United States: The New, New (EPCRS Voluntary Correction) Thing: 457(b) Plans

The IRS's Employee Plans Compliance Resolution System (or "EPCRS") permits corrections, both voluntary and on audit, of a broad range of "qualification failures" — i.e., violations of sometimes arcane and complex tax rules — in tax-qualified plans and other retirement arrangements. Judged against any reasonable standard, EPCRS is a resounding success, for which the Internal Revenue Service deserves credit. Before 1991, the options available to qualified plan sponsors for the correction of qualification failures were extremely limited. Even the most modest of innocuous qualification failures resulted in disqualification. Sponsors discovering such failures were forced either to accept the risk of audit; disclose the failure to, and negotiate the correction with, the IRS; or treat the plan as disqualified. There was no formal administrative correction mechanism of general application that could match the severity of a violation with the appropriateness of the corresponding sanction. The penalty, in short, rarely fit the crime.

Recognizing the difficult position in which the regulatory environment placed plan sponsors, the IRS in 1991 established a targeted "closing agreements program" (or "CAP"), which sought to create a mechanism to encourage plan sponsors of tax-qualified plans to step forward voluntarily to correct failures. Over the years that followed, CAP was made more standardized and user friendly, and it was expanded to allow for the preservation of tax-deferred benefits for participants in Code Section 401(a) tax-qualified plans, tax-sheltered annuities, SEPs and SARSEPs, and SIMPLE IRAs. EPCRS's most current iteration permits the reinstatement of tax-qualified plan status, correction of failures relating to plan loans, and correction of failures involving minimum required distributions, excess elective and matching contributions, among other available corrections.

While the list of EPCRS-eligible plans and arrangements is comprehensive, it is not all-inclusive. For years, plan sponsors, their advisors, and other interested parties urged the IRS to allow EPCRS to permit correction of failures involving eligible, non-qualified plans of deferred compensation under Code Section 457(b). In Rev. Proc. 2013-12, which revised and updated EPCRS, the IRS for the first time provided that governmental entities may submit correction applications for 457(b) plans based on standards that are similar to EPCRS. In the case of 457(b) plans maintained by tax-exempt employers, Rev. Proc. 2013-12 states that the IRS will allow for correction in limited instances.

The provisions of Rev. Proc. 2013-12 (Section 4.09) dealing with corrections of 457(b) plans provide as follows:

"Submissions relating to § 457(b) will be accepted by the Service on a provisional basis outside of EPCRS through standards that are similar to EPCRS. The availability of correction is generally limited to plans that are sponsored by governmental entities described in § 457(e)(1)(A). In the case of a § 457(b) plan that is an unfunded deferred compensation plan established for the benefit of top hat employees of a tax-exempt entity described in § 457(e)(1)(B), the Service generally will not enter into an agreement to address problems associated with such a plan. However, the Service may consider a submission where, for example, the plan was erroneously established to benefit the entity's non-highly compensated employees and the plan has been operated in a manner that is similar to a Qualified Plan."


Code Section 457, which was added by the Revenue Act of 1978, codified a practice of state and local governments that had developed over many years. These plans provide for salary deferrals by employees of state and local governments and (later) tax-exempt organizations. Unlike their tax-qualified counterparts, 457 plans are not generally offered to all employees, and in the case of private sector, tax-exempt employers, coverage is limited to the "top-hat" group (senior management, in most cases) in order to escape the reach of the eligibility, vesting, and funding rules imposed by the Employee Retirement Income Security Act of 1974 (ERISA). Code Section 457 refers to the arrangements that it regulates as "non-qualified," since they are not subject to the more strict rules of Code Section 401(a) (relating to tax-qualified plans). Because coverage under 457 plans is limited to more senior and higher-paid employees, the IRS has historically been reticent to permit correction under EPCRS.

Code Section 457 recognizes two types of non-qualified plans, eligible and ineligible:

1. Eligible plans of deferred compensation under Code Section 457(b)

Eligible plans of deferred compensation may be established and maintained only by a state or local government or a tax-exempt organization under Code Section 501(c). Employers, or employees through elective salary reductions, are generally allowed to make annual contributions to the plan to up to the Code Section 402(g) limit ($17,500 in 2013 and 2014). Contributions and earnings are tax-deferred, and the tax is generally postponed until plan benefits are paid.

457(b) plans of state and local governments

A governmental 457(b) plan may cover common-law employees and independent contractors. There is no requirement that the plan pass any minimum coverage test. In addition to employer and employee contributions of up to $17,500 (in 2013 and 2014), an age 50 or over salary reduction "catch-up" contribution is allowed. There is also a special catch-up rule that applies to participants during the three years prior to their normal retirement age that permits additional contributions of the lesser of (i) $35,000 (twice the basic annual limit) in 2013 or 2014, or (ii) the basic annual limit plus the aggregate amount of all underutilized basic annual limits in prior years (only allowed if not utilizing the age 50 or over catch-up). A governmental 457(b) plan may also permit designated Roth contributions.

