QDROs and 457(f) plans

[davef]

As I read the EGTRRA changes to 457 plans, the extension of the QDRO rules only applies to 457(B) plans, not (f) plans. So, does this mean anything has changed with respect to a payment from a 457(f) plan pursuant to a divorce? For example, if such a payment were made to an ex-spouse, I assume the participant would be taxed on the amount. Would FICA taxes be due as well?

Thanks for any help.

[Carol V. Calhoun]

A 457(f) plan is not subject to QDRO rules. Thus, it might have to comply with a QDRO that would not apply to other plans, but the employee would be taxed (for both income and FICA purposes) as though s/he had received a distribution if one were made to an alternate payee. The only question on FICA would be whether the distribution would have been subject to FICA if made to the employee. Presumably, an amount could not be subject to a QDRO if it were not vested, and if it were vested, it should already have been subject to FICA taxes under 3121(v).

[mbozek]

Isn't there a different rule in community property states where each spouse owns 50% of marital assets? The employee would not be taxed if the spouse receives the 50% marital property interest in the 457 plan.

[Carol V. Calhoun]

Actually, it would appear that in a community property state, each spouse might be taxed on a 50% share, regardless of which spouse actually received the payments. See Johnson v. US, 135 F.2d 125 (9th Cir. 1943). Footnote 8 in Balding v. Comm'r, 98 T.C. 368 (1992) specifically reserved the question of whether the Johnson holding would apply to the ultimate payment of benefits under a nonqualified deferred compensation plan. And of course, under section 457(f), the tax would be imposed when the amounts became vested, not necessarily when they were paid.

This question is not merely academic. Courts do not necessarily divide each asset in accordance with community property laws. For example, a court might assign an employee spouse the right to 100% of unfunded deferred compensation, in exchange for the nonemployee spouse receiving 100% of the value of the family home. Would the nonemployee spouse nevertheless be taxed on 50% of the amount includible in income under section 457(f)?

And if the parties were not married during the entire term of employment, things get even murkier. Suppose the parties were married for 5 years, and one of them had an unfunded plan that promised to pay out 2% of compensation for each year of service. Would someone have to figure out the actuarial value of the portion of the benefit accrued during the marriage, and would the nonemployee spouse be taxed on that?

Moreover, the calculation would presumably have to be made by the employee and the spouse, not the plan. Under TAM 199903032 (October 2, 1998), the employer's income tax withholding and reporting obligation does not necessarily follow the actual inclusion in income by the employee and/or spouse.

[mbozek]

Isnt the short answer that each spouse in a cp state has a 50% interest in nonqualfied plan benefits exempt from ERISA and there is no taxation if each party receives that 50% interest. see PLR 9647033. Under the assignment of interest rule the non employee spouse would be taxed on the transfer of his/her interest in nonqualified dc to the employee spouse. If the benefits are subject to ERISA then it appears that state cp rules are preempted and the allocation of the 50% cp interest to the non employee spouse would be an assignment of interest by the

employee for tax purposes. Yes, if there are contingencies and vesting provisons then the cts must determine the allocation of the dc benefits to the parties. See DeJesus v. DeJesus, 665 NYS2d 36. The taxation will depend on wther it is a cp state or common law state, whether the plans are subject to ERISA, whether there is a transfer of property under IRC 1041 and whether there is a pre nuptial agreement which affects non ERISA plans.

[Carol V. Calhoun]

I'm not sure that it's really true that the community property share of a 457(f) benefit is always 50%. For example, suppose that the parties were married for some but not all of the term of employment that gave rise to the benefit, and the court assigned the employee spouse 60% of the total benefit from the plan while the nonemployee spouse got 40%. Is it then up to the parties to determine whether the nonemployee spouse in fact (a) got his or her 50% share of that portion of the benefit accrued during the marriage, (B) got less than 50% of the portion of plan accrued during the marriage in exchange for getting other (nonplan) assets, or © got more than 50% of the portion of the plan accrued during marriage in exchange for giving up other assets? In many instances, property divisions in a divorce are not really worked out through a court decision that values each property right separately, but through a court ratification of the parties' overall agreement as to who is to get what. Thus, the court may never explain what value it would have given to each party's community share of the plan itself.

If the parties in fact were married for the entire term of employment, and no more than the term of employment, you're right that dividing the plan so that 50% went to each should not give rise to taxation. But it seems to me that there could be a lot of situations (particularly those in which the 457(f) plan is structured as a defined benefit plan rather than a defined contribution plan) in which the calculation of the division would be more complicated than that.

[mbozek]

I am confused by your analysis--- Under cp rules the value of the benefit accrued during the term of the marriage is determined first. Then that marital interest is divided equally between the parties. Thus if the employee participated in a dc plan for 10 years and was married for 6 of those years then 60% of the benefit would be a marital asset and each spouse would have 30% as the marital benefit. The employee spouse would receive 70% of the accrued benefit and the spouse would receive 30%. The spouses's 30% would be taxed to the spouse as the spouse's cp interest. The 40% of the benefit accrued outside of the marriage is the employee's separate property and will be taxed to the ee. The 30% cp interest will also be taxed to the employee since there is no assignment of that interest. The tax problems to the spouse arise if the spouse transfers his/her cp interest to the employee in return for other property or if the dc plan is subject to ERISA so as to preempt cp law. If the dc plan is established by a np it doesn't matter whether it is a 457(B) or (f) plan it only matters if the plan is subject to ERISA.

The reason it is not advisable to use the method you suggested is because it creates the tax questions you raised. While the calculation of the division of benefits can be complicated, good drafting will prevent the nightmare of inadverdent taxation of the cp interest.

