

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

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

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

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

Severance from Employment

  1. 26 CFR 1.457-6(b)(1) provides an employee has a severance from employment with the Eligible Employer if the employee dies, retires, or otherwise has a severance from employment (including leave for certain military service as described in IRC 414(u)(12)(B)) with the Eligible Employer.

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

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

      Example:

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

  2. 26 CFR 1.457-6(b)(2)(i) provides that an independent contractor has a severance from service upon the expiration of all contracts requiring services to be performed for the Eligible Employer provided the expiration of the contract(s) constitutes a good faith and complete termination of the contractual relationship. For additional guidance relating to good faith expiration of the contractual relationship see 26 CFR 1.457-6(b)(2)(i).

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

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

Unforeseeable Emergencies

  1. 26 CFR 1.457-6(c) provides an exception to the general rule barring distributions before the earlier of age 70 ½, or severance from employment, where the participant or beneficiary is faced with an unforeseeable emergency resulting from an unanticipated event.

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

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

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

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

      Example:

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

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

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

    Example:

    Medical expenses for cosmetic surgery or cosmetic dental work generally would not qualify unless due to an unforeseen 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. Reimbursement or compensation from insurance or otherwise,

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

    3. The cessation of deferrals under the plan.

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

Required Distributions

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

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

Distributions of Smaller Accounts

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

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

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

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

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

  3. A Plan may provide that the distribution will be made automatically, at the election of the participant, or a combination thereof. See 26 CFR 1.457-6(e).

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

Loans

  1. 26 CFR 1.457-6(f)(1) provides that an Eligible Tax Exempt 457 Plan may not allow for participant loans.

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

    2. A loan from an IRC 457(b) plan of a tax exempt entity would cause the plan to fail the requirements under IRC 457(b); thereby, causing it to become an Ineligible Plan subject to taxation under IRC 457(f) and 26 CFR 1.457-11.

  2. 26 CFR 1.457-6(f)(2) provides that Eligible 457 Plans of a governmental entity may provide for participant loans. A facts and circumstances test is used to determine whether the availability of loans, the making of a loan, or the failure to repay loans violate any requirement of IRC 457(b), or whether a violation of the plan distribution restrictions has occurred. Factors to consider include:

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

    2. There must be a fixed repayment schedule.

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

    4. A loan from an Eligible Governmental 457 Plan which satisfies the requirements of 26 CFR 1.72(p)-1 Q&A 3 and deemed distributions as defined in 26 CFR 1.72(p)-1 Q&A 4, would not in and of itself violate IRC 457(d).

    5. 26 CFR 1.457-7(b)(3) provides that the amount of any loan from an Eligible Governmental 457 Plan to a participant or beneficiary that does not satisfy IRC 72(p)(2) is treated as having been received as a distribution from the plan under IRC 72(p) and is includible in the gross income of the participant or beneficiary for the taxable year in which the loan is made.

Qualified Domestic Relations Orders (QDROs)

  1. 26 CFR 1.457-10(c) provides that an Eligible 457 Plan will not violate the restrictions on distributions under IRC 457(d) due to payment to an alternate payee under a QDRO, as defined in IRC 414(p).

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

Commencement of Distributions

  1. There are no requirements under IRC 457 that an Eligible 457 Plan must satisfy for establishing the date for the commencement of distributions, other than the requirements associated with required minimum distributions under IRC 401(a)(9). The conditions for distributions and the timing of distributions, however, are required plan provisions, and once established must be followed in operation pursuant to 26 CFR 1.457-3.

  2. 26 CFR 1.457-7(c)(2)(iv) provides that an Eligible Tax Exempt 457 Plan may provide a period for making an initial election by the participant or beneficiary, in accordance with the terms of the plan, to defer the payment of some, or all of the amounts deferred, to a fixed or determinable future time.

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

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

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

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

  3. An Eligible Tax Exempt 457 Plan may provide for a default payment schedule that would apply if no election is made under 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.

  4. An Eligible Tax Exempt 457 Plan may provide an election as to the method of payment to be made prior to the date the amounts are distributed in accordance with the initial or additional election to defer commencement of payment under 26 CFR 1.457-7(c)(2)(iv).

