diff --git a/compiler/frontend/src/org/jetbrains/kotlin/diagnostics/Errors.java b/compiler/frontend/src/org/jetbrains/kotlin/diagnostics/Errors.java
index cb25a3c7ad9..dbe4d46b633 100644
--- a/compiler/frontend/src/org/jetbrains/kotlin/diagnostics/Errors.java
+++ b/compiler/frontend/src/org/jetbrains/kotlin/diagnostics/Errors.java
@@ -120,6 +120,7 @@ public interface Errors {
     DiagnosticFactory1<JetAnnotationEntry, String> WRONG_ANNOTATION_TARGET = DiagnosticFactory1.create(ERROR);
     DiagnosticFactory2<JetAnnotationEntry, String, String> WRONG_ANNOTATION_TARGET_WITH_USE_SITE_TARGET = DiagnosticFactory2.create(ERROR);
     DiagnosticFactory0<JetAnnotationEntry> REPEATED_ANNOTATION = DiagnosticFactory0.create(ERROR);
+    DiagnosticFactory0<JetAnnotationEntry> NON_SOURCE_ANNOTATION_ON_INLINED_FUNCTION_LITERAL = DiagnosticFactory0.create(ERROR);
 
     // Annotations
 
diff --git a/compiler/frontend/src/org/jetbrains/kotlin/diagnostics/rendering/DefaultErrorMessages.java b/compiler/frontend/src/org/jetbrains/kotlin/diagnostics/rendering/DefaultErrorMessages.java
index 3bbea8e2d08..2da965a47cb 100644
--- a/compiler/frontend/src/org/jetbrains/kotlin/diagnostics/rendering/DefaultErrorMessages.java
+++ b/compiler/frontend/src/org/jetbrains/kotlin/diagnostics/rendering/DefaultErrorMessages.java
@@ -127,6 +127,7 @@ public class DefaultErrorMessages {
         MAP.put(WRONG_ANNOTATION_TARGET, "This annotation is not applicable to target ''{0}''", TO_STRING);
         MAP.put(WRONG_ANNOTATION_TARGET_WITH_USE_SITE_TARGET, "This annotation is not applicable to target ''{0}'' and use site target ''@{1}''", TO_STRING, TO_STRING);
         MAP.put(REPEATED_ANNOTATION, "This annotation is not repeatable");
+        MAP.put(NON_SOURCE_ANNOTATION_ON_INLINED_FUNCTION_LITERAL, "Function literal here is an inlined argument so this annotation cannot be stored anywhere");
 
         MAP.put(INAPPLICABLE_TARGET_ON_PROPERTY, "''@{0}'' annotations could be applied only to property declarations", TO_STRING);
         MAP.put(INAPPLICABLE_FIELD_TARGET_NO_BACKING_FIELD, "Property has neither a backing field nor a delegate");
diff --git a/compiler/frontend/src/org/jetbrains/kotlin/psi/JetPsiUtil.java b/compiler/frontend/src/org/jetbrains/kotlin/psi/JetPsiUtil.java
index ac6ecbcc2e6..894f94f9c09 100644
--- a/compiler/frontend/src/org/jetbrains/kotlin/psi/JetPsiUtil.java
+++ b/compiler/frontend/src/org/jetbrains/kotlin/psi/JetPsiUtil.java
@@ -874,7 +874,7 @@ public class JetPsiUtil {
             else if (parent instanceof JetValueArgument || parent instanceof JetValueArgumentList) {
                 parent = parent.getParent();
             }
-            else if (parent instanceof JetFunctionLiteralExpression) {
+            else if (parent instanceof JetFunctionLiteralExpression || parent instanceof JetAnnotatedExpression) {
                 parent = parent.getParent();
             }
             else {
diff --git a/compiler/frontend/src/org/jetbrains/kotlin/resolve/AnnotationChecker.kt b/compiler/frontend/src/org/jetbrains/kotlin/resolve/AnnotationChecker.kt
index 56f5b54c034..0c20e4cd409 100644
--- a/compiler/frontend/src/org/jetbrains/kotlin/resolve/AnnotationChecker.kt
+++ b/compiler/frontend/src/org/jetbrains/kotlin/resolve/AnnotationChecker.kt
@@ -28,7 +28,10 @@ import org.jetbrains.kotlin.types.JetType
 import org.jetbrains.kotlin.types.TypeUtils
 import org.jetbrains.kotlin.resolve.descriptorUtil.isRepeatableAnnotation
 import org.jetbrains.kotlin.descriptors.annotations.KotlinTarget.*
+import org.jetbrains.kotlin.psi.psiUtil.getStrictParentOfType
 import org.jetbrains.kotlin.resolve.descriptorUtil.fqNameSafe
+import org.jetbrains.kotlin.resolve.descriptorUtil.getAnnotationRetention
+import org.jetbrains.kotlin.resolve.inline.InlineUtil
 
