Deadline for Amending Governmental Section 457 Plans Approaching (Posted on October 19, 1998 by )


Carol V. Calhoun, Counsel
Venable LLP
575 7th Street, NW
Washington, DC 20004
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Carol V. Calhoun

Internal Revenue Service ("IRS") officials have recently expressed concern that many state and local governmental section 457 plans will become "ineligible plans" as defined in Internal Revenue Code ("Code") section 457(f) as of January 1, 1999. The result would be to cause covered employees to be liable for income taxes on vested amounts deferred under the plans, and to cause state and local governmental employers which sponsored such plans to be liable for the amount of income tax which should have been withheld on deferred amounts.

The source of the problem is section 1448 of the Small Business Jobs Protection Act of 1996 ("SBJPA"), which added Code Sec. 457(g). Until the SBJPA, Code Sec. 457(b)(6) prohibited employers from "funding" section 457 plans, i.e., from setting up a trust, custodial account, or annuity contract insulated from the claims of the employer’s creditors to hold plan assets. Beginning with the SBJPA, governmental section 457 plans were not only permitted but required to set up such trusts, custodial accounts, or annuity contracts.

Section 457 plans which existed before the SBJPA are currently covered by a transitional rule, under which they do not have to move plan assets into a trust, custodial account, or annuity contract immediately. However, that transitional rule expires on January 1, 1999. By that time, any existing governmental section 457 plan must have moved its assets to a trust, custodial account, or annuity contract. If it fails to do so, all contributions to the section 457 plan will become taxable to employees at the point at which they become vested. Thus, if contributions to a plan which does not satisfy the requirement are immediately vested, they will be taxable when made. If they are not vested until some later date (e.g., attainment of age 65), the account balance as of the vesting date will be taxable in the year of vesting.

And the tax consequences will affect employers as well as employees. An employer is liable under Code Sec. 3403 for all income taxes it should have withheld from an employee, whether or not it actually withheld such taxes. Thus, even if an employer fails to withhold from a contribution to a plan because the employer believes that the plan qualifies under section 457, the employer can be held liable for the taxes it should have withheld.

Solving the Problem

How can an employer avoid such problems? Notice 98-8, 1998-4 I.R.B. 6; Rev Proc 98-40, 1998-32 I.R.B. 6 and Rev Proc 98-41, 1998-32 I.R.B. 7 provide some guidance.

Annuity Contracts

The new requirements are most simple if the section 457 plan is currently funded by an annuity contract issued by an insurance company, and if the employer wishes to continue to fund the plan with the same annuity contract. The plan must be amended to provide that it will be impossible, prior to the satisfaction of all liabilities with respect to plan participants and beneficiaries, for any part of the value of the annuity contract to be used for, or diverted to, purposes other than for the exclusive benefit of plan participants and their beneficiaries. Also, future amounts deferred under the plan must be transferred to the annuity contract within a period that is not longer than is reasonable for the proper administration of the accounts of participants. Notice 98-8 states that a plan provision under which amounts deferred under the plan are contributed to the contract within 15 business days following the month in which the amounts would otherwise have been paid to the participant would satisfy this requirement. Rev Proc 98-40 provides a model plan amendment (see below) which can be used to satisfy all of the requirements applicable to annuity contracts held under section 457 plans.

One issue with respect to an annuity contract is that the model amendment requires that the prohibition on use of plan assets for purposes other than satisfying liabilities to plan participants and beneficiaries must apply "[n]otwithstanding any contrary provision of the Plan, including any annuity contract issued under the plan…." Annuity contracts routinely include language to the effect that the language of the plan does not bind the annuity issuer, which is bound only by the language of the annuity contract itself. In the common situation in which the language of the annuity contract reflects former Code Sec. 457(b)(6), and states that the annuity shall be subject to the claims of the employer’s creditors, it is not clear whether the plan provision set forth in the model amendments could be effective. Thus, the conservative course would be to ensure that the insurance company which issues the annuity contract amends the contract itself before January 1, 1999. Of course, getting such an amendment in place by that time may be difficult, given the requirement in most states that all changes to insurance and annuity contracts be approved in advance by state regulators. At a minimum, the appropriate plan provision should be in effect before January 1, 1999, and the annuity contract should be amended retroactively as soon thereafter as possible.

