Special rules apply under Sec. 457(f) to unfunded deferred compensation plans of state governments, local governments, and their agencies as well as nongovernmental tax-exempt organizations. (1) The IRS has issued comprehensive proposed regulations to replace the existing regulations applicable to Sec. 457(f). (2)
This article discusses the treatment of Sec. 457(f) plans under the new regulations and their interaction with the Sec. 409A regulations that usually apply to unfunded deferred compensation plans.
When deferred compensation is included in income under Sec. 457(f)
The present value of compensation deferred under a Sec. 457(f) plan is included in the gross income of an employee or beneficiary (1) when he or she has a legally binding right to the compensation or, if later, (2) when the compensation is no longer subject to a substantial risk of forfeiture. (3)
The present value of the deferred compensation is generally determined by first multiplying each future payment by the probability that all conditions on the payment will be satisfied. The amount so computed is then discounted using a reasonable assumed rate of interest. (4) However, for a plan with a hypothetical account balance that is earning a reasonable imputed rate of return, the present value is the account balance, including the earnings previously credited to the account. (5)
The valuation of a future payment cannot take into account the possibility that payments will not be made or will be reduced (1) because the plan is unfunded; (2) because of investment risk or the risk that the obligor will not make payment; (3) because of future plan amendments or a change in the law; or (4) because of similar circumstances. (6)
After the present value of deferred compensation is included in income, future imputed earnings under the plan are not immediately taxable. Instead, plan amounts actually or constructively received by a participant or beneficiary are taxable under the rules applicable to annuities. That is, they are taxable under the annuity rules as annuity payments or as non-annuity payments, with amounts previously included in income treated as investment in the plan. (7)
Actual or constructive receipt of payments includes receipt of any taxable or nontaxable benefit from the plan. It includes a transfer of cash, a transfer of property, inclusion in income under the economic benefit doctrine, a taxable contribution to (or taxable receipt of an interest in) a Sec. 402(b) nonexempt trust, or receipt of welfare or fringe benefits.
Exclusions from treatment as Sec. 457(f) deferred compensation
Sec. 457(f) plans are defined largely by exclusion. For example, they do not include qualified plans, Sec. 403(b) tax-sheltered annuities, Sec. 402(b) nonexempt trusts, Sec. 403(c) nonqualified annuities, Sec. 83 property transfers, qualified governmental excess benefit arrangements (QGEBAs), certain employee retention plans, and Sec. 457(b) eligible plans. (9)
Discretion to reduce or eliminate compensation
Compensation is not deferred under a Sec. 457(f) plan if an employee does not have a legally binding right to the compensation. For example, no such right exists if any other person has complete discretion to reduce or eliminate the compensation. However, the regulations ignore that discretion if its exercise depends on the occurrence of some objective event or if the discretion lacks substance. Discretion may lack substance, for example, because of a family or economic relationship between the employee and the person with the discretionary power. (10)
Exclusion of short-term deferrals
Deferred compensation under a Sec. 457(f) plan does not include short-term deferrals. (11) A deferral is short term if (1) the governing plan does not expressly provide for a deferred payment and (2) absent exceptional circumstances, (12) the compensation is paid before the end of a 2 1/2-month period. For this purpose, a plan does not expressly provide for a deferred payment if no payment date is specified, or all specified payment dates occur before expiration of the 2 1/2-month period. (13) The 2 1/2-month period ends on the 15th day of the third month after the later of the employee's or the employer's tax year in which the employee first possesses a legally binding right to the payment unhampered by a substantial risk of forfeiture. (14)
Nevertheless, a payment after expiration of the 2 1/2-month period may not jeopardize short-term treatment if (1) timely payment is administratively impractical due to unforeseeable events or (2) an earlier payment would jeopardize the going concern status of the employer. Nor will a late payment jeopardize short-term treatment if the employer reasonably believes that payment would violate a provision of law other than federal tax law. However, the employer must make the payment as soon after as reasonably practicable. (15)
Exclusion of recurring part-year compensation
Delayed payment of an employee's recurring part-year compensation (e.g., a teacher's part-year compensation) is not deferred compensation under Sec. 457(f) if the following conditions are satisfied. First, the employee's service period must be a period of less than 12 months (e.g., 10 months for a teacher), and the employee must reasonably expect the deferral arrangement to continue substantially unchanged in succeeding years.
