3550 / What is a “substantial risk of forfeiture” for Section 409A purposes?

On May 29, 2012, the IRS released proposed Section 83 regulations clarifying “substantial risk of forfeiture” as to funded Section 83 “transfer of property plans” and it has drawn some language from Section 409A in doing so ( Q 3538). On February 25, 2014, the IRS released final Section 83 regulations that are substantially similar to the proposed regulations. It appears that the IRS may be trying to better integrate Section 83 with 409A by dropping 409A concepts into these Section 83 regulations. However, in doing so, it may be making substantive changes to “substantial risk of forfeiture” requirements for Section 83 plans by adopting the more stringent 409A requirements, although the IRS has always claimed that its interpretation of regulations under Section 83 have never changed. Of course these changes to Section 83 impact only funded “transfer of property” plans and not unfunded promise-to-pay plans that are specifically exempt from Section 83 coverage.

For example, the final Section 409A regulations note the following as to certain specific circumstances that do not constitute a 409A SROF:

Voluntary salary deferrals (because the deferrals are fully vested and so such a plan is covered and therefore must comply with Section 409A requirements as to form and operation);

A covenant not to compete, even if the compensation is forfeitable in the event of on a breach;

Compensation following an extension or modification of an existing 409A SROF (hence rolling vesting dates do not create a 409A SROF and, unless there is new consideration for the extension or modification, the amount will be treated as vested and subject to 409A compliance requirements);

Compensation beyond the time at which the employee could have otherwise received it, unless the present value of the amount subject to the 409A SROF is materially greater than the present value of the amount the employee could have elected to receive in the absence of the 409A SROF;

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Planning Point: These 2007 rules primarily created a problem for “ineligible” 457(f) voluntary deferral plans operating under the then-applicable guidance of IRS Notice 2007-62. This was because in the Notice the IRS proposed to substitute the 409A SROF definition for the definition found in 457(f). In addition, the IRS indicated that it did not believe any risks of forfeiture are real in a Section 457(f) voluntary deferral design unless there is a significant employer match that would provide a materially greater benefit on a present value basis to the employee for deferring and placing otherwise vested compensation back at risk. However, the IRS failed to provide guidance on a minimum safe harbor employer amount.

Then, in June 2016 the IRS released the long-delayed proposed 457/409A integration regulations. In these proposed regulations, the IRS created a unique definition of substantial risk of forfeiture for Section 457, and did not adopt the current 409A definition directly into Section 457. These proposed regulations still seem to drive planners toward Section 457(b) “eligible” plans as the preferred alternative for voluntary deferral plans under Section 457, especially if the employer does not and cannot make the substantial employer match as proposed.

However, if a match can be contemplated, the minimum safe harbor for a “materially greater” safe harbor match has been defined as more than 125 percent on a present value basis as required for a 457(f) “ineligible” voluntary deferral plan covering vested compensation (for example, salary, bonus deferral) to establish a substantial risk of forfeiture for purposes of a plan covered by Section 457. However, there is no guidance in the 2016 proposed regulations as to treatment or correction for a 457(f) plan that may have used a lesser employer matching percentage during the long interim in which there was no substantive guidance defining a “materially greater” match. Practitioners should check for guidance when the propped regulations are finalized.

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Payments based on attainment of a prescribed level of earnings, unless there is a substantial risk that this level may not be achieved;

Payments based on an initial IPO unless the risk there will be no initial IPO is substantial from the beginning; and

Stock options immediately exercisable in exchange for substantially vested stock, even if the ability to exercise the option would terminate on a separation from service.

In the first reported Section 409A case (where the facts occurred during the transition period in 2005 when there were no regulations and only the bare statute and IRS Notice 2005-1 to review), the Tax Court held in a summary opinion (meaning it is not legal precedent) that a surrender charge on an annuity was not a substantial risk of forfeiture. The case is confusing at best because the taxpayer was arguing that the situation was covered by Section 409A and a deferral existed, while the IRS argued only that there was a constructive receipt of income under Section 61 and made no 409A violation arguments at all.¹

In 2016, IRS Chief Counsel advised an audit team in a memo that the use of a 25 percent matching formula on a continuation of a voluntary deferral of current salary until a future fixed date, but forfeitable (along with the match) was sufficient to create a materially greater present value amount to qualify as a 409A SROF.²