Examination Steps

  1. Request a listing of distributions from the plan, including loans and unforeseeable emergency requests.

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

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

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

    3. Examine relevant records to corroborate oral testimony.

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

  4. Examine payroll and personnel records to determine the identity of individuals who terminated employment during the year under examination and to identify individuals who are age 70 ½ or older. Compare this with any report identifying the participants who received distributions in excess of the dollar amount in IRC 411(a)(11)(D) for small accounts. See IRM 4.72.19.14.4, Distributions of Smaller Accounts.

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

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

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

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

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

  7. Inspect the language in the plan document to determine whether the plan allows loans to participants. If the plan provides for loans, document whether the Plan is sponsored by an Eligible Governmental Employer. Verify and document that plan provisions comply with 26 CFR 1.457-6(f)(2).

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

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

    2. Document whether the safe harbor requirements in IRC 72(p)(2) were satisfied. Document and explain the facts and circumstances of the loan. Determine whether the loan violates the distribution restrictions of IRC 457(d) and 26 CFR 1.457-6(f)(1), in the case of a plan of a tax exempt organization, or 26 CFR 1.457-6(f)(2) in the case of a plan of a state or local government entity.

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

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

Taxation of Distributions

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

  2. 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).

    Note:

    Form 1099-R is used to report distributions from Eligible Governmental 457(b) Plans.

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

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

    2. Any trustee-to-trustee transfer under 26 CFR 1.457-7(b)(2) from an Eligible Governmental 457 Plan is a distribution that is subject to the distribution requirements of 26 CFR 1.457-6.

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

  5. Benefits under Eligible Tax Exempt 457 Plans are taxable to participants or beneficiaries in the year amounts first become available under 26 CFR 1.457-7(c)(1).

    Note:

    Distributions from Eligible Tax Exempt 457(b) Plans are reported on Form W-2 and are subject to FICA.

  6. Amounts deferred under an Eligible Tax Exempt 457 Plan are includible in the gross income of the participant or beneficiary in the year the amounts are first made available under the terms of the plan, even if the plan has not distributed the amounts deferred under 26 CFR 1.457-7(c)(2).

Amounts Made Available Under Eligible Tax Exempt 457 Plans

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

  2. Transfers between Eligible Tax Exempt 457 Plans are the only method to defer taxation under 26 CFR 1.457-10(b)(5).

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

    2. Rollovers to and from non Eligible Tax Exempt 457 plans are not permitted.

  3. Under 26 CFR 1.457-7(c)(2)(i) amounts are generally considered to be made available to a participant at the earliest date on or after severance from employment, on which the plan allows distributions to commence, but in no event later than the date on which distributions must commence pursuant to IRC 401(a)(9). Thus, in the absence of an election to defer the timing of distributions or the method of distributions, amounts payable under the terms of the plan will be includible in the gross income of the participant or beneficiary for the year in which amounts become payable regardless of whether there has been an actual distribution.

  4. Distributions from an Eligible Governmental 457(b) Plan used to pay qualified health insurance premiums for an eligible public safety officer will be excluded from income pursuant to IRC 402(l).

  5. An Eligible Tax Exempt 457 Plan may allow a participant or beneficiary an initial election to defer the payment of benefits to a future date under 26 CFR 1.457-7(c)(2)(ii) and (iii).

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

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

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

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

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

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

    2. The availability of distributions satisfy the requirements for "unforeseeable emergencies" under 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).

Loans

  1. 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.

  2. Deemed distributions are includible in the gross income of participants or beneficiaries in the year in which the loan first fails to satisfy one or more of those requirements under 26 CFR 1.72(p)-1 Q&A 4.

Qualified Domestic Relations Orders

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

  2. Payments made under IRC 414(p) to alternate payees other than the spouse or former spouse of the participant are includible in the gross income of the participant under IRC 402(e)(1), and 26 CFR 1.457-10(c).

Examination Steps

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

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

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

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

      Note:

      Take a sample from the distributions listing and conduct IDRS research for those sampled.

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

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

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

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

Funding

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

  2. Salary reduction agreements must be entered into in the month prior to the first day of the month in which the compensation is paid or made available under 26 CFR 1.457-4(b).