For a governmental employer which does not now maintain an annuity contract to hold assets under a section 457 plan, which maintains an annuity contract issued by an entity other than an insurance company (e.g., a bank), or which wishes to change annuity carriers, the situation is more complex. In order to meet the new requirements, the annuity contract must be in place on or before January 1, 1999. Given the large number of plans that will need to convert to funded status by that date, insurance companies may face difficulties in complying with end-of-year requests to set up new contracts. Thus, it is critical that section 457 plans that choose to fund through annuities for the first time, or to change annuity contracts, approach insurance companies early about setting up appropriate contracts.

Trusts

A second funding alternative is a trust. The requirements for a trust, in terms of having the assets insulated from the claims of the employer’s creditors and placing assets in the trust within a period that is not longer than is reasonable for the proper administration of the accounts of participants, are virtually identical to the requirements for an annuity contract. And the trustee of a trust can be any party, not necessarily an insurance company.

The one disadvantage of a trust is that unlike the model IRS language governing annuity contracts, the model IRS language for plans funded through a trust does not completely meet the new requirements. Rather, the model language states that a trust is to be established under the plan pursuant to a written agreement that constitutes a valid trust under the law of the applicable state. And the IRS does not provide model trust language.

However, as a practical matter, the requirements for a trust are minimal. The trust need not be a document separate from the plan; rather, trust provisions could be included in the plan itself. The trustees can be individuals (e.g., the individuals who are members of the board of trustees for another plan maintained by the employer) or an institution such as a bank or investment firm. The important point is that a trust agreement (or an amendment to the plan imposing trust provisions) must be in place before January 1, 1999.

A more difficult problem is getting plan assets transferred to the trust in a timely manner. Unlike an annuity contract, which is a single asset, a trust can hold a variety of assets. To have the plan assets in trust by January 1, 1999 may involve transfers of title to items such as stocks, real estate, bank accounts, etc. All of such transfers must comply with the requirements of local law in order to fulfill the requirement that assets be placed in trust. This can be an issue if, for example, stock certificates must be transferred or new deeds must be executed and filed with appropriate authorities.

Custodial Accounts

The requirements for a custodial account are virtually identical to those for a trust, except that the custodian must be a bank or other entity authorized to act as a custodian for individual retirement accounts. Thus, both the benefits and detriments of a custodial account are the same as for a trust.

Other Issues

Governmental plans are not subject to the fiduciary requirements of the Employee Retirement Income Security Act of 1974 ("ERISA"). At the same time, they are not subject to the provision of ERISA which preempts state law fiduciary requirements. In the past, sponsors of section 457 plans have often ignored state fiduciary requirements, either because employers were unaware of them or because the fact that assets could be used to meet claims against the employer made it less likely that participants would have a cause of action for misuse of plan assets. However, it is clear that the new requirements were intended to ensure that all plan assets would be held for the benefit of plan participants and beneficiaries. Thus, it is important to consider what local law restrictions (e.g., "legal list" statutes or prudence and diversification requirements) might apply to the trusts, annuity contracts, or custodial agreements set up pursuant to the new law.

Also, potential trustees may want some guarantees that they will not be held personally liable for trust losses. The ability of a governmental employer to indemnify trustees will vary according to local law.

Finally, the IRS has stated that it will not issue rulings on section 457 plans which already have rulings, and which simply adopt the model amendments. However, if a plan has never obtained a ruling before, the employer will need to give thought to whether the extra security available by obtaining an IRS ruling justifies the time and expense of obtaining such a ruling.

