3583 / How does Code Section 409A impact Section 457(b) “eligible” and Section 457(f) “ineligible” plans?

In an initial attempt to reconcile the requirements of Section 457(f) with Section 409A, the IRS released Notice 2007-62 while promising the future release of comprehensive integration regulations.³ In the Notice, the IRS redefined certain terms for Section 457(f) purposes. Of significance, the IRS made the Section 409A definition of a “substantial risk of forfeiture” (SROF) the 457(f) definition. The 409A definition of SROF was and remains the most stringent and is more of a timing rule (it governs the availability of the short-term deferral exception) than a taxation rule. Therefore, the Notice had a significant negative impact on the design of certain 457(f) plans.

The negative impact of the guidance in the Notice primarily applied to voluntary deferral plans of vested compensation. Under the Notice, such plans could not achieve a substantial risk of forfeiture for 457(f) purposes to avoid current taxation. This was the result of the 409A/457(f) definition that precluded the existence of a SROF unless there was a substantial employer contribution to create a “materially larger benefit” (which was ill defined in 409A). Under 409A, as transposed into 457(f) under the Notice, it was unclear how much of an employer match was required to satisfy the 409A/457(f) requirement.

Before the Notice, a plan might have independently satisfied the old 457(f) SROF requirements (as then understood) and the individual “detail” Section 409A requirements (i.e., minimum documentation, permissible distributions, prohibitions against accelerations, and the timing of elections). The Notice’s use of the Section 409A definition in Section 457(f) also eliminated the possibility of installment payments being treated as taxable as received under all designs. Such taxation was based upon using noncompetiton provisions to parallel the installment period and thus extend the vesting period until each payment was made.⁴ The Section 409A definition (made the 457(f) definition under the Notice) does not recognize noncompetition and consulting agreements as a SROF to further delay taxation.

The IRS in Notice 2007-62 also redefined the definition of “severance plans” as to a voluntary and involuntary separation from service for purposes of Section 457(f) to engraft the 409A definition.

However, in June 2016 the IRS release the long-overdue proposed 457(f) regulations. In these proposed 457/409A integration regulations, the IRS has taken a surprising favorable change of direction and does not follow Notice 2007-62. Importantly, the IRS has adopted a separate definition for “substantial risk of forfeiture” than the one used in Section 409A (or other Code sections). It does remain clear that 457(f) plans are covered by Section 409A as well as 457(f), and therefore must comply with both Sections 457(f) and 409A to achieve and maintain deferral of taxation. However, these 2016 proposed 457(f)/409A integration regulations provide significant revised guidance on how to design both voluntary deferral plans of vested compensation (i.e., salary and bonus) as well as employer-paid SERPs to comply with both 457(f) and 409A. Detail on these proposed regulations can be found in Q 3603.

However, the 2016 proposed 457 regulations do not provide grandfathering or any specific guidance for dealing with or amending plans designed under Notice 2007-62 during the long interim period.

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Planning Point: Under Notice 2007-62, employer-paid supplemental plans (account balance or nonaccount balance), were largely left unhindered, but even here the payments had to be made in a lump sum (or risk Section 72 taxation). Unless a voluntary deferral plan involved a significant employer match, a voluntary deferred compensation account balance plan was unlikely to satisfy the revised standard for income deferral under Section 457(f).

In the June 2016 proposed integration regulations, the IRS surprised everyone and took a different and more helpful approach to its integration of Sections 457(f) and 409A. These proposed regulations not only provide clarity on how to achieve tax deferral on vested compensation (by providing a safe harbor “materially greater benefit” rule), but also allow use of a “rolling risk of forfeiture” and noncompetition provisions to extend vesting again (although within very narrowly prescribed and defined conditions). Moreover, these regulations may immediately be relied upon for designing compliant new plans. However, these proposed regulations do not provide any grandfathering for existing plans so it is not clear how to address the many plans created during the period when only the Notice was available. In general, many of those plans will require modification because of the substantial differences between the Notice and the proposed regulations. Planners will need to follow the IRS’s handling of the final regulations where it is hoped some guidance on handling existing 457(f) plans will be provided.

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