In 2002, the Internal Revenue Service issued proposed regulations under Internal Revenue Code section 457, providing comprehensive guidance for Code section 457(b) plans ("eligible plans") and addressing statutory changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"). Proposed rules on specific issues under Code section 457(f) plans ("ineligible plans") were also included in the regulations. The proposed regulations generated numerous comments and requests for changes, some of which were incorporated in the final regulationspublished in the Federal Register on July 11, 2003.
The final regulations are generally effective for taxable years beginning after December 31, 2001, subject to a number of transition rules. For taxable years beginning after December 31, 2001 and prior to January 1, 2004, a plan that is operated in accordance with a reasonable good faith interpretation of section 457(b) will be treated as an eligible plan, and whether this reasonable good faith standard is met will generally be determined based on the facts and circumstances. A safe harbor provides that a plan will be deemed to meet the reasonable good faith standard if it is operated in accordance with (i) the final regulations; (ii) the 1982 regulations, for taxable years beginning before January 1, 2002 (to the extent those 1982 regulations are consistent with subsequent changes in law, including EGTRRA); or (iii) the 2002 proposed regulations.
This legal alert analyzes the final regulations, focusing on changes from the proposed regulations and outstanding issues not fully addressed by the regulations. It also highlights the remaining areas covered in the final regulations.
Summary of Significant Changes From the Proposed Regulations
Self-Correction of Excess Deferrals.
Under the proposed regulations, if a governmental plan distributed any excess deferrals (together with earnings) as soon as administratively practicable after discovering the excess, the plan would remain an eligible plan. Conversely, the proposal said a non-governmental plan would cease to be an eligible plan in the event an excess deferral was made.As a result of numerous comments protesting the automatic disqualification provision, the final regulations provide that both governmental and non-governmental plans may selfcorrect excess deferrals. Different rules apply to (i) excess deferrals that are solely the result of a violation of the individual combined plan limit (i.e., that occur only because the individual has deferrals under two or more plans for the year and the combined contributions exceed the limits); and (ii) all other excess deferrals. With respect to excess deferrals that are not solely the result of the individual combined plan limit, the plan must provide for the distribution of excess deferrals. For governmental plans, the rule from the proposed regulation is retained, and the amounts must be distributed as soon as administratively practicable after they are discovered.
Nongovernmental plans must distribute these excess deferrals (plus earnings) by April 15 of the succeeding year to avoid being treated as an ineligible plan. In contrast, a governmental or nongovernmental plan may, but is not obligated to, provide that excess deferrals resulting solely from the individual combined plan limit will be distributed (with income) as soon as administratively practicable after their discovery. Whether distributed or not, the amount of the excess deferral is taxable to the participant in the later of the year the excess deferral is made or it is no longer subject to a substantial risk of forfeiture, and earnings are taxable when distributed. Non-governmental plans will need to monitor the deferral limitations carefully to meet the tight deadline for distributing general excess deferrals. There are also countervailing considerations in determining whether to include a provision in a plan allowing the distribution of excess deferrals resulting solely from the individual combined plan limit. In some cases, particularly with governmental plans which do not have to contend with the substantial risk of forfeiture requirement, it may be in the participant’s interest to distribute these amounts so that the participant has funds available to pay the tax liability. However, any distribution must include earnings; thus, upon distribution the participant would lose the ability to continue to defer taxation of the earnings.
Deferral of Sick, Vacation and Back Pay.
The proposed regulations allowed the deferral of accumulated sick pay, accumulated vacation pay and back pay under an eligible plan, provided that the applicable deferral election was made before the first month in which the participant could actually receive these amounts in cash. The final regulations retain this rule, but include a special exception that allows an individual who is retiring or severing from employment during a month to defer such amounts if they are payable before the employee’s severance date and the deferral election is made prior to the date the amounts are payable.The regulations illustrate this principle through an example showing a sick leave policy that permits unused accumulations to be paid in "the month in which a participant ceases to be employed by the employer." The facts of the example involve a participant who elects on January 4 to defer accumulations payable on January 15 as a result of his impending severance of employment on January 17. Employers therefore should be cautious and permit these elections only if the accumulated leave policy allows payouts before the date of the severance from employment.
Unforeseeable Emergency Distributions.
The proposed regulations contained examples illustrating unforeseeable emergencies, one of which is a need to pay for the funeral expenses of a "family member." As a result of requests by commentators to clarify the meaning of this term, the final regulations say the need to pay such expenses for a participant’s spouse or dependent (as defined in section 152(a)) may be such an emergency. Accordingly, an unforeseeable emergency distribution may not be available to pay for the funeral of, e.g., a non-dependent child, parent, or domestic partner.Plan Terminations.
Practitioners have historically questioned whether a section 457(b) plan could contain standard language allowing it to be terminated, in light of distribution restrictions that do not include termination of the plan. The final regulations now clarify that a section 457(b) plan may indeed allow for a termination, with distributions to be made in that event.Plan-to-Plan Transfers.
