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Sec. 457 deferred compensation plans.

Employees of governments and nonprofit organizations who participate in Sec. 457 deferred compensation plans should carefully consider the status of the deferred compensation and accumulated earnings. Many participants in Sec. 457 plans are unaware that ownership of "their" deferred compensation and all earnings rests irrevocably with the employer until paid or made available. The irrevocable ownership provision dictates that Sec. 457 plans are subject to the employer's general creditors. In addition, some states' Comprehensive Annual Financial Reports include notes that attorney generals have determined that their governments are not liable to plan participants if investment losses are incurred.

Sec. 457 plans are not required to be funded until retirement. Therefore, future cash flow of the government or nonprofit employer should be carefully assessed. The current and projected future fiscal problems of both governments and nonprofits indicate that now is a good time for tax advisers of Sec. 457 plan participants to weigh carefully the tax benefits of these plans against their risk. This article will discuss solutions available to plan participants who determine that the risk is currently not worth the tax benefit.

Deferred Compensation Plans

Sec. 457(a) offers a tax benefit to employees of governments and nonprofit organizations: taxation of deferred compensation and earnings thereon is delayed until paid or made available to the employee. Generally, the deferred compensation is paid to the employee on retirement, thus effectively deferring the tax at least until then. On retirement, plan balances will be taxed as gross income if a single payment is elected or the tax will be matched to installment payments.

* Compensation, earnings and all assets belong to the employer

Congress originally limited the tax benefits of Sec. 457 plans to employees of state and local governments. The Tax Reform Act of 1986 (TRA) added nonprofits as eligible employers.(1) These entities must offer an elective, eligible plan. For a plan to be eligible, all deferred compensation, all earnings on that compensation and any assets purchased with either must be solely the property of the employer. In addition, the assets are subject to the general creditors of that employer. The deferral tax benefit of the participant is based on this definition of ownership.(2) Until the deferred compensation and its earnings are paid or made available to the participant, ownership rests irrevocably with the employer entity; therefore, the deferred tax and earnings are not taxable income.

* Fiscal problems of governments affect ownership provisions

The current fiscal problems of many states, counties and cities indicate that the ownership provision of Sec. 457 should be assessed carefully in 1993. Plan participants may not be aware that the employer is the sole owner of all assets. Participants who are concerned about the ability of their employer to pay out on their Sec. 457 plan might wish to consider leaving the plan until fiscal conditions improve. A Sec. 457 plan may not be nonelective; therefore, participants should be able to elect out of the plan.(3) At retirement, participants might wish to elect to receive the plan balance in a single payment rather than installments spread over a number of years determined with actuarial tables. Although the single payment requires a larger current tax payment, the retiree might feel the cost is justified because the assets will be under his ownership; if installments are chosen, the unpaid balance in the Sec. 457 plan belongs solely to the entity and is subject to its general creditors.

* Previously deferred amounts

A participant's ability to collect previously deferred amounts is difficult, as the election to defer is irrevocable. Generally, Sec. 457 amounts can be distributed to participants or their heirs only on the participant's reaching age 70 1/2, retirement, death, termination of employment or facing an unforeseen emergency.(4) Regs. Sec. 1.457-2(h)(4) 2(h)(4) defines an unforeseen emergency as severe financial hardship resulting from a sudden and unexpected illness or accident, loss of property due to a casualty, or other unforeseeable circumstances that are extraordinary and beyond the control of the employee. It would be difficult, therefore, to remove assets from a Sec. 457 plan under the emergency provisions. Anticipation of a government's inability to pay the plan at retirement or thereafter would surely not qualify as an unforeseen emergency as no event has occurred.

In certain circumstances, employees are permitted to transfer plans from one eligible employer to another.(5) A plan participant concerned about either employer's financial condition and ability to pay the plan balance might choose not to transfer the plan between employers but instead to collect the plan balance and suffer the tax consequences.