Conclusion

In less than three months, all governmental section 457 plans which have not already complied with the new rules will be forced to do so. Because of the complications of setting up funding vehicles to comply with the new rules, it is critical that state and local governments which sponsor such plans begin compliance efforts immediately.


TEXT OF IRS MODEL AMENDMENTS

(From Rev. Proc. 98-41, 1998-32 I.R.B. 7)

OPTION A: TRUST

“Notwithstanding any contrary provision of the Plan, in accordance with section 457(g) of the Internal Revenue Code, all amounts of compensation deferred pursuant to the Plan, all property and rights purchased with such amounts, and all income attributable to such amounts, property, or rights shall be held in trust for the exclusive benefit of participants and beneficiaries under the Plan. Any trust under the Plan shall be established pursuant to a written agreement that constitutes a valid trust under the law of [insert name of applicable state] .

All amounts of compensation deferred under the Plan shall be transferred to a trust established under the Plan within a period that is not longer than is reasonable for the proper administration of the accounts of participants. To comply with this requirement, all amounts of compensation deferred under the Plan shall be transferred to a trust established under the Plan not later than 15 business days after the end of the month in which the compensation would otherwise have been paid to the employee.”

OPTION B: ANNUITY CONTRACT

“Notwithstanding any contrary provision of the Plan, including any annuity contract issued under the plan, in accordance with section 457(g) of the Internal Revenue Code, all amounts of compensation deferred pursuant to the Plan, all property and rights purchased with such amounts, and all income attributable to such amounts, property, or rights shall be held in one or more annuity contracts, as defined in section 401(g) of such Code, issued by an insurance company qualified to do business in the state where the contract was issued, for the exclusive benefit of participants and beneficiaries under the Plan. For this purpose, the term “annuity contract” does not include a life, health or accident, property, casualty, or liability insurance contract.

All amounts of compensation deferred under the Plan shall be transferred to an annuity contract described in section 401(f) of the Internal Revenue Code within a period that is not longer than is reasonable for the proper administration of the accounts of participants. To comply with this requirement, all amounts of compensation deferred under the Plan shall be transferred to a contract described in section 401(f) of such Code not later than 15 business days after the end of the month in which the compensation would otherwise have been paid to the employee.”

OPTION C: CUSTODIAL ACCOUNT

“Notwithstanding any contrary provision of the Plan, in accordance with section 457(g) of the Internal Revenue Code, all amounts of compensation deferred pursuant to the Plan, all property and rights purchased with such amounts, and all income attributable to such amounts, property, or rights shall be held in one or more custodial accounts for the exclusive benefit of participants and beneficiaries under the Plan. For purposes of this paragraph, the custodian of any custodial account created pursuant to the Plan must be a bank, as described in section 408(n) of the Internal Revenue Code, or a person who meets the nonbank trustee requirements of paragraphs (2)-(6) of section 1.408-2(e) of the Income Tax Regulations relating to the use of non-bank trustees.

All amounts of compensation deferred under the Plan shall be transferred to a custodial account described in section 401(f) of the Internal Revenue Code within a period that is not longer than is reasonable for the proper administration of the accounts of participants. To comply with this requirement, all amounts of compensation deferred under the Plan shall be transferred to a custodial account described in section 401(f) of such Code not later than 15 business days after the end of the month in which the compensation would otherwise have been paid to the employee.”

Footnotes:
1. Although many section 457 plans maintained trusts or annuity contracts to hold plan assets, such trusts or contracts were not considered to be “funding” the plans, because they were subject to the claims of the employer’s creditors.
2. Nongovernmental tax-exempt employers are still subject to the old rules, under which they are prohibited from funding section 457 plans.
Although many section 457 plans maintained trusts or annuity contracts to hold plan assets, such trusts or contracts were not considered to be “funding” the plans, because they were subject to the claims of the employer’s creditors.
Nongovernmental tax-exempt employers are still subject to the old rules, under which they are prohibited from funding section 457 plans.