 public class AnnotationChecker(private val additionalCheckers: Iterable<AdditionalAnnotationChecker>) {
 
@@ -92,11 +95,28 @@ public class AnnotationChecker(private val additionalCheckers: Iterable<Addition
             it in applicableTargets && (useSiteTarget == null || KotlinTarget.USE_SITE_MAPPING[useSiteTarget] == it)
         }
 
-        if (check(actualTargets.defaultTargets) || check(actualTargets.canBeSubstituted)) return
+        fun checkUselessFunctionLiteralAnnotation() {
+            // TODO: tests on different JetAnnotatedExpression (?!)
+            if (KotlinTarget.FUNCTION !in applicableTargets) return
+            val annotatedExpression = entry.parent as? JetAnnotatedExpression ?: return
+            val descriptor = trace.get(BindingContext.ANNOTATION, entry) ?: return
+            val retention = descriptor.type.constructor.declarationDescriptor?.getAnnotationRetention()
+            if (retention == KotlinRetention.SOURCE) return
 
-        if (useSiteTarget != null && actualTargets.onlyWithUseSiteTarget.any {
+            val functionLiteralExpression = annotatedExpression.baseExpression as? JetFunctionLiteralExpression ?: return
+            if (InlineUtil.isInlinedArgument(functionLiteralExpression.functionLiteral, trace.bindingContext, false)) {
+                trace.report(Errors.NON_SOURCE_ANNOTATION_ON_INLINED_FUNCTION_LITERAL.on(entry))
+            }
+        }
+
+        fun applicableWithUseSiteTarget() = useSiteTarget != null && actualTargets.onlyWithUseSiteTarget.any {
             it in applicableTargets && KotlinTarget.USE_SITE_MAPPING[useSiteTarget] == it
-        }) return
+        }
+
+        if (check(actualTargets.defaultTargets) || check(actualTargets.canBeSubstituted) || applicableWithUseSiteTarget()) {
+            checkUselessFunctionLiteralAnnotation()
+            return
+        }
 
         if (useSiteTarget != null) {
             trace.report(Errors.WRONG_ANNOTATION_TARGET_WITH_USE_SITE_TARGET.on(
diff --git a/compiler/testData/diagnostics/tests/annotations/options/functions.kt b/compiler/testData/diagnostics/tests/annotations/options/functions.kt
index 082fd9fb760..65b97d28e46 100644
--- a/compiler/testData/diagnostics/tests/annotations/options/functions.kt
+++ b/compiler/testData/diagnostics/tests/annotations/options/functions.kt
@@ -1,16 +1,38 @@
 @Target(AnnotationTarget.FUNCTION)
 annotation class FunAnn
 
+@Target(AnnotationTarget.FUNCTION)
+@Retention(AnnotationRetention.SOURCE)
+annotation class SourceAnn
+
+@Target(AnnotationTarget.EXPRESSION)
+annotation class ExprAnn
+
 fun bar(arg: () -> Int) = arg()
 
