Guest Article

(From the July 21, 2003 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

Overview of Final Section 457 Regulations

As reported in last week's Washington Bulletin, the Treasury Department and IRS on July 10 issued final regulations relating to IRC section 457 eligible deferred compensation plans maintained by state and local governments and tax-exempt entities. The final regulations appeared in the July 11 edition of the Federal Register, at 68 FR 41230.

Section 457 Plans-- In General

IRC section 457 deferred compensation plans must be established and maintained by an "eligible employer"-- i.e., a state or local government (or an agency or instrumentality thereof) or a tax-exempt entity-- in order to be an "eligible" plan. Furthermore, there are specific rules that must be adhered to if a plan is to keep its status as an eligible plan. In many cases the rules are different for "eligible governmental plans" and "eligible plans maintained by a tax-exempt entity." For example, eligible governmental plans must be funded, and the plan's assets must be held in trust; eligible plans maintained by a tax-exempt entity must be unfunded.

Subject to certain limits, "annual deferrals" to an eligible plan are not immediately taxable to participants. (Annual deferrals include all compensation deferred under the plan, whether by salary reduction or by nonelective employer contribution.) In the case of an eligible governmental plan deferrals are taxed only when distributed to the participant. If the eligible plan is maintained by a tax-exempt entity, deferrals are taxed when distributed or otherwise made available to the participant or beneficiary, whichever is earlier. Deferrals generally are considered made available on the earliest date that distributions may begin after the participant's termination, subject to certain exceptions.

Ineligible Plans

The final regulations include specific rules relating to so-called "ineligible plans"-- i.e., deferred compensation plans maintained by eligible employers that do not satisfy all of the section 457 eligibility requirements. The ineligible plan rules do not apply to section 401(a) plans, section 403 annuities or contracts, and any portion of a plan that consists of a transfer of property for services described in IRC section 83.

The basic rule under IRC section 457(f) is that compensation deferred to an ineligible plan is taxable to the participant or beneficiary as soon as the deferred amounts are no longer subject to a "substantial risk of forfeiture." According to IRC section 457(f)(3)(B), an individual's rights to compensation are subject to a substantial risk of forfeiture if "conditioned upon the future performance of substantial services by any individual." When the substantial risk of forfeiture with respect to specific deferrals ends, the participant is taxed on the deferral amount plus any earnings to date. Subsequent earnings generally are taxable under the rules of IRC section 72 (relating to taxing annuities) when paid or made available to the participant.

One of the more controversial aspects of the proposed regulations was its rule for coordinating IRC section 457(f) and section 83. According to the preamble to the final regulations, some commentators complained the rule "would place tax-exempt employers at a competitive disadvantage with respect to attracting and retaining executives because it would effectively eliminate the use of discounted mutual fund options as a tax effective component of total compensation."

The final regulations retain the coordination rule, which provides that section 457(f) applies if the date on which there is no substantial risk of forfeiture with respect to the compensation deferred precedes the date on which there is a transfer of property to which section 83 applies. But the final regulations do clarify that, "when benefits are paid or made available under an ineligible plan, the amount included in gross income is equal to the amount paid or made available, but only to the extent that the amount exceeds the amount the participant included in gross income when he or she obtained a vested right to the benefit." The final regulations also attempt to clarify the application of the rule with the following example involving an option grant.

Example 3. (i) Facts. In 2004, Z, a tax-exempt entity, grants an option to acquire property to employee C. The option lacks a readily ascertainable fair market value, within the meaning of section 83(e)(3), has a value on the date of grant equal to $100,000, and is not subject to a substantial risk of forfeiture (within the meaning of section 457(f)(3)(B) and within the meaning of section 83(c)(1)). Z exercises the option in 2012 by paying an exercise price of $75,000 and receives property that has a fair market value (for purposes of section 83) equal to $300,000.

(ii) Conclusion. In this Example 3, under section 83(e)(3), section 83 does not apply to the grant of the option. Accordingly, C has income of $100,000 in 2004 under section 457(f). In 2012, C has income of $125,000, which is the value of the property transferred in 2012, minus the allocable portion of the basis that results from the $100,000 of income in 2004 and $75,000 exercise price.

This coordination rule does not apply with respect to an option without a readily ascertainable fair market value that was granted on or before May 8, 2002.

Plan Ceiling

The maximum amount eligible plans may allow participants to defer (the "plan ceiling") in 2003 is $12,000 or 100 percent of the participant's "includible compensation," whichever is less. The dollar limit will increase in $1,000 increments until it reaches $15,000 in 2006, and it will be adjusted for inflation in subsequent years.

