The enactment of Section 409A of the Internal Revenue Code (the “Code”) in 2004 has changed the rules for designing and drafting deferred compensation arrangements for state and local governments and tax-exempt organizations. Although these arrangements were already subject to regulation under Section 457, only “eligible” deferred compensation arrangements subject to the restrictions of Section 457(b) of the Code are exempt from Section 409A’s scope. “Ineligible” arrangements must comply both with the rules under Section 457(f ) of the Code and the rules under Section 409A. While this scheme of dual regulation provides hazards for the unwary, it also may provide tax planning opportunities. In particular, the inclusion of an amount into income under Section 457(f ) can be structured so that it is treated as a payment for purposes of the short-term deferral exemption, even if the amount continues to be set aside and credited with earnings. In addition, the prospect of stricter regulations under Section 457(f ) may make it more advantageous for companies to correct their 457(f ) plans now, to the extent that they contain provisions that run afoul of 409A, than after the new guidance is issued.
Congress enacted Section 457 of the Code in 1978 in response to proposed regulations that would have applied assignment of income principles to unfunded deferred compensation. The position of the Internal Revenue Service (the “Service”) at the time was that an elective deferral of compensation was tantamount to an anticipatory assignment of income back to the employer, in violation of longstanding judicial doctrine treating the disposal of income as a tax event. Debates about the proper tax treatment of deferred compensation were of particular concern for governmental plans because those plans do not reflect the tension that would otherwise exist between the employer’s desire to obtain an immediate deduction and the employee’s desire to defer taxation.
As originally enacted, Section 457(b) of the Code permitted government employees to defer taxation on their income until the deferrals are otherwise paid or “made available.” This relatively lenient treatment of unfunded deferred compensation was subject to an annual dollar limit1 and was available only under “eligible” plans that complied with a number of other restrictions. Most notably, elections to defer compensation under an eligible plan were to be made in writing no later than the beginning of the month of the deferral, and distributions were not allowed prior to the participant’s severance from employment or age 70½, except on account of an unforeseeable emergency.
Deferrals in excess of the Section 457(b) limit or made under a plan that did not incorporate the restrictions of Section 457(b) were subject to the Service’s assignment of income theory. Under Section 457(f ) of the Code, these arrangements are taxable at the time of deferral or, if later, in the year in which the amounts are no longer subject to a substantial risk of forfeiture. As Section 457 was initially drafted, therefore, if a government employee received a deferral of income subject to a service requirement, he would generally be permitted to defer taxation until the amount was paid or made available if the deferral did not exceed the applicable dollar limits and the arrangement otherwise complied with Section 457(b). If the plan was subject to Section 457(f ), however, the payment would generally become includible in the participant’s gross income as he vested into the benefit, even if the amount was not distributed until a later date.
Over time, this elegant solution to a thorny policy dilemma was complicated by numerous amendments. In 1986, legislation was adopted extending Section 457 to deferred compensation arrangements maintained by tax-exempt organizations. Because tax-exempt organizations are not categorically exempt from ERISA’s funding rules, however, they can take advantage of Section 457 only if they meet another exemption—generally, by limiting participation to a select group of management or highly compensated employees.
Section 457 was further amended in 1996, following the bankruptcy of Orange County, California, to require state and local governments to set aside from any assets subject to creditors all deferrals under a Section 457(b) plan and all income, property and rights attributable to those deferrals. This requirement was not extended to tax-exempt organizations, and therefore Section 457(b) plans maintained by tax-exempt entities must remain unfunded. The trust requirement makes available several features under eligible governmental plans that are not available under plans maintained by tax-exempt entities, including participant loans, rollover distributions and trust-to-trust transfers with other eligible retirement plans.2
Other amendments have lengthened the list of exclusions to the Section 457 scheme. From its inception, Section 457 has excluded qualified plans under Sections 401(a) and 403(a), nonqualified funded plans under Section 402(b), 403(b) tax-deferred annuities and transfers of property under Section 83. After Section 457 was amended to include tax-exempt plans, the Service issued a notice clarifying that church plans were also to be excluded. And after the Service clarified that Section 457(f ) could also apply to nonelective arrangements, the Code was amended to carve out bona fide vacation leave, sick leave, compensatory time, disability pay, death benefit and severance pay plans. The scope of this last amendment – the exclusion of severance pay plans – has proven to be particularly controversial, as discussed below.
