3603 / How are the participants in a Section 457(f) “ineligible” plan taxed?

Prior to the enactment of Section 409A,¹ the general income tax rule was that compensation deferred under an ineligible and unfunded Section 457(f) plan was includable in gross income in the first taxable year during which it is not subject to a Section 457(f) “substantial risk of forfeiture” that pointed to Section 83, governing funded deferred compensation plans, for its definition of substantial risk of forfeiture ( Q 3538).² Where no 457(f) substantial risk of forfeiture existed in the initial year of deferral, all compensation deferred under the plan had to be included in the participant’s gross income for that year. This rule still applies to any 457(f) plan amounts in plans in existence prior to the enactment of Section 409A that may be eligible to be grandfathered. They would also apply to amounts in a plan if it can claim the short-term deferral exception to Section 409A coverage, since it has been made clear that 457(f) plans can claim the 409A short- term deferral exception.

Section 409A, which specifically included 457(f) ineligible plans under Section 409A coverage, requires such ineligible plans to comply with both the requirements under Section 457(f) and Section 409A. Unfortunately, the two IRC sections did not integrate smoothly. The IRS tried to reconcile them in IRS Notice 2007-62 shortly after the final regulations to Section 409A were issued in 2007. The IRS also promised to issue comprehensive 457/409A integration regulations (see Q 3603 for a discussion of these regulations). Commentators saw significant problems in the Notice’s proposed solutions, at least as to the substantial risk of forfeiture requirement that proposed to substitute the 409A definition of substantial risk of forfeiture for the one in 457(f), which had been less onerous.

Prior Guidance: Prior to the enactment of Section 409A, a participant’s right to deferred compensation under an ineligible Section 457 plan was subject to a 457(f) substantial risk of forfeiture if it was conditioned on the future performance of substantial services by any individual.³ Because this is the same language as used in IRC Section 83, governing transfers of property as compensation, it generally was believed that Section 83 concepts governed this definition for 457(f) purposes. Hence, distributions would become taxable when no longer subject to a Section 457(f) substantial risk of forfeiture, which might be as late as the date of each payment by the proper use of covenants not to compete, consulting agreements, and similar devices to continue the risk of forfeiture until payment actually was made.⁴

If the risk were to lapse before or at the time payments began, however, distributions from an ineligible plan would be taxable according to the Section 72 annuity rules.⁵ Property (including an insurance contract or annuity) distributed from an ineligible plan is includable in gross income at its fair market value.⁶ Once the annuity contract has been distributed, payments or withdrawals from that contract may be subject to the “interest first” rule ( Q 10, Q 515).