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401 Chaos

409A and 457(f) Big Picture

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Not really a question about the detailed overlap between the two sections, etc. but more a big picture question based on the interaction of the two rules and presumed increased regulatory focus / scrutiny on 457(f) arrangements as a result of 409A.

My question is this--does it really make any tax sense for an executive to want to have amounts go to a 457(f) plan as opposed to being able to get the same amounts paid currently. In this case, the company could probably be convinced to pay the same or nearly the same amounts now as it will set aside under the 457(f) Plan although that hasn't been officially decided.

Amounts going to the 457(f) plan will be subject to forfeiture if executive does not remain employed through x date which coincides with end of employment term and the individual's planned retirement. Deferred amounts will be paid to executive upon his "retirement" or shortly thereafter. It seems unlikely that the individual will leave the company before x date so, although real, the risk of forfeiture is not particularly great.

Executive desires to defer amounts on advice of financial consultant. The consultant thinks that deferring recognition of income (and thus taxes) until the executive's retirement is a good thing tax wise. I am no so certain that is the case in a 457(f) context though.

Given 409A and recent rumblings about the IRS's skepticism of, and likely future clarification to, the significant risk of forfeiture rules under 457(f), the employer is not interested in linking vesting / substantial risk of forfeiture under 457(f) to a noncompete. The Company also would not likely permit Exec to make a "rolling risk of forfeiture" if current plans change and the executive continues employment past x date. In short, the company fully intends that amounts going to the 457(f) plan will vest and be paid to executive on x date as long as the executive remains employed through such date.

In this scenario, the vesting / payment date is mid-year so that the deferred amounts (plus earnings) will all be paid to the individual in a year in which he will have earned significant income from his regular salary through mid-year. If, as planned, he retires after that time and has no other regular salary for the year, it may be that he has a lower overall income as compared to the prior year. However, he will undoubtedly have some salary increases over the next few years and there will be some special bonus payments in the retirement year that may jack total pay up. As a result, I suspect the Executive would have a significant income in his retirement year and thus is likely to be in roughly the same tax bracket as he is currently.

In short, there is no clear guarantee that the deferred amounts will be paid out in a tax year in which the Executive clearly has a much lower income. As a result, I don't see any clear tax advantage to deferring the amounts. If I were him, I would prefer to get the amounts now and invest on my own to try and get capital gain / dividend tax treatment instead of having all earnings taxed at ordinary income rates. And that doesn't even address the fact that the amounts going to the 457(f) plan will be subject to forfeiture.

What would be ideal----and what I suppose I'm really getting at with this question----is whether there is any way in having the deferred comp amounts vest and be paid out in the tax year following his retirement (or maybe even later) so that there is a real chance he will be in a lower tax bracket. Given the company's reluctance to try and tie vesting to a noncompete or permit some rolling risk of forfeiture and 457(f)'s requirement that amounts be taxed when they are no longer tied to a substantial risk of forfeiture (i.e., conditioned upon the future performance of substantial services), I'm just not getting where a 457(f) arrangement makes any sense. What does the financial consultant see that the company does not?

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Forget about 409A and any increased enforcement/tightening of 457(f). There is a larger question here.

Since the 86 Act expanded 457 to non-profits, I have never heard one sensible explanation for why an executive should be willing to subject his or her current compensation, or additional compensation which his or her Board would be willing to pay currently, to a BONA FIDE srf in exchange for some tax deferral. It is a very bad idea, typically suggested only for the purpose of selling product. Human beings tend to change their minds from time to time, like deciding to leave a job earlier than originally anticipated.

Golden handcuffs and other employer-funded retirement benefits are another story.

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Thanks jpod. That was sort of my take as well.

I can see where such an arrangement might make sense if the Company were not going to provide the compensation unless it went to a 457(f) plan. Perhaps that would end up being the company's ultimate position here anyway but the 457(f) arrangement was initially floated / requested by the executive / consultant under the assumption there was a general tax advantage and it would be a win-win for both parties (i.e., instead of asking for 15,000 more per year in salary, they asked for 15,000 more to a 457(f) plan).

I suspect the company might end up agreeing to provide more under a 457(f) plan than they would have if paid out currently but I doubt the difference would be substantial and the company would just assume to avoid the whole 457(f) arrangement for relatively small amounts for one person.

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The Company also would not likely permit Exec to make a "rolling risk of forfeiture" if current plans change and the executive continues employment past x date

Can't the agreement pay on separation from service, whenever that is? There is nothing controversial about that and it is not what I would call a rolling risk of forfeiture.

Capital gains is your best point favoring current payout, although you should be able to pay out within the first 2 1/2 months of the close of the year of separation and attain the goal of a lower marginal rate.

I believe that 457s were cool when they could be tricked out with rolling risk, regulated investment company options, etc. There is not much to them now, I guess.

That said, all of the old 457(f)s have to be updated for 409A now because the term and pay out transition relief under 409A expired after 2005, correct? There will still be a lot of 409A compliant 457 plans, but it sounds like there is not much benefit to setting one up now with new money.

