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Avoiding the Trap of Inadvertent Section 457(f) Plans

June 07, 2005

We understand that, through collective bargaining, some governmental employers (including school districts) provide retiring employees early retirement and other benefits whose value is determined based upon days of accumulated, unused sick, vacation, or general leave, years of service or other similar factors. These benefits are sometimes paid in cash installments over a period of years following retirement, and are treated as subject to income taxes only when paid. Although paying these benefits in installments over a period of years may ease governmental employers' cash flow concerns, this method could result in unexpected adverse tax consequences for these employers and their retirees.

Inadvertent Section 457(f) Plans
Unless these benefits are payable under a "bona fide" vacation leave, sick leave, compensatory time, severance pay, disability pay, or death benefit plan, the payment of these benefits in installments over a period of years inadvertently may create an "ineligible" governmental nonqualified deferred compensation plan subject to Internal Revenue Code Section 457(f). Benefits payable under a Section 457(f) plan are immediately subject to federal income tax when vested (here, in the year of retirement). For example, if a school district provides a retiring teacher with a benefit in the amount of 100% of the teacher's final year's salary and pays that benefit in installments over a period of years following retirement, that entire amount is likely to be includable in federal gross income in the year of retirement.

Additionally, if these benefits are paid more than 2½ months after the end of the taxable year in which the employee retires, they could be treated as "nonqualified deferred compensation" subject to onerous new restrictions under Code Section 409A.
Audit Risks
If the IRS discovers these benefits on audit, affected retirees could be forced to amend their prior years' income tax returns to include the applicable amounts as taxable income in those years. If the IRS cannot recover delinquent income taxes, interest and penalties from the retirees, it could seek to recover those amounts from the employer. Finally, the IRS could seek to recover delinquent payroll (FICA and FUTA) taxes from the employer, and could assess penalties and interest against the employer for its failure to timely withhold and remit income and payroll taxes.

There are a variety of tax-favored vehicles that governmental employers can use to provide these benefits to retirees, including Section 403(b) tax-sheltered annuity plans, Section 457(b) "eligible" nonqualified deferred compensation plans, and health reimbursement arrangements (HRAs). If you have any questions about these vehicles or Section 457(f) plans, please contact any member of the Employee Benefits Practice Group.

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