Although final regulations were issued under Section 457 in 2003, many of the most difficult issues for employers were not addressed in that guidance. In particular, the Service did not provide any clarification of the meaning of “substantial risk of forfeiture” beyond the statutory definition of “conditioned upon the future performance of substantial services.” Thus, it was left open whether participants in a 457(f ) plan could elect to subject compensation for which they had already performed services to a substantial risk of forfeiture or extend a substantial risk of forfeiture that already applied. Similarly, the regulations did not clarify what would be considered “substantial” for this purpose. For example, it was not clear whether a post-termination consulting agreement or covenant not to compete was sufficient to defer taxation beyond the date of a participant’s severance from employment. Finally, the 2003 regulations did not provide any assistance on the distinction between a Section 457 plan that is payable upon severance from employment and a “severance pay plan” that is exempt from Section 457 entirely.
In the absence of contrary guidance, many practitioners took an aggressive stance on these issues, drafting Section 457(f ) plans that permitted deferral elections to be made up to the time that the compensation would otherwise have been paid, allowed participants to accelerate the distribution of their deferrals subject to a reduction in the amount of the benefit paid (known as a “haircut”) or extend the risk of forfeiture beyond that date that it would otherwise have lapsed (known as a “rolling risk of forfeiture”), and incorporated provisions, such as consulting agreements and covenants not to compete, that purported to extend the date on which the payments were no longer subject to a risk of forfeiture beyond the date on which they would otherwise vest. In addition, some practitioners argued that any compensation deferred to a participant’s severance from employment, even if the amounts were not payable on account of the severance, should be exempt from Section 457 under the “severance pay plan” exemption.
Most reputable practitioners questioned the validity of these practices. In informal guidance, the Service had approved of participant deferral elections under Section 457(f ) only where the elections were to be made in advance of the service date, and many representatives of the Service had publicly questioned the validity of rolling risks of forfeiture, which rarely have a legitimate business purpose other than the deferral of taxation. In addition, the phrases at issue had been defined more narrowly in parallel provisions of the law. The phrase “substantial risk of forfeiture” is also used in Section 83 of the Code. Regulations under Section 83 listed covenants not to compete and awards conditioned on the provision of consulting services as examples of risks of forfeiture that are generally not “substantial,” except where the particular facts and circumstances indicate otherwise. The phrase “severance pay plan” is also used in regulations under Section 3 of the Employee Retirement Income Security Act (“ERISA”), where they are distinguished from plans providing for a deferral of income if the severance payments are not contingent on the employee’s retirement, the amount payable does not exceed twice the employee’s annual compensation, and all payments are completed within 24 months after the termination of the employee’s services.
To the extent that there was any ambiguity about the validity of these practices, it was resolved with the enactment of Section 409A of the Code. Section 409A provides that a nonqualified compensation plan must comply with certain restrictions on the timing of deferral elections and the distribution of benefits, or the deferred amounts will become includible in gross income and subject to an additional tax equal to 20% of the deferral when they are no longer subject to a substantial risk of forfeiture. Section 409A excludes eligible deferred compensation plans under Section 457(b) from its scope, but Notice 2005-1, the first piece of formal guidance issued under Section 409A, clarified that ineligible deferred compensation plans maintained by a state or local government or tax-exempt organization are subject to Section 409A in addition to Section 457(f ).
On its face, Section 409A included several restrictions that were of direct relevance to the manner in which many 457(f ) plans were being administered. For example, it required that any deferral election be made by the end of the taxable year preceding the year in which the participant performs services, a date much earlier than was required under many 457(f ) plans. In addition, Section 409A included a prohibition on acceleration of payments without exception for “haircuts” or many of the other practices commonly used to cut off deferral periods under Section 457(f ).
However, the stringency of the restrictions under Section 409A was not fully apparent until final regulations were issued in 2007. These regulations included a much narrower definition of “substantial risk of forfeiture” than many had hoped would apply, narrower even than the definition under Section 83. For example, a service provider cannot add a risk of forfeiture after he already has a legally binding right to the compensation. Nor can he subject a payment to a substantial risk of forfeiture beyond the date on which he otherwise could elect to receive it, unless the present value of the amount subject to a substantial risk of forfeiture is materially greater than the present value of the amount the recipient otherwise could have elected to receive. These provisions crystallize a position long held by staff members at the Service that no rational person would voluntarily subject to a risk of forfeiture compensation to which he is otherwise freely entitled, unless the person was substantially certain that there was no real risk of forfeiture or likelihood of future gain.
