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:
|The Two Cells for Serving a Section 457 Sentence|
|Who can sponsor?||Any 501(c) tax-exempt organization.||Usually tax-exempts. Rarely used by governments.|
|How safe are assets?||Assets are as safe as employer’s solvency (i.e., available to general creditors in the event of insolvency).||Assets are as safe as employer’s solvency (i.e., available to general creditors in the event of insolvency).|
|Who participates?||Select group of management or highly compensated employees.||Select group of management or highly compensated employees.|
|How much can be contributed?||$18,000 for 2016 and 2017, increasing at same rate as 401(k) and 403(b) limits.||Generally no limit on amount of contributions.|
|Are age 50 and older catch-up contributions allowed?||Not available.||Not applicable because no funding limit applies.|
|Are there catch-ups within three years of retirement for previous missed contributions?||Yes.||Not applicable.|
|Do vesting provisions apply?||Can apply to employer contributions.||Contributions must remain unvested to maintain tax-deferred status.|
|Are rollovers permitted?||No.||No.|
|Are transfers permitted?||Yes, only to another 457(b) plan.||No.|
|Are in-service withdrawals permitted?||Only unforeseeable emergencies; small inactive accounts.||No.|
|How flexible are the distribution provisions?||Very flexible for a nonqualified plan—though not as flexible as qualified plans.||Very inflexible—usually limited to lump sum only.|
|Do minimum distribution rules required at age 70-1/2 apply?||Yes.||No.|
|Are loans permitted?||No.||No.|
|Subject to IRC Section 409A?||No.||Yes.|
457(b) before and after 2002: Restricted contributions/maximum flexibility
Before 2002, NDCP benefits for executives of tax-exempt employers usually could not survive a 457(b) sentence. Very few could coexist with the most stifling stipulation of the pre-2002 457(b) rules: a maximum annual contribution limit of $7,500 (eventually rising to $8,500 in 2001) with the killer catch that this maximum contribution amount be reduced dollar for dollar by any salary reduction amounts contributed to a 401(k) or 403(b) plan. To make matters even worse, both employee and employer contributions had to fit inside this tiny cell. The result was that, because each year’s 401(k)/403(b) dollar limit was higher than the respective 457(b) limit, executives who maximized their 401(k) or 403(b) savings in a given year could not contribute any amount to a 457(b) plan for that year. Effective January 1, 2002, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) softened this stipulation considerably by: (1) increasing the annual 457(b) dollar limitation so that it mirrors the 401(k)/403(b) limit, and (2) delinking the amount that executives can save under the 457(b) plan from the amount they save under a 401(k) or 403(b) plan. For example, in 2016 an executive could defer $18,000 under a 401(k) or 403(b) plan and still have up to another $18,000 deferred under a 457(b) plan. The limit will remain at $18,000 in 2017 and then will be adjusted for cost-of-living increases each year thereafter in increments of $500—not as open-ended as the unlimited deferrals available to NDCPs maintained by for-profit sponsors (“Section 457(b)-free NDCPs”) but practically spacious in contrast to the cramped confines of the pre-2002 conditions.
Apart from the attendant contribution limits, there is a great deal of appeal to the remainder of a Section 457(b) sentence, compared not only with 457(f) plans but even with the 457-free NDCPs. Similar to the 457-free plans, 457(b) arrangements can include withdrawal provisions under which participants can access the vested portion of their funds while still employed, provided they need such funds for a severe, unforeseeable financial hardship (unlike the requirement for the 401[k] plan, college tuition and home purchase would not be deemed acceptable reasons for meeting this requirement). Participants are not taxed on their benefits until they actually receive them. However, unlike the 457-free and 457(f) plans, NDCPs under 457(b) are subject to neither the strict provisions of Section 409A nor its penalties for noncompliance (i.e., retroactive taxation, interest payments, and 20% additional excise tax). Accordingly, 457(b) plan participants enjoy greater flexibility regarding the timing and frequency of their distribution elections than their corporate counterparts. In addition, 457(b) plans can (1) allow executives to defer accumulated sick pay, vacation pay, and back pay, in addition to salary and bonuses; (2) retain their eligible plan status even if the contributions for a given year exceed the annual contribution limit in effect, as long as any excess deferrals are distributed by April 15 of the next year; and (3) allow plan sponsors to retain the right to terminate the plan and distribute assets at any time (a right that Section 409A severely limits under 457-free plans).
457(f) forfeiture: Unrestricted contributions/minimum flexibility
The mirror image of the 457(b) plan, the 457(f) ineligible plan permits unlimited contributions, but in exchange takes away the flexibility participants enjoy under the 457(b) option. The Section 457(f) designation is quite apropos, because while huge amounts may be deferred under these plans, the catch is that they remain tax-deferred only so long as they are subject to a “substantial risk of forfeiture” (SROF). Plan sponsors must take extreme care that the provisions of their 457(f) plans are drafted so as to clearly maintain this level of risk until such time as the benefits are intended to be included in the participant’s taxable income. How is this accomplished? According to the tax code, the participants’ right to receive the benefits must be conditioned upon the future performance of substantial services and there must be a substantial possibility that such benefits will be forfeited if the participants fail to complete such service. As with most IRS determinations, this comes down to a facts and circumstances test. Over the years the IRS has rejected a broad range of provisions for their lack of “substance.”
