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Finally! Proposed Regulations Issued for 457(f) Plans and 409A Plans

Susan D. Diehl

Editor’s Note: The issuance of proposed regulations for 457(f) plans, and the applicability of IRC 409A to those plans is likely to lead to more interest in establishing those plans for key employees of 501(c) non profits and state and local government employers. Readers are encouraged to let NTSA know if a special webcast should be offered to members interested in offering 457(f) plans. NTSA members will also want to note that a Nov. 16 webcast,“Fall 2016: What’s New That Impacts You,” will include some coverage of the proposed regulations addressed in this article.

In General

After almost nine years of waiting, finally IRS has issued these proposed regulations! Many tax-exempt and governmental employers rely on nonqualified deferred compensation plans to recruit and retain executives in the company or at the non-profit or school.

The new proposed regulations for government and tax-exempt 457(b) and 457(f) plans and for profit-companies’ top-hat plans under 409A made expected changes but also were meant to deal with some areas that IRS felt were potential areas for abuse. So at the end of the day very few surprises came from these proposed regulations. What we expected was more references to the 409A nonqualified deferred compensation regs and we got that.

Under Internal Revenue Code Section 457, a deferred compensation arrangement can be either “eligible or ineligible.” Eligible plans are under Section 457(b), and must satisfy certain rules and are subject to an overall limit for annual contributions; while ineligible plans are under Section 457(f).

So What Changed in the 457(f) Area?

Employers may rely on the proposed regulations until they become final. Some of the key changes include:

  • Substantial Risk of Forfeiture, which is extremely important since this affects the taxation to the participant.

A substantial risk of forfeiture exists under Section 457(f) if entitlement to the compensation is conditioned on the future performance of substantial services or on the occurrence of a condition that is substantially related to a purpose of the compensation, provided that the possibility of forfeiture is substantial. Keep in mind these will be difficult to track after termination of service.

However, unlike Section 409A, a covenant not to compete is a substantial risk of forfeiture for Section 457 purposes if certain conditions are met.

  • A severance pay plan is exempt from 457(f), and unlike a 409A plan there is no rule to limit the amount to 2x the compensation limit (currently $265,000).
  • If the employer has a disability plan, this definition is picked up from the 409A regs.
  • The regulations for governmental 457(b) plans were updated to reflect changes that already have occurred, so many employers probably have made these changes.
  • It is clear that 457(f) plans are subject to some (but not all) of the rules under 409A. We expected no less than that. The proposed regulations expressly state that an ineligible plan is subject to the rules of Section 457(f) in addition to any requirements applicable to the ineligible plan under Section 409A.
  • Probably the biggest change was to how to determine taxation when for example there is no longer a substantial risk of forfeiture on some of the assets but not all. The taxable amount is reported on a W-2, but then the record kept until a distributable event occurs under the plan. The growth on the amount reported is then reported when the distributable event occurs. Although there are exceptions to these rules as well.

Effective Date

Of course, employers can rely on the proposed regulations until such time that they are made final. They will become effective for the tax year after the regulations become final, which could be 2017 or a future year. Time will tell.

What Do Employers Do Now?

Employers should take the following steps.

Contact their document provider, TPA, attorney or other tax advisor to see how these rules may affect their current plan document. Amendments do not have to be made yet, but preparing for changes in operations may be something they should look at or at least discuss now.

Particular attention should be placed on the definition of a “substantial risk of forfeiture” as defined under their current plan; this may need to be amended to make sure that the employee is not “taxed before their time”!

In light of these regulations, there are now more planning opportunities. Make sure your client (the employer) is using the services of a tax professional to handle this piece and the drafting of the 457(f) document. One slip of the pen and your client could be taxed “before their time”!

Susan D. Diehl, CPC, QPA, ERPA, is President, PenServ Plan Services, Inc. and Chair of the NTSA Communications Committee.

Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA or its members.