Does a sec. 457 plan work with a sec. 501(c) (7) organization?

• Author: Stump, Mitchell L.
• Position: Retirement benefit plans

Many membership organizations exempt under Sec. 501(c)(7), especially country clubs, have established Sec. 457 deferred compensation plans for their key executives and employees without fully understanding the tax ramifications of such plans. Depending on the choice of investment vehicle, the investment income earned on the contributions may be taxable as unrelated business taxable income, with no offsetting deductions.

Sec. 512(a)(3) requires a Sec. 501(c)(7) organization to include investment income as unrelated business income (UBI) subject to income tax, even though it is a tax-exempt entity. More specifically, investments in deferred annuities, a common investment vehicle for deferred compensation plans of clubs, may not fund non-qualified deferred compensation plans on a tax-favored basis, effective for amounts invested in annuity contracts after Feb. 28, 1986 (Sec. 72(u)). More troubling is the fact that there does not appear to be a corresponding deduction to offset UBI in the year in which the deferred compensation is ultimately paid out to the retiring individual.

Currently, the Treasury Department is working on a regulation project to address Sec. 457 plans and their application to state and local governments and tax-exempt organizations. What are the tax issues that should be addressed by the tax adviser of a Sec. 501(c)(7) organization with a Sec. 457 plan?

* First, the tax adviser must determine whether a Sec. 457 plan exists within the tax-exempt entity. This is not so obvious; for financial accounting purposes, the contribution to a Sec. 457 plan is recorded as an expense in the compensation account for the key employee and is deemed to be a current period expense. If a plan does exist, it is necessary to determine what portion of the investment income, if any, is subject to unrelated business income tax (UBIT).

* Sec. 501(c)(7) organizations could invest their Sec. 457 moneys in vehicles that are nontaxable for both state and Federal purposes to keep income from being taxable as UBI under Sec. 512 (e.g., tax-exempt bonds or bond funds). (Rev. Rul. 76-337 discusses the exemption from taxability of Sec. 501(c)(7) organizations.) There are insurance products on the market, such as variable life insurance contracts, that can also meet this goal. The employee must make a determination based on risk factors and goals. The employer, however, should have a say in the investment vehicle if it will be required to pay tax on the...