Is this a 457(f) plan?

[Guest Nodak]

I am very new to government benefit plans. While I have a fair amount of experience with employee benefit plans, they are all ERISA plans in private industry. Obviously, this is not much help to me in my position with the government.

One of our state agencies would like to start a retention program for key executive employees. Initially the agency would purchase some financial instruments (likely a number of mutual funds). The plan would require the employee to meet certain goals set out by the agency. If the goals were met, the employee would be given the option to buy the financial interment anytime during the following 10 years. The purchase price for the mutual fund would be the fair market value price on the day of the initial offer, and that price would be held firm for 10 years, or until the employee elects to purchase the mutual fund. If the employee were to leave the employment of the agency within one year of purchasing the financial instruments, any gains realized would be repaid to the agency.

From a brief reading of the IRS website and a few federal regs, if appears that what they need is an unqualified plan under 457(f). Would you agree? If so, do you know of any guides regarding setting this up? (E.g. 457 Plans for Dummies). I am assuming that there are requirements similar to ERISA that would require a plan document, and possibly many other requirements. If I am off track in assuming this should be an unqualified plan under 457(f), could you set me on the right track?

Any information you could provide would be greatly appreciated.

[Guest hwhans]

Before implementing the proposed program you need to look closelyb at Treas. Reg. section 1.457-11(d) which was issued last July. That regulation coordinates section 457(f) with section 83. Under the general rules of the regulation, an employee must recognize option-related compensation on the date the option is no longer subject to a substantial risk of forfeiture even if the option is not exercised at that time. The application of this rule is demonstrated by Example 3. The Preamble to the regulation discusses "synthetic" or "derivative" option programs that are similar to the one you described and make it clear that there is an income recognition event when the options vest under section 457 and another income recognition event when the option is exercised under section 83. I assume that the option price being locked in under your proposed program is the FMV of the mutual fund when the performance goals are presented to the executive and that vesting occurs after the goals are met at some point in time in future.

[Guest Nodak]

Thanks for the reply. Your way would make more sense – having the FMV locked in at the time of offer. What they want to do is offer the FMV on the day the goals have been met. In other words, if the employee meets the goals set out by the employer the employee may purchase the mutual fund at the FMV on the day that the goals are met. Since it is done this way, rather than your way or, alternatively, at a discount of FMV, does it take it out of the 457(f) plan?

[Guest hwhans]

The Regulations are clear that section 457(f) has to be taken into account where a covered entity employs a compenation program design that otherwise falls under section 83, the provision governing the transfer of property by an employer to an employee. From a Regs. section 1.457-11(d) perspective, the only difference under section 457(f) between vested, discounted options and vested options at FMV is the value that is attributed to the option, because in either case the executive will recognize ordinary income when the vested option is granted by the governmental entity. See Example 3 in the regulations. It lays out the income tax results of granting an employee a vested option. What you should be considering in your plan design is (1) how to value the option that will be granted after the performance period, and (2) the income and FICA tax expense that the executive will have to recognize and then will have to come up with the cash for the taxes. Assume a 10 year option on $100,000 worth of Popular Mutual Fund is $25,000. The executive will have to come up with cash to pay the taxes on the $25,000, but he won't get that cash by exercising the option. In fact, he will have to come up with $100,000 to purchase shares of Popular worth $100,000. You have to ask your consultant and yourself what impact these tax and cash needs results on the executive will have on the retention goal.