[Carol V. Calhoun]

The problem is that if an employee participated in a 457(f) dc plan for 10 years and was married for 6 of those years, it would not necessarily be true that 60% of the benefit would be a marital asset. For example, if the employee's salary had risen sharply over the 10-year period, but investment returns had not been that great, you might find that 90% of the benefit was attributable to the last 6 of the 10 years of plan participation. In that case, the spouse's share should be 45%, not 30%. If the spouse took 30%, wouldn't s/he be taxed on the 15% s/he presumably gave up to get other assets?

And that's just in the context of a dc-type plan. If it's a db-type plan, the calculations can get even stranger.

[mbozek]

Carol: I am still confused with your analysis--- ct cases involving marital property generally determine the value of the marital assets as of the date divorce commences. When it comes to items with investment potential the courts determine what part of the assets are cp based on past service of the employee during the marriage not what the relative investment returns are over the period of the marriage because investment gains are considered to be passive interest not due to the efforts of the employee. It is up to the state ct to determine the interest of the spouse in community property. It is my understanding that state community property decisions routinely define cp interest in nq plans exempt from ERISA as no more than 50% of the marital benefit to avoid the problem you keep referring to. The cts will award a spouse a greater than 50% interest in a Q plan under a QDRO, an IRA or hard assets such as the home or stock which are not taxable under 1041.

[Carol V. Calhoun]

Perhaps an example will make this clearer. Assume a 457(f) plan with a 10% contribution formula, a 7% rate of return, and contributions all made on the last day of the year. Assume further that on the date of her marriage (which is the first day of year 5), the employee gets a huge promotion, and goes from a $30,000 salary to a $100,000 salary.

Year 1

Employee not married

Salary $30,000

Compensation deferred: $3,000

Total at end of year: $3,000

Year 2

Employee not married

Salary $30,000

Compensation deferred: $3,000

Earnings: $210

Total at end of year: $6,210

Year 3

Employee not married

Salary $30,000

Compensation deferred: $3,000

Earnings: $435

Total at end of year: $9,645

Year 4

Employee not married

Salary $30,000

Compensation deferred: $3,000

Earnings: $675

Total at end of year: $10,320

Year 5

Employee married on first day of year

Salary $100,000

Compensation deferred: $10,000

Earnings (all on separate property): $722

Total separate property at end of year: $11,042

Total community property at end of year: $10,000

Year 6

Employee married

Salary $100,000

Compensation deferred: $10,000

Earnings on separate property: $773

Earnings on community property: $700

Total separate property at end of year: $11,815

Total community property at end of year: $20,700

Year 7

Employee married

Salary $100,000

Compensation deferred: $10,000

Earnings on separate property: $827

Earnings on community property: $1,449

Total separate property at end of year: $12,642

Total community property at end of year: $32,149

Year 8

Employee married

Salary $100,000

Compensation deferred: $10,000

Earnings on separate property: $885

Earnings on community property: $2,250

Total separate property at end of year: $13,527

Total community property at end of year: $44,399

Year 9

Employee married

Salary $100,000

Compensation deferred: $10,000

Earnings on separate property: $947

Earnings on community property: $3,108

Total separate property at end of year: $14,474

Total community property at end of year: $57,507

Year 10

Employee divorces on last day of year

Salary $100,000

Compensation deferred: $10,000

Earnings on separate property: $1,103

Earnings on community property: $4,025

Total separate property at end of year: $15,487

Total community property at end of year: $71,532

Thus, at the end of year 10, which is the date for division of property, the total benefit is $87,019. The nonemployee spouse's share of that is 50% of $71,532, or $35,766. This is not equal to 30% of the total benefit. (30% of the total benefit would be $26,106.)

If the court goes through the calculations I just went through, and declares the nonemployee spouse's share to be $35,766, presumably there is no tax. However, the court may well not do that. If the parties have entered into a separation agreement that says that the nonemployee spouse's share of the plan will be $30,000, the court may well just ratify that agreement without comment. If both parties were well represented by counsel, the reason the parties agreed to the share of the nonemployee spouse being only $30,000, not $35,766, would presumably be because the nonemployee spouse was getting more than his share of cash or some other item of community property. Thus, in theory, the nonemployee spouse has "sold" $5,766 of his share of the plan to the employee spouse in exchange for that cash or other item of property.

The question is, in this circumstance, is the nonemployee spouse taxed on the $35,766 value of his community property interest in the plan, even though he got only $30,000 of it? And if so, who is responsible for making the calculation to determine that the value of his community property interest is $35,766, if the court approves only a general separation agreement?

And these facts are relatively simple, as such things go. In the context of a db plan, if the investment return varied from year to year, if the employment, marriage, and divorce did not all fit neatly at the beginning or end of a year, etc., the calculations could quickly turn into a complete nightmare.

[mbozek]

Carol: Isn't it up to the ct to determine the cp interest based upon the state law in its discretion. Each state (both cp and non cp) has a different view of the amount of retirement benefits, stock options, etc which are included as marital property which does not follow a mathematical formula. If 35k is the 50% cp interest then that amount is not taxed to the employee. If the spouse elects to take only 30 K & trade the other 5k to the employee for other property then clearly there is an assignment of interest which is taxable to the spouse. The goal of good drafting and negotiation is to get the court to declare that the amount of the nqual plan benefit the spouse receives is a 50% cp interest and that other property eligible for 1041 treatment is transferred ( or spouse receives IRA/ Q plan benefits tax free) in return for a lower amount of the nq plan benefits. This is not devious -- its just requires good negotiation and awareness of the application of the tax laws to state laws governing retirement benefits subject to divorce. My review of the case law concludes that the ct only decides what is the spouse's cp/marital interest if the parties cannot come to an agreement.