The Internal Revenue Service (IRS) has issued long-anticipated proposed regulations governing Internal Revenue Code (Code) Section 457(f), which applies to nonqualified, unfunded deferred compensation plans or arrangements established by state and local governments and tax-exempt employers. The proposed regulations and related proposed regulations under Code Section 409A were published in the Federal Register on June 22, 2016.

The proposed regulations make changes to the 2003 final regulations issued under Section 457 and provide guidance on certain issues that were not addressed in the 2003 final regulations. This Client Alert covers key topics addressed in the proposed regulations under Section 457. Future Client Alerts will cover key topics addressed in the proposed regulations issued under Section 409A.

The 457(f) Proposed Regulations Include These Key Points and More

The proposed regulations provide that if structured appropriately:

  • “Short-term deferrals” are not subject to Section 457(f).
  • Covenants not to compete may be used to create a substantial risk of forfeiture.
  • A rolling risk of forfeiture feature may be used to extend a substantial risk of forfeiture.
  • A substantial risk of forfeiture may be applied to current compensation (i.e., elective deferrals).


In general, the proposed regulations will apply to compensation deferred under a plan for calendar years beginning after the date the IRS adopts the proposed regulations as final regulations (the “applicability date”), including deferred amounts to which the participant’s legally binding right arose during prior calendar years that were not previously included in income. Employers may rely on the proposed regulations until the applicability date.

Definition of “Deferral of Compensation” under Section 457

A nonqualified plan or arrangement (collectively referred to as a “plan” or “plans” in this Alert) that provides for the deferral of compensation but fails to meet the requirements of Section 457(b) is considered an “ineligible plan” that is subject to Section 457(f). Prior to the issuance of the proposed regulations, it was unclear how certain aspects of deferred compensation would be treated for purposes of Section 457(f). Under the proposed regulations, a plan generally provides for the deferral of compensation if the participant has a legally binding right during a tax year to compensation that is or may be payable in a later tax year. The proposed regulations state that a participant does not have a legally binding right to compensation if the employer may unilaterally reduce or eliminate the compensation.

Plan Amendments

Whether a plan provides for the deferral of compensation is based on the terms of the plan and the facts and circumstances at the time the participant obtains a legally binding right to the compensation. If a plan does not provide for the deferral of compensation but is amended to do so, a participant may obtain a legally binding right to compensation for purposes of Section 457(f) at the time of the amendment.

The proposed regulations also state that if a Section 457(f) plan is amended to exchange a participant’s right to deferred compensation for some other right or benefit that would otherwise be excluded from the participant’s gross income, post-amendment the plan will still be considered to provide for the deferral of compensation (and will still be subject to Section 457(f)).

Example 1: An employer sponsors a plan that provides for retiree health benefits and that does not provide for the deferral of compensation. If the employer amends the plan to provide participants with future cash payments instead of retiree health benefits, it may become a plan that provides for the deferral of compensation at the time of the amendment (and become subject to Section 457(f)).

Example 2: If a plan that provides for the deferral of compensation is amended to provide health benefits instead of cash, the plan will retain its character as a plan that provides for the deferral of compensation.

Short-term Deferrals

As anticipated, the proposed regulations adopt the “short-term deferral exemption” concept from Section 409A. Under the proposed regulations, a deferral of compensation does not occur (and therefore the compensation is not subject to Section 457(f)) if the compensation is required to be paid and is actually or constructively paid on or before the 15th day of the third month following the end of the employee’s or the employer’s tax year (whichever is later) in which the employee’s right to the payment is no longer subject to a substantial risk of forfeiture.

Example 3: If a plan provides for the payment of a bonus on or before March 15 of the year following the year in which the employee’s right to the bonus is no longer subject to a substantial risk of forfeiture (as defined in the proposed regulations and in Section 409A) and the bonus is paid on or before that March 15, the plan would not provide for the deferral of compensation within the meaning of Section 457(f) or Section 409A.

Certain Other Exceptions

The proposed regulations also provide that a deferral of compensation for purposes of Section 457(f) does not occur to the extent a plan provides for:

  • The payment of expense reimbursements, medical benefits, or in-kind benefits as described under the applicable regulations of Section 409A.
     
  • Certain indemnification rights, liability insurance, or legal settlements as described under the applicable regulations of Section 409A.
     
  • Taxable educational assistance benefits for an employee (but not for the employee’s spouse, child or other family member) as described in Section 127(c)(1).
     
  • Recurring part-year compensation, provided (i) payment of the recurring part-year compensation is not deferred beyond the last day of the 13th month following the first day of the period of service over which it is earned, and (ii) the recurring part-year compensation does not exceed the annual compensation limit applicable to qualified plans for the calendar year in which the service period begins (this limit is $265,000 for 2016).

