1. Guidance on Deferred Compensation: IRC 409A and IRC 457
Marcia S. Wagner, Esq.

2. Overview of Nonqualified Deferred Compensation
IRC 409A
General Requirements
Exclusions From Coverage
IRC 457
457(f) Plans
457(b) Plans
INTRODUCTION
In today’s presentation, we’ll be discussing the treatment of nonqualified deferred compensation under Sections 409A and 457 of the Internal Revenue Code of 1986, as amended (the “Code”). First, we’ll talk about nonqualified deferred compensation plans generally and the enactment of Code Section 409A. We’ll focus on the general requirements under Section 409A for nonqualified deferred compensation plans, and the various types of arrangements which are excluded from coverage by these rules. In the second half of this presentation, we will provide a broad overview of Code Section 457, and its application to 457(f) plans and 457(b) plans maintained by governmental employers and tax-exempt organizations.

3. Qualified Plans v. 409A Plans
Tax-Favored Plans
409A Plans
Discrimination prohibited and benefit limits apply.
Nondiscrimination rules and most limits are n/a.
Minimum standards apply to basic plan features.
ERISA minimum standards do not apply.
Must be funded (except non-gov. 457(b) plans).
Must be unfunded.
Employee not taxed until payment.
Not taxed until payment or “constructive receipt.”
Qualified Plans v. 409A Plans
A Code Section 409A plan includes any arrangement that enables an employee to defer receiving compensation to be earned until a subsequent year and thus delay taxation on the deferred compensation. Although Section 409A covers a broad array of arrangements, it does not apply to tax-qualified retirement plans (e.g., 401(k) plans, 403(b) plans, 457(b) plans, or similar tax-favored plans), even though these plans also delay taxation on the compensation deferred thereunder. The key differences between tax-favored plans and typical 409A plans are summarized on this slide.
As you can see, tax-favored plans prohibit discrimination in favor of highly compensated employees and they impose contribution and benefit limits. They are also subject to minimum standards with regard to eligibility, participation, vesting, funding, etc. Tax-favored plan generally must be funded (except for non-governmental 457(b) plans). And a participant in a tax-favored plan is not taxed on his benefits until the date of actual payment, even though he has free access to his money before the payment date.
On the other hand, 409A plans are not subject to any nondiscrimination rules and most benefit limits do not apply. The minimum standards under ERISA do not apply, and they must be unfunded. Also, 409A plan participants are taxed on benefits when they first become freely available to them from the plan, under the IRS’s “constructive receipt” rules.

4. NQ Plan Design Practices Prior to Enactment of IRC 409A
Employee could easily “re-defer” payments.
After initial deferral but before payment, employee elects to delay payment again.
Plan could permit early access to payments.
“Haircut” penalty for early payments.
Plan could help participants avoid loss of benefits when/if employer goes insolvent.
Financial triggers accelerate payment before employer enters bankruptcy.
Pre-Section 409A Plan Design Practices
Before Section 409A was enacted, tax practitioners had developed several techniques to soften the harder edges of the deferred compensation taxation rules. After their initial compensation deferral elections, employees could subsequently delay taxation again by making a subsequent payment deferral election before their deferred compensation was otherwise payable. Employees could easily accelerate receiving their deferred compensation without concerns about “constructive receipt,” if the nonqualified deferred compensation plan imposed a “haircut” (i.e., the employee forfeited a small portion of the deferred compensation upon accessing it). Employees with unfunded deferred compensation could reduce the risk of losing their deferred compensation upon their employer’s bankruptcy if the plan included financial triggers that caused the deferred compensation to be paid as the employer approached bankruptcy.

5. Key Concepts in IRC 409A Rules
American Jobs Protection Act adds IRC 409 to federal tax code.
Bars employees from accelerating payment.
Restricts timing of deferral and re-deferral elections.
Penalties are severe.
Deferred compensation becomes taxable to employee.
Subject to additional 20% penalty tax.
Premium interest tax may also apply.
Key Concepts in Section 409A Rules
The American Jobs Protection Act of 2004 added Section 409A to the Code to regulate compensation deferral and payment elections. The new Section 409A rules essentially bar employees from accelerating the payment of deferred compensation. They also restrict the timing of initial compensation deferral elections and subsequent payment deferral elections.
The penalties for not complying with these rules are severe. Noncompliance will cause an employee’s deferred compensation (and related investment earnings) to become taxable and subject to a 20% additional tax penalty with a possible assessment of interest.

6. IRC 409A Effective Date and Transition Rules
Effective date was Jan. 1, 2009.
Previously, plans had to comply in good faith.
409A plan documents had to be amended to comply by Dec. 31, 2008.
Grandfathered Plans
Plans in effect on Oct. 3, 2004 are exempt from IRC 409A rules.
Exemption lost if plan is materially modified.
Effective Date
Beginning January 1, 2009, plans must be operated in accordance with the final regulations under Code Section 409A. Before this date, plans needed to operate in “good faith compliance” with Section 409A and interim guidance from January 1, 2005, through December 31, 2008.
2008 Plan Amendment Deadline
Existing plan documents had to be amended to comply with Section 409A on or before December 31,  
Grandfathered Plans
Compensation earned and vested under a nonqualified deferred compensation plan in effect on October 3, 2004, need not comply with Section 409A. However, if these grandfathered plans are materially modified after October 3, 2004, they become subject to Section 409A.

