Category Archives: Section 457(b) Plans

Beyond the 403(b) Plan: Top 5 Things to Know About Deferred Compensation for Non-Profit Executives

Tax-exempt employers may offer deferred compensation plans to their select executives to allow for retirement savings over and above the dollar limits applicable under a Section 403(b) plan. However the rules governing these arrangements, which fall under Section 457 of the Internal Revenue Code (Code), are complex and often misunderstood.  Below are five things top things to keep in mind in this area, to get the most that the law offers without unpleasant tax surprises along the way.

1.  It’s complicated……

First, there are two types of 457 plans: 457(b) plans and 457(f) plans.  A tax-exempt employer can use both for the same executives but careful planning is advised.  The (b) plans allow set-aside (in the form of employee deferrals or employer contributions) of only $18,000 (in 2017) per year, with no age 50+ catch-up allowance.  Amounts set aside under a (b) plan are not taxed until they are distributed to the executive, an event which must be delayed until termination of employment/retirement, or on the occurrence of unforeseeable circumstances (narrowly defined).  Taxation is delayed until distribution even though the amounts are generally “vested” (no longer subject to forfeiture) when they are contributed.  By contrast there is no dollar limit on the amount that may be set aside under a 457(f) plan (subject to item no. 4, below), but the amounts are taxable upon completion of a vesting schedule (e.g., from 3 to 10 years).  Therefore distribution in full almost always happens upon completion of vesting.  Put most simply, (b) plans are a good way to double an executive’s 403(b) deferral budget, and (f) plans are a good way to help an executive catch up on retirement savings when a retirement or other departure date is within a 3 to 10 year time horizon. Further, in order for an exemption from ERISA to apply, participation in these plans must be limited to a “select group of management or highly compensated employees,” comprising no more than 5% – 10% of the total workforce, referred to as the “top-hat” group.  In a small tax-exempt employer with 10 or 20 employees this may mean only 1 or 2 executives may participate.

2.  You (usually) can’t roll to an IRA.

Generally when an executive is ready to take distribution of benefits from a 457(b) or (f) plan a taxable cash distribution is required, and rollover to an IRA is not an option. (One exception is when the executive moves to a new employer that maintains a 457(b) plan that accepts rollover contributions).  Under a (b) plan, which may allow installment distributions over a period of years, the lack of an IRA rollover option is not so severe, but in a 457(f) plan setting, which generally calls for lump-sum distributions, the tax impact can be severe and the executives should be advised to do advance tax planning with their own CPAs or other tax advisors, well ahead of their planned retirement date or other vesting trigger.  In my experience, lack of the IRA rollover option often comes as an unwelcome surprise to the covered executives.

3.  The assets belong to the organization.

Section 457 plans are non-qualified meaning in relevant part that they assets the plans hold belong to the tax-exempt organization that sponsors the plan until the date(s) they are paid out to the participants. The assets must be held in an account in the name of the organization “FBO” the 457 plan account for the name of the executive.  There is no form of creditor protection but it is possible to put in place a “rabbi trust,” so called because the trust format was first approved by the IRS on behalf of a synagogue for its spiritual leader.  The rabbi trust will not protect the 457 assets from the organization’s creditors, but it will prevent the organization from reneging on the deferred compensation promise to an executive.  This is particularly helpful for an organization that anticipates changes in its board structure after approval of a 457 arrangement.

4.  The normal “reasonable compensation” rules still apply.

Tax-exempt organizations must pay only reasonable compensation, in light of the services provided, to employees and other individuals who comprise “disqualified persons,” a category that includes executive directors and other “C-suite” members. Under the “intermediate sanction” regime the IRS imposes excise taxes on individuals who benefit under, and organization managers (e.g., board members) who approve, compensation arrangements that fail the reasonableness standard.  Deferred compensation arrangements must be reasonable in light of all other compensation and benefits provided to the executives in question and in most cases this will require a third-party compensation consultant’s evaluation and review.  This is a vitally important and often-overlooked piece of deferred compensation compliance in the tax-exempt arena.

5.  DOL notification is required.

As part of the ERISA exemption for top-hat deferred compensation plans, a tax-exempt organization must provide a “top-hat notification letter” to the Department of Labor within 120 days of implementing such a plan. Top-hat letters must be filed electronically.  Failure to timely file a top-hat letter could mean that your deferred compensation plan is liable for ERISA penalties for failure to file annual information returns (Form 5500), to hold plan assets in trust, to make certain disclosures to participants, and on a host of other compliance points.  The Department of Labor permits late filing of top-hat notification letters for payment of a modest fee.  If your organization has a deferred compensation plan in place you should have ready access to a copy of the top-hat notification letter (or confirmation of its online filing) and should consider the DOL correction program if you cannot do so.

