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:
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.
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