Accordingly, a 457(f) plan that provides for 100% vesting if the participant remains employed until a specified age or upon completion of a number of years of service will result in the benefits being taxable to the participant once such targets are met, regardless of whether or not the participant continues employment with the plan sponsor beyond such date. Thus, there is the potential for participants to receive what could be substantial distributions during a tax year in which they are also earning salaries from their employers. Some plan sponsors have sought to evade this undesirable outcome by including a “rolling risk of forfeiture” provision in their plans. A “rolling risk of forfeiture” is generally a provision in an arrangement that permits the participant to voluntarily extend the period during which the benefit is subject to forfeiture by making a written election in advance of the date the benefits become vested. The concept is that by extending the risk period, the employee can further delay the receipt of the compensation to a future date, and thus defer taxation on the amounts until that future date. For years, the IRS had indicated that it never really bought into this concept and refused to rule favorably on plans that contained such provisions, while advising its agents to subject such plans to close scrutiny to determine whether a risk really exists. In addition to 457(f) plans with “rolling risk” provisions, the IRS has also been leery of the legitimacy of both (1) noncompetition agreements as a means of creating or extending a SROF, and (2) 457(f) plans featuring salary reduction contributions (i.e., believing that few employees would find such arrangements acceptable alternatives to current compensation, unless they are very near retirement and felt secure in their jobs, thereby raising considerable doubt about the reason that the required SROF was created).
Clemency for 457(f) rolling risk and deferral provisions
Despite its history of staunch opposition to these provisions, the IRS showed mercy for 457(f) plan sponsors and participants with its recent guidance, specifying parameters under which such provisions would be permissible, as opposed to outlawing them altogether. Though the guidance was issued in the form of a proposed rule, the IRS stated that taxpayers may rely on it before the final rule is issued and that until then, the IRS will not assert positions that are contrary to those set forth in the proposed rule. The following summarizes the key elements of this guidance, which may unlock new planning opportunities for sponsors and participants alike:
Creation or extension of SROF: To create a SROF for new elective deferrals or extend a SROF for an existing plan benefit, the proposed rule requires each of the following to be satisfied:
• The present value of the amount payable upon the lapse of the initial SROF (or as extended, if applicable) must be more than 125% of the amount the employee otherwise would be paid in the absence of the SROF (or of the extension). The proposed rule measures the present value as of the date the amount would have otherwise been paid (or the date the SROF would have lapsed without regard to an extension).
• The initial or extended SROF must be based upon a participant’s future performance of substantial services or adherence to an agreement not to compete, and must not be based solely on the occurrence of a condition (e.g., meeting a performance goal), although such a condition may be combined with a sufficient service condition.
• The minimum period for which a participant must perform substantial future services is two years (unless there is an intervening event such as the participant’s death, disability, or involuntary severance from employment).
• For initial elective deferrals, an agreement subjecting the deferrals to a SROF must be made in writing before the start of the calendar year in which services are performed. For SROF extensions, an agreement must be made at least 90 days before the existing SROF expires. A special rule applies to newly hired employees: if the employee has been providing services to the plan sponsor for a period of less than 90 days before the initial election or extension, such initial election or extension may be agreed to in writing within 30 days after the employee’s commencement of employment, but only with respect to amounts attributable to services rendered after the initial election or extension is agreed to in writing. However, this exception is not available for employees newly eligible to participate in a plan.
Noncompetition clauses: The proposed rule provides that noncompetition clauses will create a SROF that is acceptable only if:
• The employee’s right to the compensation is expressly conditioned on his or her refraining from performing future similar services for a competitor under a written agreement that is enforceable under applicable law (e.g., state law).
• The employer must consistently make reasonable efforts to verify compliance with all of its noncompetition agreements, not just selected ones.
• When the noncompetition agreement becomes binding, the employer must have a substantial and bona fide interest in preventing the employee from performing the prohibited services and the employee must have a bona fide interest in engaging, and an ability to engage, in providing the prohibited services. Factors the proposed rule takes into account for this purpose include: the employer’s ability to show that significant adverse economic consequences would likely result from an employee performing the prohibited services for a competitor; the employee’s marketability based on specialized skills, reputation, or other components; and the employee’s interest, financial need, and ability to engage in the prohibited services.
If the parties do not clearly intend to actually enforce the agreement, the IRS could deem the SROF condition not satisfied.
A 457 sentence can be time well-served
With the IRS crackdown on excessive executive compensation spreading to tax-exempt organizations, there has been an increase in IRS audits of these employers’ NDCPs. Accordingly, it is vital for not-for-profit NDCP sponsors to know and follow the terms of their Section 457 sentences in order to avoid the consequences of the IRS uncovering contraband provisions in their plans. In summation, plan sponsors and their executives can survive and even thrive under the terms of their 457 sentence if their plans conform to the IRS’s standards for “good behavior.” The recent clemency granted by the IRS regarding what constitutes a permissible SROF now provides enhanced flexibility and planning opportunities for sponsors and participants. However, because of the complexities of the 457 incarceration, they may still face a “hard time” if they fail to use their phone calls to consult an attorney or other benefits expert for assistance.