3604 / What rules regarding the tax treatment of participants in “ineligible” Section 457(f) plans were released in proposed Section 457/Section 409A integration regulations?

As noted in Q 3603, nearly 10 years passed without the promised proposed integration regulations leaving only Notice 2007-62 for guidance. The Notice had a significant negative design impact on 457(f) case designs, especially voluntary deferral plans of vested compensation (i.e., salary and bonus). Finally, in June 2016,¹ the IRS released its long-awaited proposed comprehensive 457/409A integration regulations. These 2016 proposed regulations had been expected to follow the logic in IRS Notice 2007-62. However, the IRS surprised everyone by issuing proposed 457 regulations that took a distinctly different, but welcome, direction that would allow more flexibility in plan design, including a separate and unique definition for the definition of ‘substantial risk of forfeiture” for purposes of 457(f) “ineligible” plans.²

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Planning Point: The 2016 proposed 457/409A integration regulations may be relied upon immediately pending finalization. Therefore, planners may immediately use them for designing new 457 plans, especially 457(f) “ineligible” plans. However, there is no grandfathering currently in the proposed regulations for “ineligible” plans created in the interim. While the proposed regulations generally provide for more liberal plan designs and provide more clarity for compliant plan design, amendment of existing plans will be more complex. For instance, it is not clear how to address noncompliant design in existing plans, such as a voluntary deferral plan of vested compensation that does not provide more than 125 percent present value increase safe harbor match/benefit increase (25 percent employer match) under the “materially greater benefit” rule. Nor does it direct how to handle an existing severance plan that was thought to be exempt from coverage by Sections 457 and 409A that does not meet the new definition of an exempt 457 severance plan. It is hoped that the finalized regulations will provide guidance on these plans and similar questions caused by the unfortunate long delay in significant guidance.

Proposed Guidance: The general rule of taxation for 457(f) plans under the 2016 proposed regulations affirms that compliance requires both the Section 457(f) guidance and Section 409A guidance. This was not unexpected since Section 409A is additive tax law further defining the constructive receipt doctrine ( Q 3542). The proposed regulations are most helpful in this regard, but do not eliminate all issues in regard to integration of the two Sections. For example, it remains unclear whether a 457(f) plan need only comply with the proposed rolling risk of forfeiture rules (that permits an extension of a substantial risk of forfeiture) or whether it must integrate both this rule and the subsequent election rules under Section 409A. Informally, the IRS has suggested the former,³ but until this is clarified, planners may wish to take a more conservative approach, at least with regard to voluntary deferral plans of vested compensation. Continuation of deferral of compensation under a renewed employment contract presents a more difficult situation if integration is required.

Under the 2016 proposed regulations, there is also a deferral of compensation, and a covered 457(f)/409A plan will exist, if the plan 1) provides for compensation that is or may be payable in a future year, and 2) there is a legally binding right to such compensation in the tax year. In general, a participant does not have a legally binding right if the employer may unilaterally reduce or eliminate compensation. In addition, any plan that can qualify for the “short-term deferral” exception under 409A is also not subject to 457(f).

As noted, the 2016 proposed regulations did not adopt the Section 409A definition of a “substantial risk of forfeiture.” Although similar to the 409A definition in some respects, a 457(f) plan will be subject to a 457(f) substantial risk of forfeiture and achieve deferral from current taxation if the amount is conditioned on the: 1) future performance of substantial service (which appears to be a minimum of two tax years, although the hours need to be substantial in respect to the amount of the compensation provided); or 2) occurrence of a condition that is related to the compensation. An amount will not be subject to a 457(f) substantial risk of forfeiture if the facts and circumstances suggest that the forfeiture condition is unlikely to be enforced, based upon factors such as the participant’s level of influence and control as to payment (majority shareholder), enforceability under applicable law (noncompetition agreements), and past practices of the employer, as well as other relevant applicable factors governing enforceability.

Under the 457(f) definition in the proposed regulations (and contrary to Notice 2007-64), a noncompetition agreement is allowed as a potential substantial risk of forfeiture. However, the requirements for a noncompetition agreement to be considered a substantial risk of forfeiture for purposes of a 457(f) plan are: 1) a written agreement that is enforceable under applicable law, which is state law (for instance, noncompetition agreements are not generally enforceable under California law); 2) the employer is consistently making reasonable efforts to enforce all of its noncompetition agreements; and 3) the facts and circumstances indicate that the employer has a bona fide interest in preventing competition and the employee has a reasonable bona fide interest to compete.

