Compliance: A common pitfall of 457 plans
Deferred compensation arrangements under Internal Revenue Code (IRC) Section 457 (457 plans) are highly effective in attracting and retaining top talent in governmental and tax-exempt organizations. With economic conditions on the upturn, organizations are finding themselves better equipped to enhance their compensation packages for key executive positions. In order to solidify the organization’s standing and remain competitive with the market, employers should review the design of their executive compensation programs and determine the extent to which the current structure aligns with the intended objectives. An employer who either currently maintains or is planning to implement a 457(b) plan (also known as an Eligible 457 plan) or 457(f) plan (also known as an Ineligible 457 plan) should consider how their company can most effectively utilize 457 plans to meet their goals and understand what is required to maintain compliance.
A brief overview of Section 457 plans
Section 457 covers governmental organizations (such as a state, or a political agency, or subdivision of a state), as well as nongovernmental tax-exempt organizations. This article will focus on 457 plans sponsored by tax-exempt organizations, but it is important to note that a different set of rules applies to governmental 457 plans.
Under Section 457, tax-exempt organizations must limit eligibility to a select group of highly compensated employees, managers, officers, or executives; "rank-and-file" employees must be excluded.
457 plans must remain “unfunded” in that plan assets remain the property of the employer rather than being held in trust for participants.
457(b) plans permit employee salary deferrals and employer contributions up to a maximum annual contribution limit ($17,500 in 2014). In contrast, 457(f) plans are generally limited to employer contributions and are not subject to a maximum annual contribution limit.
- Tax treatment.
Benefits under 457(b) plans receive more tax-favorable treatment than those under 457(f) plans. In general, income tax is deferred on 457(f) amounts only where there is a "substantial risk of forfeiture" — this “risk” is most commonly incorporated though vesting schedules or other contingency agreements. When the risk of forfeiture has been removed, such as when an employee becomes fully vested in a contribution amount, the amount becomes taxable. By contrast, amounts deferred under a 457(b) plan are not required to remain at risk to delay income taxation until the time of payment. As a practical matter, 457(b) plans are typically designed to be fully vested at all times.
- Distributions from 457 plans are treated as ordinary W-2 wages to participants when paid. Note that while 457(f) distributions are subject to FICA tax, 457(b) distributions are exempt.
Advantages of 457 plans
Whether offered on their own or in conjunction with a qualified plan, such as a 401(k) or 403(b) plan, the Section 457 plans offer distinct advantages in maximizing benefits to key employees. These advantages include the following:
- Design flexibility.
In structuring executive compensation programs, employers must bear in mind that every company and executive is unique, and that various forms of compensation may provide different levels of value when compared to the relative cost. Section 457 plans provide employers the flexibility to customize compensation plans to balance the executive’s preferences with the company’s goals. Creative deferral arrangements can be designed to incentivize specific behaviors that further company goals within a specified timeframe while providing benefits to certain highly compensated individuals in the plans. A common technique for accomplishing this is attaching a vesting schedule to 457(f) amounts, so a meaningful amount is left behind if an executive leaves prematurely.
- Deferred liability.
457 plans also may be designed to more closely align the timing of benefit payments with the availability of organization resources. As 457 plans do not require contributions to be separated from employer assets and held in specific participant accounts, the cash flow impact to the organization is deferred until the amounts are distributed. Nonetheless, as a practical matter, many organizations set aside funds to pay benefits as they accrue, particularly benefits that accrue under 457(b) plans.
- Reduced filing and reporting requirements.
457 plans are not required to file Form 5500 as they are eligible for an exemption from many of the ERISA requirements; however, 457 plans sponsored by tax-exempt organizations must file a notification of the plan’s existence with the Department of Labor.
Recent IRS 457(b) compliance activities
The IRS Employee Plan Compliance Unit (EPCU), whose primary purpose is to analyze data from various employee benefit plans to determine potential areas of noncompliance, has developed a project to focus on nongovernmental, nonqualified deferred compensation plans under IRC Section 457(b). This project is designed to verify areas of compliance with IRC guidelines, identify issues of noncompliance, and recommend methods of improving compliance for these types of plans. As part of its review, EPCU sent out compliance check letters and questionnaires to an estimated 200 organizations in 2013 and plans to send out an additional 200 in 2014.
The purpose of these compliance check letters is to gather information about the characteristics and features of organizations' 457(b) plans. Organizations who receive a compliance check letter should provide a timely response to the request for information, as a lack of response may prompt further inquiry from the IRS, including an audit of the plan or organization. Although EPCU will not inspect company books and records to determine a filing liability for a particular tax period, if EPCU determines that the plan has not been established or operated in accordance with IRC Section 457(b), it will inform the sponsor of the corrective actions needed. These may include an audit of the plan or correction under the IRS Voluntary Correction Program.
The EPCU Nongovernmental 457(b) Plans Project intends to do the following:
- Verify that the deferrals reported on the sponsors’ Forms W-2 represent a 457(b) plan
- Determine whether the plan sponsor is eligible to have a 457(b) plan; and, if eligible, determine whether the sponsor is a governmental unit, exempt from income tax under IRC Section 501(c), or a ‘dual status’ entity that is both governmental and exempt under 501(c)
- Verify that participation in the plan is limited to a select group of highly compensated employees, managers, directors, or officers
- Determine whether the plan contains features not permitted in a top hat plan, such as loans, age 50 catch-up provisions, or contributions placed in a trust for the exclusive benefit of participants
- Determine whether unforeseeable emergency distributions have been made
As 457 plans play a crucial role in helping tax-exempt organizations attract and retain top talent and incentivize behavior, they should be considered essential components of any successful executive compensation strategy. However, it is important to remember that along with their great potential comes a responsibility of ensuring compliance. The more knowledgeable employers become about the benefits and common pitfalls of 457 plans, the better they can position their organizations for success.
For more information on structuring executive compensation, or assessing your 457 plans for compliance, please feel free to contact the Plante Moran Employee Benefits Consulting Group.