Drafting a 457(f) Plan: A How-To

Section 457(f) plans serve tax-exempt employers, and many are drafted to qualify as top hat plans. A blog entry argues that drafting them can be challenging, and offers practical tips for doing that. 

In “A Checklist for Drafting Section 457(f) Plans for Tax-Exempt Employers,” Lori Jones, chair of Thompson Coburn’s Employee Benefits practice, notes that drafting a Section 457(f) plan for a tax-exempt employer can be difficult because of the various statutory and regulatory rules that apply. Jones offers eight best practice tips.

1. Draft the plan so it is exempt from certain ERISA provisions.

In most cases, Jones says, a 457(f) plan of a tax-exempt entity is drafted to qualify as a top hat plan. And, she writes, such plans are maintained primarily to provide deferred compensation “for a select group of management or highly compensated employees” and are exempt from ERISA eligibility, vesting, funding and fiduciary rules. 

2. Consider the requirements of Code Sections 457(f) and 409A.

The Section 409A final regulations and the Section 457(f) proposed regulations, says Jones, confirm that tax-exempt employers drafting nonqualified deferred compensation plans must consider both. Therefore, she writes, “unless a Section 409A exemption applies, benefits provided under a Section 457(f) plan must comply with the Section 409A requirements relating to the time of payment of nonqualified deferred compensation and other plan document requirements.” Jones warns that failing to comply with Section 409A will result in:

• an employee being subject to income tax in the year nonqualified deferred compensation is vested, regardless of when that compensation is to be paid;
• a 20% excise tax on noncompliant nonqualified deferred compensation; 
• interest on any late payment of income taxes; and 
• possible imposition of penalties and interest on employers for failure to timely report and withhold income taxes concerning nonqualified deferred compensation that does not comply with Section 409A.

3. Short-term deferral exemptions under Sections 457(f) and 409A are similar but not the same.

Section 409A and Section 457(f) both include an exemption for plans providing short-term deferrals. But they differ regarding the definitions of “substantial risk of forfeiture” under these two Code sections concerning noncompete provisions and the rolling risk of forfeiture, Jones observes. 

4. The Section 457(f) bona fide severance plan exemption is similar —but not identical to — the Section 409A separation pay plan exemption.

A bona fide severance pay plan is a key exemption from Section 457(f), writes Jones, also noting that Section 409A includes a similar exemption for separation pay plans. While both provide that a “good reason” termination can qualify as an involuntary termination and employ a similar safe harbor definition of “good reason,” she also notes that the Section 457(f) exemption differs from that of Section 409A in one key way: The 409A exemption requires that the benefits not exceed twice the compensation limit under Code Section 401(a)(17).

5. Include a provision allowing accelerated payment of benefits as necessary to satisfy tax withholdings.

Benefits provided under a plan that is subject to Section 457(f) will be taxed in the year of vesting, regardless when the benefits actually are paid, Jones notes. She adds that if such a plan generally provides that benefits will be paid in a future year, the plan should be drafted to permit the accelerated payment of an amount necessary to pay income and employment tax withholding on the present value of benefits taxed in the year of vesting. This, she adds, will provide a participant with some or all of the cash needed to pay those taxes.

6. Do not guarantee the tax consequences of the plan.

Since Sections 457(f) and 409A have extensive requirements, and the chance that courts and governmental entities could interpret the regulations under them in conflicting ways, Jones suggests that tax-exempt employers may want to expressly state in a Section 457(f) plan that the employer does not guarantee the tax consequences of the plan.

7. Consider including a savings clause in the plan.

Jones defines a savings clause as a means by which a tax-exempt employer can expressly state: 

1. the intent of a plan, e.g., to be exempt from both Section 457(f) and Section 409A under the short-term deferral rule; and 
2. the desire that the plan be interpreted and administered in a way that to accomplishes that exemption. 

She argues that such a provision may be beneficial to include even though it is not clear whether a court will be convinced by such a provision to “blue-line” a plan and accomplish the stated intent.

8. File a top hat plan statement with the Department of Labor.

Jones reminds that a 457(f) plan that qualifies as a top hat plan will be subject to limited reporting and disclosure requirements under ERISA and will have to file the Form 5500. However, she notes, a tax-exempt employer will be deemed to those requirements by filing a top hat plan statement with the DOL.