Section 457(f) is a special Tax Code provision that deals with
the taxation of certain deferred compensation arrangements for
workers employed by tax-exempt organizations, such as hospitals and
universities, and state and local governments. It covers
arrangements that do not meet the special qualification
requirements in other parts of Section 457.
Under the statute, any worker covered by a plan to which Section
457(f) applies will have current income at the time his/her
employer unconditionally agrees to pay compensation to him/her in
the future, or when an initially forfeitable promise to
pay compensation to him/her in the future ceases to be forfeitable.
Workers in the private sector are treated more favorably under a
different Tax Code provision-Section 409A. For them, under a
properly drafted and administered program, deferred compensation
will not become taxable until it is actually paid, although the
failure to satisfy 409A's requirements will trigger not only
current income but also a 20 percent excise tax.
There are some helpful statutory provisions that, if applicable,
will remove some deferrals from coverage under the current
inclusion rules in Section 457(f). By its terms, the provision does
not apply to qualified retirement and annuity plans, property
transfers to which Tax Code Section 83 applies, and nonqualified
trusts covered by Tax Code Section 402(b). Also, 457(f) does not
affect bona fide vacation, sick leave, disability pay,
severance pay and death benefit plans, because they are treated as
not providing for a deferral of compensation.
In the past, the Internal Revenue Service has provided very
little guidance on how to interpret Section 457(f) - most
significantly on when a deferred benefit ceases to be forfeitable
and what is a bona fide severance pay plan.
Intending to fill in the gaps, the government has now proposed
regulations under Section 457(f). This article summarizes questions
addressed by the proposed regulations and the government's proposed
positions. Many provisions are based on previously finalized
regulations under Section 409A.
In general, what is Section 457(f) deferred
A worker's compensation will be deemed to have been deferred if,
under the terms of a plan, he/she currently has a legally binding
right to the compensation but it is or may be payable in a later
calendar year. Facts and circumstances are critical. A legally
binding right will not exist if the employer has the unilateral
right to reduce or eliminate compensation once it has been earned
by performing services.
Compensation not initially treated as deferred compensation can
turn into a deferral at a later date. As an example, the proposed
regulations cite a retiree health care plan that is amended to
allow participants to receive future cash payments instead of
Even if technically "deferred compensation," some deferrals fall
outside the scope of Section 457(f) due to some useful exceptions
in the proposed regulations. These are taken from the final
regulations under Section 409A. A deferral of compensation will not
occur to the extent a plan provides:
A short-term deferral - due not more than 2-½ months after the
end of the worker's or employer's tax year in which the
compensation vests, applying the definition of a substantial risk
of forfeiture under the 457(f) regulations,
"Recurring part-year compensation" that does not exceed the
annual qualified retirement plan limit ($270,000 for 2017) - like
the annual salary of a permanent teacher who provides services
during a school year comprised of 10 consecutive months but whose
salary is paid over no more than 13 months after the start of
his/her service period,
Expense reimbursements, medical benefits, and in-kind benefits
due in connection with a worker's termination of employment,
whether or not involuntary,
Payments under an indemnification plan, or to purchase an
insurance policy, covering expenses incurred or damages payable by
a worker on account of a bona fide claim against him/her or his/her
Settlements or awards to resolve bona fide legal claims based on
wrongful termination, employment discrimination, the Fair Labor
Standards Act, or worker's compensation statutes, and
Taxable educational expenses for an employee.
What types of plans are
not covered by Section 457 - and
hence not by
An important part of the proposed regulations is the discussion
of certain plans to which none of the provisions of Section 457
apply - because the Tax Code itself excludes them. The definitions
provided are instructive. All excepted plans must be bona fide.
Vacation and Sick Leave Plans
The primary purpose of a bona fide vacation or sick leave plan
is to provide workers with paid time-off due to vacation, sickness
or other personal reasons. A number of relevant facts and
circumstances are listed in the proposed regulations. Positive
factors include a plan's availability to more than a limited number
of employees, the payment of benefits promptly upon a worker's
termination of employment, and the fact that ordinarily benefits
would have been used up in the normal course while the worker was
Disability Pay Plan
A bona fide disability pay plan provides benefits only when a
participant is disabled. One of three definitions of disability
must be met: the participant must be unable to engage in any
substantial gainful activity due to a medically determinable
physical or mental impairment that can be expected to result in
death or last for not less than 12 continuous months, must, for the
same reason, be receiving income replacement benefits for not less
than three months under an employer sponsored accident and health
plan or must be determined to be totally disabled by the Social
Security Administration or the Railroad Retirement Board.
