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.