Ineligible 457 plan and installment payments

[smm]

Employer has an ineligible 457 plan for an employee. Plan provides for installment payments (monthly for 60 months)following termination of employment for any reason at any age. Plan has a no-compete clause (assume for argument sakes that this works) that runs for 36 months. No other risk of forfeiture clause following that. Is employee taxed on the balance (remaining 24 months) at the end of the 36 months?

Thanks.

[Carol V. Calhoun]

Assuming the noncompete agreement works (and that's a big assumption), the employee would still be taxed on the present value of the benefit as it became vested. Thus, at the end of the year, the employee would be taxed on the present value (not quite equal to the remaining 24 months due to present value assumptions) of the remaining 24 months of payments.

[smm]

Thanks for the quick response. I thought that was the answer, but wasn't thinking about the present value - I was thinking about the entire amount, but, you are correct. Assuming the non-compete clause works, presumably, if it applies to the entire period of installments, then the entire amount would be taxable when paid. Any thoughts on what type of "risk" would apply during the period of installment payouts. I don't like the idea of "consulting" (neither does the IRS in the Section 83 regulations).

Thanks again.

[Kirk Maldonado]

Unfortunately, the only thing that I know works (because it is in the statute) is continued employment. Needless to say, that doesn't work too well in this situation.

[pjkoehler]

smm: Kirk is right. Take a look at the definition of "substantial risk of forfeiture" set forth in Sec. 457(f)(3)(B). Such a condition exists only so long as the participant would forfeit its right to receive the "compensation" by failing to perform substantial services for the employer in the future. The lapse of such a condition almost certainly occurred because the plan gives the employee the right to an immediate distribution on termination of employment. Sec. 83 is not applicable to taxation of deferred compensation. See Reg. Sec. 1.83(d)(e). The noncompete agreement mentioned in Reg. 1.83-3(B)(2) is not a factor given any significance in the 457 regs for purposes of the timing rule set forth in Sec. 457(f)(1)(A).

[jpod]

To PJKoehler:

Is there authority to confirm that 457(f)(3)(B) is intented to be all-inclusive? In other words, maybe the "substantial services" rule set forth in that provision is a safe harbor, but other risks of forfeiture may work too. For example, what about a CEO of a major hospital who retires at age 60 and must complete an econcomically-meaningful 2-year covenant not to compete before he has the right to receive his 457(f) benefits?

[pjkoehler]

jpod: I'm not aware of any case law that concluded that 457(f)(3)(B) was somehow ambiguous and should be given a more expansive reading. If you're looking for a policy reason that may have motivated Congress to use this more stringent standard, you should research the Committee Minutes. There, you'll find that Congress was concerned that, unlike deferred compensation plans for employees of taxable entities where a natural tension between the employee's ongoing deferral of taxation and the employer's desire to obtain a compensation expense deduction arises, tax exempts have no financial interest in the length of the deferral of their employees. Thus, to avoid the potential of indeterminate deferral periods in 457(f) plans, Congress imposed a more stringent standard of the "substantial risk of forfeiture."

[jpod]

PJKoehler:

I understand what you're saying, but I'm not convinced that "future services" will be the only risk of forfeiture that works in a 457(f) plan.

What if the plan said that the executive gets his money if (1) he remains with the organization until age 60, and (2) within the next two years thereafter the United States lands a man on the planet Neptune?

OK, that's silly.

But, what if the plan said that the executive gets his money if (1) he remains with the organization until age 60, and (2) within the next two years thereafter the organization's outstanding debt is reduced below some dollar threshold? Under your interpretation, the executive would be taxed at age 60 no matter how great the risk that the debt reduction requirement may never be satisfied.

I find it hard to believe that the intent of Congress was to automatically tax the executive at age 60 in this situation, either in 1978 at the time that 457 was enacted or in 1986 when it was extended to non-profits.

[mbozek]

Isn't the logical outcome that the employee will be taxed on the deferred compensation in the year of termination but will be able to claim a miscellaneous deduction in a future year to the extent the benefits are forfeited because of the non compete clause. The only way for the employee to avoid taxation in year of termination would be argue that there is no claim of right to extent the benefit are subject to the noncompete clause because of the potential forfeiture but this would be difficult since the benefits are statutorily taxed as income under 457(f) when there is no requirement to perform substantial services. Further the forfeiture of the benefits would be contingent on the employees voluntary act after receipt of the funds.

[pjkoehler]

jpod: Let's try to keep this on terra firma. I don't think you've framed the issue correctly. We're not looking for a plan provision that sets conditions which must be satified before the 60-year old, former employee "gets" his money. We're looking for a plan provision that sets conditions the lapse of which automatically causes the executive to forfeit his entire benefit. This is an essential distinction with deferred comp plans of taxable entities with respect to which a risk of "forfeiture"may exist even if the employee is fully vested under the terms of the plan.