Death Benefit Plan
The term "death benefit" is defined by reference to the
employment tax regulations, under which benefits provided
only upon death may be viewed as having been provided
under a death benefit plan. The proposed regulations make only one
modification. Death benefits may be provided through insurance, in
which case the value of term life insurance coverage that is
included in income is not a prohibited lifetime benefit.
Severance Pay Plan
The most anticipated definition in the proposed regulations
deals with bona fide severance pay plans. In the past, workers and
employers most often sought to have their deferred compensation
arrangements characterized as severance pay plans because Section
457(f) does not apply to them.
Severance is addressed in other regulations promulgated under
the Tax Code and the Employee Retirement Income Security Act of
1974. The proposed 457(f) regulations borrow from them, but it is
important to keep in mind that the Section 457(f) rules have not
been copied verbatim from these other regulations. As a general
matter, a bona severance pay plan must meet three requirements:
benefits can be payable only on involuntary severance from
employment, the amount due can be no more than twice the worker's
annualized pay for the calendar year preceding the calendar year of
severance (the dollar cap in the final 409A regulations does not
apply) and the benefit, per a written plan document, must be paid
in full no later than the last day of the second calendar year
after the year in which the severance occurs. Benefits under
so-called "window programs" and voluntary early retirement
incentive plans are automatically treated as separation pay plans
if the regulatory prerequisites can be met.
What does "involuntary" mean? Essentially, a severance is
involuntary if an employer exercises its unilateral authority to
terminate a worker's services when the worker was willing and able
to continue to work and did not implicitly or explicitly request a
severance. When a worker quits for "good reason," the severance
will be treated as involuntary if it can be demonstrated that
unilateral action on the employer's part caused a material negative
change in the worker's relationship with the employer. In this
context, it is good to be able to show that payments due because of
a severance for "good reason" are equal (i) in amount to, (ii)
payable in the same form as, and (iii) due at the same time as,
benefits payable when an actual involuntary severance occurs. If
the conditions of a regulatory a safe harbor can be met, "good
reason" will be presumed to exist.
When is a benefit not subject to a substantial risk of
forfeiture and hence taxable?
Taxation will not be immediate if a worker's benefits, when
granted, are subject to a "substantial risk of forfeiture." This
concept appears in other Tax Code provisions. However, the proposed
457(f) regulations interpret the concept differently.
Entitlement must be conditioned on the future performance of
substantial services or the occurrence of a condition related to a
purpose of the compensation. In every case, the possibility of
forfeiture must be substantial. Facts and circumstances will
determine whether a substantial risk of forfeiture exists. As an
example of a good forfeiture condition, the government cites
involuntary severance from employment without cause where the
possibility of forfeiture is substantial.
The proposed regulations take the position that, in the right
case, compensation will be treated as forfeitable when payment is
conditioned on not competing with the employer, so long as
there is an enforceable written non-competition agreement, the
employer makes reasonable ongoing efforts to verify compliance, and
at the time the agreement becomes binding, it can be demonstrated
that the employer has a substantial and bona fide interest in
preventing the services, and the worker has a bona interest in
engaging in the prohibited competition and the ability to do
Another helpful aspect of the proposed regulations is their
recognition of rolling risks of forfeiture. As a general rule, an
employer cannot extend a forfeiture condition after a worker
becomes legally entitled to compensation. But the proposed
regulations provide that, under certain defined circumstances, an
employer can. As a threshold matter, the present value of the
amount made subject to the new forfeiture condition must be
materially greater than the present value of the amount the worker
would have received absent the extended risk of forfeiture.
Materially greater is defined to mean more than 125 percent. Two
other conditions must also be met. First, the worker must perform
substantial services (or refrain from competing) for at least two
years after he/she could have received the compensation, unless
there is an intervening death, disability, or involuntary
termination of employment without cause. Second, a written
agreement must be entered into at least 90 days before the existing
substantial risk of forfeiture would have lapsed.