Second, the employee must receive the compensation on or before the last day of the 13th month following the beginning of the employee's service period. Third, the employee's total compensation for the service period must be less than a specified inflation-adjusted amount ($265,000 for service periods beginning in 2016; $270,000 for service periods beginning in 2017). (16)
Exclusion of bona fide severance pay plans
Sec. 457(f) plans do not include bona fide severance pay plans (17) that satisfy all the following requirements:
* Severance benefits must be payable only upon involuntary severance from employment. (18) For this purpose, involuntary severances may include a separation for "good reason" effectively caused by negative changes imposed by the employer, e.g., negative changes in employee pay, authority, duties, or working conditions. (19)
* The amount payable must not exceed twice the employee's ongoing annual rate of pay for the tax year preceding separation (or if none, for the tax year of separation). (20)
* The benefit must be paid by the end of the second calendar year following the calendar year of separation, as required by a written plan document. (21)
Exclusion of window retirement programs
A "window" retirement program (a retirement program that gives employees a specified period or window in which to accept early retirement benefits) is not subject to Sec. 457(f) even though the severance of an employee is voluntary. To qualify, the window program must be available to employees for only a limited time (typically 12 months or less), and the program cannot be part of a recurring pattern of providing similar programs. (22)
In addition, a window program must satisfy the other requirements for a bona fide severance pay plan. That is, the amount payable cannot exceed twice the employee's ongoing annual rate of pay for the tax year preceding separation, and the amount must be paid by the end of the second calendar year following the calendar year of separation. (23)
Exclusion of other plans and payments
Sec. 457(f) plans do not include bona fide sick leave, (24) vacation, (25) disability pay, (26) and death benefit plans. (27) Also excluded are certain specified (1) payments of employee expenses, (28) medical benefits, and in-kind benefits; (2) indemnification rights, liability insurance, and legal settlements; (29) (3) taxable education benefits, (30) bona fide compensatory time programs, (31) and length-of-service awards to bona fide volunteers; (32) (4) employment retention plans for educators; (33) (5) voluntary early retirement incentive plans for educators; (34) (6) types of independent contractor deferrals; (35) and (7) grand-fathered plans. (36)
Substantial risk of forfeiture
As noted above, compensation is generally deferred under Sec. 457(f) as long as it is subject to a substantial risk of forfeiture. Substantial risks of forfeiture include risks of forfeiture conditioned on the future performance of substantial services. (37)
Example 1: OnJan. 15, 2017, a state governmental unit enters into a Sec. 457(f) agreement providing for a bonus payment of $250,000 to an employee on Jan. 15,2019, if the employee provides substantial services until that date. The employee subsequently satisfies his obligation and receives payment on Jan. 15,2019. The employee includes the $250,000 payment in his gross income for the year 2019, the year of receipt (and includes none in 2017, the year he entered into the agreement).
Example 2: On Jan. 15,2017, an employee severs her employment with a tax-exempt entity and enters into a Sec. 457(f) agreement providing for payment of $250,000 to the employee onJan.15, 2019. However, the employee must provide consulting services to the employer until that date. Unfortunately, the consulting services required are not substantial in relation to the payment. Accordingly, the present value of the future $250,000 payment is includible in the employee's gross income on Jan. 15,2017. When the employee actually receives the $250,000 payment, she must include in gross income the amount of the payment less the amount included in gross income on the date of her severance from employment. (38)
Condition related to the purpose of the compensation
Compensation is also subject to a substantial risk of forfeiture if forfeiture may be triggered by a condition related to the purpose of the compensation, provided the possibility of forfeiture is substantial. A condition related to a purpose of the compensation must relate to (1) the employee's performance of services for the employer or (2) the employer's governmental or...