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

Governmental Employers

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

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

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

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

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

  6. IRC 457(g)(4) provides that an Eligible Governmental 457 Plan must meet the requirements of IRC 401(a)(37) (providing that, in the case of a participant who dies while performing qualified military service, the survivors of the participant are entitled to any additional benefits (other than benefit accruals relating to the period of qualified military service) provided under the plan had the participant resumed and then terminated employment on account of death).

Tax Exempt Employers

  1. By contrast, under IRC 457(b)(6) and 26 CFR 1.457-8(b), the assets of Eligible Tax Exempt 457 Plans must be unfunded. This is true for both employee and employer contributions.

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

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

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

  3. See IRM 4.71.17.7, Procedures for Correction of Eligible IRC 457 Plan Failures, for current procedures to correct plan failures.

Dual Status Employers

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

Examination Steps

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

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

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

    1. If so, obtain copies of those documents and verify that title to plan assets is in the name of the employer and are subject to the claims of the creditors of the employer.

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

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

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

  6. A Governmental 457 Plan that has not established a trust, that satisfies 26 CFR 1.457-8(a), within their applicable 180 day correction period is not an Eligible 457 Plan; relief may be offered by the Service outside of EPCRS through standards similar to those found in Rev. Proc. 2013-12.

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

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

    2. A referral to DOL may be necessary.

Plan Terminations and Frozen Plans

  1. A plan may contain provisions permitting plan termination whereupon amounts can be distributed without violating the distribution restrictions under IRC 457 and 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 amounts are not timely distributed.

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

  2. Employers that cease to be Eligible Employers under IRC 457(e)(1) and 26 CFR 1.457-2(e) may no longer maintain an Eligible 457 Plan.

    1. If the employer is tax exempt and the plan is not terminated, the tax consequences to participants and beneficiaries are determined in accordance with IRC 451 if the employer becomes an entity other than a state, and 26 CFR 1.457-11 if the employer becomes a state entity.

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

Examination Steps

  1. Review the plan document.

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

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

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

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

  4. In the case of a former tax exempt employer who is no longer eligible to maintain an IRC 457(b) Plan, but the plan has not been terminated, document whether the tax consequences to participants and beneficiaries was determined in accordance with either IRC 451 (if the employer becomes an entity other than a state) or 26 CFR 1.457-11 (if the employer becomes a state entity).

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

  6. Verify whether Eligible Governmental 457 Plan assets of a state have been transferred to another Eligible Governmental 457 Plan within the same state as permitted under 26 CFR 1.457-10(b).

Rollovers and Plan to Plan Transfers

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

  2. Effective with 2010, in-plan Roth rollovers may be permitted in an Eligible 457(b) Plan.

    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 nondistributible.

    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 section 411(d)(6). See IRM 4.72.19.24, Deemed IRAs under Eligible Governmental Plans, for additional information.

Rollovers to Eligible Governmental 457 Plans

  1. 26 CFR 1.457-10(e) permits an Eligible Governmental 457 Plan to receive contributions that are eligible rollover distributions from qualified retirement plans, 403(b) annuities, traditional IRAs, and Governmental 457(b) plans.

  2. Such amounts are not subject to the annual deferral limits but are otherwise treated in the same manner as amounts deferred under IRC 457 for purposes of 26 CFR 1.457-3 through 26 CFR 1.457-9.

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

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

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

Purchase of Permissive Service Credit

  1. Under 26 CFR 1.457-10(b)(8) an Eligible Governmental 457 Plan of a state may provide for the transfer of amounts deferred by a participant or beneficiary to a defined benefit governmental plan (as defined in IRC 414(d)), and no amount shall be includible in gross income by reason of the transfer, if the transfer is for either of the following reasons:

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

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

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

  3. 26 CFR 1.457-10(b)(8) was revised to coincide with the issuance of the final 415 Regulations issued on April 5, 2007, which deleted the word "past" from permissive service credit. The final 415 regulations and corresponding changes to the 457 regulations are effective for plan years beginning on or after July 1, 2007.

Direct Plan to Plan Transfers Between Eligible 457 Plans

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

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

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

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

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

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

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

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

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

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

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

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

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

Examination Steps

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

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

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

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

Death Benefit and Life Insurance

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

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

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

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

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

  3. No amount paid as death benefits or life insurance proceeds under an Eligible Governmental 457 Plan or made available under an Eligible Tax Exempt 457 Plan is excludable from gross income under IRC 101(a) and 26 CFR 1.457-10(d).