Eligible Participants

Plan participants who work for nonprofit organizations, other than churches,(6) as well as state and local governments need to be reminded of the true ownership of "their" deferred compensation plans. Eligible employers include a state, and all political subdivisions, agencies or instruments of a state.(7) Therefore, counties, cities and state agencies may offer Sec. 457 plans. In addition, the District of Columbia is an eligible employer, as are nongovernmental tax-exempt organizations (except churches). New employees of eligible employers may also need to be reminded of the ownership provision of Sec. 457. Although Sec. 457 requires an elective plan that participants must enter before the beginning of the month for which compensation is deferred, the regulations permit a new employee to defer compensation from the first day of employment, providing the deferral agreement is signed before or on the first day of employment.(8)

Under Sec. 457, both participants and the plan itself are subject to various requirements. Employees, to be eligible, must perform a service for the employer;(9) there are special rules for independent contractors.(10) An eligible plan may not be a Sec. 401 (a) plan or an exempt trust under Sec. 501(a), or a Sec. 403 or 402(b) plan.(11) The benefits of Sec. 457 are reduced by participation in other plans; in general, the ceiling established under Sec. 457 includes other plans.(12) Therefore, although a Sec. 457 plan is separate and distinct from other annuities and trusts, its deferral benefits are limited by deferrals under those other plans. The IRS established in Notice 88-68(13) that an eligible plan may not include deferral of compensation from vacation leave, sick leave, compensatory time, severance pay, disability pay or death benefit plans. Distributions before retirement can be made only when employment is terminated or in the presence of an unforeseeable emergency. Minimum distribution requirements prevent an employee from turning a Sec. 45 7 plan into a type of life insurance with the intention of benefiting a beneficiary.(14)

Participants Have Only the Rights of a General Creditor

In these times of fiscal distress on the governmental as well as personal level, tax advisers should consider that all deferred compensation, assets purchased with that compensation and earnings (including gains and losses from sales of investments) of Sec. 457 deferred compensation plans belong strictly to the state and its general creditors. Participants have only the rights of general creditors of the entity, rather than absolute rights to "their" deferred compensation account. Plan participants may be under the impression that the deferred compensation, assets and earnings belong to them. On the contrary, the Code specifically requires that compensation, assets and earnings belong to the state and its general creditors.(15)

* Deferred amounts may be transferred under certain circumstances

Regs. Sec. 1.457-2(k) permits a terminating employee to transfer the balance in his deferred compensation plan to his new employer, provided that the new employer is an eligible employer, in the same state, with an eligible plan. For example, an employee could leave the employ of the state of Virginia, accept employment with a city or county in Virginia with an eligible plan and "take" his Sec. 457 deferred amount with him. It is not clear whether the participant could transfer his account from a state or local government to a nonprofit organization within the same state; the regulations have not been updated since Congress extended the benefits of Sec. 457 plans to nonprofits in 1986. The regulations require that the sending and receiving plans be within the same state and provide for such transfers.(16)

This ability to transfer amounts may mislead some employees into thinking of a Sec. 457 plan balance as "theirs" rather than as the sole property of the employer, subject to the employer's general creditors. Employees may lose sight of the stringent requirements that must be satisfied in order to transfer the deferred amounts and simply focus on the ability of the account to "go with them." Now is probably a good time for tax advisers to remind clients of the true ownership of Sec. 457 plans and to help them assess whether such a plan should still be part of their tax planning.

* Participants may direct investments

Other circumstances may lead to misunderstandings concerning ownership of the deferred compensation and any earnings. In a funded plan, the participant is permitted to direct investment of the compensation, assets and earnings.(17) For example, the notes to the financial statements in the 1992 Commonwealth of Virginia Comprehensive Annual Report indicate that deferred compensation Sec. 457 plans are administered through the Virginia Supplemental Retirement System. As part of this administration, however, each participant directs the investment of his account. Participants may choose investment options based on their risk aversion and desire for current return or capital growth. Because the participant participates in, or actually directs, the investment of the deferred compensation, the participant may forget that those assets still belong to the state.

Governments Are Generally Not Liable

Governments are not generally liable for losses incurred on the investment of deferred compensation plans. For example, the 1992 Comprehensive Annual Report of Maryland includes a note to the effect that Maryland's legal counsel has determined that the state does not have liability for losses; it has only the duty of an ordinary prudent investor. Virginia's Comprehensive Annual Financial Report merely notifies the reader that the state's attorney general has determined that Virginia has no liability for losses under a Sec. 457 plan. Montana has a statute requiring that neither the state nor any of its political subdivisions may be liable for investment losses on deferred compensation plans. This lack of liability for losses may be reasonable given the nature of a Sec. 457 plan; since all assets of the plan are solely and irrevocably the property of the eligible employer, there is no liability to plan participants for losses.