7. Deferral Election Rules Under IRC 409A
General Rule
Must make deferral election prior to year compensation is earned.
Key Exceptions to General Rule
New participant may elect to defer within 30 days of becoming eligible.
May defer annual or long-term bonus as late as 6 months prior to end of performance period.
May defer ad hoc bonus if it does not vest for months and election made within 30 days.
General Rule
An employee generally must make a compensation deferral election prior to the year in which the compensation is earned. For example, deferral elections for compensation to be earned in 2008 must be made by December 31, However, there are many exceptions to the general rule, including the key exceptions described below.
Key Exceptions
1. Employees newly eligible to participate in a 409A plan can make their initial compensation deferral elections within 30 days of becoming eligible. However, the deferral election will apply only to compensation earned after the election.
2. Deferral elections for performance-based compensation can be made as late as six months before the end of the performance period. However, the performance period must be at least 12 months. The amount or payment of the compensation must be contingent upon the satisfaction of the performance-based objectives (e.g., bonus tied to achieving sales targets for a year) established at the beginning of the performance period. Also, whether the objectives would be achieved must be substantially uncertain when they are established.
3. An employee may elect to defer an ad hoc bonus if:
- the employee will forfeit the bonus if he or she terminates employment within 12 months after the bonus is awarded, and
- the deferral election is made within 30 days after the bonus is awarded and at least 12 months in advance of the earliest date at which the forfeiture condition could lapse.

8. Another Exception to 409A Deferral Election Rules
Excess Plans
Excess plans are linked to benefits limit and accruals under tax-qualified plan.
Special exception available to new participant in excess plan.
New participant may make payment election within first 30 days of 2nd year of participation.
All excess plans are aggregated for purposes of special rule for new participants.
409A Exception for Excess Plans
Excess plans typically provide benefits based on a formula in a qualified plan that produces benefits that exceed the plan qualification limits designed to restrict benefits for the highly compensated employees. Accruing benefits under excess plans is usually automatic. The design of an excess plan may or may not allow an employee to choose the time and form of payment.
The final regulations allow an excess plan to permit employees accruing a benefit to elect the time and form of payment within the first 30 days of the plan year following the year during which they first accrue a benefit. The election applies to benefits that were accrued in the prior plan year as well as those that accrue after the payment election. For purposes of this rule, however, all excess benefit plans are aggregated. Thus, if an employee participates in an excess 401(k) plan, the employee cannot rely on the 30-day special election rule if the employee later accrues a benefit under another excess pension plan. When an employee first accrues a benefit under any excess plan, the employee should make payment elections for all excess plans under which the employee may accrue a benefit.

9. Payment Election Rules Under IRC 409A
Deferral election must also include payment terms.
Employee or plan must specify payment terms.
Payment must not be earlier than:
Separation From Service
Disability
Death
Change of Control
Unforeseeable Emergency
Fixed Date or Schedule
IRC 409A Payment Elections
When employees make compensation deferral elections under a 409A plan, they must also elect the time and form of payment. Alternatively, the plan must specify the time and form of payment. A 409A plan may allow for payment no earlier than one of the following events:
- separation from service;
- disability (and to be disabled you have to meet a strict definition of disability. You must be receiving disability benefits for at least 3 months, or you must unable to engage in any substantial gainful activity due to an impairment that is be expected to last for at least 12 months or result in death);
- death;
- a change of control;
- an unforeseeable emergency; or
- a fixed date or according to a fixed schedule specified by the plan or an employee’s irrevocable election.
In certain circumstances, different forms of payment can be elected for different types of payment events. For example, a participant can elect to receive a lump sum payment at disability and installment payments at separation from service.
If you are a “specified employee”, payment cannot be made upon separation from service. Instead, payment must be delayed at least six months after your termination date. A “specified employee” is basically a key employees as defined in the so-called “top-heavy” rules for qualified plans (which includes officers with compensation over certain limits and certain types of shareholder-employees).

10. Other Rules Under IRC 409A Anti-Acceleration Rule
Employee/plan must specify when deferred compensation will be paid.
Thereafter payment cannot be accelerated.
Rule examines substance over form.
Beneficiary Payment Rule
Payment election for death benefits must be made when regular payment election is made.
Changing identity of beneficiary is permitted.
Anti-Acceleration Rule
Once an employee or the 409A plan has specified when the deferred compensation will be paid, the payment of the deferred compensation payment cannot be accelerated. (As discussed on the previous slide, a payment made on separation from service, disability, death, change of control, etc. would not violate the anti-acceleration rule if the 409A plan provided for payments upon the occurrence of these events.)
The anti-acceleration rule is designed to look at the substance (rather than the form) of the benefits transaction. For example, the Section 409A regulations would treat the payment of a bonus that just happens to be paid simultaneously with the employee’s waiver of an equivalent amount of deferred compensation under the 409A plan as a prohibited acceleration. Similarly, granting a loan to an employee that is secured by an offset under the 409A plan would also violate the anti-acceleration rule.
Beneficiary Payment Elections
The time and form of payment election for death or survivor benefits payable to a beneficiary must generally be made at the same time as the employee's payment election (e.g., whether the employee’s beneficiary will receive a lump sum or an annuity). However, the Section 409A regulations allow an employee to subsequently change beneficiaries so long as the change does not affect the time or form of payment.

