IRS explains what constitutes an unforeseeable emergency distribution from a deferred compensation planArticle added by Richard Niles on December 6, 2010
Richard Niles

Richard Niles

Joined: October 07, 2010

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In Revenue Ruling 2010-27, 2010-45 IRB 620, the Internal Revenue Service explains an unforeseeable emergency distribution from a Section 457 deferred compensation plan of a state or local government or tax-exempt organization. The Revenue Ruling also applies to distributions from a Section 409A nonqualified deferred compensation plan. To be an eligible deferred compensation plan under Section 457 and corresponding regulations, the plan must allow distributions to be made available only in certain events, which include when the participant is faced with an unforeseeable emergency.

An “unforeseeable emergency” is severe financial hardship of the participant or beneficiary resulting from: an illness or accident to the participant or beneficiary or their spouse or dependent; loss of the participant's or beneficiary's property due to casualty — including the need to rebuild a home following damage not otherwise covered by homeowner's insurance, e.g ., a natural disaster; or other extraordinary and unforeseeable circumstances as a result of events beyond the control of the participant or the beneficiary.

For example, the imminent foreclosure of or eviction from the participant's or beneficiary's primary residence may constitute an unforeseeable emergency. In addition, the need to pay for medical expenses, including non-refundable deductibles and the cost of prescription drug medication, may constitute an unforeseeable emergency. Finally, the need to pay for funeral expenses of a spouse or a dependent may be an unforeseeable emergency. However, the purchase of a home and the payment of college tuition are not unforeseeable emergencies.

A distribution due to an unforeseeable emergency may not be made if the emergency is or may be relieved through reimbursement or compensation from insurance, by liquidation of the participant's assets to the extent the liquidation would not cause severe financial hardship, or by cessation of deferrals under the plan.

A distribution due to an unforeseeable emergency is limited to the amount reasonably necessary to satisfy the emergency. However, the distribution may include any amount necessary to pay any federal, state, or local income taxes or penalties from the distribution.

Section 409A applies to amounts deferred under a nonqualified deferred compensation plan. If such a plan fails to meet specified requirements, all amounts deferred under the plan for that taxable year and all previous taxable years are includible in income and subject to additional taxes. One of the provisions of Section 409A requires the plan provide that amounts deferred are payable only upon one or more specified events. These include an unforeseeable emergency.

The Revenue Ruling provides the following example
State X maintains plan Y, an eligible deferred compensation plan under Section 457(b). Under the terms of plan Y, a participant who has an unforeseeable emergency before retirement or other severance from employment may request an unforeseeable emergency distribution.

Plan Y defines an unforeseeable emergency as a severe financial hardship of the participant resulting from any of the following: an illness or accident of the participant, his or her spouse or dependent; loss of the participant's property due to casualty — including the need to rebuild a home following damage not otherwise covered by homeowner's insurance, such as a natural disaster; the need to pay for the funeral expenses of the participant's spouse or dependent; or other similar extraordinary and unforeseeable circumstances arising from events beyond the control of the participant. The plan document provides various examples of an unforeseeable emergency, including the foreclosure of or eviction from a primary residence. The plan document states that, except as otherwise specifically provided, neither the purchase of a home nor the payment of college tuition is an unforeseeable emergency.

The plan document limits the amount of a distribution due to an unforeseeable emergency to the extent that such emergency is or may be relieved either: through reimbursement or compensation from insurance or otherwise; by liquidation of the participant's assets to the extent the liquidation of such assets would not cause severe financial hardship; or by cessation of deferrals under plan Y. While distributions because of an unforeseeable emergency may not exceed the amount reasonably necessary to satisfy the need, plan Y allows any distribution to include the amount necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result.

In each of the situations below, the plan participant requests a distribution to pay certain expenses, as well as an additional amount to pay federal, state or local income taxes that will result from the distribution, and the participant provides adequate documentation under the facts and circumstances regarding the claimed expense — including the amount (if any) of insurance that will cover the expense — and that the participant has no other source of funds to pay the expense.

Situation 1. Participant A requests an unforeseeable emergency distribution from plan Y to pay for the cost of having A's principal residence repaired after significant damage from a water leak that was discovered in the basement. Participant A provides written estimates of the repair cost.

Situation 2. Participant B requests an unforeseeable emergency distribution from plan Y to pay for funeral expenses for B's adult son, who is not a dependent of B. B provides a bill from the funeral home that itemizes the costs.

Situation 3. Participant C requests an unforeseeable emergency distribution from plan Y to pay accumulated credit card debt, which is not due to any events that are extraordinary and unforeseeable circumstances arising as a result of events beyond the control of C.

IRS analysis
The facts in situation one do not necessarily constitute an unforeseeable emergency, yet plan Y can authorize distribution in other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant. The need to repair the principal residence because of significant water damage not covered by insurance is an extraordinary and unforeseeable circumstance that arises as a result of events beyond the control of the participant, and is substantially similar to the need to pay for damage due to a natural disaster.

The facts in situation two also do not fit within any of the specific examples that are listed in Section 457 or plan Y as an unforeseeable emergency. The need to pay funeral expenses of a spouse or dependent is one of the examples listed in the regulations and the plan document as constituting an unforeseeable emergency, but the facts in situation two involve the death of an adult son who is not a dependent of the participant. Nevertheless, the regulations and plan Y authorize payment in other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant. The need to pay for the funeral expenses of a non-dependent adult son is an extraordinary and unforeseeable circumstance that arises as a result of events beyond the control of the participant, and that is substantially similar to the need to pay for the funeral expenses of a dependent.

However, the facts in situation three do not fit within any of the specific examples set forth in the regulations or Plan Y as constituting an unforeseeable emergency, nor do they present facts indicating that an unforeseeable emergency circumstance has arisen as a result of events beyond the control of the participant.
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