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Does a sec. 457 plan work with a sec. 501(c)(7) organization?

Many membership organizations exempt under Sec. 501(c)(7), especially country clubs, have established Sec. 457 deferred compensation plans for their key executives and employees without fully understanding the tax ramifications of such plans. Depending on the choice of investment vehicle, the investment income earned on the contributions may be taxable as unrelated business taxable income, with no offsetting deductions.

Sec. 512(a)(3) requires a Sec. 501(c)(7) organization to include investment income as unrelated business income (UBI) subject to income tax, even though it is a tax-exempt entity. More specifically, investments in deferred annuities, a common investment vehicle for deferred compensation plans of clubs, may not fund non-qualified deferred compensation plans on a tax-favored basis, effective for amounts invested in annuity contracts after Feb. 28, 1986 (Sec. 72(u)). More troubling is the fact that there does not appear to be a corresponding deduction to offset UBI in the year in which the deferred compensation is ultimately paid out to the retiring individual.

Currently, the Treasury Department is working on a regulation project to address Sec. 457 plans and their application to state and local governments and tax-exempt organizations. What are the tax issues that should be addressed by the tax adviser of a Sec. 501(c)(7) organization with a Sec. 457 plan?

* First, the tax adviser must determine whether a Sec. 457 plan exists within the tax-exempt entity. This is not so obvious; for financial accounting purposes, the contribution to a Sec. 457 plan is recorded as an expense in the compensation account for the key employee and is deemed to be a current period expense. If a plan does exist, it is necessary to determine what portion of the investment income, if any, is subject to unrelated business income tax (UBIT).

* Sec. 501(c)(7) organizations could invest their Sec. 457 moneys in vehicles that are nontaxable for both state and Federal purposes to keep income from being taxable as UBI under Sec. 512 (e.g., tax-exempt bonds or bond funds). (Rev. Rul. 76-337 discusses the exemption from taxability of Sec. 501(c)(7) organizations.) There are insurance products on the market, such as variable life insurance contracts, that can also meet this goal. The employee must make a determination based on risk factors and goals. The employer, however, should have a say in the investment vehicle if it will be required to pay tax on the investment income.

* Sec. 501(c)(7) organizations could consider taking a tax deduction from UBIT, if and when the interest factor of the retirement benefit is paid out to the retired employee. This would require maintaining an accurate account of the income for each individual participant. If the funds are not paid out in one lump sum, a percentage computation on an annual basis would seem to be necessary. Currently, there does not appear to be authorization to take such a tax deduction from UBIT, since the deduction for retirement payments to former employees is deemed a member-related expense, although there may be some logic to such a deduction. Forthcoming regulations should address this issue.

* Sec. 501(c)(7) organizations should prohibit an employee from requesting a transfer of the Sec. 457 plan assets from one employer organization to another employer organization unless the employee is prepared to pay income tax on the distribution of the funds. Because country club personnel are required to be very mobile and move within their industry frequently, employees want to continue to have funds contributed to the same investment vehicle by their subsequent employer. The Sec. 457 plans, however, do not appear to be transportable between employers. (IRS Letter Ruling 8906066 allowed for the transfer of funds from one eligible plan to another of the same employer, but not between employers.) Question: Can a Sec. 501(c)(7) organization transport its plan to another organization? If not, can it sell its investment in the Sec. 457 plan assets, and the corresponding contingent retirement liability to the employee, to a subsequent employer for $1 (so that the plan can follow the employee)? No guidance appears available at this time to allow for this, even though such a contract should be valid.

* Sec. 501(c)(7) organizations should be cautioned as to the number of employees to be covered by their Sec. 457 plans. Too many covered employees will bring the plan under the provisions of the Employee Retirement Income Security Act of 1974. An exempt organization can unknowingly fall into a trap of covering too many employees, unless clearly guided.

These and possibly other issues, such as how the exempt organization is to be reimbursed for its out-of-pocket tax cost of paying the tax on Sec. 457 investment UBIT income, need to be addressed in forthcoming regulations. Without such guidance, in the interim, caution must be taken in advising Sec. 501(c)(7) organizations on establishing and continuing Sec. 457 deferred compensation plans. It is important to insure that the proper investment vehicle is used and that both the employer and employee understand the tax consequences. From Mitchell L. Stump, CPA, and Cynthia Loftus, CPA, West Palm Beach, Fla.
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Title Annotation:retirement benefit plans
Author:Loftus, Cynthia
Publication:The Tax Adviser
Date:Sep 1, 1993
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