11. Other Rules Under IRC 409A (cont’d)
Electing to Change Payment Terms
Must be made at least 12 months before first payment.
Must postpone first payment at least 5 years.
Exemption for electing to change annuity to another equivalent annuity form.
Election to Change Payment Terms
Changes in payment options must be made at least 12 months prior to the first payment and postpone the first payment a minimum of five years. For example, suppose an employee initially elects to receive deferred compensation in a lump sum at age 65 but now wants to change to installment payments. The employee must make the payment deferral election by age 64 and cannot receive the first installment payment until age 70.
A change in the form of a payment from one type of life annuity to another life annuity with the same date for the first annuity payment is not considered a change in the time and form of payment if the annuities are actuarially equivalent. Generally, certain features (e.g., cash refund) are disregarded in determining whether the annuity is a life annuity but not in determining actuarial equivalence. However, the value of a joint and survivor annuity subsidy may be disregarded in determining actuarial equivalence if the amount of annuity, both before and after the first death, does not exceed the amount that would be paid under a single life annuity.

12. Coordination of 409A Plan With Qualified Plan
No Payment Linkage
Payments from 409A plan must not be directly linked to qualified plan payments.
Amount Linkage
401(k) deferral elections that affect 409A plan deferrals must comply with IRC 409A.
Funding Restrictions for 409A Plan
Funding for top employees restricted when plan is poorly funded or employer is bankrupt
Also restricted if underfunded DB plan terminates.
409A Plan Coordination with Qualified Plans
409A plans are frequently linked to qualified plans. The final regulations continue to allow some coordination but restrict current practices, particularly in the area of the time and form of payment under the 409A plan.
No Payment Linkage
As of January 1, 2009, however, direct linkage of the time and form of payments between a qualified plan and a 409A plan is no longer permitted. In other words, a 409A plan cannot piggyback on the time and form of payment elections that an employee has made under a qualified plan.
Amount Linkage
An employee can increase or decrease elective deferrals (and other employee pre-tax contributions) under qualified plans up to the 401(k) salary reduction limit ($16,500 for 2011, plus where applicable the catch-up limit) without regard to the Section 409A rules. However, elective deferrals (or other pre-tax contributions) made under a qualified plan that cause decreases or increases in the amount of deferred compensation under a 409A plan in excess of the salary reduction limit must conform to the Section 409A compensation deferral and anti-acceleration rules.
Funding Restrictions for 409A Plan
An employer maintaining a 409A plan cannot fund the 409A plan for the top five officers (or certain other key employees) while any qualified defined benefit plan is in “at-risk” status because it is poorly funded or while the employer is in bankruptcy. The funding restriction also applies six months before or after an underfunded qualified defined benefit plan is terminated. The 409A plan funding restriction applies even to amounts set aside in a so-called “rabbi trust” whose assets remain subject to the employer’s creditors in bankruptcy.

13. 409A Plan Terminations
Employer can terminate 409A plan without tax penalty if:
Unrelated to fiscal downturn.
All similar 409A plans terminated.
Payments only made between months after termination.
No new 409A plan adopted for 3 years.
Plan Terminations
Employers can terminate a 409A plan without adverse tax consequences under Section 409A if:
- the plan termination is not proximate to a downturn in the employer’s financial health;
- the employer terminates all other similar 409A plans;
- payments under the plan are made no earlier than 12 months, and no later than 24 months, after the employer takes the necessary steps to terminate the plan; and
- the employer does not adopt another similar 409A plan for three years.

14. Split Dollar Life Insurance
Generally subject to 409A rules if cash value earned is payable in future year.
Deferral election rules are not applicable if employer pays premiums on non-elective basis.
Anti-acceleration rules restricts employee’s ability to borrow cash value.
Split Dollar Life Insurance Arrangements
An equity split-dollar arrangement is subject to Section 409A if the employee earns a right to cash value that is payable in a later year. However, the Section 409A compensation deferral election rules are usually not relevant because employers typically make nonelective premium payments to the insurer. On the other hand, the Section 409A anti-acceleration rule and the restrictions on changing the time and form of payment could come into play. For example, the anti-acceleration rule could be problematic if an employee could borrow the cash value from the insurance policy before employment termination.

