Section 457 of the tax code governs the taxation of nonqualified deferred compensation plans sponsored by tax-exempt employers. It divides plans into two categories:
“Eligible deferred compensation plans” that limit annual deferrals (no more than $18,000 in 2015) and that meet a variety of limitations similar to qualified plans are subject to 457(b); and
All other plans. These other plans are governed by section 457(f). Common names for these plans are SERPs, Capital Accumulation Accounts, and Retention Payment Plans.
Two different models govern the taxation of 457(b) and (f) plan benefits. Benefits under a 457(b) plan are not taxed until received. Benefits under a 457(f) plan are taxed as soon as they are no longer subject to a “substantial risk of forfeiture” (SRF), which could be years before they are received.1
Section 457(f) provides that an SRF exists when the employee’s receipt of the benefits is “conditioned upon the future performance of substantial services.”2 Section 457(f) and its regulations do not elaborate further. However, analogous regulations under section 83 allow noncompete covenants as SRFs if all the facts and circumstances indicate the covenant imposes a substantial risk of the employee forfeiting the benefit.3
A key focus of the “anticipated” regulations is what constitutes an SRF. In 2007, when announcing the anticipated changes, the IRS said it anticipated following section 409A.4 An SRF exists under section 409A only if the deferral is non-elective5 and subject to cliff vesting (i.e., the participant forfeits the benefit by voluntarily terminating prior to the vesting date). Under section 409A, noncompete restrictions do not defer taxation.
If adopted in that form, the regulations would require changes to any 457(f) plan that allows elective deferrals (either actual salary reduction deferrals or elections to postpone vesting and payment dates) or that uses noncompete restrictions as the SRF.
Beyond clarifying the SRF issue, the guidance is also expected to address what qualifies as a bona fide severance benefit for purposes of 457(f). Compensation paid under a bona fide severance plan is taxed as received. Compensation in excess of the bona fide severance limits would be taxed in a lump sum at termination. We expect the bona fide plan limit to be the lesser of two times the executive’s annual total compensation or two times the qualified plan compensation limit (two times $265,000 in 2015). Employers can still pay severance in excess of the two times limit, if reasonable, but the taxation may be different.
Tax-exempt employers will need to understand and conform to the anticipated regulations once they are issued. Failing to do so could result in accelerated taxation for nonqualified deferred compensation plan and severance plan participants. While grandfathering of current plans is unlikely, we are hopeful the IRS will provide a significant transition period for bringing plans into compliance.
26 U.S.C. § 457(f)(1)(A).↩
Id. § 457(f)(3)(B).↩
Section 83 contains the same statutory language as section 457(f) regarding “future performance of substantial services.” Therefore, in the absence of regulations under section 457, the IRS has used the section 83 regulations to define what constitutes an SRF under section 457. See, e.g., PLR 200321002; PLR 200128006. Although private letter rulings are binding on the IRS only with respect to the specific taxpayer to whom they are issued, and cannot be cited as precedent, they do indicate how the IRS interprets provisions of the law at the time of the ruling. Moreover, in the 1999 Continuing Professional Education Text, at section 3A, the IRS stated: “Section 83 of the Code and the regulations thereunder provide additional assistance in determining what is a substantial risk of forfeiture and what kind of services are substantial for purposes of section 457(f).”↩
IRS Notice 2007-62.↩
An exception is made if the benefits for electing a deferral are materially greater than without the deferral (e.g., if there is some level of employer matching contribution).↩