457(b) Late Distribution

[jpod]

Tax-exempt 457(b). Employee terminated in June 2009. Because he made no deferral election, entire account balance was to be distributed 90 days after termination. No distribution was made, and error not discovered until 2016! We have no idea what participant knew or thought at the time.

1. Was it "made available" in 2009 and therefore taxable?

2. If so, was it reportable on W-2 and subject to withholding in 2009, even though there was no actual distribution? IRS Notice 2003-20 implies that it was.

3. Is this an operational error that places entire plan at risk? If so, any ideas as to what to do other than distribute the entire account balance now and report it on a 2016 W-2 with income tax withholding?

[Belgarath]

IMHO...

1. Yes, on a W-2.

2. I agree, yes, subject to wage withholding rules. But it appears that perhaps there is an optional flat rate withholding under 31.3402(g)-1(a), which eventually gets you to, I think, (a)(7) in this situation. But this is getting far into the weeds, and is quite old, and I'm not sure how it applies or if it applies to something like this that happened years ago.

3. Honestly don't have an opinion as to whether it places the entire plan at risk. Since the participant owes back taxes, interest, and penalties, it seems unreasonable that the plan would be deemed ineligible, but I have no experience with this situation! I'll be interested to see what people think. I don't think that just doing it in 2016 as if nothing ever went wrong previously is a legitimate option, but I guess I'd leave that to tax/legal counsel.

[jpod]

It's a pickle. I was thinking about issuing a late 2009 W-2 for the account balance at 12/31/09, then one for 2010 reporting any increases in the balance through 12/31/10, etc., etc. However, due to statute of limitations issues I thought the IRS would be happy with reporting everything in full as a 2016 event. Participant can fight it out with IRS if he would like to hide behind statute of limitations for closed years.

[Belgarath]

Yeah, I wondered about the SOL angle, but honestly, I don't know much about how that really works in real life. I was thinking (just guessing, really) that the IRS would be far more likely to "disqualify" the entire plan if you go with the "sweep it under the rug and do it in 2016 and hope they let it go" approach. Hopefully there is someone out there who has actually dealt with such a situation and can give you some educated opinions. Good luck!

[Kevin C]

Has anyone dealt with a similar issue before?

We were approached yesterday by a non-profit with a similar situation, plus an extra issue. They have 3 executives with 457(b) benefits. Two are retired and one still active. Unfortunately, they can not find a copy of any 457(b) documents. Their HR person is fairly new and the plan(s) were put in place years ago. the executives don't have a copy, either. The 457(b) is briefly referenced in their employment contracts, but no information about payment timing. It's likely the retired executives should have already been paid. But, without a document, we don't know what the default distribution timing was supposed to be. Per Rev. Proc. 2013-12, the IRS won't accept a non-profit 457(b) under EPCRS, so a non-amender VCP filing to fix the document problem is not possible. Any suggestions other than to run?

[jpod]

I had hoped that Carol Calhoun might chime in because her observations are always useful. Maybe she's on a beach somewhere this week!

[Kevin C]

Anyone?

[Kevin C]

One more try ...

[Carol V. Calhoun]

Sorry, I'm here!

The problem you've got is that there is no program similar to EPCRS for nongovernmental 457(b)s.So you really can't get an answer, until and unless there is an audit.

The amount should have been reported on the W-2 in 2009. However, given that both the statute of limitations will have passed on both the employer and the employee, I don't know that you need to do anything about that now.

One question is whether you now pay him only the amount that should have been paid in 2009, or some kind of earnings since then. Payment of the earnings could generate a new reporting obligation.

As for the plan, in theory the IRS could go after it, but I doubt it would. It's not like a plan with a trust fund, in which tax benefits have been accruing to the plan all these years (due to untaxed earnings on account balances). In the case of a nongovernmental 457(b), the plan for each employee is more or less self-contained. (The tax consequences of one plan for each employee, or one plan for the whole group, would be identical.) So it wouldn't make sense to remove the tax benefits to current employees due to something that happened to a different employee back in 2009.

[gc@chimentowebb.com]

This is a tough and frequent problem. Technically, the plan fails and 457(f) applies to the "plan." I'd like to think this just means the employee's "plan" -the 409A approach to defining "plan" - and not the "plan" of everyone.

Alternatives? None of them happy.

- Filing a retroactive W-2 is probably the "safest." Then give the employee some sort of taxable gross-up.

- Or. take the position that employee elected a timely postponement within the plan terms and file a current W-2. That is probably the most practical, assuming the plan has permissive postponement terms. 

The danger of that second approach is, technically, conversion of the "plan" to a 457(f) if the IRS disagrees that there has been a timely election. In that event, 409A penalties might even apply because there was not a timely election to defer a 457(f) short term deferral, and the "plan" has lost its 457(b) exemption from 409A. 

This entire area of the law is way too complicated.