The regulations also provided guidance on when a risk of forfeiture is “substantial.” Taxation under Section 409A cannot be deferred merely because a payment is conditioned upon “refraining from the performance of services,” such as a covenant not to compete. Furthermore, any extension of a period during which compensation is subject to a risk of forfeiture is to be disregarded. Therefore, a rolling risk of forfeiture is invalid unless the participant complies with the rules on subsequent elections. These rules permit a delay in payment only if the election is made at least 12 months prior to the date on which the payment of the deferred amount would otherwise commence, the election takes effect no earlier than 12 months after it is made, and payment is deferred for at least five (5) years after the date on which payment has been made.
Finally, the regulations provided an exemption for “separation pay plans” that was narrower than the exemption of “severance pay plans” under ERISA. Not only does the definition of “separation pay plan” incorporate ERISA’s restrictions on the amount and timing of payment, but is also requires an exempt separation pay plan to limit payment to an involuntary separation from service or pursuant to a window program.
Although the regulations under Section 409A clearly did not permit some practices that had become commonplace under Section 457(f ), there was still some debate as to how the two sets of rules fit together. For example, could it be argued that a rolling risk of forfeiture put into place prior to the enactment of Section 409A would still be valid under Section 457(f )? Or that a severance arrangement that failed the definition of “separation pay plan” under Section 409A could still be exempt from Section 457?
Three months after the release of the final regulations under 409A of the Code, the Service issued IRS Notice 2007-62, which announced its intent to issue new guidance under Section 457(f ) that would define “substantial risk of forfeiture” under rules similar to Section 409A. The notice makes specific mention of the rules that would prohibit rolling risks of forfeiture and unilateral deferrals of compensation to which a participant is already entitled, as well as the rules that would not treat a covenant not to compete or other agreement not to perform services as a substantial risk of forfeiture. The notice also states that the Service anticipates issuing guidance defining “severance pay plan,” for purposes of the exemption from Section 457, in a manner that is substantially similar to the exception for “separation pay plan” under Section 409A.
At least one staff member of the Service has said publicly that the new 457(f ) guidance is expected to be issued later this year. In light of the Service’s stated intent to square Section 457(f ) with Section 409A, any new Section 457(f ) plan should be drafted with a view to complying with both sets of regulations, including Section 409A’s stricter restrictions on the timing of deferrals, payment and vesting. Although the new Section 457(f ) guidance is expected to be prospective, employers may currently rely on the anticipatory guidance under Notice 2007-62. Doing so will avoid the uncertainty that comes, for example, with a salary deferral or rolling risk of forfeiture that turns out to be invalid.
In this regard, the short-term deferral exemption can be a particularly valuable opportunity for Section 457(f ) plans. The final regulations under Section 409A carve out from the definition of “deferral of compensation” any payment made under a plan that requires actual or constructive receipt within 2½ months after the taxable year in which the payment is no longer subject to a substantial risk of forfeiture. The inclusion of an amount into income under Section 457(f ) is treated as a payment for this purpose. If the plan incorporates a risk of forfeiture that passes muster under both sets of rules, the compensation will become includible under Section 457(f ) at the same time that the risk of forfeiture lapses under Section 409A, and therefore would qualify as a short-term deferral.
Typically, participants in Section 457(f ) plans elect to receive a payment of their deferral when the amount becomes includible in income. Doing so ensures that participants have funds to meet the corresponding tax obligation. If compensation is deferred beyond the date on which it is no longer subject to a substantial risk of forfeiture, any earnings that accrue after that date may be excluded from gross income until they are paid or made available. However, this additional deferral can pose a problem under Section 409A because any amounts that are not includible in income under
Section 457(f ) on the date on which the substantial risk of forfeiture lapses will not automatically be covered by the short-term deferral exception. Therefore, participants who do not take a complete distribution of their 457(f ) deferrals will need to satisfy a separate exemption with respect to post-vesting earnings or ensure that they are subject to a valid deferral election under Section 409A. Section 457(f ) plans that already incorporate some of the provisions that would not be effective under Section 409A, such as invalid deferral elections, rolling risks of forfeiture and risks of forfeiture that purport to extend beyond the vesting date, should be reviewed on a case-by-case basis. Some of these provisions may need to be corrected under the documentary correction program outlined in Notices 2010-6 and 2010-80. Other provisions may not be eligible for immediate correction or may be more effectively addressed after the new Section 457(f ) guidance is issued.