The proposed regulations allow plan-to-plan transfers between governmental plans in limited situations. The final regulations expand the availability of plan-toplan transfers to include the following situations.- Transfers directed by individual participants –
- From an eligible governmental plan maintained by the participant’s former employer to one maintained by his or her current employer;
- From a plan maintained by a tax-exempt entity that previously employed the participant to the plan of the tax-exempt entity for which the participant currently performs service;
- Between eligible governmental plans sponsored by the same governmental employer;
- Transfer of an entire eligible governmental plan’s assets to another eligible governmental plan within the same state;
- Plan-to-plan transfers from an eligible governmental plan to a defined benefit plan maintained by a governmental entity, for the purchase of permissive service credit, regardless of whether the governmental entity is in the same state (proposed regulations would have required that it be located in the same state).
Ineligible Plans.
The final regulations retain the coordination rules between sections 83 and 457(f) articulated in the proposed regulations. The Service makes clear, through a new example, that these rules are intended to subject a participant who is granted an option on property, such as stock or a mutual fund, to immediate taxation on the value of the option at the time of the grant. The example also clarifies that the participant will be subject to tax on any gain (less basis resulting from the tax of the value of the grant and the payment of the exercise price) at the time of exercise.Note that the transitional effective date permitting a reasonable good faith interpretation applies only to the rules for eligible plans and not to the rules for ineligible plans. The coordination rules between section 83 and section 457(f), however, do not apply with respect to an option without a readily ascertainable fair market value (within the meaning of section 83(e)(3)) that was granted on or before May 8, 2002.
Outstanding Issues
Distribution Restrictions on Rollover Contributions.
The proposed regulations provided that amounts rolled into governmental section 457(b) plans would be subject to the same distribution restrictions applicable to amounts deferred under the 457 plan. Commentators pointed out that rollover contributions to other types of plans (e.g., 401(a) and 403(b)) are permitted to be made available at any time, which is logical because, by definition, the participant has already satisfied any distribution restrictions applicable to such amounts.Nevertheless, the final regulations retain the rule that rollover contributions are subject to the section 457(b) distribution restrictions, subject to any future guidance to be issued by the Service. Providing some hope for a future change, the preamble notes that, in the near future, the IRS is expected to publish guidance on this issue applying to all types of plans. Accordingly, a special transition rule provides that the distribution restrictions on rollover amounts will not go into effect until January 1, 2004.
Severance Pay.
The Service continues to seek comments on bona fide severance pay arrangements, for which interim guidance was provided in Announcement 2000-1, 2000-1 C.B. 294.Guidance Found Only in the Preamble to the Proposed Regulations.
The preamble to the proposed regulations included some significant guidance that is not articulated in the regulations themselves. Rev. Rul. 2000-33, 2000-2 C.B. 142, permitting "negative elections" for deferrals under section 401(k) plans, may be applied to section 457(b) plans. Plan amendments are not required until guidance is issued as to when plans must be amended.Other Highlights of The Final Regulations
The remaining final regulations generally retain rules set forth in the proposed regulations. The more significant points are as follows:
Definitions.
[Section 1.457-2] The final regulations define a number of terms, some of the more noteworthy of which are as follows.- "Annual Deferrals" include both nonelective employer contributions (including matching contributions) to a section 457(b) plan and salary reduction contributions.
- The definition of "Ineligible Plan" does not include a plan established by an ineligible employer.
General Rules for Eligible Plans.
[Section 1.457-3] The following rules from the proposed regulations have been retained.- A written plan document containing material terms and conditions for benefits is required for qualification as an eligible plan.
- An anti-abuse rule permits the Service to aggregate plans to prevent abuse of section 457(b) eligibility principles.
Annual Deferrals.
[Section 1.457-4] The rules provide guidance on the following issues related to annual deferrals.- Standards for deferral agreements
- Maximum deferral limitations
- Coordination among various catch-up contribution provisions
- Definition and purpose of normal retirement age
- Multiple eligible plans
Individual Limitation for Combined Annual Deferrals under Multiple Plans.
[Section 1.457-5] The final regulations include general guidance on the application of the individual combined plan limitation, as well as specific guidance as to how catch-up amounts are applied in such situations.Distributions.
[Sections 1.457-6 and 1.457-7] The rules address a number of distribution issues, including the following:- Timing of distributions
- Unforeseeable emergencies
- Application of minimum required distribution rules
- Distributions of smaller amounts
- Taxation rules, in general
- Loans and deemed distributions
- Rollovers
- When amounts are "made available" under tax-exempt plans
Funding Rules for Eligible Plans.
[Section 1.457-8] Provisions on funding set forth standards for trusts, annuity contracts and custodial accounts for governmental plans, and requirements relating to the concept of "unfunded" tax-exempt plans. A section on combining assets under governmental plans has been reserved.Disqualification of Eligible Plans.
[Section 1.457-9] The effects of failing to operate in accordance with the eligible plan rules are outlined in this section of the regulations.Miscellaneous Provisions.
[Section 1.457-10] The guidance also includes rules regarding:- Plan terminations and frozen plans
- Plan-to-plan transfers
- Qualified Domestic Relations Orders
- Death benefits and life insurance proceeds
- Rollovers
- Deemed IRAs
Ineligible Plans.
[Section 1.457-11] In addition to general guidance as to the taxation of ineligible plans, this section of the regulations emphasizes the relationship between Code sections 457(f) and 83.The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.
