IRS Updates Info on Tax Consequences of Noncompliance by Tax-Exempt 457(b) Plans

The IRS has updated the information on its website concerning the tax consequences of noncompliance by tax-exempt 457(b) plans. 

Specifically, in the Issue Snapshot the IRS discusses rules under Internal Revenue Code Section 457 regarding nonqualified deferred compensation plans established by eligible employers—state and local governments and tax-exempt organizations—and explores the tax consequences to the participants and employer when a 457(b) tax exempt plan becomes an ineligible plan. 

An eligible 457(b) deferred compensation plan sponsored by a non-governmental tax-exempt entity that fails one or more of the Section 457(b) requirements becomes an ineligible plan subject to Section 457(f). 

Tax Consequences to the Employee

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

Tax Consequences to the Employer

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

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

Audit Tips

The IRS offers tips to help tax-exempt 457(b) plans and their sponsors and administrators stay in compliance: 

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