15. IRS Procedures for Operational Failures
Eligibility for correction procedures.
Failure must be covered by IRS Notice
No substantial financial downturn by employer.
Other related conditions and limitations.
Illustration of a correction procedure.
Employee elects to defer $20,000 bonus.
Operationally, employer improperly pays bonus.
Procedures allow employee to quickly repay $20,000 and avoid taxes and 409A penalties.
Special statements needed for tax returns.
The IRS has correction procedures for 409A violations. These rules are highly technical and fact-specific, and there are separate procedures for operational failures and plan document failures under 409A.
Correcting Operational Failures
The IRS’s correction procedures for operational failures are described in Notice To be eligible for the program,:
• the failure must be specifically covered by the IRS Notice;
• the employer cannot be experiencing a substantial financial downturn;
• the plan’s terms must meet the requirements of §409A;
• the employer must take reasonable steps to avoid a recurrence of the failure; and
• the failure cannot involve an IRS “listed transaction” (e.g., abusive tax shelter).
• Certain relief is not available to “insiders” (i.e., officers, directors, 10 percent owners). Also, relief is generally not available to any employee who is under IRS audit.
Example: Let’s say that a regular employee (non-insider) properly elects to defer his $20,000 bonus. But the employer forgets to defer this money and incorrectly pays the $20,000 to the employee. Relying on a specific IRS procedure, if the employee quickly returns this money to the employer before the end of the calendar year, he will not be subject to taxation on the $20,000 and can also avoid the 409A penalty.
For reporting purposes, a special statement indicating that the employer is relying on “409A Relief” must be attached to the employer’s tax return. Unless the failure is corrected in the same calendar year, a similar statement generally must also be provided to each affected employee, for attachment to the employee's tax return.

16. IRS Procedures for Document Failures
Document failure and IRC 409A.
Ordinarily triggers current taxes and 409A penalties on all amounts deferred under plan.
IRS relief may be full or partial (e.g., 50% relief).
Illustration of a correction procedure.
Plan pays 10 annual installments at age 65, unless employer pays lump sum in its discretion.
Procedures allow plan to be corrected by eliminating employer’s lump sum discretion.
If employee turns 65 within 1 yr of correction, taxes/penalties only apply to 50% of benefit.
Correcting Plan Document Failures
The IRS's procedures for correcting document failures in 409A plans are described in Notices and   A a general rule, eligibility conditions and reporting procedures for correcting document failures are similar to the procedures we just discussed for correcting operational failures. A document failure causes all amounts deferred under the plan to be currently taxable and subject to full 409A penalties (i.e., 20% penalty tax and premium interest tax).  Fortunately, relief is available if the defective document is properly amended.  However, if a defect-related "payment event" occurs within 1 year after correction, then the affected employees are taxed on some portion (typically 50%) of the amount deferred and subject to the 20% penalty tax (but not the premium interest tax).  For example, let's say that a defective plan states that benefits are payable at age 65 in 10 annual installments, but improperly states that the employer has the discretion to pay a lump sum instead.  The IRS would allow the employer to adopt a corrective amendment eliminating its improper lump sum discretion.  But if an employee turns 65 within 1 year after the correction date, 50% of the amount he deferred under the defective plan would be taxable and subject to the 20% penalty.  This limited relief is, of course, better than no relief at all.  Under the customary 409A penalties, all participants would be taxed on all amounts deferred under the defective plan and full 409A penalties would apply to all amounts.

17. Arrangements Exempt From Coverage By IRC 409A
IRC 409A broadly covers all types of nonqualified deferred compensation.
But 409A reg’s provide exemptions for specific types of plans and arrangements.
409A exemption for short-term deferrals.
Payment must be made within 2 ½ months after tax year.
For example, bonus plan for calendar year 2011 pays cash bonuses on March 1, 2012.
EXCEPTIONS FROM 409A COVERAGE
The Section 409A definition of nonqualified deferred compensation is broad and captures many arrangements that, until recently, were not considered to constitute nonqualified deferred compensation. To provide relief, Section 409A regulations create exceptions for many arrangements, although the exceptions are frequently packaged with their own restrictions.
Short-Term Deferral Arrangements
One of the more noteworthy exceptions to coverage under the 409A rules is the exemption for short-term deferral arrangements.
The Section 409A regulations carve out an exception for deferred compensation that is paid within 2 ½ months after the employee’s or employer’s tax year in which the deferred compensation is earned or, if later, becomes vested. This is known as the “short-term deferral exception.”
For example, a calendar year bonus plan that does not pay cash bonuses until March 1st (i.e., 2 months after the applicable tax year) would not be subject to the 409A tax rules. However, if cash bonuses were not payable until March 31st (i.e., 3 months after the applicable tax year), the short-term deferral exception would not apply and the bonus plan would be subject to both the document requirement and the operational conditions of IRC 409A. Not surprisingly, for this reason, annual bonus plans are now customarily designed to fall within this 2 ½ month timing rule.

18. 409A Exemption for Severance Pay
“Separation Pay” Exemption
Separation must be involuntary, or voluntary for a Good Reason.
Permissible benefit amount is lower of: % of annual compensation, or % of compensation limit for qualified plan.
Must be paid by end of 2nd calendar year following year of separation.
Voluntary separation with Good Reason must satisfy IRC 409A definition.
Other special rules apply to plans that allow voluntary separation with good reason.
409A Exception for Severance Pay
Section 409A does not apply to severance pay (called “separation pay” in the Section 409A regulations) if certain conditions are satisfied, including:
- the pay is available only if the employee’s separation from service is (a) involuntary or (b) voluntary for a good reason,
- the pay is limited to two times the employee’s annualized compensation rate for the year prior to separation or, if less, two times the compensation limit for tax-qualified plans for the year in which the separation occurs ($245,000 for 2011), and
- the payments are completed no later than the end of the second year beginning after the employee separates from service.
For purposes of determining whether a voluntary separation from service is with good reason, the 409A rules have very specific standards. “Good reason” includes a material diminution in the employee’s base compensation, duties, or budget, according to a safe harbor definition in the Section 409A regulations. It also includes a material change in the employee’s geographic location or material breach of the employment agreement. In addition, the employee must provide the employer with notice of the good reason condition within 90 days of its initial existence, and the employer must have at least 30 days to remedy the good reason condition.
The 409A rules also impose other additional rules concerning severance paid in connection with a voluntary termination with good reason. The severance pay must be paid within two years following the initial existence of the good reason condition. The amount, time and form of payment for a voluntary good reason separation must be identical to the amount, time and form of payment for an involuntary separation. Finally, these good reason requirements must be incorporated into the severance plan.

