For many years, the IRS has promised to issue regulations for Sec. 457(f) plans, largely because detailed guidance addressing certain issues was sorely needed. Finally, proposed regulations (REG-147196-07) were issued in June 2016, and they provide helpful guidance and even some welcome news. The regulations are effective for calendar years beginning after the date final regulations are published, but taxpayers may rely on the proposed regulations now.
A Sec. 457(f) plan is a deferred compensation plan sponsored by a state or local government or by a tax-exempt entity. The rules regarding Sec. 457(f) plans receive a great deal of attention because the benefits an employee has in such a plan are subject to income tax upon vesting, even if the payment of the benefits is deferred to a later date. The fact that benefits are subject to income tax upon vesting is usually viewed as unfavorable. Employers and employees that do not realize they have a Sec. 457(f) plan, or do not realize that the amounts have become vested and are therefore currently taxable, can be in for a shock and can be liable for interest and penalties for not paying taxes on time.
The proposed regulations define deferred compensation as an arrangement under which "the participant has a legally binding right during a calendar year to compensation that, pursuant to the terms of the plan, is or may be payable to (or on behalf of) the participant in a later calendar year." Many types of arrangements fall within this definition, but not all of them are Sec. 457(f) plans.
The rules are written in a manner that specifically exempts certain arrangements from treatment as a Sec. 457(f) plan and then treat as a Sec. 457(f) plan any arrangement that falls within the definition of deferred compensation that is not specifically exempt. In other words, Sec. 457(f) is the default. Benefits under exempt arrangements are not subject to income tax until the benefits are paid. A Sec. 457(f) plan is the only plan under which the benefits are subject to income tax upon vesting, even if they are not paid out at that time.
Exempt arrangements include qualified retirement plans such as defined benefit and Sec. 401(k) plans. Exempt arrangements also include Sec. 403(b) plans and Sec. 457(b) plans. These plans are easy to identify because a written plan document states the type of plan. These plans can also be identified by specific characteristics. For example, a Sec. 457(b) plan imposes an annual contribution limit for 2017 of $18,000, plus a catch-up contribution of $6,000 for governmental employees who are age 50 or older. Sec. 457(f) plans, in contrast, have no contribution limits or distribution restrictions.
The proposed regulations bring good news with regard to exemptions by both expanding the list of exemptions and clarifying certain exemptions that existed previously. The exemptions include "short-term deferrals," vacation leave, sick leave, severance pay, disability pay, death benefit plans, and some additional, narrower exemptions. The exemptions in the proposed regulations that have gotten the most attention are for short-term deferrals and severance pay.
For a detailed discussion of the issues in this area, see "Tax Clinic: Proposed Regulations Provide Helpful Guidance for Sec. 457(f) Plans," by G. Edgar Adkins Jr., CPA, and Jeffrey A. Martin, CPA, in the February 2017 issue of The Tax Adviser.
—Alistair M. Nevius, editor-in-chief, The Tax Adviser
The Tax Adviser is the AICPA's monthly journal of tax planning, trends, and techniques.
Also in the February issue:
- An analysis of preparer penalties under Secs. 6694 and 6695.
- A look at recent developments in the taxation of partners and partnerships.
- A discussion of what to do about errors on tax returns.
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