EGTRRA added a catch-up contribution exception to the otherwise applicable contribution limits for age 50 or older participants in 401(k) plans, 403(b) annuities, and section 457 plans. In general, for 2003 these participants may be allowed to contribute an extra $2,000 (increasing incrementally to $5,000 in 2006) over what the plan or the law otherwise would permit. The IRS issued final guidance on the new catch-up contribution rules earlier this month.

There also is a separate section 457 catch-up provision that applies during the last three years ending before a participant attains the plan's normal retirement age. During these years, section 457 participants may be able to defer as much as twice the annual deferral dollar limit-- i.e., $24,000 in 2003.

Section 457 plan participants may take advantage of both catch-up provisions, but not at the same time. If the section 457 catch-up would allow a participant to defer more than the age 50 catch-up, then the age 50 catch-up will not be available to the participant for that year. The final regulations include specific rules for coordinating the age 50 and section 457 catch-ups and applying the section 457 catch-up rules, as well as examples to illustrate these rules.

Deferral of Sick, Vacation, and Back Pay

Participants may be allowed to defer accumulated sick pay, vacation pay, and back pay to an eligible plan. These deferrals are treated as part of the participant's "annual deferrals," and are subject to the plan ceiling and catch-up contribution limits (if applicable).

The agreement to defer accumulated sick pay, vacation pay, and back pay to an eligible plan generally must be made before the beginning of the month in which such amounts would be paid or made available, and the participant must be an employee in that month. But the final regulations include a special rule for terminating participants. Specifically, an employee who is retiring or otherwise having a severance from employment during a month may nevertheless elect to defer, for example, his unused vacation pay after the beginning of the month, provided that the vacation pay would otherwise have been payable before the employee has a severance from employment and the election is made before the date on which the vacation pay would otherwise have been payable. (The proposed regulations did not include this special rule.)

Excess Deferrals

If a participant's total deferrals to an eligible plan during a year exceed the plan ceiling plus any applicable catch-up contribution limits, the excess is taxable to that participant in the year deferred or, if later, the first taxable year in which there is no substantial risk of forfeiture. Under the final regulations, an eligible governmental plan must provide for distribution of any such excess deferrals (including income thereon) to the participant "as soon as administratively practicable after the plan determines that the amount is an excess deferral."

The proposed regulations did not include a similar self-correcting mechanism for eligible plans maintained by tax-exempt entities. But the final regulations allow these plans to protect their status as eligible plans by distributing any excess deferrals (and any income allocable to such amount) to participants "not later than the first April 15 following the close of the taxable year of the excess deferrals."

What if an individual participates in more than one eligible plan, and total deferrals to all plans exceed the individual's annual deferral limitation (including any applicable catch-up contribution limit)? This too is an excess deferral, and the participant is immediately taxable on the excess amount. The eligible plans may return the excess to the participant, but are not required to do so. This type of excess deferral does not affect the plans' eligible status, even if the plans do not return the excess to the participant.

Eligible Plan Distribution Rules

In general, eligible plans may not distribute deferrals (and income thereon) to a participant or beneficiary before the participant has a "severance from employment." The final regulations include a special safe harbor for satisfying this rule with respect to participants who are independent contractors. Pursuant to the safe harbor, a plan will be considered to satisfy this "no distribution before severance from employment" rule with respect to amounts payable to participants who are independent contractors, if the plan provides--

• no amount will be paid to the participant before a date at least 12 months after the day on which the contract expires under which services are performed for the eligible employer (or, in the case of more than one contract, all such contracts expire); and

• 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 employee.

One exception to the "severance from employment" requirement is that eligible plans may permit a distribution to a participant or beneficiary faced with an "unforeseeable emergency." According to the final regulations, plans that allow distributions in these circumstances must limit the distribution amount to the amount reasonably necessary to satisfy the emergency need. Additionally, plans that allow these distributions must define "unforeseeable emergency" as--

a severe financial hardship of the participant or beneficiary resulting from 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] section 152(a)); 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, e.g., as a result of a natural disaster); or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant or the beneficiary.

Possible examples of unforeseeable emergencies include the imminent foreclosure of or eviction from the participant's primary residence, or the need to pay for the funeral expenses of a spouse or a dependent. But the purchase of a home or payment of college tuition generally are not unforeseeable emergencies, according to the final regulations.

Eligible governmental plans may make loans available to participants subject to the IRC section 72(p) rules-- i.e., loans will be treated as improper distributions unless they satisfy specific restrictions relating to amount and repayment terms, among other things. Eligible plans maintained by tax-exempt entities may not make loans to participants.

Finally, eligible plans are subject to the IRC section 401(a)(9) minimum distribution rules. The IRS recently issued final regulations under IRC section 401(a)(9) last year.

Rollovers and Plan-to-Plan Transfers

Prior to EGTRRA eligible plan benefits could be transferred only to another eligible plan. Distributions from an eligible plan could not be rolled over into any other tax-preferred savings vehicle, and distributions from such other vehicles could not be rolled over into an eligible plan.