19. 409A Exemption for Equity Awards
Restricted Stock
Awards of non-vested employer stock are exempt from IRC 409A.
Not taxable so long as award is subject to substantial risk of forfeiture.
Stock Options
ESPP and ISOs are exempt from IRC 409A.
Nonstatutory options and SARs are exempt only if granted at FMV exercise price.
For terminated employees, option term may be extended (not beyond 10 yrs or original term).
409A Exception for Equity Compensation
Restricted Stock
An employee who receives restricted property (e.g., employer stock) in connection with the performance of services is not subject to Section 409A, even if taxation is deferred under Section 83. Generally, the value of restricted stock is not included in an employee’s gross income under Section 83 so long as the restrictions make the stock subject to a substantial risk of forfeiture.
Stock Options
Section 409A does not apply to options granted under an employee stock purchase plan or incentive stock options (i.e., statutory stock options). Nonstatutory stock options and stock appreciation rights also are not subject to Section 409A if they are granted or are awarded at fair market value and if there is no additional tax deferral feature after employees exercise them. However, extending the exercise period for terminated employees will not be treated as an additional deferral feature if the extension does not exceed the original exercise period or, if less, 10 years from the date of grant. For publicly-traded companies, fair market value must generally be based on market prices in actual transactions. For non-publicly traded companies, a valuation expert must determine the fair market value taking into account all available relevant information, including the present value of anticipated future cash flows, recent arm’s length transactions in the stock, control premiums, and discounts for lack of marketability.

20. Overview of IRC 457 Background Types of Eligible Employers
Governs federal tax treatment of deferred compensation paid by any “Eligible Employer.”
Types of Eligible Employers
State and local governmental employers.
Tax-exempt organizations.
Policy Rationale Behind IRC 457
Special rules required since Eligible Employers, are not influenced by deduction-based tax rules.
OVERVIEW OF IRC 457
Okay, we’ll be switching gears now and moving on to the second part of today’s presentation, Internal Revenue Code Section 457.
Background for Code Section 457
Code Section 457 governs the federal tax treatment of the deferred compensation paid by any eligible employer, which is defined to include state and local governmental employers as well as tax-exempt organizations. As a matter of public policy, these special rules were deemed necessary, in part, because eligible employers are not subject to taxation and are not concerned with the tax benefits or timing of deductions. The tax treatment under Code Section 457 of an eligible employer’s deferred compensation arrangement depends on whether it qualifies as a 457(b) plan or a 457(f) plan.

21. Basic Types of 457 Plans 457(b) Plans 457(f) Plans
Referred to as “Eligible Deferred Comp. Plans” in IRC 457.
Defined to include plans sponsored by Eligible Employers meeting requirements of IRC 457(b).
Designed as DC plans.
457(f) Plans
Broadly includes all other plans sponsored by Eligible Employers.
Known as “Ineligible Deferred Comp. Plans.”
Designed as DC or DB plans.
There are two types of 457 plans, 457(b) plans and 457(f) plans.
457(b) Plan
A 457(b) plan is an “eligible deferred compensation plan” under Code Section 457, which is narrowly defined to include plans established and maintained by eligible employers that meet all the specific requirements of Section 457(b) of the Code. Because of the nature of these requirements, 457(b) plans are designed to be defined contribution arrangements.
457(f) Plan
Conversely, a 457(f) plan is broadly defined to encompass every type of agreement or arrangement of an eligible employer providing for the deferral of compensation, other than an eligible deferred compensation plan. For this reason, 457(f) plans are also referred to as “ineligible deferred compensation plans.” Even though a governmental employer or tax-exempt organization may not have intended to establish a formal “plan” which defers the compensation of one or more employees, any such informal arrangement will be viewed as a 457(f) plan for federal tax purposes if it does not satisfy the requirements of Code Section 457(b). Since they are often used to supplement the contributions made under 457(b) plans, 457(f) plans are often designed as defined contribution arrangements. However, 457(f) plans can also be designed as defined benefit plans, such as a supplemental executive retirement plan (a “457(f) SERP”).