The lack of liability for investment losses is a relevant, timely concern. In December 1991, several municipal governments saw their investment accounts of more than $1 billion, frozen due to alleged securities fraud and fraudulent management by the investment firm handling the accounts,(18) with little hope of recouping their investment pools. Some county governments combine Sec. 457 plan balances with escrow funds for investment. Therefore, the possibility exists that government clients of the investment firm had Sec. 45 7 plan balances in the investment pool. If so, the governments may have no liability to the participants. The participants' only recourse would be to prove either violation of fiduciary duty or fraud on the part of the government. It is not clear whether violation of fiduciary duty would be an applicable charge given the fact that the government owns the assets in the Sec. 457 plan. For example, in Maryland this might be chargeable, while in Virginia it is probably not. If the governments have no liability, participants might be in a worse position than if the government went bankrupt, in which case they would presumably have a claim equal to a general creditor.

If a state or local government or nonprofit employer should become bankrupt, general creditors could reach the Sec. 457 investments. Just a few years ago, this scenario might have seemed inconceivable. But in the last few years, state and local governments have suffered serious fiscal distress. And in the future, more serious problems will probably arise as governments continue to respond to the recession. Many states, cities and counties are still adjusting to the significant growth of services in the 1980s that coincided with the steep decline in Federal revenue sharing. A government that is either in default on debt or bankrupt raises real concerns for participants in Sec. 457 plans. The situation raises the specter of a bankrupt employer whose general creditors would have (presumably) first claim on all Sec. 457 plans.

Cash Flow Concerns

Cash flow concerns are also important to participants in these plans. Sec. 457 does not require deferred compensation plans to be funded; thus governments may be planning to pay participants out of current revenue or borrowing. Standard and Poors downgraded a significant amount of municipal debt in 1991. Although much of this debt was revenue bonds, rather than general obligation bonds, defaults or potential defaults on this type of debt can harm governments' ability to borrow, thus affecting cash flow. The plan participant needs assurance that the government will be able to pay the plan balance either at retirement or in installments. Whether the plan is funded or unfunded, irrevocable employer ownership of all deferred compensation and earnings under Sec. 457 makes cash flow an important consideration in choosing to defer compensation under Sec. 457.

Early Retirement

An interesting question is whether participants can elect a single payment or installments on early retirement or whether they must wait for normal retirement. The Code specifies that distributions cannot be made available until the calendar year in which the participant attains age 70 1/2 or separates from service.(19) The regulations discuss normal retirement age either as specified under the plan or as age 65.(20) If early retirement is not considered "normal" retirement under the Sec. 457 plan, early retirees may have to wait until attaining at least 65 years of age to collect under deferred compensation plans.


Sec. 457 provides a tax benefit to employees of governments and nonprofit organizations; however, the irrevocable ownership provision needs to be assessed carefully in light of the current fiscal problems faced by state and local governments. Although participants probably cannot withdraw existing resources from Sec. 457 plans, consideration should be given to the yearly election to defer compensation. Participants may decide not to elect any further deferrals for the foreseeable future. When governments' financial conditions improve, participants may wish to resume deferrals. Sec. 457 permits a limited catch-up provision in the last three years before retirement that could be used to offset the years passed.(21) (1) Sec. 457(e)(1)(B), added by TRA Section 1107(a). (2) Sec. 457(b)(6). (3) Sec. 457(d)(12)(A). (4) Sec. 457(d)(1)(A). (5) Sec. 457(e)(10). (6) Churches were exempted from the definition of eligible employer by the Omnibus Budget Reconciliation Act of 1989 (OBRA). See Sec. 457(e)(13), amended by OBRA Section 7816(j). (7) Sec. 457(e)(1)(A). (8) Regs. Sec. 1.457-2(g). (9) Sec. 457(b)(1); Regs. Sec. 1.457-2(d). (10) See, e.g., Regs. Sec. 1.457-2(h)(3). (11) Sec. 457(f)(2). (12) Sec. 45 7(c)(2). (13) Notice 88-68, 1988-1 CB 556. (14) Sec. 457(d)(2). (15) Sec. 457(b)(6). (16) Regs. Sec. 1.457-2(k). (17) Regs. Sec. 1.457-2(j). (18) Richmond Times Dispatch, 1/3/92. (19) Sec. 45 7(d)(1)(A)(i). (20) Regs. Sec. 1.457-2(f)(4). (21) Regs. Sec. 1.457-2(f)(1).
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Author:Gilfillan, Sally W.
Publication:The Tax Adviser
Date:Aug 1, 1993
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