Tax-Exempt Entity Retirement Plans and the Tax Consequences of Noncompliance

The Internal Revenue Service recently issued a reminder in the form of FAQs of the tax implications to participants and employers when a 457(b) plan becomes an ineligible plan and, as a result, is governed by Section 457(f). This latest IRS publication on 457(b) plans stems from the concern that there is an historical and ongoing pattern of noncompliance with respect to these programs and serves as a warning to employers that there are risks and costs associated with noncompliance.

SECTION 457 SUMMARY

Section 457 is home to the rules for nonqualified deferred compensation plans established by eligible employers. Eligible employers include certain governmental and tax-exempt entities, including states, cities, towns or political subdivisions, and generally any organizations exempt from federal income tax, except for churches and synagogues.

There are two types of 457 plans: eligible plans that satisfy the requirements under Section 457(b); and ineligible plans that are subject to Section 457(f).

If the following 457(b) plan requirements are met, then, in general, the participants will not pay income tax on the deferrals until they are distributed from the plan:

• restricting participation to employees and independent contractors performing services for an eligible employer (see above);
• limiting annual deferrals under the plan ($19,500 for 2020);
• meeting specific distribution events, as well as timing rules (i.e. age 701/2 or separation from service);
• requiring that deferral elections be made for the month prior to the deferral taking effect;
• and treating the amounts deferred as an asset of the employer subject to the reach of creditors in the case of a non-governmental employer.

Please note that even if the 457(b) eligibility requirements have been satisfied, and the income tax on the deferral is postponed until the distribution date, social security and Medicare taxes are due when the deferrals are no longer subject to a substantial risk of forfeiture.

If a plan does not satisfy the requirements under 457(b), then the Section 457(f) rules on the taxation of deferred compensation apply. Under Section 457(f), plan participation must be limited to a select group of managers or highly compensated employees and deferred compensation is taxable in the first year in which the deferrals are no longer subject to a substantial risk of forfeiture.

In the FAQs, the IRS stressed that any vested deferrals for years the plan becomes subject to 457(f), and where the statute of limitations is open, are taxable to the participant in those open years. This may result in a discrepancy adjustment to the Form 1040 and additional tax for the years involved as well as penalties and interest. If the deferrals become vested in a year in which the plan is subject to 457(f), the earnings on the deferrals should be calculated through the date of vesting to determine the additional amount includible in gross income for the year. Any attempted rollovers to an IRA of amounts distributed from a 457(f) plan (or a tax-exempt 457(b) plan) will be subject to excise taxes.

Lastly, the FAQs remind employers that federal income tax withholding applies to deferrals under a 457(f) plan at the point in time when they are no longer subject to a substantial risk of forfeiture and in the event there is a failure to properly withhold penalties and interest may apply.

COMMON ERRORS TO WATCH FOR

In light of the IRS’s heightened interest in 457(b) programs, the prevalence of noncompliance and risk of IRS audit, it is worthwhile to consider the following list of some commonly reported plan compliance issues:

• failure of the employer to qualify as an eligible plan sponsor;
• failure of the satisfy the 457(b) plan documentation requirements;
• failure to limit eligibility to a select group of management or highly compensated employees under for a 457(f) plan;
• failure to limit the deferrals to the annual contribution and catch-up maximums;
• failure to properly document and limit distributions for unforeseeable emergencies;
• failure to report contributions on behalf of participants as wages for FICA and Medicare purposes;
• failure to maintain an unfunded program and treat the funds as employer assets;
• failure to report contributions on Form W-2;
• failure to file a top hat compliance statement with the Department of Labor; and,
• failure to prevent loans to plan participants of non-governmental tax-exempt employers.

THE TAKEAWAY

The axiom that prevention is better than the cure is apropos in many circumstances and is particularly true in the case of employer deferred compensation plans. The longer a plan’s compliance issues remain outstanding, the more severe the organizational and financial consequences. Therefore, a thorough review of your 457(b) plans as a prudent course of action is recommended. If compliance issues are discovered during the review process, then remedies for curing these compliance matters may be available.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Anthony P. DaSilva, Jr. is a shareholder at Boston law firm Davis Malm. He has over two decades of experience counseling clients on the tax and regulatory issues impacting compensation and benefits arrangements. As a former business leader at industry-leading global firms, including two of the Big Four, Tony’s unique insider perspective makes him a valuable resource for tax directors, general counsel, boards of directors, senior executives, compensation committees and human resources professionals. He can be contacted via email at adasilva@davismalm.com.