22. Scope of 457 Rules Plans exempt from IRC 457.
Qualified plans, equity plans, secular trusts, gov. excess benefits and retention plans.
Plans that do not provide for deferral are also exempt (e.g., vacation, severance, disability).
Interaction of IRC 457 and IRC 409A
409A rules only apply to 457(f) plans if they provide for deferrals beyond vesting date.
IRC 409A does not apply to 457(b) plans.
Scope of Code Section 457
The rules under Code Section 457 specifically exempt a laundry list of plan types maintained by Eligible Employers, even though they involve the deferral of compensation. Specifically, IRC 457 does not apply to plans which are qualified under Code Sections 401(a) or 403, equity compensation plans, plans funded with a 402(b) or “secular” trust, qualified governmental excess benefit arrangements, and applicable employment retention plans. Code Section 457 also excludes arrangements that do not involve compensation deferrals, including exempts bona fide vacation leave, sick leave, severance, disability and death benefit plans.
Interaction of 457 and 409A
The restrictions and limitations under Code Section 409A apply to 457(f) plans to the extent any such plan provides for the “deferral of compensation” within the meaning of Code Section 409A. As clarified by the IRS in Notice , a 457(f) plan that allows participants to defer the payment of benefits beyond their vesting date is generally subject to Code Section 409A.
Conversely, if a 457(f) plan does not provide for the deferral of compensation for purposes of Code Section 409A, the 409A-related limitations on deferrals and distributions would not apply. For example, a 457(f) plan that provided for the full and immediate payment of benefits upon vesting would not be deemed to provide for the deferral of compensation within the meaning Code Section 409A.
And, as discussed earlier, IRC 409A does not apply to tax-favored plans, including 457(b) plans.

23. Eligibility Rules for 457(f) Plans
Tax-exempt Organization’s 457(f) Plan
Must limit participation in 457(f) plan to “Top Hat” group of HCEs.
Top Hat exclusion allows plan to avoid becoming subject to ERISA funding requirement.
Unfavorable tax treatment if 457(f) plan benefits of tax-exempt organization are funded.
Governmental Employer’s 457(f) Plan
Special rules exempt governmental plans from ERISA and unfavorable tax rules.
No limits on participation in plan.
ELIGIBILITY RULES FOR 457(f) PLANS
A tax-exempt organization must limit participation in its 457(f) plan to a “top hat” group, or a select group of management or highly compensated employees. The plan must restrict eligibility in this manner in order to avoid being subject to the participation, vesting and funding requirements under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). It is particularly important for a 457(f) plan to avoid being subject to ERISA’s funding requirement. If such plan were funded, interests in the plan would become taxable to participants in accordance with Sections 83 and 402(b) of the Code, and the favorable tax treatment of earnings would no longer be available to participants.
On the other hand, governmental plans are automatically exempt from ERISA. Thus, a governmental employer has the flexibility to include any employee or group of employees in its 457(f) plan.

24. Rules of Taxation for 457(f) Plans
Taxation of 457(f) plan benefits.
Participants are taxed when benefits are no longer subject to substantial risk of forfeiture.
Earnings may accumulate on tax-deferred basis after vesting date.
Benefits must be unfunded as provided under Treas. Reg (a)(1).
Participants earn benefits on pre-tax basis.
Plan may permit pre-tax deferrals or employer contributions.
Alternatively, plan may be a DB plan.
RULES OF TAXATION FOR 457(f) PLANS
Vesting and Earnings
Code Section 457(f) provides that benefits are taxable to the participant in the first calendar year in which there is no substantial risk of forfeiture. However, even though 457(f) plan benefits are taxed upon vesting, any earnings on such benefits after the vesting date will accumulate on a tax-deferred basis if the applicable conditions are met. Treas. Reg. Section (a)(3) provides that earnings credited on such vested benefits will be subject to taxation only when paid or made available to the participant, provided that the interest of the participant in any assets of the employer (including amounts deferred under the plan) is not senior to the employer’s general creditors.
Plan Design and Types of Contributions
457(f) plans may be designed to allow participants to make pre-tax payroll contributions, which may be supplemented with non-elective employer contributions. Alternatively, 457(f) plans can be designed to permit non-elective employer contributions only or provide for defined benefits. No contribution or benefit limits are imposed under the Code with respect to 457(f) plans.

25. 409A Deferral Election Rules Applied to 457(f) Plans
457(f) plan deferrals are subject to IRC 409A.
Generally, election must be made in prior year.
New participants may make deferral election within 30 days.
409A deferral election rules may (or may not) be applicable to 457(f) plans.
IRS Notice
Generally, 409A election rules will only apply if plan defers payments beyond vesting date.
409A Deferral Election Rules Applied to 457(f) Plans
If a 457(f) plan provides for the deferral of compensation within the meaning of Code Section 409A, any pre-tax deferral elections made by the participants must be made in accordance with the requirements of Code Section 409A. Thus, the participants of such plan generally must make a compensation deferral election prior to the year in which the compensation is earned, and employees newly eligible to participate in a 457(f) plan can make their initial compensation deferral elections within 30 days after becoming eligible. On the other hand, such deferral rules would not apply to a 457(f) plan that was not subject to Code Section 409A.
In Notice , the IRS clarified that a 457(f) plan which allows participants to defer the payment of benefits beyond their vesting date, generally would be subject to Code Section 409A.