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"Can't the agreement pay on separation from service, whenever that is? There is nothing controversial about that and it is not what I would call a rolling risk of forfeiture."

Namealreadyinuse,

Seems to me you could structure the Plan to pay out on a "separation from service" and be compliant with 409A's specific distribution requirements; however, I don't think that would comply with 457(f) unless it was also tied to continued employment through a specific date. If you vest automatically upon a separation from service, seems there would be no real substantial risk of forfeiture and thus taxed when set aside.

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Let me expand on my last post. Perhaps I'm making this more complicated than it needs to be.

Suppose tax-exempt wants to pay executive director 457(f) deferred comp amounts provided the executive remains employed through the end of a 4 year term per employment agreement that about to be signed effective July 1st. The Employment Agreement, however, also includes provisions allowing for an automatic 1 year extension of the original 4-year term unless executive or company provides notice of non-renewal.

There is a good chance the executive will retire at the end of the 4-year term thus making the extended term a non-issue. There is, however, also a pretty good chance that employment will be extended, at least for one additional year. If extended, the executive presumably would prefer not to receive the deferred comp amounts until separation from service under the employment agreement (i.e., at the end of year 5).

Providing for vesting and distribution of the 457(f) amounts upon the earlier of (1) continuous employment through the end of the original 4 year term, (2) death, or (3) disability all seems fairly simple enough under both 457(f) and 409A. Things are subject to a substantial risk of forfeiture for both 457(f) tax purposes and there are specific distribution dates or distribution events for 409A purposes.

Trying to arrange it so that the amounts would not get paid out until the end of the term under the employment agreement----whether that is at the end of the original 4-year term or possibly at the end of an extended term----seems potentially troublesome.

Tax exempt could presumably tie distribution timing broadly to executive's "Separation from Service" without significant issues under 409A. However, wouldn't any attempt to provide for vesting / distribution upon "separation from service" following the end of the original 4-year term of the Employment Agreement raise rolling risk of forfeiture issues?

Seems to me once they reach the end of the original 4 year term, an executive is arguably vested in the 457(f) amounts and any attempt to further delay vesting / distribution until the end of an extended term woud be pretty much the same as relying on a rolling risk of forfeiture.

Alternatively, simply drafting the 457(f) plan to tie vesting tied to a participant's "separation from service" without providing that it be a separation from service on or after the end of the 4-year term leaves things too open and would not constitute a substantial risk of forfeiture under 457(f)--i.e., executive would presumably have a right to amounts upon termination of employment at any time.

Any clarity would be much appreciated.

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Rolling risk of fofeiture is dead (assuming it was ever alive -- why do you think we got 409A?) . The 409A regulations state that a layered risk is disregarded. The IRS was not going to let this abuse get by.

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QDROphile.

No argument that it is dead. Just wondering if there is any way to structure a 457(f) arrangement to vest and payat end of optional extended term of employment agreement rather than end of original term of employment agreement without creating a rolling risk issue. I don't really think there is but wanted to be sure I wasn't missing some way around this. Thanks.

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For what it's worth, it seems that the tension b/w 457(f) and 409A make it impossible to extend the SRF beyond the initial term. Even if 457(f) did allow for an extension through creative drafting, it would not meet 409A since the "extension" would occur after the performance of services. 409A would force the executive into the subsequent election rules in order to "further defer" taxation, which don't seem to be conducive to tax or payment planning in any manner.

BTW I think the point in your OP is true with all deferred comp. There are a lot of folks who just don't think deferring compensation will necessarily result in tax savings, even in the for profit sector.

Agree with earlier poster that subjecting earned compensation to SRF is ridiculous. Any one remember why congress thought this was necessary in the tax exempt world?

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Steelerfan,

Thanks for your response. I agree with you that the tax savings with deferred compensation arrangements often don't pan out even in the for profit world. I see so many that are designed to pay in a lump sum immediately following termination (some of the benefits of which I understand) but it sure seems like a lot of people go to a good deal of trouble to save little if anything in taxes.

At least in the for profit world there is often the ability to spread the payments out and do in installments making it more retirement like. That at least gives participants a shot at reduced taxes it seems. Given 457(f)'s taxation of amounts at vesting, however, it seems it is very difficult if not impossible to get the benefit of a reduced tax rate under a general application of 457(f).

I suppose if you tied vesting to a noncompete so that you delayed vesting until a year (or years) after active employment under 457(f) you could have payout in a lower tax rate year but that would seem to then raise 409A compliance issues since a noncompete is not considered a substantial risk of forfeiture for 409A purposes. Do you tie vesting of amounts to the end of noncompete period for 457(f) tax purposes but provide for a fixed payout date (i.e., end of noncompete period) for 409A purposes?

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As long as the initial 409A payment election was timely made, such as by the end of the calendar year before the year in which the services will be performed, I think that would work fine. Seems like this could also defer taxation under section 83, as long as the initial election rules of 409A are satisfied at the time of grant.

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