Are you saying that you have a 457(f) plan under which a 60-year old, former employee forfeits his entire account balance if the company fails to achieve specified performance goals over a 2-year period and that the achievement of these goals is subject to a substantial risk of not occurring. You raise an interesting theoretical question, but I've never seen a plan where an executive placed such a value on a 2-year tax deferral over benefit security. If the deferred comp is anything other than play money, that's a heck of a roll of the dice for anyone on the threshhold of retirement to make. I suspect that virtually no one would participate in such a deferred comp plan and that's the reason for the lack of any official guidance on the question you ask.

[Guest Tom Geer]

As often happens in 457 discussions, I think that we may be confusing issues.

If a plan is an eligible plan under 457, the timing of taxation depends entirely on the constructive receipt rules. These were developed for deferred comp plans generally, and still apply to plans of employers that cannot maintain eligible plans under 457. Risk of forfeiture has an effect on eligible plans under 457 only when looking at payroll taxes under 3121 and in determining the amount of deferrals (amounts not being deemed deferred until any substantial risk of forfeiture has goen away.

The ineligible plan rules, or at least the language of 457(f) look back to the rules under Section 83, where "A substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture is substantial if such condition is not satisfied." (Regs 1.83-3) The second part of that clause "condition related to the transfer" allows ineligible employers to set up employment-related conditions as long as they have some economic reality. However 457(f)(3)(B) only allows future performance of substantial services. Do other conditions have some chance of working? That's definitely swimming upstream, and you would have trouble finding any authority to support you.

The executive needs a competent adviser who will tell the executive the problems coming up when he hits 60. Ignorantium legit non excusat.

So,

[jpod]

My hypothetical does not involve elective deferred comp. To the contrary, it involves something in the nature of an employer-funded SERP. It is a very real example of how a non-profit may wish to provide deferred compensation to an executive, yet subject it to a condition other than, or in addition to, the completion of a period of service.

If you folks are saying that 457(f) applies only to elective deferred comp., I respectfully disagree.

[pjkoehler]

Tom Greer: Talk about confusing! There is nothing in the definition of a "substantial risk of forfeiture" set forth in Code Sec. 457(f)(3)(B) that refers to, "looks back" to or floats around within the penumbra of that term as it is defined Code Sec. 83. To the contrary, Code Section 457(f)(2)(3) expressly exempts "transfers of property described in section 83" from the application of the general timing rule set forth in sec. 457(f)(1). The term "property" doesn't include an unfunded and unsecured promise to pay money or property in the future. Reg. Sec. 1.83-3(e). Interpreting section 457(f)(3)(B) by imputing the section 83 principles flies in the face of this unambiguous statutory language.

[Guest Tom Geer]

One of my basic notions about 457 is that the rules are sort of based on the NQDCP rules and Section 83, with modifications based on the legislative and regulatory process. In order for an individual coming from a tax background to follow 457's internal logic (which may be a misnomer), these differences are what have to be emphasized, so I do so whenever it seems relevant. Particularly, I do so when the conversation seems to be jumping from notion to notion. This does not imply any "penumbra", it simply reflects the diverse conceptual backgrounds of 457(B) and (f).

If you would like the argument for other substantial risks, it is that the language of 457(f)(3)(B) is at least slightly ambiguous. It says the substantial future services do constitute a substantial risk of forfeiture, but it does not say nothing else does. I don't believe that's a very good argument, but at least it is an argument, particularly since the 457 regulations pass on the opportunity to make it exclusive. Assuming that (not very good) argument, then 83 has the only definition that could possibly be applicable.

Perhaps my preference for laying out, then evaluating, all arguments, rather the saying "that's the rule," is confusing. However, simplifying the analysis is limiting. Describing risks is the job of the adviser; deciding what risks to take is the job of the taxpayer.

To jpod--

It's specifically with respect to non-salary reduction money that the second sentence of 1.457-2(e)(3) is relevant, so you are absoultely right. Most 457 plans are salary reduction plans, so that side of the plan type is ignores.

[jpod]

Tom:

I'm not grasping your point(s), but that's ok.

Also, while the vast majority of 457(B) plans are elective plans, the vast majority of legitimate 457(f) plans are not elective. (I use the term "legitimate" because I don't believe that any rational executive would agree to make an elective deferral of compensation that is subject to a BONA FIDE substantial risk of forfeiture.) The 457(f) plans which I have seen are, typically, SERP-type plans that serve as handcuffs.

[pjkoehler]

Tom Greer: First of all, beyond asserting "your notions" you haven't laid out, let alone analyzed, any "arguments" that create a logical nexus between the factors taken into account under the section 83 regulations and an expansion of the term "substantial risk of forfeiture" set forth in section 457(f)(3)(B) beyond the plain language of the statute. What authority do you have for "your notions?" All your notions do is demonstrate a preference for an Internal Revenue Code, which often fuels the Zen-like belief systems apparent in these threads, in which identical terms used for arguably analogous purposes must have indentical meanings.

By the way, of what possible relevance is Reg. Sec. 1.457-2(e)(3) to a discussion of ineligible plans? See what's confusing?

[jpod]

Anyone still interested in this topic should check out the IRS' 2001 CPE text. In that text, the IRS indicates that there may be other ways to establish a substantial risk of forfeiture besides continued services for purposes of 457(f). The discussion in the CPE text then proceeds to analyze the Section 83 regs to a variety of 457(f) scenarios.