26. How Does 409A Apply to 457(f) Plan?
IRS Notice states that 409A rules only apply if participants defer compensation.
“Deferral of Compensation” occurs if paid more than 2 ½ months after end of year it is earned.
If benefit is fully paid at vesting, no 409A deferral occurs.
If not fully paid at vesting, earnings will grow on tax-deferred basis, and 409A deferral occurs.
409A election rules apply when benefits (including earnings) are paid after vesting.
How Does 409A Apply to 457(f) Plans?
In Notice , the IRS outlined its logic for determining when a 457(f) plan will become subject to the 409A deferral election rules. A 457(f) plan that features elective contributions from participants will become subject to the 409A election rules only if participants can “defer” compensation.
Under the applicable regulations, a 457(f) plan is deemed to provide for the “deferral of compensation” if the employee has a legally binding right during a calendar year to compensation that, pursuant to the terms of the 457(f) plan, is or may be payable more than 2 ½ months after the end of such year (or the employer’s taxable year, if later).
For purposes of determining whether a “deferral” occurs for 409A purposes, a 457(f) plan participant is deemed to receive payment when amounts are taxed. Since the participant is taxed and deemed to receive payment upon vesting, a “deferral” does not occur even if actual payment is delayed beyond the vesting date.
However, since earnings accumulate under a 457(f) plan on a tax-deferred basis after the vesting date, Code Section 409A generally would apply to such plan if it allowed participants to defer payment of such earnings beyond the year in which benefits vested (and the applicable 2 ½ month period).

27. Past 457(f) Plan Practices
Plans with Rolling Risk of Forfeiture (RRF)
Previously, participants could easily delay vesting at regular intervals to delay taxation.
Now, 457(f) plans with RRF feature are viewed as deferred comp. plans under IRC 409A.
Thus, RRF feature must now conform to 409A deferral election and payment rules.
Notice
IRS will issue 457(f) guidance on “Substantial Risk of Forfeiture” to conform to 409A rules.
Once issued, RRF feature (even if conformed to 409A) will no longer delay taxes under 457(f).
Past 457(f) Plan Design and Practices
Historically, many 457(f) plans were designed to allow an employee to make pretax deferrals and to defer the taxation of these amounts pursuant to a “rolling risk of forfeiture.” Under this type of 457(f) plan, the benefit would remain subject to a substantial risk of forfeiture until the end of a stated employment period, but participants would have the ability to delay the vesting date (and taxation of benefits) indefinitely by making elections to extend the vesting period at regular intervals.
Treas. Reg. Section 1.409A-1(d)(1) provides that any extension of a period during which compensation is subject to a risk of forfeiture is generally disregarded for purposes of determining whether such compensation is subject to a substantial risk of forfeiture under Section 409A. Thus, a 457(f) plan with a rolling risk of forfeiture generally would be viewed as providing for the “deferral of compensation” for Section 409A purposes, even if by its terms it provided for the full and immediate payment of benefits immediately after the extended vesting date. As a result, such 457(f) plan would be subject to the applicable limitations on deferral elections and distributions as mandated by Code Section 409A.
In Notice , the IRS announced that it would be issuing guidance under Code Section 457(f) regarding the definition of a “substantial risk of forfeiture” under rules similar to those set forth under Treas. Reg. Section 1.409A-1(d). Upon issuance of such guidance, which is to take effect on a prospective basis only, benefits under a 457(f) plan with a rolling risk of forfeiture would become taxable upon the lapse of the original vesting period, without regard to any extensions elected by the participant.

28. Funding of 457(f) Plan Benefits
457(f) plan benefits must be unfunded.
May be informally funded with rabbi trust.
Assets set aside in a grantor trust.
Trust assets remain property of grantor, and trust earnings are taxable to employer.
Trust assets remain subject to claims of employer’s general creditors.
Funding
457(f) plans are legally “unfunded,” meaning that the employer cannot set aside assets that are earmarked exclusively for the benefit of 457(f) plan participants. However, they may be informally funded through a grantor trust or a “rabbi trust”. (These informal funding arrangements are sometimes referred to as rabbi trusts because the first relevant private ruling by the IRS was issued to a religious organization with rabbis.)
Assets can be set aside assets in a grantor trust, which means that the contributions and investment earnings remain the property of the employer for tax purposes. In addition, the assets of the grantor trust are subject to the claims of the employer’s creditors until paid to a participant. Thus, in the event the employer becomes bankrupt, the assets of the grantor trust are subject to the claims of the employer’s creditors and plan participants do not have any preference or priority with respect to the assets held in the grantor trust.

29. Distributions from 457(f) Plans
Alternatives in Plan Design
Distribute benefits at or after vesting date.
Payment form may be lump sum or installments.
Provide for partial lump sum distribution at vesting, sufficient to pay tax withholding due.
If 457(f) plan provides for deferral of compensation, 409A payment rules apply.
Distributions and Plan Design
As a matter of plan design, 457(f) plans may provide for distribution of benefits in full as of the vesting date. Alternatively, they may provide for distribution at a later date, and/or may provide for the payment of benefits in installments or other payment forms. If the 457(f) plan provides for the payment of benefits after the applicable vesting date, such plan could by design provide for a limited partial distribution that is sufficient to satisfy the required income tax withholding due on such vesting date.
If a 457(f) plan provides for the deferral of compensation within the meaning of Code Section 409A (by, for example, providing for benefit payments after the vesting date), any distributions from the plan must be made in accordance with the requirements of Code Section 409A.