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

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

    2. Is the sole beneficiary under the policy; and

    3. Is under no obligation to transfer the policy or pass through the proceeds of the policy under 26 CFR 1.457-8(b)(1).

Deemed IRAs under Eligible Governmental Plans

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

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

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

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

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

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

  7. Amounts contributed to a Roth IRA are subject to the dollar limitation in effect for the year contributed, limiting the amount that can be contributed pre-tax.

Examination Steps

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

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

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

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

Ineligible Plans

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

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

Substantial Risk of Forfeiture

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

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

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

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

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

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

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

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

    4. Elective Deferrals - Unilateral imposition of a risk of forfeiture by an employee on salary or bonuses that have already been earned to delay taxation until the risk of forfeiture lapses.

      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 Code by section 885 of the American Jobs Creation Act of 2004, Pub. L. 108-357.

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

    2. In addition, interest will be owed at the income tax underpayment rate plus 1 percent, as well as a penalty tax equal to 20 percent of the amount required to be included in income.

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

    4. 26 CFR 1.409A-1(d) does not consider "Covenants not to Compete" , "Rolling Risk of Forfeitures" , and "Elective Deferrals" , described in paragraph (2) above, to be "substantial risks of forfeiture."

    5. The Treasury and Service anticipate issuing guidance regarding "substantial risk of forfeiture" for purposes of IRC 457(f)(3)(B) similar to those under 26 CFR 1.409A-1(d).

  4. It is common to find issues with IRC 457(b) plans of tax exempt employers and IRC 457(f) arrangements that fail to satisfy the substantial risk of forfeiture requirement. The following steps should be taken when these issues arise:

    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, request assistance from EO or FSLG 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 Form SS-10 as necessary.

    Note:

    Not all 457(f) failures can be corrected by an amendment to bring the plan back into 457(f) compliance. Consult with Area Counsel for guidance.

Examination Steps

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

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

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

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

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

  9. 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.

Reporting and Withholding Requirements for Eligible 457 Plans

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

Withholding and Reporting on Annual Deferrals

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

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

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

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

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

  6. Annual deferrals under an Eligible 457 Plan are reported on Form W-2, in accordance with the instructions to that form.

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

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

Income Tax Withholding and Reporting on Eligible Tax Exempt 457 Plan Distributions

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

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

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

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

  5. Income tax withheld is required to be deposited in accordance with 26 CFR 31.6302 and reported on Form 941.

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

Income Tax Withholding and Reporting on Eligible Governmental 457 Plan Distributions

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

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

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

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

  5. Additional information regarding the withholding rules under IRC 3405 can be found in 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.

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

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

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

    2. Payroll taxes are reported on Form 941.

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

Income Tax Withholding and Reporting on Ineligible 457 Plan Distributions

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

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

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

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

    Note:

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

  3. 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. It is the individual’s responsibility to report this on Form 1040 for the year distributed. See IRC 72 for additional guidance on what constitutes basis. See also Pub 575, Pension and Annuity Income, and Pub 525, Taxable and Nontaxable Income.

Eligible Governmental 457 Plan as Social Security Replacement

  1. Governmental employers can avoid mandatory social security coverage by providing membership in a public retirement system under IRC 3121(b)(7)(F) that meets the minimum benefit requirements under 26 CFR 31.3121(b)(7)-2(e) and Rev. Proc. 91-40, 1991-2 CB 694. Such plans are commonly referred to as Social Security Replacement Plans.

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

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

FICA and FUTA Taxes and Reporting on Eligible 457 Plan Contributions

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

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

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

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

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

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

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

    2. The date on which the right to that amount is no longer subject to a "substantial risk of forfeiture" under 26 CFR 31.3121(v)(2)-1(e)(1).

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

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

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

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

Examination Steps

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

  2. Request and review Forms W-2 to verify annual deferrals were properly reported.

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

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

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

    Note:

    Income tax withholding is not required.

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

  7. Request and review any Social Security Replacement Plans of governmental employers to ensure they meet the minimum benefit requirements.

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

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