Government Plans Will Receive Face-Lift

Art by Tim BowerGovernmental employers and tax-exempt institutions operate under significant restrictions when offeringnonqualified deferred compensation (NQDC) plans to management and other key employees. After signaling to these employers that further restrictions were in the offing, the Internal Revenue Service (IRS) recently issued a package of proposed regulations revamping the rules governing so-called “ineligible plans” or “Section 457(f) plans”; the rules are, in fact, more liberal than anticipated and will make it easier to design and operate these plans.

Section 457(f) plans, named after the Internal Revenue Code (IRC) provision that controls the tax treatment of their participants, are to be distinguished from 457(b) plans—or “eligible plans”—the other type of NQDC plan that may be maintained by government and tax-exempt employers. Unlike 457(b) plans and tax-qualified plans such as 401(k)s, there is no limit on the amount that may be deferred under a 457(f) plan. However, 457(f) plans suffer an important disadvantage when compared with those other types of plans; specifically, the amounts deferred are taxable to the employee when they become vested, rather than when they are paid to him. As a result, 457(f) plans can only be offered to highly compensated employees, because their benefits are neither secured nor vested.

In order to prevent contributions and earnings to a 457(f) plan from being taxed when credited, plans generally subject them to a “substantial risk of forfeiture” that delays taxation until the year the forfeiture provisions lapse. The proposed regulations continue the special treatment afforded by current rules stating that earnings accruing after a contribution has initially vested become taxable only when paid or made available to the participant.

A substantial risk of forfeiture under a 457(f) plan typically makes the right to payment of plan benefits conditional on the performance of future services measured by time served. Benefits can also be conditioned on the achievement of organizational goals, but only if they are combined with time-based requirements. An amount is not subject to a substantial risk of forfeiture if the surrounding facts and circumstances indicate that the condition is unlikely to be enforced. Death, disability and involuntary employment termination other than for cause are events that enable vesting to be accelerated without meeting the original conditions.

In addition, under the proposal, compliance with a covenant not to compete may be a substantial risk of forfeiture if: it is in writing; the employer makes reasonable ongoing efforts to verify compliance with non-competition agreements generally and has a substantial and bona fide interest in enforcing non-compete agreements; and the employee has such an interest in engaging in prohibited competition. Thus, special circumstances would need to be shown in order to support a risk of forfeiture if an employee has attained retirement age and is, for that reason, unlikely to engage in competition with the employer. The position taken by the proposed regulations on covenants not to compete is a reversal of prior IRS announcements that forthcoming rules would fail to honor them.

Rolling Risk of Forfeiture
In the past, some 457(f) plans have allowed employees to extend the date when a risk of forfeiture would lapse, shortly before it occurred, in order to delay taxation. Under this technique, referred to as a “rolling risk of forfeiture,” a five-year vesting period could be extended for another five years, provided the extension was elected before the end of the employee’s fifth year of service under the plan. An employee who wished to defer taxation would extend the period during which plan benefits would be subject to the risk if he felt comfortable that employment would continue until the extended vesting date. The IRS had stated that a rolling risk of forfeiture would be disregarded for purposes of determining whether deferred compensation is subject to a substantial risk of forfeiture.

The proposed regulations also relax the IRS’ restrictive stance on rolling vesting. Under the proposed rule, a risk of forfeiture may be extended if it is made pursuant to a notice executed at least 90 days before the existing forfeiture would have lapsed. In addition, the employee must be required to perform substantial services in the future or refrain from competing for a minimum period of two years after the original vesting date, subject to lapsing of the condition in the event of death, disability or termination of employment without cause. Finally, the present value of the amount subject to the extension must be more than 125% of the present value of the amount the employee would have received if the extension had not occurred.

In my next column, I will discuss salary deferrals.

Marcia S. 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 articles.