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Planning Point: Prior to enactment of Section 409A and Notice 2007-62, noncompetition agreements were often added to 457(f) plans to justify installment (annuity-like) payment of benefits by continuing a substantial risk of forfeiture into the benefit distribution period so benefit payments would be taxed as paid rather than under the IRC Section 72 (annuity) rules. Noncompetition agreements may again constitute a substantial risk of forfeiture. This approach is available under the proposed regulations so long as the noncompetition agreement is valid under the proposed regulations, but the requirements present a high hurdle. The rules for the calculation of the present value (PV) for tax purposes under Section 457(f) specifies that the PV of deferred compensation (including earnings) is taxable when the risk lapses; but future earnings (if amounts are left in the plan) are includible when finally paid or made available.

There are circumstances in which the PV of future earnings must also be included at the time of the first income tax inclusion. This taxation structure as proposed suggests that installments taxable as received, even if there is a valid noncompetition agreement, may not avoid Section 72 taxation on the benefit stream in the tax year in which the primary (substantial service vesting date or occurrence of a condition tied to employment) substantial risk of forfeiture lapses. Here again, more clarification is necessary, since a noncompetition agreement would seem to be able to serve as the primary condition, and layering of conditions does not seem to be precluded. On the positive side, delaying distribution should not be a violation of Section 409A that attracts its penalties.

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Extensions of the period of risks of forfeiture (referred to as “rolling risks of forfeitures” in the tax-exempt context) are permitted by the proposed regulations so long as certain conditions are met. The same conditions are required in order to achieve and maintain deferral of vested compensation (i.e., salary and bonus). These requirements are:

(1)   PV of amount to be paid upon the lapse of the risk of forfeiture (extended or otherwise) must be materially greater than the amount the employee would have otherwise been paid absent the risk of forfeiture. The safe harbor required by the proposed regulations is more than 125 percent on a PV basis. The proposed regulations provide a specific example of a voluntary account balance deferral plan with a match of 30 percent as clearly more than meeting the safe harbor requirement.

(2)   Initial or renewed risk of forfeiture must be based only upon the performance of substantial services, or compliance with a noncompetition agreement (but not for the achievement of a performance goal or other condition related to a purpose of the compensation).

(3)   The period of future services must be for a minimum of two tax years, except in the case of death, disability, or involuntary severance from employment without cause.

(4)   A written agreement that meets the following requirements:

A. For an initial deferral of vested compensation, the agreement must be in writing in the calendar year prior to the year in which the compensation is being earned;

B. For an extension, the agreement must be in writing at least 90 days prior to the date on which the 457(f) substantial risk of forfeiture would have lapsed; and

C. For newly hired employees, the agreement must be writing within 30 days after the date of hire, but only as to amounts attributable to services rendered after the extension or deferral is agreed to in writing.

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Planning Point: Subject to the need for an employer match or increased benefit that achieves more than 125 percent present value increase safe harbor to satisfy the “materially greater benefit” requirement for achieving and maintaining a 457(f) substantial risk of forfeiture, the revival of the ability to create plans that allow voluntary deferral of vested compensation, or to allow renewal and, therefore, a continuation of deferral under a 457(f) substantial risk of forfeiture (as in a sequence of employment contracts that are typically three to five years in length) is a very positive development for planners to design useful plans under 457(f) for tax-exempt employers. However, because of the differences between 457(f) and 409A definitions of substantial risk of forfeiture, the compensation might be tax-deferred for 457(f) purposes and yet still need to comply with 409A in its design.

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A 457(f) plan under the regulations can also allow for: 1) an involuntary termination by an employer without cause; or 2) a voluntary termination by an employee with good reason if the possibility is substantial. This allows an early payment event that does not void an otherwise valid 457(f) substantial risk of forfeiture. The definition of “voluntary termination for good reason” is similar, but not identical to, the Section 409A definition. A termination is for “good reason” under 457(f) if it results from a unilateral action of the employer that creates a material adverse or negative change to the working relationship. It includes changes like reduction in duties or position, working conditions, or pay. These “good reason” changes should be established in a written agreement, which is required by 409A anyway.

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Planning Point: These are very important provisions for 457(f) plans, notably voluntary deferral plans involving deferral of an employee’s vested compensation. A 457(f) plan must provide for a real forfeiture event so an employee cannot have the right to voluntarily terminate employment (just walk away) prior to the vesting or lapse of the substantial risk of forfeiture and still receive the benefit without voiding the risk of forfeiture. These termination right provisions provide two cases in which termination of the employee may occur early and the employee may still receive the plan benefits.

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