IRS Audits of Eligible and Ineligible 457 Plans
Michael A. Laing
I.COMMON DEFECTS IN SECTION 457 PLANS
Michael A. Laing
is a partner in the Tax group at Taft Stettinius &
Hollister LLP, where he specializes in employee
benefits and executive compensation. He represents clients who maintain broad-based retirement plans, group welfare plans, and fringe
benefit arrangements for their rank-and-file
employees as well as stock-based incentive
plans, non-qualified deferred compensation
plans, and other perquisites provided to executives. Michael has been an active member of
the American Bar Association, where he is past
Section 457 subcommittee chairman of the
Employee Benefits Committee of the ABA’s Tax
Section. He is a frequent speaker for the American Law Institute Continuing Legal Education
seminars and is a Fellow of the American College of Employee Benefits Counsel. In addition,
he is a Trustee of the Southern Federal Tax Institute. Michael is admitted to practice in Florida
and Ohio.
A.Untimely Election to Defer. In order to be an eligible
plan, Section 457(b)(4) requires that an agreement
providing for the deferral of income must be entered
into before the beginning of the month for which
compensation will be deferred. Treas. Reg. 1.4574(b) provides that in the case of salary reduction contributions, the agreement providing for the deferral
must be entered into before the first day of the month
in which the compensation is paid or made available.
A new employee, however, may defer compensation
payable in the calendar month during which the participant first becomes an employee if an agreement
providing for the deferral is entered into on or before
the first day on which the participant performs services for the eligible employer. Nonelective employer
contributions are treated as being made under an
agreement entered into before the first day of the
calendar month. Often deferrals are made for compensation earned during the same calendar month in
which the election is made.
B.Employer Contributions in Excess of 457 Maximum
Deferral Limitations. Employer contributions made
in excess of the maximum deferral limitations, which
is comprised of the basic annual limitation (100%
of includible compensation or $17,500 (as adjusted),
the Section 414(v) age 50 catch-up limit, and the special Section 457 catch-up limit (i.e., twice the dollar
amount in effect under the basic annual limit or the
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underutilized limitation1). This generally occurs as a result of the mistaken belief that plan is subject
to Section 415 limits or where the employee is not employed by an eligible employer.
1.Excess Special 457 Contributions. As described above, contributions may be limited under the
special 457 catch-up limit. This limit applies during one or more of the participant’s last three taxable years ending before the participant attains normal retirement age, This limit is often violated
because participant use the special Section 457 catch-up limit for the last year of service. In addition, this limit is often violated under the mistaken belief that there was some underutilized limit
available.
C.Excess Contributions violating the Coordination Limit. Section 457(c)(2), prior to its repeal by EGTRRA, provided that the basic annual limitation and the special Section 457 catch-up limitation for
years in effect prior to 2002 were reduced by amounts excluded from the participant’s income for
any prior taxable year by reason of a nonelective employer contribution, salary reduction or elective
contribution under any other eligible section 457(b) plan, or a salary reduction or elective contribution
under any 401(k) plan, SARSEP, section 403(b) annuity contract, and section 408(p) simple retirement account, or under any plan for which a deduction is allowed because of a contribution to an
organization described in section 501(c)(18). It is not uncommon to find contributions in excess of this
coordination limit.
D.
Unforeseeable Emergency Distribution. Common violations include: inadequate documentation
of the unforeseeable emergency, lack of proper internal controls, and distributions that exceed the
amount needed for the unforeseeable emergency.
E.Ineligible Plan Sponsors. The organization must be a state or local government or a tax exempt organization under IRC 501(c). An example of failure is where a quasi-federal government organizations
adopting IRC 457(b) type plans (federal credit unions).
F.Nonexistent or Inadequate Substantial Risks of Forfeiture under Ineligible Plans. Section 457(f) plans
that do not have any actual substantial risks of forfeiture for substantial services performed. For example, a 457(f) plan that has a non-compete restriction as one of the risks of forfeiture, but in operation
is not likely to ever be applied, or a non-compete that allows following the voluntary resignation of
the executive a short non-compete period or an unrealistic non-compete clause (i.e., not a meaningful
restriction) and payment of plan benefits.
G.Section 457(f) Plan Cafeteria-Style Benefits. A plan that allows participants to apply an annual credit
amount among a number of different types of non-taxable welfare benefits and deferred compensation plans, including 403(b) plan, 457(b) plan and 457(f) plan, with any remaining credit amount being
The “underutilized limitation” is (a) the sum of (i) the basic annual limit for the taxable year, plus (ii) the basic annual limit
for any prior taxable year or years, reduced by (b) the amount of annual deferrals under the plan for such prior taxable year or
years, other than any annual deferrals under the plan permitted under the age 50 catch-up.
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credited under the 457(f) plan. Some of the 457(f) plans do not contain an adequate substantial risk of
forfeiture.
H. Deferred Compensation Disguised as Severance. See TAM 199903032.
I.Failure to Limit to Top Hat Employees. For a non-governmental sponsor, the failure to limit participation in the 457(b) plan to top hat employees. Thus, plan fails ERISA top-hat exemption and must be
funded under ERISA, which if funded would cause a violation of IRC Section 457(b)(6) (requiring
that the plan must provide that all amounts of compensation deferred under the plan, all property and
rights purchased with such amounts, and all income attributable to such amounts, property, or rights
will remain solely the property and rights of the employer (without being restricted to the provision of
benefits under the plan), subject only to the claims of the employer’s general creditors).
II. CORRECTION PROCEDURES
A.Correction of Excess Deferrals under an Eligible Plan. Any amount deferred under an eligible plan
for the taxable year of a participant that exceeds the maximum deferral limitations (i.e., the basic annual limitation, the age 50 catch-up limit ant the special Section 457 catch-up limit), and any amount
that exceeds the individual limitation (i.e., maximum deferral limitations applied by taking into account the combined annual deferral for the participant for any taxable year under all eligible plans),
constitutes an excess deferral that is taxable in accordance with Section 457(f) for that taxable year.
Thus, an excess deferral is includible in gross income in the taxable year deferred or, if later, the first
taxable year in which there is no substantial risk of forfeiture.
1.Excess Deferrals under an Eligible Governmental Plan Other than as a Result of the Individual
Limitation. In order to be an eligible governmental plan, the plan must provide that any excess
deferral resulting from a failure of a plan to apply the maximum deferral limitations to amounts
deferred under the eligible plan (computed without regard to the individual limitation) will 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. For purposes of determining whether
there is an excess deferral resulting from a failure of a plan to apply the maximum deferral limitations, all plans under which an individual participates by virtue of his or her relationship with a
single employer are treated as a single plan (without regard to any differences in funding). If such
excess deferrals are not corrected by distribution, the plan will be an ineligible plan under which
benefits are taxable in accordance with Section 457(f).
2.Excess deferrals under an Eligible Plan of a Tax-Exempt Employer Other than as a Result of the
Individual Limitation. If a plan of a tax-exempt employer fails to comply with the maximum deferral limitations, the plan will be an ineligible plan under which benefits are taxable in accordance
with Section 457(f). However, a plan may distribute to a participant any excess deferrals (and any
income allocable to such amount) not later than the first April 15 following the close of the taxable year of the excess deferrals. In such a case, the plan will continue to be treated as an eligible