Section 457(b) plans are an effective way for tax-exempt employers to increase the retirement savings of their key employees through employee and/or employer contributions and earnings on those contributions. A 457(b) plan must be maintained pursuant to a written plan document that contains all of the material terms and conditions for benefits under the plan, and that complies with all of the requirements in the Code and regulations governing eligibility for benefits, contribution limits, funding, timing of distributions, tax reporting, etc. Whenever these requirements change because of changes in the Code or regulations, the plan must be amended.
IRS audits of 457(b) plans have increased in the past year. This follows the “compliance checks” the IRS performed on a number of these plans beginning in 2013. The IRS has been focusing on the following issues in its audits:
- Whether there has been timely adoption of the original plan document and the amendments required by recent law changes, including Windsor (same-sex marriage decision by the Supreme Court), WRERA 2008, HEART Act 2008, Pension Protection Act 2006, and EGTRRA 2005. Many employers are using prototype plan documents that are not being amended when necessary.
- Whether the group of eligible employees has been properly limited to a select group of management or highly-compensated employees as required by ERISA.
- Whether there has been compliance with the annual contribution limits and special catch-up rules that apply to employee and employer contributions, and whether those limits have been applied correctly to defined benefit plans and plans with risks of forfeiture.
- Whether there has been compliance with the rules governing the time and manner of distributions, and whether loans have been impermissibly allowed.
- Whether FICA and income taxes have been properly and timely withheld, paid and reported on contributions and distributions.
- Whether the top-hat notice required by DOL regulations was properly filed.
Failure to meet these requirements can result in all plan accounts becoming immediately taxable in full to the employees, a terrible result for both the employees and the employer.
If an employer discovers, not in the context of an audit, that its 457(b) plan is out of compliance, it may be possible to correct the error without adverse tax consequences. The IRS maintains programs that allow some types of retirement plans to correct document and operational errors in order to avoid loss of the tax benefits provided by these plans. However, none of these programs apply explicitly to 457(b) plans. The correction program for qualified retirement plans (EPCRS), has this to say on the subject: “The IRS will accept submissions relating to 457(b) plans on a provisional basis outside of EPCRS through standards that are similar to EPCRS.” The IRS website expands on this statement, and says the IRS “retains complete discretion to accept or reject these requests.”
One part of EPCRS is the self-correction program, which allows employers to correct insignificant plan errors to their qualified retirement plans at any time, and also allows correction of significant plan errors if the correction is completed within two years after the error occurred. Although the self-correction program technically does not apply to 457(b) plans, we have generally been advising clients that they can apply the principles of the program to self-correct insignificant errors in their 457(b) plans. Although self-correction of significant errors within two years might also be possible, there is no guarantee the IRS will allow that.
The risk of expensive and time-consuming IRS audits, and the limited ability to correct plan errors, are reasons why employers need to be conscientious about keeping their 457(b) plans in compliance with the changing law and regulations. This includes amending their plans when necessary.
Best & Flanagan can help employers make necessary amendments to their plans, correct plan errors, and manage an audit. Please contact Charlie Berquist or Elizabeth Davydov for assistance.