Guidance on Unforeseeable Emergency Distributions

Employee Benefits & Pensions

The IRS ruled on whether a Sec. 457 government retirement plan or a nonqualified deferred compensation plan could make an unforeseeable emergency distribution to a plan participant in three situations.

Law

In order to be an eligible deferred compensation plan under Sec. 457(b), a plan may allow distributions to be made available only in certain events, including unforeseeable emergencies. An unforeseeable emergency is defined in the regulations as a severe financial hardship of the participant or beneficiary resulting from an illness or accident of the participant or beneficiary, the participant’s or beneficiary’s spouse, or the participant’s or beneficiary’s dependent; loss of the participant’s or beneficiary’s property due to casualty (including the need to rebuild a home following damage to a home not otherwise covered by homeowner’s insurance, such as damage caused by a natural disaster); or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant or the beneficiary.

The regulations provide a number of examples of what may be considered an unforeseeable emergency. The imminent foreclosure on or eviction from the participant’s or beneficiary’s primary residence may be an unforeseeable emergency. In addition, the need to pay for medical expenses, including nonrefundable deductibles, as well as for the cost of prescription drug medication may be an unforeseeable emergency. Finally, the need to pay for the funeral expenses of a spouse or a dependent (as defined in Sec. 152(a)) may also be an unforeseeable emergency.

Whether a participant or beneficiary faces an unforeseeable emergency permitting a distribution is determined based on the relevant facts and circumstances of each case. In any event, however, a distribution on account of an unforeseeable emergency may not be made to the extent that the emergency is or may be relieved 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 itself cause severe financial hardship), or by cessation of deferrals under the plan. A distribution due to an unforeseeable emergency must be 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 reasonably anticipated to result from the distribution.

Rev. Rul. 2010-27

Plan terms: In the revenue ruling, State X maintains Plan Y, an eligible deferred compensation plan under Sec. 457(b). Under the terms of the plan, a participant who has an unforeseeable emergency before retirement or other severance from employment may request an unforeseeable emergency distribution. The provisions of the plan governing unforeseeable emergency distributions are substantially similar to the model provisions in Rev. Proc. 2004-56.

Ruling scenarios: In the first scenario, a plan participant requests an unforeseeable emergency distribution from the plan to pay for the cost of having her principal residence repaired after significant water damage from a leak in the house’s basement. The participant provided written estimates of the repair cost. Although the regulations do not specifically address this fact pattern, the revenue ruling held that this was an unforeseeable emergency because damage caused to a home by a water leak is analogous to damage caused by a natural disaster, which the regulations specifically include as an unforeseeable emergency.

In the second scenario, a plan participant requests an unforeseeable emergency distribution from the plan to pay for funeral expenses for his adult son, who is not his dependent (as defined in Sec. 152(a)). The participant provides a bill from the funeral home that itemizes the cost of the funeral expenses. Once again, the ruling points out that the situation does not fall into one of the specific examples in the regulations but holds that it is an unforeseeable emergency because the need to pay for the funeral expenses of the participant’s nondependent son is an extraordinary and unforeseeable circumstance not within the taxpayer’s control and is similar to the need to pay for the funeral expenses of a dependent.

In the third situation, the participant requests an unforeseeable emergency distribution from the plan to pay accumulated credit card debt, which is not due to any events that are extraordinary or unforeseeable circumstances arising as a result of events beyond the participant’s control. Not surprisingly, the IRS holds that this is not an unforeseeable emergency for which a plan can make a distribution because the situation was not unforeseeable or extraordinary to the taxpayer.

NQDC Plans

Although a plan described in Sec. 457(b) is not subject to the nonqualified deferred compensation (NQDC) provision in Sec. 409A, the definition of unforeseeable emergency in the regulations under both Code sections is substantially similar. Accordingly, the revenue ruling states that the principles and rulings that it sets forth apply to an amount deferred under an NQDC plan subject to Sec. 409A(a) that may be paid under the terms of the plan upon the occurrence of an event constituting an unforeseeable emergency that complies with Sec. 409A(a) and the regulations.

Reflections

In Rev. Rul. 2010-27, the IRS takes a reasonable approach to its interpretation of what is an unforeseeable emergency. Based on the ruling, it seems likely that the IRS will treat as an unforeseeable emergency any situation that is not specifically included in the examples in the regulations if the situation is clearly analogous to one of the situations specifically included as examples.

Rev. Rul. 2010-27, 2010-45 I.R.B. 620