These same provisions are available to workers and employers who
want to introduce a risk of forfeiture where one was not previously
present. Then, the required agreement must normally be entered into
before the start of the calendar year in which any services giving
rise to the compensation subject to the new condition are
When a deferral first becomes taxable, how much is
includible in income?
Determining the taxable amount when deferred compensation first
vests, can be difficult. The proposed regulations tax the present
value of deferred compensation on the first date on which there is
a legally binding right to it, or, in the case of a forfeitable
amount, the first date on which the substantial risk of forfeiture
lapses. Under the basic rule, each payment due must be multiplied
by the probability that any relevant contingency will be satisfied,
and discounted using an assumed rate of interest to reflect the
time value of money. Contingencies that cannot be taken into
account include death (except in the case of a benefit forfeitable
upon death), the unfunded status of a plan, possible future changes
in the law, and investment risk. Special provisions deal with
formula amounts, payment restrictions, and alternative times and
forms of payment.
Fortunately, the proposed regulations provide a more
administrable rule for a plain vanilla "account balance plan,"
under which a worker will receive the principal amount credited to
an unfunded account in his/her name, plus all earnings credited to
that account until the payment date, determined using a fixed rate
of return. If the rate of return is reasonable, the worker will be
taxed on the amount actually credited to the account when his/her
benefit first vests. To be able to apply this provision, an
employer must determine earnings using either an interest rate
permitted under the employment tax regulations dealing with the
current taxability of deferred compensation for FICA purposes or a
return based on a predetermined actual investment, again in
accordance with the employment tax regulations.
When benefits are ultimately paid, will an additional
tax be due?
Once a deferred amount has been taxed under Section 457(f), an
additional tax will be imposed only when the benefit is actually
paid or made available at a later time.
First, it is worth noting that the proposed regulations discuss
some less obvious circumstances under which deferred compensation
will be deemed to have been paid or made available. These include a
transfer or cancellation of a deferral in exchange for benefits
under a tax exempt welfare benefit plan or any other benefit
excludible from gross income. Under these circumstances, the worker
will be deemed to have constructively received cash.
When deferred compensation is actually or constructively paid or
made available to a worker, a worker will realize additional income
- determined by taking into account the amount on which he/she was
previously was taxed. The rules in Tax Code Section 72 apply here,
treating the deferred compensation plan like an annuity contract.
The proposed regulations give an individual an "investment in the
contract," which can be recovered tax-free ratably over the payout
period. The proposed regulations make it clear that a worker will
have an investment in the contract for this purpose only if he/she
actually reported the proper amount of income when his/her deferral
first became subject to tax.
What happens if previously taxed benefits are never
It is not beyond the realm of possibility that a worker will pay
tax on deferrals under Section 457(f) that he/she never receives.
The proposed regulations allow a worker to deduct a previously
taxed amount that is never paid if he/she can be demonstrate that
the compensation is permanently forfeited under a plan's terms or
otherwise permanently lost. A permanent loss does not include an
investment loss or an actuarial reduction in benefits if the worker
retains the right to any payment under the plan. Essentially a
benefit must become wholly worthless.
The bad part about this provision is that the deduction will be
subject to the statutory limitations on miscellaneous itemized
How does 457(f) relate to Section 409A?
Another Tax Code provision dealing with the taxation of deferred
409A, addresses when deferral elections must be made, and when
and how payments under certain deferred compensation arrangements
must occur. Unfortunately, Sections 457(f) and 409A can both apply.
This means that a footfall under 409A can trigger an additional 20
percent excise tax under Section 409A when deferrals not taxed
under Section 457(f) are or become subject to 409A - for example,
if 457(f) benefits are accelerated. The moral here is that, when
putting together and administering a deferred compensation program
for its workers, a tax-exempt organization or state or local
government may need to satisfy the requirements of 409A to the
extent they are different from those in 457(f).
When do the provisions in the proposed regulations take
The provisions in the proposed 457(f) regulations, when
finalized, will generally apply to compensation deferred for
calendar years beginning after the Treasury Decision adopting the
provisions is published in the Federal Register. The effective date
is not entirely prospective. The final regulations will affect
deferred amounts to which a legally binding right arose in prior
calendar years that were not previously included in
There are special deferred effective dates for collectively
bargained and governmental plans. Also, before the regulations are
finalized, taxpayers may rely in them.