Having practiced law in Santa Barbara, California, a haven for charitable organizations, for over 20 years I have had the privilege of working with these special deferred compensation plan rules in many different factual settings and would be happy to help your organization navigate them in order to best retain and reward your valued executives.

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Filed under 403(b) Plans, Benefit Plan Design, Section 457(b) Plans, Section 457(f) Plans, Tax-Exempt Organizations, Top-Hat Exemption

IRS Announces New Benefit Limits for 2017

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On October 28, 2017 the IRS announced 2017 cost-of-living adjustments for annual contribution and other dollar limits affecting 401(k) and other retirement plans.   Salary deferral limits to 401(k) and 403(b) plans remained unchanged for the second year in a row, but other dollar limit adjustments were made. Citations below are to the Internal Revenue Code.

Limits That Remain the Same for 2017 Are As Follows:

–The annual Salary Deferral Limit for 401(k), 403(b), and most 457 plans, currently $18,000, stays the same.

–The age 50 and up catch-up deferral limit, currently $6,000, also remains the same. For 2017 as in this year, the maximum salary deferral an individual age 50 or older may make is $24,000.

–The compensation threshold for determining a “highly compensated employee” remains unchanged at $120,000.

–Traditional and Roth IRA contributions and catch-up amounts remain unchanged at $5,500 and $1,000, respectively.

–The compensation threshold for SEP participation remained the same at $600.

–The SIMPLE 401(k) and IRA contribution limit remained the same at $12,500.

Limits That Changed for 2017 Are As Follows:

–The maximum total annual contribution to a 401(k) or other “defined contribution” plan under 415(c) increased from $53,000 ($59,000 for employees aged 50 and older) to $54,000 ($60,000 for employees aged 50 and olded).

–The maximum annual benefit under a defined benefit plan increased from $210,000 to $215,000.

–The maximum amount of compensation on which contributions may be based under 401(a)(17) increased from $265,000 to $270,000.

-The compensation dollar limit used to determine key employees in a top-heavy plan increased from $170,000 to $175,000.

In a separate announcement, the Social Security Taxable Wage Base for 2017 increased from $118,500 to $127,200.  

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Filed under 401(k) Plans, 403(b) Plans, Benefit Plan Design, COLA Increases, ERISA, IRA Issues, Profit Sharing Plan, Section 457(b) Plans

Section 457(f) Gets Its Groove Back

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In June of this year the IRS issued proposed regulations under Section 457 of the Internal Revenue Code (“Code”) that primarily affect “ineligible” plans under Code § 457(f).  These are plans for employees of governmental entities and tax-exempt employers, limited in the latter instance to a select group of management or highly compensated employees (the “top-hat” group), that permit deferral of compensation in excess of the limits that apply under Code § 457(b).  Our prior post looked at some exceptions to these rules; this post focuses on when deferred amounts are subject to a substantial risk of forfeiture or “SROF.”

Amounts set aside under Section 457(f) plans must be included in the executive’s taxable compensation once the amounts are no longer subject to a “substantial risk of forfeiture,” for instance upon completion of a vesting schedule. Due to the requirement that income inclusion/taxation occur when the risk of forfeiture lapses, Section 457(f) plans generally work best when retirement is in the fairly near future (e.g., 2 to 7 years out), and where vesting occurs on or near the anticipated retirement date.

Traditionally it was not uncommon under Section 457(f) plans for organizations to push back a previously established vesting date, to allow the executive to work additional years for the organization without triggering taxation of their plan accounts. This practice of “rolling vesting” was popular for the planning flexibility it allowed.  Another popular practice under Section 457(f) plans was to use a covenant not to compete to prolong the substantial risk of forfeiture (and hence postpone taxation) for several years after an executive’s departure.

Both of these practices – “rolling” vesting, and use of covenants not to compete, came under a cloud, however, when the Congress passed legislation in 2005 that included a comprehensive set of rules governing nonqualified compensation plans. The rules, codified at Section 409A of the Code, were passed due to perceived and actual abuses of deferred compensation plans (for instance, the Enron executives triggered acceleration clauses under their plans when they foresaw the company’s demise).  Section 409A disallowed acceleration clauses and imposed a plethora of other design restrictions on nonqualified deferred compensation.  Section 409A was expressly made applicable to Section 457(f) plans, but final regulations issued in 2007 did not fully explain the intersection of Sections 409A and 457(f).  Separate guidance, in the form of Notice 2007-62, suggested that when formal guidance did issue, it would not recognize rolling vesting as a legitimate tax deferral measures.  Final Section 409A regulations expressly disallowed covenants not to compete as means of creating a substantial risk of forfeiture.  Therefore, for nine years, risk-averse sponsors of Section 457(f) plans have avoided rolling vesting and covenants not to compete, and have accustomed themselves to the stricter, post-Enron plan design rules.

