This blog is part of a 12-part series entitled “The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.” To read the introduction to the series, click here.
By the time executives of the corporate world-at-large experienced the first full-fledged legislative lockdown of their nonqualified deferred compensations, when the American Jobs Creation Act of 2004 instituted Internal Revenue Code (IRC) Section 409A, most of their counterparts in the tax-exempt sector had already been long used to having such benefits confined. Many years earlier, the Tax Reform Act of 1986 (TRA 86) sentenced these benefits to the custody of IRC Section 457, generally effective for taxable years beginning after December 31, 1986. The problem is that even as we approach the 30th anniversary of this sentence, Section 457 applicability and compliance still remain sources of confusion and frustration for many not-for-profit employers as they seek to provide significant executive compensation programs.
Tax-exempt employers, not employees
When not-for-profit organizations hire key decision-makers from the “for-profit” world, these organizations frequently find individuals desiring deferred compensation benefits similar to those offered by their former employers. Unfortunately, too often the tax-exempt organization complies and implements a plan that, while perfectly in compliance with the tax laws governing similar plans sponsored by corporations in the for-profit sector, does not comply with the more restrictive limitations applicable to most not-for-profit entities. If the Internal Revenue Service (IRS) discovers such a plan during an audit of the individual or the organization, the employer’s good intentions could result in extremely adverse tax consequences for the executive.
The deliberations that led to the 457 sentence
Why are tax-exempt employers subject to stricter limits than their for-profit counterparts? Because the IRS gives these organizations a pass come tax time, they cannot afford to offer the same charity to their employees. The IRS does not mind if executives of taxable entities defer as much as 100% of their compensation because, while the opportunity to tax this pay is generally deferred until the funds are distributed, the plan sponsor’s ability to take a tax deduction on such amounts is similarly delayed, thereby creating a vital trade-off that enables the U.S. Department of the Treasury to view these arrangements as tax-neutral. In contrast, tax-exempt employers have no tax deductions that can be deferred and thus no trade-off to offset the Treasury’s loss of current tax revenue incurred by their employees’ deferrals of compensation. Because tax-exempt entities as non-taxpayers are not concerned with deductibility of compensation, unless it involves unrelated trade or business income, there would be no incentive for them to limit their employees’ deferrals on their own if Section 457 did not exist.
Applicability of Section 457: Not all tax-exempts are treated equally
• Free from Section 457: No separation of Church and the Feds: Originally sentenced to Section 457 by TRA 86 with the other tax-exempts, NDCPs maintained by churches and qualified church-controlled organizations (QCCOs) were paroled in 1988, when the Technical and Miscellaneous Revenue Act exempted this congregation of plans from the application of Section 457 (however, a nursing home or hospital that is associated with a church, but which is not itself a church or a QCCO, would be covered by Section 457 if it is a tax-exempt entity). The only other NDCPs granted Section 457 immunity are those established by the federal government or any agency or instrumentality thereof; although this should not be too surprising given that the creation of these rules as well as determining who must comply with them is, after all, a federal function.
• Those sentenced to Section 457: The states, cities, towns, and the rest of the tax-exempts: If an employer is an entity that is a state or local government or a tax-exempt entity other than those described in the preceding paragraph, any NDCP it establishes must comply with Section 457. Plans of states and local governments have been subject to Section 457 from its creation in 1978; however, because the rules governing these arrangements are more similar to those covering qualified plans (e.g., all employees—not just executives—participate, and plan assets must be held in a separate trust for the exclusive benefit of participants), the remainder of this blog will focus on the rules applicable to the nongovernmental tax-exempts sentenced to 457.
What are the terms of a Section 457 sentence?
While a 457 sentence is mandatory, in the sense that it is levied based on the employer’s status, tax-exempt employers do have considerable discretion over the manner in which they choose to serve this sentence: a 457(b) plan (aka an eligible 457 plan), a 457(f) plan (aka an ineligible plan), or concurrently using both. The following chart reveals their major differences: