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Update on rolling vesting under 409A and 457(f)?


Locust

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Rolling Vesting - At least one well-known benefit professional has written that rolling vesting will still be allowed for 457(f) arrangements because the "substantial risk of forfeiture" standard under 457 (b) will be different from the standard under ss 83(b) and 409A. [There is not an explanation of why it should be different.]

But then I saw an article from a national benefits consulting firm that seemed to say that not only will rolling vesting not be allowed for 457(b) arrangements under the new rules, but that the IRS was actively auditing old 457(f) arrangements and finding the rolling vesting to be per se bogus.

Anybody heard of IRS audits of this issue?

Any update from the IRS?

One of the arrangements I'm working on now has rolling vesting. I'm thinking of leaving it in there for now. It seems to me that there are so many rolling vesting provisions out there that the IRS will be forced to provide some transtional relief, even if it disapproves of the concept.

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It is clear that 457(f) plans are subject to 409A, so 457(f) plans are going to have to adopt a 409A concept of risk of forfeiture or be subject to 409A. If subject to 409A, rolling risks are not going to work.

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Guest lvegas

Per Notice 2005-1, rolling ROF under 409A, for 409A purposes, is not respected. However, that guidance does not then by necessity mean that rolling ROF cannot work for 457(f) purposes (assuming, of course, that a roll under 457(f) is actually permissible - my understanding is that the IRS has informally indicated its disfavor on this point).

The fact of a ROF lapse under 409A itself should not be a tax event to the extent you are otherwise in compliance with 409A's various requirements. To the contrary, a lapse under 457(f) most definitely will trigger tax in the year it occurs.

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Vesting is the key event under 457(f) (with the question being whether rolling risk is a true substantial risk of forfeiture/vesting issue). Distribution is the key event under 409A. You probably have to comply with the plan provisions restricting distribution under 409A. You can't use the lapse of the risk as the time of distribution (it's not on the list). So you will be tracking two different taxation rules and trying to figure out how they coordinate. So even if rolling risk is okay, it's going to be a lot more complicated to figure out the taxes on this plan.

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E - That's an interesting point. The way I am thinking it may go is that once the benefit is vested, it is taxed, so 409A won't apply to that part of the benefit. The issue under 409A might be the earnings after the benefit is vested, which are taxed when paid or made available. I'm hoping we'll get a pass from the IRS on the earnings, so that when the benefit is vested, the employee would be able to defer payment at that point under rules similar to 457(b). This makes sense to me but I have no statutory basis for this, other than that it makes sense. L

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I'm assuming that 409A would only subject the increment to taxation. I'm assuming that the bigger issue is that you can't pay out the benefit at the time that it is taxed under 457(f) without violating 409A (assuming that the SRF is not valid for 409A so it is not exempt from the rules). You might want the plan to provide for a distribution to pay for taxes under 457(f) (which 409A guidance would allow).

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Help, this 457(f) / 409A interplay really has me confused.

I have been asked to review a 457(f) plan that was put in place by someone else in 2002. It calls for 100% vesting and distribution of benefits on July 31, 2006--the same date the executive's current employment agreement expires. I assume that the general intent was to allow for some rolling vesting provision on the eve of the vesting / distribution date but the plan does not expressly provide for rolling vesting.

Based on what I have read here and elsewhere, I am assuming that the plan as currently drafted does not raise major problems. There has been no prior rolling of the vesting to create a potential 457(f) problem and the distribution date for the deferred amounts is already established as a fixed date for 409A purposes.

The problem is that the participant does not anticipate retiring in 2006 but instead anticipates entering into another 4 or 5-year employment agreement. As a result, the participant does not wish to receive the deferred amounts in 2006. The amounts being deferred under the 457(f) plan are not that large and so I think the partiicpant is generally fine putting off vesting and distribution until a much later date--say normal retirement age--which is likely to be well beyond her termination of employment with her current employer (although not necessarily a time when she has actually retired from all employment).

I would appreciate others' thoughts on common recommendations that make the most sense in terms of vesting and payout dates in such situations given the interplay between 409A and 457(f).

Also, given the promise of additional guidance on certain 409A rules, I would prefer to hold off on amending the current plan until late in 2005 to allow for the possibiity that the IRS may provide some additional guidance in the 457(f) area. However, I wonder if there is any thought that the good faith compliance requirement and 12-month / 5 year re-deferral rule requires that any amendment pushing back the distribution date in this case be made by July 31, 2005 (1 year before the current distribution date) and thus cuts short the general December 31, 2005 deadline for making amendments under the 409A transition rules.

Thanks in advance for any guidance.

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A fundamental question is whether the participant should, even if it is possible, exclude the deferred comp from income in 2006. Vesting is not necessarily a bad thing because it gives the participant a contractual right to the money in the event of a change of heart of the board of the NP at a later date. If the funds are not vested the participant could be denied the right to the funds after 2006 if a different board or a gov regulator decides that the amounts deferred under 457(f)are excessive. Payment of income tax in the year the deferral vests is a pro rata payment of the amount that will be due at a later date and prevents taxation of the amount in a future tax year when the recipient could be in a higher tax bracket. The participant can defer 15k of the amount vested in 2006 under IRC 457(b). There may be vaild reasons to defer inclusion of the deferred amount in 2006, e.g, if inclusion will trigger AMT which could be avoided at a later date.

mjb

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Mbozek,

Thank you for your helpful response. We have discussed some of the pros and cons of recognizing the amounts in income in 2006 and the participant feels that she is very likley to be in a higher tax bracket in 2006 and over the next 10 years or so and then drop down to a lower bracket with any later employment and retirement. For better or worse, she is also very trusting that the NP will be around and will not change the arrangement later on--the amounts are not terribly large and I suspect the participant could make a real PR issue out of it for the NP if they later balked. I am not sure that AMT would be a concern in 2006 but will investigate.

Assuming the participant trusts the NP and wishes to push the tax hit back past 2006 (say until 2017 or so) is the alternative basically to amend the plan to provide for vesting and distribution on January 1, 2017 (or some other fixed date) that the participant feels would approximate commencement of retirement.

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Notice 2005-1 Q-18 defines material modification to a plan if a benefit or right existing as of 10/3/04 is enhanced or a new benefit or right is added. Isnt the right to defer vesting a new right to the particpant similar to amending the plan to allow distributions subject to a 10% haircut which is specifically prohibited?

mjb

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Mbozek,

Thanks, you hit on a big part of my concern. It does seem clear that any change would be a material modification under 409A but I guess I think that isn't a big concern as long as 409A would allow the particular change. (Seems to me the problem with a material modification adding a haircut provision is not that it's a material modification but that the haircut provision is not allowed under 409A. This plan is already subject to 409A whether or not it is materially modified so I am not concerned about a modification for those purposes.)

My argument is that 409A allows changes in the time and form of distribution ("redeferrals") provided they comply with the 12 month / 5 year rules. So you could amend the Plan to allow such redeferrals (admittedly a material modification) and then allow the participant to exercise this new right 12 months before the initial July 2006 payment date and still comply with 409A. Obviously, the other piece is the vesting issue. As others have noted in prior posts, however, 409A does not seem to care so much about vesting and instead focuses on distributions. I believe the IRS has said you can accelerate vesting for certain purposes without causing a 409A problem so why not reduce or delay vesting? That seems to put you squarely back in the position of having to do some type of rolling vesting for 457(f) purposes--again a real concern given the Service's disfavor of those actions--but that does not really put the participant in any worse position than she would have been in outside of the 409A changes and was confronting the need to do a rolling vesting in 2006.

I'm not saying any of this works--just trying to get my hands around the various arguments.

Mbozek, should I assume from your comments that you think there is really no way to amend or alter this current plan? thanks

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I think you need to wait until the IRS issues further guidance this year on what amendments are required to comply with 409A. My own view is that extending a vesting date currently in a Def comp plan would be viewed as a material modificaton of the plan under the 409A regs because for 60 years IRS has been opposed to amending plans to extend deferral of comp.

mjb

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E, thanks for your response. Perhaps we are saying the same thing but given the unvested nature of the 457(f) benefits, I don't see any way my plan qualifies for grandfathering for 409A purposes. Thus, if there is no grandfathering option and the Plan is already subject to the 409A rules, then what do I have to lose by making a material modification to the Plan if it helps our cause. Thanks.

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You might do something similar to rolling vesting, which would be to accept taxation and payment of the current ineligible arrangement in 2006, but defer other 2006 income (election made before 2006) to a later period. Of course, you'd have to put a substantial risk of forfeiture on the new deferral to avoid taxation, which may be unpalatable.

But this approach raises the issue of whether the IRS will accept a substantial risk of forfeiture on salary reduction amounts. Q/A 10 of 2005-1 - says the IRS won't recognize as legitimate a vesting condition on salary reduction compensation - "a salary deferral generally may not be made subject to a substantial risk of forfeiture."

We need more guidance.

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I dont think the IRS will accept a substantial risk of forfeiture on compensation that is earned by the employee to avoid subjecting it to IRC 409A unless the employee can elect between a smallar amount of a deferral in an earlier year and a materially larger payment in a later year that is subject to a risk of forfeiture.

mjb

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mbozek -

I know that's what the IRS is saying, but I don't understand its reasoning. Doesn't the fact that if you don't work the whole period you get $0 mean that you are getting a materially greater amount if you do work the entire period. It just doesn't seem like a very good concept - lots of loopholes and ambiguity. Why complicate the substantial risk of forfeiture concept?

Locust

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According to the conference report on 409A, substantial risk of forfeitures may not be used to manipulate the timing of income inclusion. "It is intended that substantial risks of forfeiture should be disregarded in cases in where they are illusory or are used in a manner inconsistent with the purposes of the provision."

mjb

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I appreciate all the thoughts and certainly agree with everyone that more guidance on these issues is desperately needed.

I am concerned, however, about delaying any action on my particular plan pending such guidance if amending the plan to allow for a subsequent deferral election would be of assistance. (Again, I acknowledge that there are 457(f) rolling vesting provisions to deal with.) Under the 12 month / 5 year rule, the participant would need to make a subsequent deferral by the end of July 2005--12 months prior to the original distribution (and vesting) date under the plan--in order to push back the distribution. Is there any guidance to support that the 409A transition period for 2005 would allow for subsequent deferrals later in 2005 even if the subsequent deferrals would not meet the 12 month rule. That would seem to run afoul of the good faith compliance requirement. In other words, could the participant make a subsequent deferral election in December 2005 pushing back the distribution date of the July 2006 distribution and still comply with the 409A rules as a result of the 2005 transition period?

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Guest SpuddyMom

On the same facts, what about an amendment to the plan (I agree that once you don't have a grandfathering concern, amend away!), to force the distributions to a longer period of distribution (from lump sum to installments). You cannot accelerate payments so installments are an acceptable change but I don't want to subject the executive to the 5-year delay in commencement so we are looking at amending the plan to "force" all distributions into 20 years of installments (instead of allowing an election). The only executive covered under the arrangement is the one who is looking to hold off taxation. Any thoughts?

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SpuddyMom - what kind of name is that?

The problem I see with your solution is that the executive currently has the right to payment without the delay, and the company's unilateral amendment of the arrangement would not really bind the executive. Or if the executive waives the right to demand early payment, that is the same as an election to delay, and you're back to the 5 year rule.

L.

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SpuddyMom,

I agree with Locust that the 5 year rule would likely apply in this situation. Does the executive really need or want the installments over the next 5 years or might they prefer to be subject to the 5 year rule but then have the installments run over a shorter period (15 years, 10 years)?

I remain afraid to pursue this approach without further guidance but it is also hard for me to see that additional guidance would waive or extend the deadline for the 12 month / 5 year rule if we delay action.

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Guest SpuddyMom

Thanks for both your thoughts. In this case, the executive is uncertain about continuing employment from 65 to 70 (his benefit vests and is distributable as a lump sum at age 65 or upon death). The executive is in his late 50s and beginning to experience health issues that make long-term employment seem less likely but he would like to avoid the lump sum at 65 if possible. Taking a full 5-year delay in order to get installments is just too high a price for him to pay. I agree with the unilateral amendment problem and had not fully considered it. I would imagine we will leave the document alone for now and hope for something in the guidance, however unlikely.

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  • 2 months later...

Some additional Q&A guidance on situation raised above taken from the IRS's July 2005 Tax Talk Today webcast program on 409A

Q-11. Can you explain if the 2005 calendar year transition relief applies to re-deferrals or subsequent deferral elections generally subject to the 12 month / 5 year rule.  Specifically, if a participant wishes to make a subsequent deferrals for a deferred compensation payment originally scheduled to be paid out in early 2006.  If a plan is not amended until late 2005 after additional guidance is released, is it still possible to allow a participant to make a subsequent deferral in late 2005 of the compensation initially scheduled to be paid out in early 2006 even though the participant would not comply with the requirement that such re-deferrals must be made at least 12 months in advance of the initial distribution date or does the good-faith compliance requirement mean that the re-deferral would have had to have been made in early 2005.

A. Under Q&A 19© of Notice 2005-1, with respect to amounts subject to section 409A, a plan may be amended to provide for new payment elections with respect to amounts deferred before the election and the new election will not be treated as a change in the form and timing of payment under section 409A(a)(4) or an acceleration of payment under section 409A(a)(3). Therefore, if the plan is timely amended to provide for the new election, the participant can make the election without being required to comply with the 12 month and 5 year rules in section 409A(a)(4)©. However, prior law rules concerning constructive receipt will continue to apply.

Q-25. You previously touched on rolling vesting and substantial risk of forfeiture as well as the interplay between section 83 and 409A.  Is it be possible for a 457(f) plan that was originally intended to rely on the use of a rolling vesting or a rolling risk of forfeiture to further delay vesting of deferred amounts upon an extension or renewal of an employment agreement to comply with both sections 83 and 409A?

A. Such a plan could satisfy the requirements of section 409A by complying with the requirements of section 409A(a)(4)©. Whether a “rolling” risk of forfeiture would be effective to defer taxation under section 457(f) is beyond the scope of this program.

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It has taken me a while, but I think I understand the interplay of 409A and 457(f).

1. The definitions of substantial risk of forfeiture appear to be different in that 409A doesn't recognize post-employment conditions (noncompete, consulting agreements) as a substantial risk of forfeiture whereas 457(f) presumably adopts the 83(b) standard which recognizes post-employment conditions [that are real].

The 409A standard does not recognize rolling risks of forfeitures.

2. Substantial risk of forfeiture is important in 409A for purposes of determining whether an arrangement is deferred compensation subject to 409A. If payments from the arrangement are made within 2 1/2 months after the year in which compensation is not subject to a substantial risk of forfeiture, the compensation is not deferred compensation subject to 409A. Conversely, if payments are not made by this deadline, the compensation is subject to 409A.

3. A rolling risk of forfeiture that is coupled with a delay in payment will not work under a 457(f) plan because it would not meet 409A. For example, suppose that vesting and payment under the 457(f) plan is to occur in 2006, but an election is made (according to the plan) to extend the vesting condition and the date of payment to 2009. 409A does not recognize the extension of the vesting, so extending the payment to 2009 makes the plan subject to 409A (because payment is not made within 2 1/2 months after the end of 2006 when the 409A substantial risk of forfeiture lapses).

The extension of the payment to 2009 doesn't meet the rules for extending payment dates under 409A; consequently, the arrangement is a deferred compensation arrangement that doesn't meet 409A and the entire amount is subject to tax, the 20% additional tax, etc. in 2006 (maybe 2005 if the election is made then).

4. It is possible that there would be an arrangement that provided that vesting under 457(f) standards will occur under a rolling vesting schedule, but that payment would be made at a fixed date or separation from service date that would be independent of the vesting date.

I suppose this could ok? There might be some possibilities with this for executives - but first you'd have to feel comfortable with rolling risks of forfeiture. Now that the issue is no longer hidden from the IRS, it would seem the risk of rolling forfeiture provisions has increased.

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