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7806akp

Correcting 457(f) problem

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An employer intended for its deferred compensation plan to be a 457(f) plan, but no substantial risk of forfeiture was built into the plan. Employer and employees believed the plan allowed the taxation to be deferred to a later year, so the amounts were not taken into gross income in the year deferred, even though there was no substantial risk of forfeiture. This error occurred over 5 years, so the 3-year statute of limitations has run with respect to a few affected tax years. When should the amounts be taken into gross income with respect to tax years for which the SOL has already run? Two theories:

1. Include in gross income in the year the money is distributed from the plan; or

2. Include in gross income in the first year for which the period of limitation has not run. In other words, if the period of limitations is still open with respect to Years 3, 4 and 5 of the failure (but is closed for Years 1 and 2), report all amounts deferred under the plan for Years 1, 2 and 3 in Year 3.

Does anyone know how to handle this situation?

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Guest LeeNunn

Approach number 2. This is consistent with the 409A approach. Taxpayers don't skate on amounts that should have been reported in closed years. The lack of SROF precludes the employer from ignoring the fact that 457(f) applies. Also, additional lapses of SROF will cause additional taxation, and interest on the amounts already reported will be taxed on distribution under the Sec 72 rules.

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Approach number 2. This is consistent with the 409A approach. Taxpayers don't skate on amounts that should have been reported in closed years. The lack of SROF precludes the employer from ignoring the fact that 457(f) applies. Also, additional lapses of SROF will cause additional taxation, and interest on the amounts already reported will be taxed on distribution under the Sec 72 rules.

Are you saying that under 409A amounts which should have been taken into gross income in closed years should be taken into income in the first open year? Do you have a cite for that under 409A?

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Guest Subsequent Deferral

Not sure the statute of limitaitons would close (3 year statute), and you would have to include in income for the current year the income that is due (even if the violation and resulting income inclusion relate back to say 2007), and interest (at whatever rate + 1%) on that amount.

For example, A has a NQDC plan that violates Sectio 409A, the compensation should have been includible in income in 2007, but instead was paid out in 2011. You are not required to amend your 2007 plan, rather you would include the amounts in income in 2011, and add an interest component (and the 20%) tax to determine the penalty, income inclusion, etc.

That is my understanding, is this incorrect?

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7806akp and LeeNunn,

I don't get why approach #2 works at all.

If you have a taxable event in year 3, you report it in year 3. If you have taxable events in years 1 and 2, what makes them taxable events (or even reportable) in year 3?

Granted, there are things in the benefits world that remain open until corrected - but what's the authority for that happening here?

Why wouldn't this be more analogous to the defaulted qualified plan loan that should have been reported as a taxable distribution but wasn't (and now that the tax year is closed the taxpayer has -regrettably to some and triumphantly to others - "skated" on the taxability of that default)?

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