A 457(f) arrangement is a type of non-qualified deferred compensation plan, and taxation of that deferred compensation occurs at the first point when there is no substantial risk of forfeiture of the benefits (IRC Section 457(f)(1)). A requirement of future services is an example of a substantial risk of forfeiture. One result of this rule is that a 457(f) plan cannot be terminated after the executive is “vested” (in other words, no longer has a risk of forfeiture, i.e., no longer must continue employment in order to have rights to the benefit) in order to avoid personal income tax effects. Taxation of the benefit is triggered when vesting occurs, unrelated to any actual distributions or lack thereof.
For plans in which vesting has not yet occurred, the whole arrangement is executory and can be modified or terminated by agreement of both parties. There are, however, various tax rules and restraints when the plan is to be altered or replaced with another form of deferred compensation arrangement, whether another 457(f) plan or something different. Some of these rules are within Section 457, but most are in the much broader Section 409A, Inclusion in Gross Income of Deferred Compensation Under Non-Qualified Deferred Compensation Plans. In general, to the extent that the 457(f) plan provides deferred compensation and is not a “short-term deferral,” any changes within the Section 457(f) agreement or replacement with another deferred compensation benefit will trigger significant tax consequences unless the very stringent rules of Section 409A are complied with. Further, it would be prudent to terminate an unvested 457(f) agreement as far ahead of the vesting date as possible to avoid any risk of an IRS claim that the benefit had effectively vested. While there are no specific guidelines here, termination the day before vesting, for instance, would likely raise the risk of IRS arguments, although it would meet the stated rule of being unvested at date of termination.
When replacing a 457(f) plan with an executive owned Collateral Assignment Split Dollar Loan Agreement, the key distinction is that the parties are not replacing the 457(f) deferred compensation with another deferred compensation benefit. This form of split dollar plan is, by definition, not a compensation plan of any kind, but simply an agreement to loan funds, whether
at market rate or below market with imputed interest income. The 409A regulations are clear with respect to this type of split dollar plan, which is governed by Treas. Reg. 1.7872-15. The following quote is from IRS Notice 2007- 34, Guidance Regarding the Application of Section 409A to Split-Dollar Life Insurance Arrangements:
“Split-dollar life insurance arrangements pursuant to which payments are treated as split-dollar loans under § 1.7872-15 generally will not give rise to deferrals of compensation within the meaning of section 409A. However, in certain situations, such an arrangement may give rise to deferrals of compensation for purposes of section 409A, for example, if amounts on a split- dollar loan are waived, cancelled, or forgiven.”
It should also be possible to terminate a 457(f) plan and replace it with a “non-equity” Collateral Assignment Split Dollar Agreement. In this type of split dollar agreement, the employee only has the right to a specified death benefit and does not have access to the cash value of the policy. Under IRS Notice 2007-34 and Treas. Reg. 1.409A-1(a)(5), a split dollar agreement that gives an employee only the right to a death benefit is not treated as a deferred compensation plan but is rather classified as a death benefit plan which is exempt from Section 409A. Therefore, in this scenario, the replacement of an unvested 457(f) plan with a non-equity Collateral Assignment Split Dollar Agreement should not result in income tax consequences, as the employee only has the right to a death benefit and not to any type of deferred compensation.
The bottom line is thus that, although there is no direct IRS authority on this issue, based on existing guidance it appears that a 457(f) plan can be terminated before vesting by agreement, and there will be no income tax effects of that termination so long as it is not replaced with another deferred compensation benefit. Adoption of the right form of split dollar agreement does not change this result since it is not a deferred compensation plan for income tax purposes.
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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