The IRS has issued Notice 2007-62 (the “Notice”), regarding the interaction of Internal Revenue Code Section 457 plans and Internal Revenue Code Section 409A. Generally, Section 457 plans are deferred compensation plans of local and state governments and tax-exempt organizations. These types of employers are not subject to tax and therefore do not have the same incentives as other employers to have employees recognize deferred income so that the employer can take a deduction in the same amount. In addition, because government plans are not subject to ERISA, there are no “top-hat” considerations that limit the group of employees that an employer can allow to participate in non-qualified deferred compensation plans. Because of these differences between the deferred compensation plans of tax-paying employers and such government or tax-exempt organization employers, Section 457 was enacted to impose limitations on the plans of governmental and tax-exempt employers.

Under Section 457, if a plan under which compensation is deferred meets the requirements for an “eligible deferred compensation plan,” employees only have to include deferred amounts in gross income for the taxable year in which the amounts are paid out to the participant or beneficiary in the case of governmental plans, or in which the amounts are paid out or made available to the participant or beneficiary in the case of tax-exempt organization plans. The requirements of an “eligible deferred compensation plan” are aimed at requiring a true deferral of income and also limiting the amount of compensation that can be deferred. The requirements for a deferred compensation plan to be “eligible” are: (1) only individuals who perform services for the employer may participate; (2) only a maximum amount can be deferred (this amount is very similar to qualified plan limits; it is set at the lesser of 100 percent of compensation or an applicable dollar amount, i.e. US$15,500 for 2007); (3) a plan may have a higher maximum amount for the last three taxable years of a participant before normal retirement; (4) the plan must provide that compensation is deferred for any month, only if an agreement providing for such deferral was entered into before the beginning of the month; (5) the plan must meet certain distribution requirements and (6) all amounts of compensation that are deferred under the plan must remain the property of the employer, subject only to the claims of the employer’s general creditors. Section 457 requires that all of the assets and income of an eligible deferred compensation plan must be held in trust for the exclusive benefit of participants and their beneficiaries.

Section 457(f) provides other rules that apply to governmental and tax-exempt organization deferred compensation plans which are not “eligible” because they do not meet the requirements discussed above. For these ineligible plans, deferred compensation is included in the gross income of the participant for the first taxable year in which there is no substantial risk of forfeiture. Section 457(f) states that a substantial risk of forfeiture means that a person’s rights to deferred compensation are conditioned on the future performance of substantial services by any individual. Section 409A does not apply to eligible Section 457 plans, but it does apply to ineligible Section 457(f) plans.

Certain plans are treated as though they do not defer the receipt of compensation under the Section 457 rules. Such plans include bona fide vacation leave, sick leave, disability pay and severance pay plans. The Notice discusses the exception for bona fide severance pay plans. Section 409A also has an exception for involuntary separation pay plans, but previously there was not guidance as to whether the Section 457 bona fide severance pay plan exception functioned like the Section 409A exception. The Notice states that future guidance from the IRS will indicate that the Section 409A exception for involuntary separation pay plans is similar to the exception for bona fide severance pay plans under Section 457. This means that a bona fide severance pay plan will be exempt from the application of Section 457 if (1) the benefit under the plan is payable only upon involuntary separation from service, (2) the benefit does not exceed two times the employee’s annual rate of pay (taking into account only pay that does not exceed the maximum amount that may be taken into account under a qualified plan pursuant to Section 401(a)(17) for the year in which the employee has a severance from employment (i.e., two times US$225,000 in 2007)) and (3) the plan provides that the payments must be completed by the end of the employee’s second taxable year following the year in which the employee separates from service. It is expected that the guidance will include exceptions to the requirement that benefits are payable only upon involuntary separations from service that are similar to those provided in Section 409A for “window programs,” collectively bargained separation pay plans and certain reimbursement arrangements, e.g., certain medical reimbursement plans. Under the Section 409A final regulations, a “window program” is a program established by an employer in connection with an impending separation from service to provide separation pay, where such program is made available by the service recipient for no longer than 12 months, to service providers who separate from service during that period.

The Notice also states that there will be generally the same rules for the definition of substantial risk of forfeiture under Section 409A and Section 457(f). Currently, the Section 457 definition of a substantial risk of forfeiture is limited to a person’s rights to compensation being conditioned upon the future performance of substantial services. It appears that the IRS is considering a possible expansion of the definition of substantial risk of forfeiture provided in Section 457, to include the additional meaning under the Section 409A regulations of conditioning payment on “the occurrence of a condition related to a purpose of the compensation.” In the Notice, the IRS requests comments as to whether there should be special rules for Section 457(f) plans with respect to this aspect of the definition of substantial risk of forfeiture, because government and tax-exempt organizations have different business activities and organizational goals than taxable employers.

The Notice indicates that, as under Section 409A, deferred compensation under a Section 457(f) plan is not subject to a substantial risk of forfeiture just because the right to the deferred compensation is conditioned, directly or indirectly, upon refraining from the performance of services under a non-competition agreement. In addition, it appears that as under Section 409A, the addition of any risk of forfeiture after the right to the compensation arises, or the extension of a period during which the compensation is subject to a risk of forfeiture (sometimes referred to as a “rolling risk of forfeiture”), will be disregarded under Section 457(f) plans as a substantial risk of forfeiture.

In addition, as under Section 409A, an amount will not be considered subject to a substantial risk of forfeiture for purposes of a Section 457(f) plan beyond the time at which the recipient otherwise could have elected to receive the amount of compensation, unless the present value of the amount made 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 without such substantial risk of forfeiture. For example, salary that an individual would have received if the individual did not make a salary deferral election cannot generally be made subject to a substantial risk of forfeiture beyond the date that the salary would have been received.

The Notice also notes that under the Section 409A regulations, inclusion in income under Section 457(f) is treated as actual payment, so the lapse of a substantial risk of forfeiture under Section 457(f) and inclusion in income of deferred compensation under Section 457 will satisfy the short-term deferral exception under Section 409A. However, the same is not true with respect to earnings on deferred compensation previously included in income under Section 457(f). Earnings on amounts held in Section 457(f) plans after the deferred compensation amounts have vested are not included in the income of participants until they are paid out to participants. Such earnings must independently satisfy, or be excluded from, the rules of Section 409A. If all amounts, including the deferred compensation and the earnings, in a Section 457(f) plan are paid out upon vesting, the whole amount can meet the short-term deferral exception and avoid Section 409A.

The Notice concludes with the statement that taxpayers can rely on the definitions of bona fide severance pay plans and substantial risk of forfeiture set out in the Notice until the guidance is actually issued. This means that employers will have to choose whether to amend their plans now to follow the Notice or wait for the actual guidance. If there is any difference between the actual guidance and the Notice, employers would have to amend their plans once again to comply with the actual guidance. However, the guidance should be helpful because it should ease the burden on governmental and tax-exempt employers of complying with the requirements of both Section 409A and Section 457. For a more detailed discussion of the requirements of Section 409A, please see the article entitled “An Analysis of the Final 409A Regulations on Deferred Compensation.”