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

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).

Prior to the enactment of Section 409A and the Section 457 final regulations, it was not entirely clear when earnings on compensation deferred under an ineligible plan would be includable in gross income. The Section 457 final regulations currently provide that if amounts deferred are subject to a 457(f) substantial risk of forfeiture, then the amount includable in gross income for the first taxable year in which there is no Section 457(f) substantial risk of forfeiture includes earnings up to the date of the lapse. Earnings accruing after the date of the lapse are not includable in gross income until paid or otherwise made available, provided that the participant’s (or the beneficiary’s) interest in any assets of the employer is not senior to that of the employer’s general creditors.⁷ Based upon Notice 2007-62, the substantial risk of forfeiture applied for this purpose would become the more stringent 409A substantial risk of forfeiture definition, which for example, specifically excludes non-competes and consulting services as valid risks of forfeiture.

After enactment and release of IRS Notice 2007-62, the IRS proposed to use the Section 409A definition of substantial risk of forfeiture in place of that in Section 457(f) in an attempt to reconcile the sections. The impact of this proposed definition substitution was severely detrimental to 457(f) plans, especially 457(f) voluntary deferral plans.

Before the notice, it would have been possible for a 457(f) plan (whether a voluntary deferral or employer-paid supplemental plan) to have complied with the requirements under 457(f) as to substantial risk of forfeiture and then to have complied with the detailed coverage requirements of Section 409A separately, and avoided current income taxation under both sections.

After Notice 2007-62, this became impossible. Moreover, the Section 409A definition is the most severe definition of substantial risk of forfeiture of all the definitions currently in the IRC because it is used primarily to limit the availability of the short term deferral exception ( Q 3548) that would allow plans to escape Section 409A coverage. Hence, this most stringent Section 409A rule governed taxation under Section 457(f) plans, so that a 457(f) ineligible plan became taxable (for 457(f) purposes) when the 409A substantial risk of forfeiture lapsed. This meant that a plan could be fully compliant with the Section 409A detailed form and operation requirements and yet still fail the 457(f) substantial risk of forfeiture requirement because of the IRS’s proposed move to use the Section 409A definition in Section 457(f).

Note that under the Section 409A definition, devices such as covenants not to compete do not constitute a valid substantial risk of forfeiture (however, see the discussion of the applicability of the new proposed 409A/457 regulations to noncompetition agreements, Q ). This means that 457(f) distributions could only be paid either as a lump sum, or under Section 72 annuity treatment if paid in installments, based on Notice 2007-62 guidance. Moreover, the IRS requires a voluntary employee or director deferral plan to have an employer contribution such that it creates an amount, on a present value basis, that would make the amount of the benefit “materially greater” than the benefit without it, before it considers that a 457(f) ineligible plan has the necessary substantial risk of forfeiture (for 457(f) purposes) to permit a deferral of income taxation. This situation existed since the release of Notice 2007-62 until the release of the 2016 proposed regulations integrating 457, especially 409A-covered plans, with Section 409A. The proposed regulations did not follow the Notice, and created a more favorable, but unique and complex, rules for tax deferral under 457(f) plans.

Additionally, these 2016 Section 457 (not 409A) rules (made immediately effective) that continue to apply to the tax treatment of ineligible Section 457 plans do not extend these rules to any of the following: (1) any plan qualified under IRC Section 401, IRC Section 403, or IRC Section 415(m), (2) that portion of any plan that consists of a nonexempt trust to which IRC Section 402(b) applies, and (3) any transfer of property to which IRC Section 83 applies.⁸

The Section 457 regulations also clarify that these provisions do not apply if a IRC Section 83 transfer occurs before the lapse of a 457(f) substantial risk of forfeiture applicable to amounts deferred under an ineligible plan. If, on the other hand, the IRC Section 83 transfer occurs after the lapse of a 457(f) substantial risk of forfeiture, the provisions do apply. If such property is includable in income under IRC Section 457(f) on the lapse of a substantial risk of forfeiture, when the property is later made available to the participant, the amount includable is the excess of the value of the property when made available over the amount previously included in income on the lapse.⁹ This section does not apply to an equity option that has no readily ascertainable fair market value (as defined in IRC Section 83(e) (3)) and that was granted on or before May 8, 2002.¹⁰

If a plan starts but then ceases to be an 457(b) eligible governmental plan by operation, amounts subsequently deferred by participants will be includable in income when deferred, or, if later, when the amounts deferred cease to be subject to a 457(f) substantial risk of forfeiture. Amounts deferred before the date on which the plan ceases to be an “eligible” governmental plan, and any earnings thereon, will be treated as if the plan continues to be an “eligible” governmental plan and, thus, will not be includable in income until paid to the participant or beneficiary.¹¹

Rulings on “Ineligible” Plans

Prior to the enactment of Section 409A, the creation of a rabbi trust in connection with an “ineligible” Section 457 plan to hold employer assets in connection with the plan did not affect the tax treatment of amounts deferred thereunder.¹² Since the enactment of Section 409A, use of a rabbi trust is still possible so long as the requirements under the Section 409A(b) funding rules (e.g., the trust may not be placed offshore) are met ( Q 3567).

The right to designate “deemed” investments in an ineligible Section 457 plan will not result in current taxation under the constructive receipt doctrine ( Q 3542), the economic benefit doctrine ( Q 3563), or on account of a transfer of property under IRC Section 83.¹³ Section 409A has not changed this rule.

A Section 457 plan created prior to the enactment of Section 409A and established to provide additional benefits for an employee on an extended leave of absence was an “ineligible” plan rather than an “eligible” plan because it was unfunded and no trust was established (as would otherwise be required by IRC Section 457(g)), and because a settlement agreement called for deferrals in excess of the IRC Section 457(b) maximum amount. The IRS found, however, that a plan provision requiring service of the participant (then age 44) until age 50 was a 457(f) substantial risk of forfeiture.¹⁴