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.

Drinker Biddle Comment: While Section 409A and Section 457(f) both apply to ineligible plans, the rules are not identical. For example, the definition of “substantial risk of forfeiture” differs.

Substantial Risks of Forfeiture

Current Law

As discussed above, benefits subject to Section 457(f) are taxable when they are no longer subject to a substantial risk of forfeiture. Section 457(f) provides that benefits conditioned upon “the future performance of substantial services” are subject to a substantial risk of forfeiture, but the 2003 regulations did not provide additional guidance regarding the meaning of substantial risk of forfeiture. IRS rulings have provided some insight, resulting in the common use of certain features, including:

  • Covenants Not to Compete: Covenants not to compete have been used to create a substantial risk of forfeiture, permitting the payment of the Section 457(f) benefit (and thus avoiding forfeiture of the benefit) in the event of voluntary terminations of employment (including retirement).
     
  • Rolling Risk of Forfeiture: A “rolling risk of forfeiture” feature by which the employer and employee to mutually agree to delay the vesting date (i.e., lapse of the substantial risk of forfeiture) by written election of the employee made at least one year before vesting would otherwise have occurred.
     
  • Employee Compensation Deferrals: Use of an employee deferral election to defer the receipt of compensation on a tax-deferred and forfeitable basis subject to a substantial risk of forfeiture.

In 2007, the IRS issued Notice 2007-62, announcing its intent to issue guidance that would apply the Section 409A definition of “substantial risk of forfeiture” to Section 457(f) benefits. This would result in the features described above no longer creating a substantial risk of forfeiture for Section 457(f) purposes. Many plan sponsors and practitioners have resisted eliminating these features in hopes that the guidance ultimately issued will allow more flexibility than suggested in Notice 2007-62.

The Proposed Regulations

As many had hoped, the proposed regulations do not adopt the same definition of substantial risk of forfeiture that applies under Section 409A. While the definition in the proposed regulations is similar, it differs in several respects.

Substantial Risk of Forfeiture in General

Under the proposed regulations, an amount is generally subject to a substantial risk of forfeiture only if entitlement to that amount is conditioned on:

  1. The future performance of substantial services (e.g., the hours required to be performed are substantial in relation to the amount of compensation), or
     
  2. The occurrence of a condition that is related to a purpose of the compensation (i.e., one that relates to the employee’s performance of services or to the employer’s tax-exempt/governmental activities or organizational goals) if the possibility of forfeiture is substantial.

An amount is not subject to a substantial risk of forfeiture if the facts and circumstances indicate that the forfeiture condition is unlikely to be enforced, based on, among other things, the past practices of the employer, the level of control or influence of the employee and the enforceability of the provisions under applicable law.

Drinker Biddle Comment: An arrangement to pay a significant amount to a departing executive for consulting services “as needed” or for an insignificant amount of time during the consulting period will not create a substantial risk of forfeiture.

Amounts Payable upon Involuntary Terminations

Under the proposed regulations, an amount payable upon an involuntary termination of employment without cause or upon a voluntary termination for good reason is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial. A termination is for “good reason” if it results from a unilateral action taken by the employer and causes a material adverse change to the working relationship, such as a material reduction in duties, working conditions or pay. The “good reason” events must be pre-established in writing (which, if later changed, may constitute a rolling risk of forfeiture). The proposed regulations also provide a safe harbor definition of termination for good reason which is similar to the safe harbor definition under the Section 409A regulations.

Covenants Not to Compete as Substantial Risks of Forfeiture

Under the proposed regulations, compensation contingent upon compliance with a covenant not to compete will be considered subject to a substantial risk of forfeiture if, and only if:

  • The covenant not to compete is pursuant to a written agreement that is enforceable under applicable law;
     
  • The employer consistently makes reasonable efforts to verify compliance with all of the noncompetition agreements to which it is a party (i.e., not just the noncompetition agreement at issue); and
     
  • At the time the agreement is entered into, the facts and circumstances show that the employer has a substantial and bona fide interest in preventing the employee from competing and that the employee has a bona fide interest in competing.

Drinker Biddle Comment: Factors to be considered with respect to the last requirement include whether the employee is near retirement age, the marketability of the employee, whether the employee has any interest in continuing to work, and the potential harm the employer would experience if the employee competed.

