Art by Tim BowerIn my previous column, I discussed how new Internal Revenue
Service (IRS) rules for nonqualified deferred compensation (NQDC) plans offered
by governmental and tax-exempt institutions will ease operation of those plans.
In this column, I will concentrate on salary deferrals.
As noted, a corollary
to the rule that taxation occurs on vesting is that there must be a realistic
possibility of forfeiture of the deferred amount if the worker terminates
employment before the vesting date. For this reason, the IRS had indicated that
its new rules would not respect salary deferral elections, as no rational
employee would subject to a risk of forfeiture an amount he could elect to
receive currently. The proposed regulations also backtrack on this threat,
which would have limited contributions made by employers to 457(f) plans.
Under the proposed regulation, initial deferrals of current
salary must meet conditions similar to those required with respect to NQDCs
under Section 409A of the Internal Revenue Code (IRC). Thus, the deferral must
be reflected in a written agreement entered into by the employer and employee
before the beginning of the calendar year in which the services are to be
In the case of new employees, the salary deferral agreement
must be entered into within 30 days after the commencement of employment. As in
the case of extensions of the vesting period, the period of substantial future
services or adherence to an agreement not to compete must be at least two
years, and the amount to be paid upon lapse of these conditions must be more
than 125% of the amount deferred.
IRC Section 409A, which became effective in 2005, reformed
the rules for deferred compensation by restricting the ability of employees to
accelerate or otherwise modify the time for receiving deferred compensation
once the time for payment has been established. Amounts are not considered to
be deferred compensation for this purpose if they must be paid no later than
two and a half months after
the employee’s or employer’s taxable year in which the right
to the payment is no longer subject to a substantial risk of forfeiture.
The new proposed 457(f) regulations adopt a similar rule for
that type of plan, so that the new 457 requirements will not apply in the event
of such a short-term deferral. The proposed 457 regulations provide that the rules
under Section 457 apply to 457(f) plans separately and in addition to the
requirements of Section 409A. Accordingly, a 457(f) plan may also be an NQDC
plan subject to Section 409A. The interplay between these provisions can be
As noted, plan benefits will be included in a participant’s
gross income for income tax purposes when the risk of forfeiting the particular
benefit lapses. The amount to be included will generally be the present value
of the benefit as of such date, discounted pursuant to a reasonable interest
rate and multiplied by a factor that reflects the possibility of non-payment,
except that the funded status of the plan or the unwillingness or inability of
the employer to pay are disregarded for this purpose.
Under an account balance plan, however, the present value is
generally the amount credited to the participant’s account—including the
principal amount and any credited earnings or losses—provided that earnings and
losses are credited at least annually.
If the amount included for tax purposes exceeds the eventual
payout—e.g., because of investment performance—the participant will be entitled
to a deduction in the tax year in which the amount is permanently lost. The
amount of the deduction, which would be subject to the limitations applicable
to miscellaneous itemized deductions, would be equal to the amount previously
included in income less the total amount of compensation actually paid or made
For purposes of the income tax deduction, an amount is not
treated as permanently lost if another amount or an obligation to make a
payment in a future year is substituted for the original amount. If an amount
is lost and subsequently replaced with a right to another amount or benefit that
is subject to a risk of forfeiture, the risk of forfeiture will be disregarded
unless the 125% and two-year deferral requirements are satisfied.
If a plan that provides for deferred compensation is amended
to substitute a different benefit that does not come within the definition of
deferred compensation—e.g., health benefits for cash—the plan will,
nevertheless, retain its status as a plan that provides for deferred
compensation. However, health benefits converted to cash would transform the
plan into one of deferred compensation.
The new 457(f) regulations will not be effective until the
calendar year that begins after publication of the final rule.
Marcia Wagner is an expert in a variety of employee benefits
and executive compensation issues, including qualified and non-qualified
retirement plans, and welfare benefit arrangements. She is a summa cum laude
graduate of Cornell University and Harvard Law School and has practiced law for
29 years. Wagner is a frequent lecturer and has authored numerous books and