IRS Issues New Plan 457(f) Non-Profit Exam Guidelines

The IRS has also ruled that forfeiture only as a result of a participant's “for cause” termination or voluntary termination constitute substantial risk of forfeiture. A Section 457(f) plan may allow participants to direct the investment of their deferral accounts. Earnings credited upon the compensation deferred under the plan generally will be includable in a participant's gross income when paid to or otherwise made available to the participant or his beneficiary, provided that the participant's or his or her beneficiary's interests in the plan's assets are not senior to employer's general creditors. However, the earnings credited on the amounts deferred may be subject to earlier taxation as well additional penalties and interest if the Code Section 457(f) plan does not satisfy the requirements of Code Section 409A with respect to amounts deferred on or after Jan. 1, 2005. Distributions from the plan are taxable to the participant or his beneficiary under Code Section 72, provided that the participant's or his beneficiary's interests in the plan's assets are not senior to employer's general creditors.

The IRS has sent mixed signals in the past regarding whether an employee and an employer may agree to extend the period during which deferred compensation subject to Code Section 457(f) is subject to a substantial risk of forfeiture and thus, delay the date on which such deferred compensation is includable in gross income. In PLR 9431021 (May 6, 1994), the IRS ruled that an employee would not need to include in his or her gross income the value of certain non-vested shares of restricted stock upon postponement of the vesting dates of such stock.

In analyzing the proposed postponements, the IRS addressed the dual requirements of Code Section 83. First, the IRS determined that the restrictions to which the shares of stock would continue to be subject after postponement of vesting were sufficient to satisfy the requirement that, in order to avoid including the value of property received in return for services in gross income, the rights to such property must not be transferable. Second, in light of Code Section 83(c)(1) and the regulations thereunder, the IRS explained that the rights of a person to property are subject to a substantial risk of forfeiture if the person's rights to full enjoyment of the property are conditioned upon the future performance of substantial services by any individual. Based on this, the IRS concluded that:

Subject to the condition that the future services required of the Employee to avoid forfeiting the nonvested shares of Restricted Stock have been and continue to be substantial, … the postponement of the lapsing of restrictions on the transferability of the Restricted Stock and the prolongation of the period during which the Restricted Stock is subject to a risk of forfeiture will not cause the value of the Restricted Stock to be included in the gross income of the Employee under section 83 of the Code. In Code Section 409A(e)(5), Congress expressly authorized the Secretary of the Treasury to issue guidance to permit a substantial risk of forfeiture to be disregarded. Although this authority is specifically granted under Code Section 409A rather than 457, it appears that Congress was concerned that the use of rolling risks of forfeiture may cause the risk of forfeiture to be illusory. Notice 2005-1 provides that any election or agreement to extend the period during which compensation is subject to a substantial risk of forfeiture will be disregarded for purposes of Code Section 409A. Thus, an extension of the period during which compensation is subject to a substantial risk of forfeiture for purposes of Code Section 457(f) would subject the 457(f) arrangement to the requirements of Code Section 409A, which will make it substantially more difficult for tax exempt organizations to structure long-term deferred compensation arrangements that do not subject the service provider to a substantial risk of forfeiture for lengthy periods.

IRC 457(f)(1)(A) generally provides that, in the case of an agreement or arrangement for the deferral of compensation, if the plan is not an eligible deferred compensation plan, the deferred compensation is included in gross income when the rights to payment of the deferred compensation cease to be subject to a “substantial risk of forfeiture.”

The guidance required from the IRS was addressed with the issuance of the proposed regulations in June of 2016 (REG-147196-07). The announcement finally provides the definition of a “substantial risk of forfeiture” that specifically applies to Section 457(f). Previously, the IRS and practitioners had looked to the definitions of a substantial risk of forfeiture under regulations for Code Sections 83 and 409A to interpret what the term might mean under Section 457(f). In IRS Notice 2007-62, the IRS had stated that it expected to issue regulations under Section 457(f) defining substantial risk of forfeiture similar to the definition under Code Section 409A (Section 409A) and its applicable regulations. As expected, the proposed definition of substantial risk of forfeiture in the Proposed Regulations mostly follows the definition from the Section 409A regulations, but, as explained below, the Proposed Regulations also provide some specific flexibility for Section 457(f) plans that is not available for Section 409A plans.

The New Guidelines

The 457 Exam Guidelines 4.72.19, et. seq., issued on Dec. 7, 2018, provides the bright line test to be able to freeze, flip and fund to further defer and avoid both the penalty excise tax provisions of IRC §4960 at the employer level and the acceleration of income tax at the employee level. The new exam guidelines spell out under 4.72.19.23 (12-07-2018) Death Benefit and Life Insurance how you can apply the bona fide death benefit provisions and Treasury Regs §31.3121. Additionally, The proposed  457(f) Regulations define a bona fide death benefit plan as a death benefit plan under Treasury Regulation §31.3121(v)(2)-1(b)(4)(iv)(C) (applicable FICA tax regulations). The applicable FICA tax regulations basically treat a payment as a death benefit if the payment is not merely a replacement of the lifetime nonqualified plan benefit upon the participant's death.

Code Section 457(e)(11) provides a list of plans and other arrangements that are treated as not providing for the deferral of compensation, including any bona fide death benefit plans. However, the IRS had never issued regulations defining when any of these plans would be considered bona fide and exempt from application of Code Section 457 until the issuance of REG-147196-07. The Proposed Regulations finally provide definitions for these plans. The Proposed Regulations define a substantial risk of forfeiture as follows:

An amount of compensation is subject to a substantial risk of forfeiture only if entitlement to the amount is conditioned on the future performance of substantial services, or upon the occurrence of a condition that is related to a purpose of the compensation if the possibility of forfeiture is substantial

In “Nonprofits and Governments Face Compensation and Benefits Issues under the New Tax Law,” posted on Jan. 11, 2018, Venable LLP's Carol V. Calhoun answers what effect the excise tax has on non-Section 457(f) income:

“How does the excise tax on excess compensation affect vacations, bonuses, and other amounts not included in section 457(f)? Both income taxation under section 457(f) and inclusion in remuneration for purposes of the excise tax on excess compensation generally occur when an amount becomes vested. However, there are a number of exceptions to income taxation upon vesting under 457(f):… Any bona fide … death benefit plan.”

In order to convert funds in a 457(f) Plan subject to risks of forfeiture, one should follow the steps outlined in the IRS 457 Exam Guidelines. 4.72.19.21 (12-07-2018) Plan Terminations and Frozen Plans. A plan may contain provisions permitting plan termination or freezing whereupon amounts can be distributed without violating the distribution restrictions under IRC 457 and 26 CFR 1.457-10(a)(2)(ii). The cost of life insurance protection purchased with amounts deferred under a bona fide death benefit plan is not taxed to the participant, as long as the amount of the funding complies with the qualified direct cost rules under the IRC and the coverage is provided to top hat employees and independent contractors under a plan referenced under Treas. Reg. §31.3121 (v) (2) as adopted by the no profit organization. As with any form of employer funded welfare benefit plan the participant will be taxed on the Table 2001 economic benefit. This additional income should be reflected on the participants W-2 and referenced in box 12 C. Upon the termination of the funding the economic benefit will also terminate Rev Rul 66-110.

As with all planning opportunities the non-profit organization should review the application of this intellectual capital with competent advisers to assure its goals are met.

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Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP®, AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions. To learn more, visit www.mycpo.net.