+inline fun fast(arg: () -> Int) = arg()
+
+inline fun fast2(x: Int, arg: () -> Int) = x + arg()
+
 @FunAnn fun gav() = 13
 
 fun foo(arg: Int) {
     // Literal is annotatable
     bar @FunAnn { arg }
+    // Annotatable in principle but useless, fast is inline
+    fast <!NON_SOURCE_ANNOTATION_ON_INLINED_FUNCTION_LITERAL!>@FunAnn<!> { arg }
+    fast2(1, <!NON_SOURCE_ANNOTATION_ON_INLINED_FUNCTION_LITERAL!>@FunAnn<!> { arg })
+    // Source annotation, ok
+    fast @SourceAnn { arg }
+    fast2(1, @SourceAnn { arg })
+    // Expression annotation, ok
+    fast @ExprAnn { arg }
+    fast2(1, @ExprAnn { arg })
     // Function expression too
     val f = @FunAnn fun(): Int { return 42 }
     // But here, f and gav should be annotated instead
     bar(<!WRONG_ANNOTATION_TARGET!>@FunAnn<!> f)
     bar(<!WRONG_ANNOTATION_TARGET!>@FunAnn<!> ::gav)
+    // Function expression, ok
+    fast(f)
 }
\ No newline at end of file
diff --git a/compiler/testData/diagnostics/tests/annotations/options/functions.txt b/compiler/testData/diagnostics/tests/annotations/options/functions.txt
index 82735a9a431..b2ede3bdbdb 100644
--- a/compiler/testData/diagnostics/tests/annotations/options/functions.txt
+++ b/compiler/testData/diagnostics/tests/annotations/options/functions.txt
@@ -1,12 +1,28 @@
 package
 
 public fun bar(/*0*/ arg: () -> kotlin.Int): kotlin.Int
+@kotlin.inline() public fun fast(/*0*/ arg: () -> kotlin.Int): kotlin.Int
+@kotlin.inline() public fun fast2(/*0*/ x: kotlin.Int, /*1*/ arg: () -> kotlin.Int): kotlin.Int
 public fun foo(/*0*/ arg: kotlin.Int): kotlin.Unit
 @FunAnn() public fun gav(): kotlin.Int
 
+@kotlin.annotation.Target(allowedTargets = {AnnotationTarget.EXPRESSION}) @kotlin.annotation.annotation() public final class ExprAnn : kotlin.Annotation {
+    public constructor ExprAnn()
+    public open override /*1*/ /*fake_override*/ fun equals(/*0*/ other: kotlin.Any?): kotlin.Boolean
+    public open override /*1*/ /*fake_override*/ fun hashCode(): kotlin.Int
+    public open override /*1*/ /*fake_override*/ fun toString(): kotlin.String
+}
+
 @kotlin.annotation.Target(allowedTargets = {AnnotationTarget.FUNCTION}) @kotlin.annotation.annotation() public final class FunAnn : kotlin.Annotation {
     public constructor FunAnn()
     public open override /*1*/ /*fake_override*/ fun equals(/*0*/ other: kotlin.Any?): kotlin.Boolean
     public open override /*1*/ /*fake_override*/ fun hashCode(): kotlin.Int
     public open override /*1*/ /*fake_override*/ fun toString(): kotlin.String
 }
+
+@kotlin.annotation.Target(allowedTargets = {AnnotationTarget.FUNCTION}) @kotlin.annotation.Retention(value = AnnotationRetention.SOURCE) @kotlin.annotation.annotation() public final class SourceAnn : kotlin.Annotation {
+    public constructor SourceAnn()
+    public open override /*1*/ /*fake_override*/ fun equals(/*0*/ other: kotlin.Any?): kotlin.Boolean
+    public open override /*1*/ /*fake_override*/ fun hashCode(): kotlin.Int
+    public open override /*1*/ /*fake_override*/ fun toString(): kotlin.String
+}