Eligible governmental plans now may accept rollovers (direct or indirect) from other tax-preferred savings vehicles, but they must separately account for rollover amounts. Rollovers do not count as annual deferrals for purposes of the plan ceiling and catch-up limits. Eligible plans maintained by tax-exempt entities still may not accept rollovers, and distributions from such plans are not "eligible rollover distributions."

Under the final regulations, eligible governmental plans that accept rollovers can satisfy the separate accounting requirement by consolidating all of a participant's rollovers in a single account, or segregating such amounts into two accounts: one account that holds rollovers attributable to IRAs, tax-qualified plans, and section 403(b) contracts; and a second account that holds rollovers attributable to other eligible governmental plans. The advantage to the two-account approach for participants is that rollovers attributable to other eligible governmental plans are not subject to the IRC section 72(t) 10 percent additional tax on early withdrawals, but rollovers attributable to IRAs, tax-qualified plans, and section 403(b) contracts are subject to this early withdrawal penalty.

The final regulations also explain the plan-to-plan transfer rules relating to eligible plans. In general, if certain requirements are satisfied, an eligible governmental plan may transfer assets to another eligible governmental plan, and an eligible plan maintained by a tax-exempt entity may engage in a plan-to-plan transfer with another eligible plan maintained by a tax-exempt entity. Transfers between eligible governmental plans and eligible plans maintained by tax-exempt entities are not permitted.

Among other things, transfers between eligible governmental plans are allowed only if the participants whose deferrals are being transferred have experienced a severance from employment with the transferring plan's sponsor and is performing services for the sponsor of the transferee plan. However, there is an exception to this rule if all of the eligible governmental plan's assets are being transferred, the receiving plan is maintained by a state entity within the same state as the transferor plan, and the transferor plan's participants are not eligible for additional annual deferrals in the receiving plan unless they are performing services for the receiving plan's sponsor. This exception is designed to make it possible for eligible governmental plan sponsors that cease to be government entities to transfer the plan's assets to another eligible governmental plan within the same state instead of terminating the plan.

The exception may apply, for example, if a county hospital that maintains an eligible plan is subsequently privatized. The hospital can't continue to maintain the plan as an eligible plan because it is no longer an eligible employer; however, if it terminates the plan, all assets must be distributed to participants "as soon as administratively practicable." If the plan-to-plan transfer option is utilized, the plan will continue to be an eligible plan (although administered by another entity) and assets will not have to be distributed.

Purchase of Permissive Past Service Credit

EGTRRA amended IRC section 457 to provide that eligible governmental plan participants can be allowed to transfer deferrals to a governmental defined benefit plan to purchase permissive past service credits. There are no immediate tax consequences to the participant, and the transfer may occur even if the participant is still employed by the eligible plan's sponsor. The transfer must be accomplished by a direct trustee-to-trustee transfer.

An example in the proposed regulations implied that IRC section 415(n) (which addresses the application of maximum benefit limitations with respect to certain contributions) might apply to a plan-to-plan transfer for permissive service credit. The preamble to the final regulations states this language has been eliminated because "Treasury and the IRS have concluded that section 415(n) does not apply to such a transfer in any case in which the actuarial value of the benefit increase that results from the transfer does not exceed the amount transferred."

Maintaining Eligible Plan Status

According to the final regulations, the IRS will send a written notice to a governmental plan sponsor if it determines the plan is not being administered in accordance with one or more eligibility requirements. The plan will not lose its eligibility status until the first day of the plan year that is at least 180 days after the date the IRS notice is given. In the meantime the plan may correct the identified defects in order to avoid losing its eligibility status. (In other words, once IRS notifies an eligible governmental plan of a problem, the plan has at least 180 days, and perhaps as much as 1 year plus 179 days, to take steps to preserve the plan's eligibility status.) Note that plans maintained by tax-exempt entities lose their eligible plan status on the first day that the plan fails to satisfy one or more eligibility requirements.

The IRS Employee Plans Compliance Resolution System does not apply to 457 plans.

Terminating Eligible Plans

According to the final regulations, an eligible plan is not considered terminated unless amounts deferred under the plan are distributed to participants and beneficiaries "as soon as administratively practicable after termination." If deferrals are not distributed the plan is treated as frozen and must continue to comply with the eligibility requirements.

Effective Date

The final regulations generally apply for taxable years beginning after December 31, 2001. But under a special transition rule, a plan does not fail to be an eligible plan as a result of requirements imposed by the EGTRRA if it is operated in accordance with a reasonable, good faith interpretation of EGTRRA during taxable years beginning after December 31, 2001, and before January 1, 2004.

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.