SERVICE SAYS SECTION 457 REGULATIONS WILL NOT TAX BONA FIDE VACATION AND SICK PAY BENEFITS OF PUBLIC/EXEMPT ORGANIZATION EMPLOYEES.

Notice 88-68

Section 457 of the Internal Revenue Code, as amended by the Tax Reform Act of 1986, provides that amounts of compensation deferred under certain "eligible deferred compensation plans" maintained by state and local governments and tax-exempt employers are only included in a participant's or beneficiary's gross income in the taxable year in which the compensation is paid or otherwise made available to that individual. In general, if the plan is not an "eligible deferred compensation plan", the deferred amounts are included in the individual's gross income in the first taxable year of the individual for which there is no substantial risk of forfeiture.

Question and answer 26 in Notice 87-13, published in I.R.B. 1987-4 (January 26, 1987), clarifies that section 457 applies to both elective and nonelective deferred compensation plans of state and local governments and tax-exempt employers. In Notice 88-8, published in I.R.B. 1988-4 (January 25, 1988), the Service announced that section 457 will not apply to nonelective deferred compensation plans maintained by state and local governments and tax-exempt organizations for taxable years of employees beginning before January 1, 1988. In addition, Notice 88-8 provides that section 457 will not apply to bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, and death benefit plans maintained by state and local governments and tax-exempt organizations for taxable years of employees beginning before the issuance of guidance describing the extent to which these forms of compensation are subject to section 457. Finally, this Notice states that the Service is studying a number of issues under section 457, including the extent to which these plans are subject to section 457, and that further guidance will be provided on these issues.

Based on further study, the Service has determined that regulations under section 457 will provide that bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, and death benefit plans are not deferred compensation plans subject to section 457. This rule will apply without regard to whether such a plan is elective or nonelective in nature.

No inference should be drawn from this notice as to any issue not specifically addressed herein. A number of issues remain with respect to section 457, including when a vacation leave, sick leave, compensatory time, or severance pay plan is bona fide, and not a mere device to provide deferred compensation. The Service continues to study these other issues and welcomes all comments and suggestions. Further guidance will be provided on these issues.

This document serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the Income Tax Regulations and may be relied upon to the same extent as a revenue ruling or revenue procedure.

For further information regarding this notice, contact Mary F. Eure on (202) 566-3060 or 566-3050 (not a toll-free call).