Unlike most private employers, tax-exempt and governmental employers administering deferred compensation plans are forced to address the interplay of two tax provisions – Code section 457(f) and Code section 409A.
- Code section 409A applies to nonqualified deferred compensation plans of both tax-exempt and taxable employers.
- Code section 457(f) applies to certain nonqualified deferred compensation plans sponsored by state and local governments and tax-exempt organizations.
Thus, section 457(f) plans are subject to the requirements of both Code section 409A and Code section 457(f). There is also a year-end 2008 deadline for amending plans to comply with Code section 409A. (See 10/23/07 article, “Section 409A Transition Relief Fully Extended Until December 31, 2008”).
As a result, state and local governments and tax-exempt employers should consider taking action now before it is too late into 2008 (or too expensive) to ensure that their 457(f) plans are in full compliance.
Some of the key issues to consider are as follows:
Substantial Risk of Forfeiture
Under a section 457(f) plan, participants must pay taxes on compensation that is deferred when the compensation stops being subject to a “substantial risk of forfeiture”. The concept of “substantial risk of forfeiture” is also relevant under Code section 409A, given that it determines whether the “short-term deferral” exception under section 409A applies. (See 4/23/07 article, “Section 409A Countdown to Full Compliance – Installment No. 1: Covered Arrangements / Short-Term Deferral Exception / Plan Aggregation”).
In August 2007, the IRS and the U.S. Department of the Treasury announced that they will be issuing guidance that will conform the definition of “substantial risk of forfeiture” applicable to section 457(f) plans to the definition in Code section 409A regulations. (See IRS Notice 2007-62).
Among other things, the definition of “substantial risk of forfeiture” under Code section 409A explicitly:
- Disregards any extension of a forfeiture period, such as a “rolling risk of forfeiture” provision. Thus, the “subsequent election” rules of Code section 409A that allow an initial payment election to be deferred to a later time practically would not apply to a 457(f) plan, because the benefit would otherwise be taxable at the end of the original forfeiture period. (See 6/13/07 article, “Section 409A Countdown to Full Compliance – Installment No. 8: Changes in Deferral Elections”);
- Provides that refraining from performing services (such as a post-termination covenant not to compete) cannot by itself create a substantial risk of forfeiture;
- Provides that future salary generally cannot be made subject to a substantial risk of forfeiture, such that a salary-deferral 457(f) plan would not be possible;
- Provides that contingent compensation (such as a bonus) cannot be subjected to a risk of forfeiture, unless the present value of the amount made subject to a risk of forfeiture is materially greater than the present value of the compensation payable absent the risk; and
- Limits when compensation payable on an involuntary termination of employment (including a constructive termination or termination for “good reason”) can be treated as subject to a substantial risk of forfeiture.
Bona Fide Severance Pay Plan
A “bona fide severance pay plan” is exempt from the requirements of Code section 457(f). In the same August 2007 notice discussed above, the IRS and the Treasury Department also announced plans to define a “bona fide severance pay plan” for Code section 457(f) consistent with the “two-times” exemption under Code section 409A. (See 5/3/07 article, “Section 409A Countdown to Full Compliance – Installment No. 3: Severance Pay and Benefits”).
Severance pay is generally eligible for the “two-times” exemption only to the extent it:
- Is payable solely upon an involuntary separation from service (as defined in Code section 409A);
- Does not exceed two-times the lesser of (i) the service provider’s annual rate of compensation for the calendar year prior to the year in which the separation occurs, or (ii) the qualified-plan compensation limit in effect for the year in which the separation occurs ($230,000 for 2008); and
- Is paid on or before the end of the second calendar year following the year in which the separation occurs.
Unfortunately, the Code section 457(f) guidance promised by the IRS and the Treasury Department in 2007 has not yet been released. When it is released, it is expected to apply prospectively only. Even so, state and local governments and tax-exempt employers who: (a) sponsor 457(f) plans or severance pay plans intended to be exempt from Code section 457(f), and (b) expect to amend such plans to comply with the anticipated changes, should consider doing so while transition relief under Code section 409A remains in effect. This transition relief expires on December 31, 2008.
Example: Tax-exempt employer E sponsors a section 457(f) plan for the benefit of Participant P, an active employee who is 45 years old. The benefit is forfeited if P voluntarily quits. The compensation is distributed after the end of a two-year non-compete restriction following P’s termination of employment on or after age 60. E wishes to amend the plan to provide that the substantial risk of forfeiture will lapse instead upon P’s 60th birthday, if he remains employed until such time.
- E must make the amendment on or before December 31, 2008 under the transition relief provided by Code section 409A.
- An amendment made after December 31, 2008 would accelerate the distribution date, resulting in a Code section 409A violation.
State and local governments and tax-exempt organizations who expect to make changes to severance plans or ineligible deferred compensation plans to comply with anticipated changes to the definitions of “bona fide severance pay plan” and “substantial risk of forfeiture” should consider doing so before December 31, 2008, when the current transition relief under Code section 409A will expire.
Even employers who do not expect to amend their section 457(f) plans or severance pay plans to comply with the anticipated changes announced in Notice 2007-62 may still be required to amend such arrangements before the end of 2008 to comply with Code section 409A generally. Thus, all section 457(f) plans and severance plans sponsored by state and local governments and tax-exempt employers should be reviewed as soon as possible to determine whether amendments needed to comply with Code section 409A are required before year end.
For additional information on the rules for deferred compensation plans, see our earlier 12-part series on Section 409A Countdown to Full Compliance, and other articles on specific Code section 409A topics.
In addition, for further assistance on these or any other 409A compliance topics, please contact the authors: