This is the fourth of a series of articles that describe non-qualified deferred compensation plans (NQDC) that are available to non-profit employers. For an organization that is a 501(c) non-governmental tax-exempt organization, there are two types of NQDC plans available under Non-Profit Section 457(b) and Section 457(f) plans. NQDC plans are generally limited to a select group of management or highly compensated employees. This section covers some of the compliance issues concerning 457(b) and 457(f) plans.
Compliance with 457(b) Rules per IRS Reviews
If the following 457(b) plan requirements are met, then, in general, the participants will not pay income tax on the deferrals until they are distributed from the plan:
Restricting participation to employees performing services for the eligible employer
Limiting annual deferrals under the plan ($23,000 for 2024)
Meeting specific distribution events, as well as timing rules
Requiring that deferral elections be made for the month prior to the deferral taking effect
Treating the amounts deferred as an asset of the employer subject to the reach of creditors
Even if the 457(b) eligibility requirements have been satisfied, and the income tax on the deferral is postponed until the distribution date, Social Security and Medicare taxes are due when the deferrals are no longer subject to a substantial risk of forfeiture.
Non-Compliance with 457(b) Rules
If a plan does not satisfy the requirements under 457(b), then the Section 457(f) rules on the taxation of deferred compensation apply. Under Section 457(f), plan participation must be limited to a select group of managers or highly compensated employees and deferred compensation is taxable in the first year in which the deferrals are no longer subject to a substantial risk of forfeiture such as fully vested.
The IRS stresses that any vested deferrals for years the plan becomes subject to 457(f), and where the statute of limitations is open, are taxable to the participant in those open years. This may result in a discrepancy adjustment to the Form 1040 and additional tax for the years involved as well as penalties and interest. If the deferrals become vested in a year in which the plan is subject to 457(f), the earnings on the deferrals should be calculated through the date of vesting to determine the additional amount includible in gross income for the year. Any attempted rollovers to an IRA of amounts distributed from a 457(f) plan will be subject to excise taxes.
Federal income tax withholding applies to deferrals under a 457(f) plan at the point in time when they are no longer subject to a substantial risk of forfeiture and if there is a failure to properly withhold penalties and interest may apply.
Common Compliance Issues
Due to the IRS’s heightened interest in 457(b) programs, the prevalence of noncompliance and risk of IRS audit has increased. It is worthwhile to consider the following list of some commonly reported plan compliance issues include failure to:
Qualify as an eligible plan sponsor
Satisfy the 457(b) plan documentation requirements
Limit eligibility to a select group of management or highly compensated employees under for a 457(f) plan
Limit the deferrals to the annual contribution and catch-up maximums
Properly document and limit distributions for unforeseeable emergencies
Report contributions on behalf of participants as wages for FICA and Medicare purposes
Maintain an unfunded program and treat the funds as employer assets
Report contributions on Form W-2
File a notification statement with the Department of Labor
Prevent loans to plan participants
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