3606 / How did the 2017 tax reform legislation impact Section 457(b) and Section 457(f) plans?

The 2017 tax reform legislation did not directly change the rules governing Section 457(b) or Section 457(f) plans. However, the final law did contain a provision that could indirectly subject a tax-exempt employer that offers these plans to a steep excise penalty tax.

For tax years beginning after 2017, the 2017 tax reform legislation imposes a 21 percent penalty tax on compensation that exceeds $1 million per year when paid by a tax-exempt employer to a “covered employee.”¹ “Covered employee” includes any of the five most highly compensated employees. This penalty also applies to compensation paid to an employee who was a covered employee for any tax year beginning after December 31, 2016.² The 21 percent tax is imposed on the tax-exempt organization (the employer), not the employee receiving the compensation.

This tax can create problems for tax-exempt employers that provide 457(b) plans for nongovernmental employees or 457(f) plans.³ Both types of plans essentially defer the recognition of compensation until a later year. When the employee withdraws all (or even a substantial portion) of the 457(b) funds in his or her last year of account, especially with reference to large SERPs,, the funds will be counted toward the $1 million limit and could trigger the excise tax depending upon the amount of his or her other regular compensation and the account value. Further, 457(f) plans are generally taxable in the year the funds become vested, which means the total account value could become vested in the employee’s final year of employment (and, when added to regular compensation for the year, could trigger the excise tax).

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Planning Point: In light of this new excise tax, tax-exempt employers may wish to encourage 457(b) plan participants to withdraw funds in a later year, when they have no other compensation, and in installments to the extent possible. In that regard, an employer could also encourage 457(f) plan participants, who are covered employees, to continue to provide services (i.e., in a consulting role) in some capacity to delay vesting in hopes of spreading income recognition over a period of years to avoid the new tax. The degree of services provided would have to be relatively substantial (when compared to the amount of 457(f) funds that will vest) in order to delay vesting. Because of the many questions raised by this new tax on private nongovernment tax exempt entities, it will be important to review proposed regulations on this penalty tax when they are made available. In light of the IRS’s history of slow delivery of guidance in the case of tax-exempt entities, such guidance could be long time coming.

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