[Guest rik]

Can a participant in an ineligible 457 plan have concurrent substantial risks of forfeiture? I understand what rolling risks are, and I am not referring to this. I am not able to locate anything regarding having more than one substantial risk at time. Each substantial risk is valid, and has a different lapse time period.

Thanks,

RIK

[smm]

Any thoughts on this thread in light of the new regulations?

[Guest Tom Geer]

The proposed regs are deliberately unhelpful.

First, there is no content at all on whether other coditions can create a risk of forfeiture. In a presentation at the ABA Tax Section meeting last Friday, the IRS people said they agree that the the laguage in 457 does reflect 83 concepts, so that there can be other forfeiture conditions. They would have to be related to the purpose of the grant, and he was unwilling to elaborate on how that might be the same as or different from the purpose of the grant concept under 83.

As to options, the regs have some very confusing language. They say that 457 does not apply to transfers "subject to" 83 (457 itself says "described in"). It then says that if the property is "transferred" before the end of all substantial risks, then 83 applies and if the "transfer" is after the lapse, then 457 applies. I have no idea at present what that means. If transfer means as defined under 83. then an option grant is not a transfer at all and 457 applies.

I am helping on the ABA comments, and intend to raise the questions (1) why don't the regs use the statutory term "described in", and (2) can they give us a less opaque rule.

[jpod]

We've all seen (on this Board and elsewhere) the arguments pro and con with respect to discounted options granted to employees of tax-exempt employees, and the effect of the new proposed regulations. Surely it will be very interesting to see what happens down the road, in court or otherwise.

What is the IRS' response to the following assertion: The grant of a discounted option involves CURRENT compensation, not DEFERRED compensation. The option is a valuable property right; it is not a mere promise to pay compensation in the future. It is CURRENT compensaton which happens to be taxed in a unique way under Section 83 (i.e., no taxation until the transaction is "closed" at exercise). The grant of the option does not involve DEFERRED compensation; therefore, Section 457 does not apply. Cf. Reg. Section 3121(v)(2)-1(B)(4)(ii) (the grant of a stock option does not constitute the deferral of compensation for purposes of Section 3121(v)(2) of the Code).

[Guest Tom Geer]

they might make any of three responses. First, they could argue under the statutory language of 457 that since the option grant is not treated as a transfer under the 83 regulations (83 regs say that a grant of an option without a readily ascertainable fair market value is not yet a transfer), the 457 coordination provision does not apply because there is no transfer described in 83. Under the proposed regs they could argue that the grant is "not subject" to 83 even though described in 83 (since the proposed regs switch standards), and therefore 457 applies. Last, if there is no substantial risk of forfeiture at the time of grant, the IRS can look at the new coordination rule in the proposed regs and say that since the forfeiture conditions ceased before the transfer (as defined in 83), 457 applies.

IRS does not like these deals, and they are going to do their best to find a way to shoot them down.

[jpod]

I guess I didn't make my point clearly.

I understand what the proposed regs. say. I am conceding that the Section 83 exclusion in the statute is inapplicable because the grant of an option is not a "transfer of property" described in Section 83.

Also, let's assume that the option is immediately vested (but not transferable).

My point is simply this: what does 457(f) mean when it says "a plan . . . providing for a deferral of compensation"? What is it about a grant of a discounted, fully vested option that constitutes a deferral of compensation?

Why is it not CURRENT compensation outside the realm of Section 457?

Why would the same event - the grant of a discounted option - trigger an income tax liability under Section 457, but no FICA or Medicare tax liability under Section 3121?!? What sense does that make?!?

Believe me, I've always been skeptical about these option arrangements, but I have difficulty figuring out what it is about Section 457 that would draw them in. I understand that many of these programs involve an employee giving up current cash in exchange for a discounted option, but so what? Maybe we just have another viable loophole and if the IRS doesn't like it the Congress will have to close it.

deferral of compensation deferral of compensation

[Guest Tom Geer]

I think, emphasize think rather than know, that the logic would be that since there is no transfer "described in" or "subject to" 83 at present, the option amounts to a promise to transfer property in the future. Then, the logic would go, the fact that promise to pay is in the form of stock rather than cash is also irrelevant. Since 457 would clearly apply to a promise to pay cash, it applies to a promise to pay in kind.

I'll be seeing drafts of the ABA comments by others (my niche being loans from TE-sponsor plans and maybe application of voluntary corrections to TE-sponsor plans. If you have any analyses of the 83/457 issue, I can get it factored in. Just e-mail me the stuff and I'll get it to the right person.

[jpod]

I hear you, but that still doesn't help me understand why the grant of a discounted option is "deferred compensation." I'll even go so far as to assume that Section 457(f) trumps 83 where there is "deferred compensation" involved. But, if you compensate me for services by giving me a fully vested, discounted option to purchase shares of an S&P 500 index mutual fund, that sounds like current compensation to me, in which case I would be subject to tax when Section 83 says I'm subject to tax.