Key rules every executive should understand before structuring or evaluating a 457(f) plan.
Background and General Rules
Section 457(f) of the Internal Revenue Code (“IRC”) governs an “ineligible” deferred compensation plan of a tax-exempt entity or a governmental entity. General rule: deferred compensation under a 457(f) plan is taxable income in the first year in which there is no substantial risk of forfeiture of the right to the compensation (in other words, the compensation is “vested.”) 457(f) plans are also subject to Section 409A (if the plan provides deferred compensation.)
Example: Deferred compensation is vested on December 1, 2021, but is not scheduled to be paid until June 1, 2024. The parties agree to accelerate payment to June 1, 2023. Compensation is taxed in 2021 under IRC Section 457(f) due to lapse of the substantial risk of forfeiture. Any additional compensation paid in 2023 (such as earnings) violates the “no acceleration” rule of Section 409A and is subject to interest and the 20% additional tax as well as income tax.
Short-Term Deferral. A plan does not provide deferred compensation (and is exempt from IRC Sections 457(f) and 409A) if it is a short-term deferral (compensation is paid within 2 ½ months after the end of the year in which the substantial risk of forfeiture lapses.)
- Many plans are exempt from Section 457(f) if they are “vest and pay” plans (the participant is paid in a lump sum within 2 ½ months after the end of the year in which the compensation becomes vested.)
Substantial Risk of Forfeiture
IRC Section 457(f) defines a “substantial risk of forfeiture” as the future performance of substantial services.
- It was traditionally understood that working for at least 2 years would constitute a substantial risk of forfeiture.
Section 457(f) proposed regulations issued in June 2016 (on which taxpayers can rely; the “Proposed Regulations”) expand the term substantial risk of forfeiture to mean the future performance of substantial services OR the occurrence of a condition that is related to the purpose of the compensation if the possibility of forfeiture is substantial.
Under the Proposed Regulations, if entitlement to the compensation is conditioned on an involuntary termination without cause or a resignation for good reason, the right is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial.
Commonly Used Substantial Risks of Forfeiture
Two techniques are used to delay a payment after retirement or other termination of employment:
- Post-termination consulting services. Will constitute a substantial risk of forfeiture only if the amount of services required is substantial in relation to the amount of compensation to be paid.
- Post-termination non-compete. Under the Proposed Regulations, a non-compete covenant will be a substantial risk of forfeiture only if:
- It is pursuant to an enforceable written agreement;
- The employer makes reasonable efforts to verify compliance;
- The employer has a substantial and bona fide interest in preventing the employee from performing the services AND the employee has a bona fide interest in, and ability to, engage in the prohibited competition; and
- The possibility of actual forfeiture must be substantial.
- The present value of the compensation must be materially greater (125%) of the amount payable without the extension;
- There must be at least 2 years of substantial future services required; and
- Parties must agree in writing to the extension at least 90 days before an existing substantial risk of forfeiture would have lapsed.
Cautions
1. A non-compete may qualify as a substantial risk of forfeiture under Section 457(f), but it is not a substantial risk of forfeiture under Section 409A. Therefore, a payment tied to compliance with a non-compete would not qualify as a short-term deferral under Section 409A and would have to comply with the Section 409A rules, including the form and time of payment rules.
Reprinted with permission of Cynthia A. Moore, Dickinson Wright PLLC. The views and opinions expressed are those of the Cynthia Moore. Any discussion of taxes is for general information purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate.
Cynthia A. Moore, Member and Division Director at Dickinson Wright PLLC
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