Substantial risk of forfeiture under Sec. 457(f).

• Author: Josefowicz, Barbara

Sec. 457(f) deals with nonqualified deferred compensation (NQDC) plans of governmental and other tax-exempt employer sponsors. Specifically, Sec. 457(f) applies to plans classified as ineligible plans to distinguish them from Sec. 457(b) plans, which are called eligible plans.

Sec. 457(b) plans have a contribution dollar limit ($15,500 for 2008) but do not generate taxable income to the participant until the nonqualified deferred compensation is paid or made available to the participant. Sec. 457(f) plans, on the other hand, have no contribution limit but cause the participant to have taxable income in the first tax year in which there is no substantial risk that the participant will forfeit the nonqualified deferred compensation. In other words, the participant could have income inclusion before the deferred compensation is paid or made available. Under Sec. 457(f)(3), a substantial risk of forfeiture exists when the participant's rights to the deferred compensation are conditioned on the future performance of substantial services by any individual.

Impact of Sec. 409A

In addition to the requirements of Sec. 457(f ), governmental and tax-exempt sponsors of Sec. 457(f) ineligible plans must also deal with Sec. 409A. Sec. 409A, which generally became effective in 2005, provides for three categories of restrictions that apply to most NQDC plans, including Sec. 457(f) ineligible plans. The three types of restrictions under Sec. 409A are restrictions on the election to defer compensation, on funding, and on distributions.

Under Sec. 409A, the event that produces taxable income to the participant is failure to comply with Sec. 409A. Under Sec. 457(f), by contrast, the event that produces taxable income to the participant is the cessation of the substantial risk of forfeiture.

Income inclusion under Sec. 409A encompasses all deferred compensation that vests after 2004 plus interest thereon. There is also an additional 20% penalty imposed on the participant as well as interest on the income taxes that would have been due had the deferred compensation been reported in income (rather than deferred) in prior years (Sec. 409A(a)(1)(B)(i)(II)). The interest rate on such income is the applicable underpayment rate plus 1% (Sec. 409A(a)(1)(B)(ii)).

Caution: Deferrals that are not yet subject to income inclusion under Sec. 457(f) could violate Sec. 409A, thereby causing a taxation impact to the participant that is far more severe than income inclusion...