Withdrawals from a governmental 457(b) plan are permitted after severance from employment, and the rules governing minimum required distributions apply. Thus, participants must start receiving distributions by April 1 following the year of retirement or attainment of age 70˝. Loans are permitted, as are distributions for unforeseeable emergency and for small inactive accounts. Rollovers are permitted to another eligible retirement plan, and transfers are permitted from one governmental 457(b) plan to another governmental 457(b) plan.

All amounts deferred under eligible section 457(b) plans of state and local government employers must be set aside in trust for the exclusive benefit of plan participants.

457(b) plans of private-sector tax-exempt organizations (under Code Section 501(c))

A 457(b) plan of a private-sector tax-exempt organization may (as a result of ERISA) only cover a "select group of management or highly compensated employees" and independent contractors. As is the case with governmental 457(b) plans, there is no requirement that the plan pass any minimum coverage test. Unlike governmental plans, 457(b) plans of tax-exempt employers may not provide for an age 50 or over salary reduction catch-up contribution, nor may they accommodate Roth contributions. They may, however, include the special catch-up rule that applies to participants during the three years prior to their normal retirement age.

Withdrawals from 457(b) plans sponsored by tax-exempt employers are permitted after severance from employment, and participants must generally start receiving distributions by April 1 following the year of their retirement or attainment of age 70˝. Loans are not permitted, but post-severance transfers are permitted from one tax-exempt 457(b) plan to another tax-exempt 457(b) plan.

Lastly, 457(b) plans maintained by tax-exempt employers must be unfunded. A plan or arrangement is unfunded for tax purposes if the employee has only the employer's mere, unsecured promise to pay the deferred compensation benefits in the future. A tax-exempt employer may simply keep track of the benefit in a bookkeeping account, or it may choose to invest in annuities, securities, policies of insurance, or other arrangements — which are held in the name of the employer — to help fulfill its promise to pay the employee. Alternatively, the employer may transfer amounts to a trust that remains a part of the employer's general assets (a so-called "rabbi trust") subject to the claims of the employer's creditors if the employer becomes insolvent.

Where a 457(b) plan fails to comply with the requirements of Code Section 457(b), participants are taxed under the rules governing ineligible plans in Code Section 457(f). As a practical matter, this means that the discounted present value of benefits based on amounts credited to participants (in the case of a 457(b) plan of a tax-exempt entity) or deposited in trust for the exclusive benefit of participants (in the case of a 457(b) plan of a unit of government) would be taxed currently.

2. Ineligible plans of deferred compensation under Code Section 457(f)

Under Code Section 457(f), deferred compensation is included in gross income when deferred or, if later, when the rights to payment of the deferred compensation cease to be subject to a substantial risk of forfeiture. Code Section 457(f) modifies a basic tax doctrine — that of "constructive receipt." Under the constructive receipt doctrine, an item of income is taxable to an individual when he or she first has an unqualified right to receive it, and it is not subject to a substantial risk of forfeiture or some other substantial restriction. A mere promise to pay a sum certain at some future time does not give rise to constructive receipt. But under Code Section 457(f) a mere promise to pay a sum certain at some future time is taxable currently unless subject to a substantial risk of forfeiture.

By way of example, if a private sector employer makes an unsecured (or, in tax law parlance, "unfunded") promise to an executive to pay him or her $100 in three years, the $100 will be taxed when paid. That same promise made by a governmental or tax-exempt employer will, however, be taxed currently unless subject to a substantial risk of forfeiture — e.g., the executive must remain employed for three years to receive the promised payment.

The disparate treatment of private sector employers vs. governmental or tax-exempt employers has a basis in tax law. Congress was concerned about the absence of "the usual tension between an employee's desire to defer tax on compensation and the employer's desire to obtain a current deduction."1 Congress reasoned that a taxable employer would hesitate to provide non-qualified deferred compensation in the absence of a current deduction. A taxable employer has already paid tax on the funds from which benefits will ultimately be paid, and the earnings on such funds are taxed to the employer annually. The employer's deduction for the amounts that it contributes to the plan (but not earnings)2 is delayed, however, until the deferred compensation is paid or made available to the employee, at which point the employee is taxed on the entire amount of the distribution, earnings included.3

The governmental and tax-exempt employer's situation is different. Amounts used to fund benefits have not been previously taxed, earnings accrue tax-free, and the deduction for benefits paid is not a concern. The only way that a taxable employer can get to this result is under a tax-qualified retirement plan, which may not discriminate against rank-and-file employees. In the absence of § 457(f), a governmental or tax-exempt employer could obtain all the advantages of a tax-qualified plan without satisfying the laundry list of requirements imposed by § 401(a) on tax-qualified retirement plans (including non-discrimination rules). Code § 457(f) prevents governmental and tax-exempt employers from abandoning tax-qualified plans in favor of non-qualified deferred compensation arrangements to the detriment of rank-and-file employees.

