Guest Article

(From the May 12, 2003 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks in the article have been added by BenefitsLink.)

IRS Updates Guidance on Withholding and Reporting Rules for Section 457 Plans

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The IRS has updated its withholding and reporting rules relating to section 457 deferred compensation plans sponsored by state and local governments and tax-exempt entities. Notice 2003-20, 2003-19 I.R.B. __ (May 12, 2003). The updated rules generally apply to deferrals and distributions from eligible section 457 plans made after December 31, 2001-- the effective date of several relevant statutory changes made by the Economic Growth and Tax Relief Reconciliation Act ("EGTRRA"). But section 457 plan sponsors can continue relying on existing reporting and withholding requirements through the end of this year.

The following summary of Notice 2003-20 is for information purposes only. If you have any questions or need additional information, please contact your Deloitte advisor.

What Does Notice 2003-20 Address?

Notice 2003-20 addresses the following-

Income tax withholding and reporting with respect to annual deferrals made to a section 457 plan; Income tax withholding and reporting with respect to distributions from a section 457 plan, including changes for a section 457 plan established by a state or local government employer enacted in EGTRRA; Federal Insurance Contributions Act (FICA) payment and reporting with respect to annual deferrals under a section 457 plan; Employer identification numbers (EINs) used in connection with trusts established under IRC section 457(g); The application of annual reporting requirements to section 457 plan administrators and trustees holding a section 457 plan's assets in accordance with IRC section 457(g).

Note that Notice 2003-20 deals only with reporting and withholding rules for section 457 plan participants who are or were employees of state and local governments or tax-exempt organizations. It does not cover special reporting rules that may apply to section 457 plan participants who are or were independent contractors.

Income Tax Withholding and Reporting on Annual Deferrals

In general, EGTRRA amended IRC section 457(a)(1)(A) to prevent participants from paying federal income tax on their annual deferrals to a section 457 plan maintained by a state or local government (a "governmental section 457 plan") until those deferrals are distributed. But participants in section 457 plans maintained by tax-exempt entities must pay federal tax on their annual deferrals when distributed or "otherwise made available" to them.

In keeping with these statutory rules, Notice 2003-20 clarifies that annual deferrals under a section 457 plan are not subject to income tax withholding at the time of the deferral. (The notice defines "annual deferrals" as any amount of compensation deferred under the plan in accordance with IRC section 457, and in compliance with the plan's annual maximum deferral limitation, whether by elective deferral or nonelective employer contribution, during a taxable year.) But the employer must report these annual deferrals on the participant's Form W-2.

Any participant deferrals that exceed the plan's annual maximum deferral limitation for a year are not "annual deferrals" and thus are subject to income tax withholding.

Income Tax Withholding and Reporting on Governmental Section 457 Plan Distributions

EGTRRA amended the IRC to make distributions from governmental section 457 plans subject to the same income tax withholding requirements that apply to distributions from qualified plans, annuities, and individual retirement arrangements (IRAs), effective after December 31, 2001. This means the direct rollover and mandatory 20 percent withholding rules now apply to governmental section 457 plan distributions that qualify as eligible rollover distributions.

Additionally, EGTRRA made the elective withholding rules applicable to governmental section 457 plan distributions that do not qualify as eligible rollover distributions. As a result, periodic distributions from these plans that are not eligible rollover distributions are subject to withholding under IRC section 3405(a) as if the distribution were wages, and nonperiodic distributions from such plans that are not eligible rollover distributions are subject to withholding under IRC section 3405(b) at a 10 percent rate. In either case, the participant can elect to not have withholding apply.

EGTRRA also amended IRC section 3405(d) to make governmental section 457 plan administrators responsible for withholding from distributions, rather than the trustee or other payor. But the administrator can shift this responsibility (and the associated potential liability) to the payor by directing the payor to withhold income tax and providing the payor with the necessary information to do so.

Income Tax Withholding and Reporting on Tax-Exempt Employer's Section 457 Plan Distributions

As noted, "distributions" from section 457 plans maintained by non-governmental tax-exempt entities include all amounts that are paid or made available to participants under the plan. These distributions are "wages," and thus are subject to income tax withholding under IRC section 3402 ("Income Tax Collected At Source"). Unlike distributions from governmental section 457 plans, distributions from 457 plans maintained by tax-exempt employers are not subject to the special withholding rules under IRC section 3405 ("Special Rules for Pensions, Annuities, and Certain Other Deferred Income"). Thus, income tax withholding on distributions under a tax-exempt employer's section 457 plan is calculated in the same manner as withholding on other types of wage payments.

The tax-exempt organization or other person having control of the payment of distributions, as determined under IRC section 3401(d)(1), is responsible for withholding on distributions from tax-exempt employers' section 457 plans. Also, distributions to participants under tax-exempt employers' section 457 plans are wages and must be reported on their Forms W-2.

FICA and FUTA Taxes and Reporting

Some, but not all, state and local government employees are subject to Social Security or Medicare (i.e., FICA) taxes. Additionally, the Federal Unemployment Tax Act (FUTA) does not apply to employees of state and local governments. But FICA and FUTA do apply to employees of non-governmental tax-exempt organizations.

To the extent FICA and/or FUTA apply, amounts deferred under section 457 plans are "wages" for FICA and FUTA purposes "as of the later of when the services are performed or when there is no substantial risk of forfeiture of the rights to such amount." Thus, if a section 457 plan provides annual deferrals are immediately vested, the annual deferrals are subject to FICA and FUTA taxes (to the extent applicable) at the time of deferral. If there is a substantial risk of forfeiture (as determined under IRC section 83), then FICA and FUTA do not apply to the deferrals until the substantial risk of forfeiture ends.

If amounts deferred under a section 457 plan are properly taken into account as wages for FICA and FUTA purposes when deferred or when the substantial risk of forfeiture ends, then distributions from such plans attributable to those deferrals generally will not be subject to FICA and FUTA taxes.

Notice 2003-20 provides some useful examples of these rules.

Annual Reporting for Section 457 Plans

Governmental section 457 plans must hold all assets in a trust "for the exclusive benefit of participants and their beneficiaries." IRC section 457(g). Plans can use custodial accounts and certain annuity contracts to satisfy this requirement. The trust requirement does not apply to section 457 plans maintained by non-governmental tax-exempt organizations because these plans may not be funded.

In general, a section 457(g) trust is not required to file Form 990 (Return of Organization Exempt from Income Tax), Form 1041 (U.S. Income Tax Return for Estates and Trusts), Form 1120 (U.S. Corporation Income Tax Return), or Form 5500. But a section 457(g) trust may have to file Form 990-T, Exempt Organization Business Income Tax Return.

Tax-exempt organizations must report annual deferrals and payments to certain participants in their section 457 plans on their Forms 990.

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The information in this Washington Bulletin is general information only and not intended to provide advice or guidance for specific situations. Contact your Deloitte advisor for information regarding your specific circumstances. If you have questions or need additional information about this article and you do not have a Deloitte advisor, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Human Capital Advisory Services, Deloitte LLP, 555 12th Street NW, Suite 500, Washington, DC 20004-1207. Copyright 2003, Deloitte.

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