Rolling Risks of Forfeiture and Elective Deferrals

The proposed regulations permit rolling risks of forfeiture (i.e., the ability to extend the period covered by a substantial risk of forfeiture) as well as elective deferrals of current compensation (i.e., the application of a substantial risk of forfeiture with respect to the amount deferred) if the following conditions are met:

  1. The present value of the amount to be paid upon lapse of the substantial risk of forfeiture (as extended, if applicable) must be materially greater (i.e., more than 125 percent) than the amount the employee otherwise would be paid absent the substantial risk of forfeiture (or absent the extension);
     
  2. The initial or extended substantial risk of forfeiture must be based upon the future performance of substantial services or compliance with a covenant not to compete;
     
  3. The period for which substantial future services must be performed must be at least two years, subject to earlier payment upon death, disability, or involuntary severance from employment without cause; and
     
  4. The parties must agree in writing to the addition or extension, as follows:
  1. For initial deferrals of current compensation, the agreement must be made in writing before the calendar year in which any services giving rise to the compensation are performed;
     
  2. For rolling risks of forfeiture, the agreement must be made in writing at least 90 days before the date on which the existing substantial risk of forfeiture would have lapsed; and
     
  3. For a newly hired employee, the agreement must be made in writing within 30 days after hire, but only with respect to amounts attributable to services rendered after the addition or extension is agreed to in writing.

Drinker Biddle Comment: The use of rolling risks of forfeiture and employee elective deferrals provide significant planning opportunities for tax-exempt employers.

Taxation under Section 457(f)

Compensation deferred under a Section 457(f) plan is includible in gross income on the “applicable date,” which is the first date on which the participant obtains a legally binding right to the compensation or, if later, the first date on which the compensation is no longer subject to a substantial risk of forfeiture (as defined in the proposed regulations). The amount includible in income on such date is equal to the present value of the compensation deferred (including earnings). Subsequent earnings are includible in gross income when paid or made available to the participant.

Determination of Present Value

As explained below, the method of determining present value differs depending on the nature of the deferred compensation. The rules for determining present value for Section 457(f) purposes are substantially similar to the rules contained in the Section 409A proposed regulations; the proposed regulations provide the guidance on this point that was previously absent. One important distinction, however, is that the present value calculation under Section 457(f) is determined as of the applicable date, whereas the present value calculation under Section 409A is determined as of the end of the service provider’s tax year.

  • In General. The present value of compensation deferred under a Section 457(f) plan equals the present value of the future payments to which the participant has a legally binding right. Accordingly, the present value is determined by multiplying the amount of the payment (or the amount of each payment in a series of payments) by the probability that any conditions on which the payment is contingent will be satisfied and discounting the amount using a reasonable assumed rate of interest to reflect the time value of money. When assessing the probability that payment will be made, the likelihood of death occurring prior to payment may be considered only to the extent the payment is forfeitable upon death. Certain other factors (such as the unfunded status of the plan or the possibility of future amendments) cannot be taken into account for this purpose.
     
  • Account Balance Plans. If benefits are provided under a Section 457(f) account balance plan to which earnings are credited at least annually, present value is generally equal to the amount credited to the participant’s account (including earnings) on the applicable date. However, if the participant’s account balance is not determined using a predetermined actual investment or a reasonable rate of interest, present value is equal to the amount credited to the participant’s account, plus the present value of the excess of any earnings to be credited under the plan over the earnings that would be credited, had a reasonable rate of interest been used.
     
  • Formula Amounts. The proposed regulations contain special rules for determining the present value of “formula amounts,” which are amounts payable by reference to one or more factors that are indeterminable on the applicable date. For purposes of determining the present value of formula amounts, the amount of future payments under the Section 457(f) plan involves a facts and circumstances analysis using reasonable, good faith assumptions with respect to any contingencies as to the amount of the payment.
     
  • Other Special Rules. The proposed regulations contain special rules for determining present value when benefits are paid based upon specified events (including severance from employment), are subject to payment restrictions, or offer alternative times and forms of payment. There are also special rules for purposes of determining present value under in-kind benefit arrangements and split-dollar arrangements. These special rules are beyond the scope of this client alert.

If amounts are includible in income under Section 457(f) but the compensation subsequently paid or made available is less than the amount included in income (e.g., due to a forfeiture that occurs after the participant has included the amount in income), the participant is entitled to a deduction for the tax year in which the entire remaining right to the amount is permanently forfeited. The amount of the deduction is equal to the excess of the amount included in income under Section 457(f) over the amount of compensation actually received that constitutes the participant’s investment in the contract (as defined in the proposed regulations).

If you have any questions or would like assistance with any of the matters discussed in this alert, contact any member of our Employee Benefits and Executive Compensation Practice Group.

View a PDF version of the alert.