Correction of § 457(b) plans under EPCRS

Revenue Procedure 2013-12 did not open up the EPCRS voluntary correction program to 457(f) plans. Rather, it simply provided that the IRS would accept submissions "on a provisional basis outside of EPCRS through standards that are similar to EPCRS." Thus, correction of a 457(b) plan, whether maintained by a unit of government or a tax-exempt entity, is not available as a matter of right. Correction, if permitted at all, is at the discretion of the IRS under its general authority to enter into closing agreements. Moreover, that discretion is likely to be applied more liberally in the case of a governmental 457(b) plan, and (perhaps far) less liberally in the case of a plan maintained by a tax-exempt entity.

The extent to which the IRS may be willing to entertain corrections of 457(b) plans was expanded on in a set Questions and Answers by the American Bar Association Section of Taxation, Committee on Employee Benefits.4

Caution: These questions and answers were based on an oral exchange with Tax Section representatives and Treasury officials that was subsequently reduced to a written transcript. In the transcript, the Treasury Department makes clear that "statements contained herein cannot be relied on." In short, these Q&As do not rise to the level of formal guidance.

The questions involved a tax-exempt employer that adopted a 457(b) plan for its key executives that was operated incorrectly since its inception (i) based on a misunderstanding of the differences between a governmental and a tax-exempt 457(b) plan or (ii) as a result of having received inaccurate advice from its advisors. The specific questions involved over age 50 catch-up contributions, the making of excess deferrals, and the deposit of contributions into a trust. The IRS's response is at the same time cryptic and mildly encouraging:

"This is a plan of a non-governmental tax exempt employer. The answer is driven by Section 4.09 of Revenue Procedure 2012-13 [sic] which provides that 'submissions relating to § 457(b) will be accepted by the Service on a provisional basis outside of EPCRS .... The availability of correction is generally limited to plans that are sponsored by governmental entitles [sic] described in § 457(e)(1)(A).' The Service representative stated that there might be a way to handle this situation outside of EPCRS, such as a closing agreement or a special arrangement. The Service representative stated that he would not submit the plan under Revenue Procedure 2012-13 [sic]." (Emphasis added).

Based on Rev. Proc. 2013-12, the Q&As, informal remarks by Treasury and IRS representatives (speaking in their individual capacities and not in an official capacity), and our experience to date with 457(b) submissions, the following rules appear to govern voluntary submissions for corrections involving 457(b) plans of tax-exempt entities:

  1. There is no guarantee that the IRS will accept any submission, but the chance of a submission being accepted increases where the correction involves one or more of the issues cited in the revenue procedure or in the Q&As, i.e., benefits provided to non-highly compensated employees (and the plan has been operated in a manner similar to a qualified plan), over age 50 catch-up contributions, the making of excess deferrals, and the deposit of contributions into a trust. We understand that submissions will first be shared with, and reviewed by, representatives of the IRS Office of Chief Counsel, Employee Plans/Technical, and Employee Plans/Examinations.
  2. Because the submission is technically outside EPCRS, the EPCRS compliance fee for voluntary corrections does not apply. Rather, the fee will be a negotiated amount that presumably starts from the "maximum payment amount" as determined under Audit CAP and is negotiated downward from there. The problem, of course, is that the maximum payment amount takes into account such things as compensation deductions and trust earnings that are meaningless in the context of governments and tax-exempts. For lack of any better place to start, therefore, submissions might start with the EPCRS fee schedule for voluntary submissions, but no amount should be tendered with the application. If the application is accepted, the matter of the compliance fee will be negotiated as part of the submission process.
  3. While the submission is outside of EPCRS, there is nothing to prevent an applicant from following the EPCRS format in preparing the submission.


EPCRS has proven to be both flexible and adaptable, and it has grown and evolved in ways that few if any, whether in the government or the private sector, could have ever imagined. The program improves and changes, however, only in increments. Based on EPCRS's history, a wholesale expansion to embrace all manner of 457(b) corrections would have been something of a shock. That 457(b) has been included in the IRS's latest iteration of EPCRS telegraphs some level of perceived need for this type of correction. The early submissions of 457(b) plan corrections will be particularly challenging for both sides: 457(b) plan sponsors will need to trust that the system will work; and regulators will need to modulate their acceptance criteria and temper sanctions in order to encourage compliance but not profligacy. If the history of EPCRS is any guide, both sides should — at least for the most part — be pleased with the outcome.


1. Staff of Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1978 (Blue Book), at 654.

2. See Code § 404(a)(5) and Treas. Regs. §§ 1.404(a)-12(b)(1) and § 1.402(b)-1.

3. Code § 404(a)(5).

4. http://www.americanbar.org/content/dam/aba/events/employee_benefits/2013_irs_qa.authcheckdam.pdf. Q&A 16.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Alden J. Bianchi
Ann M. Fievet
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