30. Introduction to 457(b) Plans
Governmental 457(b) Plans
Governmental employer may include any employees without limitation.
457(b) Plans of Tax-exempt Organizations
Must limit participation to Top Hat group of HCEs to avoid becoming subject to ERISA.
Why limit a non-governmental 457(b) plan to Top Hat group only?
ERISA requires covered plans to be funded.
IRC 457 states that only governmental employers may sponsor funded 457(b) plans.
Now that we’ve finished discussing 457(f) plans, we are going to move on to 457(b) plans.
INTRODUCTION TO 457(b) PLANS
Eligibility and Participation
A governmental 457(b) plan may include any employee or group of employees without limitation.
In contrast, a tax-exempt organization must limit participation in its 457(b) plan to a “top hat” group, or a select group of management or highly compensated employees, to avoid being subject to the funding requirements under ERISA. It is critical for a 457(b) plan to avoid such funding requirements, because Code Section 457 expressly prohibits the funding of 457(b) plans maintained by tax-exempt organizations.

31. Contribution Limits for 457(b) Plans
Deferrals and employer contributions are subject to combined limit of $16,500 (2011).
Many plans allow deferrals only.
Catch-up Limit
During 3 years prior to NRA, annual limit is increased by unused limits from prior years.
Catch-up Limit may not exceed $33,000 (2011).
Catch-up Contributions
For governmental 457(b) plans only.
Participants (age 50+) can contribute higher of Catch-up Limit or Catch-up Contributions.
CONTRIBUTION LIMITS FOR 457(b) PLANS
A 457(b) plan gives participants the ability to make pre-tax payroll deferrals. A 457(b) plan by design may also provide for non-elective contributions from the employer. Generally, the combination of pre-tax payroll deferrals and non-elective employer contributions for a calendar year cannot exceed the IRS annual limit ($16,500 in 2011). Because the annual limit takes into account both elective and non-elective contributions, many 457(b) plans by design only permit elective contributions. In accordance with Code Section 457(b)(4), compensation will be deferred for any calendar month only if a deferral agreement has been entered into before the beginning of such month.
During the last three calendar years ending before a participant’s normal retirement age under the 457(b) plan, the limit (the “Catch-up Limit”) can be increased by any unused annual limit from prior years while the plan was in effect up to an amount equal to double the IRS annual limit ($33,000 in 2011).
With respect to governmental 457(b) plans only, a participant who is age 50 or older may make catch-up contributions in accordance with Code Section 414(v). If a participant in a governmental 457(b) plan is eligible for both the Catch-up Limit and for catch-up contributions under Section 414(v), the participant may take advantage of the higher of the two limits (which may not be combined).

32. Vesting and Funding for 457(b) Plans
Customarily, deferrals and employer contributions are fully/immediately vested.
Amounts are counted against annual limit at vesting, and delayed vesting could violate limit.
Funding of Benefits
Governmental 457(b) plan must be funded through trust.
457(b) plans of tax-exempt organizations must be unfunded (but informal funding is permitted).
Vesting
457(b) plans customarily provide for full and immediate vesting for all elective deferrals and any non-elective contributions. Any vesting requirement with respect to non-elective employer contributions is likely to result in a violation of the IRS annual limit, since any contributions and earnings thereon vesting in the same year must be combined and counted against the IRS annual limit under the applicable Code Section 457 rules.
Funding
Code Section 457 requires governmental 457(b) plans to be funded and held in trust for the exclusive benefit of participants.
However, 457(b) plans maintained by tax-exempt organizations must be legally unfunded, meaning that the contributions and investment earnings must remain the property of the employer and, therefore, remain subject to the claims of the employer’s creditors until paid to a participant. However, a nongovernmental 457(b) plan may be informally funded through a “rabbi trust” arrangement.

33. Distributions from 457(b) Plan
Benefits must not be available earlier than
Year of attainment of age 70 ½,
Severance from employment, and
An “unforeseeable emergency.”
Minimum Req. Distributions - IRC 401(a)(9)
Taxation of 457(b) Plan Benefits
If tax-exempt organization, benefits are taxed when distributed or made available.
If governmental employer, benefits taxed when actually distributed.
In-Service Withdrawals and Distributions
In order to satisfy the requirements under Code Section 457, a 457(b) plan may not make benefits available to participants earlier than:
- the calendar year in which the participant attains age 70 1/2,
- severance from employment, and
- a financial hardship which constitutes an “unforeseeable emergency”.
Minimum required distributions must commence under a 457(b) plan in accordance with the requirements of Code Section 401(a)(9). These are the same rules that apply to tax-qualified plans and which require participants to commence distributions by the later of age 70 ½ or retirement.
Governmental 457(b) plans are also subject to the substantive requirements under Code Section 401(a)(31) for eligible rollover distributions.
Taxation
Benefits under a 457(b) plan maintained by a tax-exempt organization are taxed when distributed or made available, whichever comes first. However, benefits under a governmental 457(b) plan are taxed only when actually distributed to the participant.

34. Guidance on Deferred Compensation: IRC 409A and IRC 457
Marcia S. Wagner, Esq.
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