As explained in the chart below, the proposed 457 regulations have resurrected rolling vesting, and also permit a covenant not to compete to create a substantial risk of forfeiture, subject in both instances to some tricky prerequisites.  This added design flexibility for 457(f) plans is good news for non-profit organizations, which increasingly must compete for talent with for-profit organizations.

457(f) SROF Chart

Also welcome is an updated definition of “substantial risk of forfeiture” which harmonizes with the Section 409A definition. Specifically, compensation is subject to a substantial risk of forfeiture under 457(f) when entitlement to it is conditioned upon:

  • the performance of substantial services (generally at least 2 years, unless earlier terminated by death, disability, or involuntary termination, including for “good reason”), or
  • the occurrence of a condition that is related to the purpose of the compensation, (such as a performance goal for the employee, or to the employer’s tax-exempt or governmental activities (such as completion of a funding campaign).

As under 409A, there is no SROF if the facts and circumstances suggest that the employer is unlikely to enforce the forfeiture condition.   Relevant facts and circumstances include the employer’s past practices in enforcing (or not enforcing) forfeitures, the level of the benefitted executive’s control of or influence over the organization, and the likelihood that the conditions would be enforceable under applicable law.

The proposed 457 regulations may be relied upon until the effective date (the “applicability date”) of the final regulations, which will follow their publication in the Federal Register. Transition relief applies only to certain union and governmental plans, such that risk-averse plan sponsors should consider taking steps to voluntarily comply with the proposed regulations in advance of the applicability date.

Finally, compensation for the non-profit executive must meet reasonableness standards or it will potentially trigger excise taxes under Code Section 4958.  This standard applies to deferred compensation amounts, and increases in those amounts, including, arguably, the minimum increase necessary under the new rolling risk of forfeiture rules.

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Filed under Benefit Plan Design, Nonqualified Deferred Compensation, Section 409A, Section 457(b) Plans, Section 457(f) Plans

Chart of Section 457(f) Carve-Outs Under New Proposed Regulations

The IRS recently announced proposed regulations under Internal Revenue Code (“Code”) Section 457 that update prior, final regulations issued in 2003 and other subsequent guidance from IRS.  Section 457 governs deferred compensation rules for government employees, and for executives of private, tax-exempt organizations it permits deferrals from compensation over and above limits set forth in Code § 403(b).  The proposed Section 457 regulations impact “ineligible” deferred compensation plans under Code § 457(f) more substantially than “eligible” deferred compensation plans under Code § 457(b) which were more comprehensively covered in the 2003 final regulations.

By contrast to eligible Section 457(b) plans, which limit annual contributions to $18,000, as adjusted for inflation (and without the age 50 catch-up for private non-profit executives), there is no dollar limit on annual contributions to a Section 457(f) plan (although as explained below other laws do set reasonableness limits upon nonprofit executive compensation in general).   However, amounts set aside under Section 457(f) plans must be included in the executive’s taxable compensation once the amounts are no longer subject to a substantial risk of forfeiture, for instance upon completion of a vesting schedule, even if amounts are not physically paid out from the plan.  Due to the requirement that income inclusion/taxation occur when the substantial risk of forfeiture lapses, Section 457(f) plans generally work best when retirement is in the fairly near future (e.g., 5 to 7 years out), and where vesting occurs on or near the anticipated retirement date.

As summarized in the chart, below, the proposed regulations clarify how certain pay arrangements are carved out from Section 457(f) compliance, either because the arrangement is not deemed to provide for a deferral of compensation, or because it defers compensation but not in a manner that does not fall under Code § 457(f). Where no deferral of compensation occurs, the pay arrangement generally is also exempt from the “Enron rules” applicable to for-profit deferred compensation plans under Code § 409A, and related regulations.  (Final regulations under Code § 409A were published in 2007; the second of two sets of proposed regulations were published the same day as the proposed Section 457 regulations).  The proposed Section 457 regulations clarify that Section 457(f) arrangements generally are also subject to Code § 409A, although there are some important distinctions between the two sets of rules which I will address in a future post.

457(f) Chart

 

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Filed under 403(b) Plans, COLA Increases, Fringe Benefits, Nonqualified Deferred Compensation, Section 409A, Section 457(b) Plans, Section 457(f) Plans