"Rolling vesting" in 457(f) plans - eliminated by 409A?

[Guest jfsinger]

Is the common "rolling vesting" technique in 457(f) plans eliminated by 409A? I've heard varying opinions on this, with the most prevalent being "wait and see". I'd be interested in your opinion. Thanks,

Joe

[Guest LeeNunn]

Not for profits have used rolling risk of forfeiture, covenants not to compete, sham consulting agreements, grandfathered discounted options to (arguably) create substantial risk of forfeiture and defer taxation under 457(f) plans.

New 409A ignores all these techniques for purposes of substantial risk of forfeiture and imposes an additional level of compliance. No grandfathering for plans that, by their nature, can’t be earned and vested without taxation.

Suppose a not for profit offers a 457(f) elective deferral. Elections need to be made on time and distributions are restricted to the six events. Second elections for certain events require five years deferral. Offshore trusts and financial health triggers are out.

To answer your question, you can't use a rolling risk of forfeiture (or any of the other traditional 457 techniques) to escape 409A. Second elections for in-service accounts are still allowed under 409A, but with 12 month notice and a minimum five year deferral.

[mbozek]

It would be beneficial if 409A put an end to the practice of NP execs making salary reduction subject to a substantial risk of forefeiture because the employee has no legal recourse to receive payment if the employer terminates the progam or revokes the benefits due to a change of board members, termination for cause, etc. It is better to pay tax on the comp then to make the distribution subject to some fickle board majority in the future.

[E as in ERISA]

I think that the Treasury has indicated that there may be differences between the definition of substantial risk of forfeiture for 409A purposes (which uses 83 and doesn't allow covenants, etc.) and 457(f) (where some of those have not been strictly disallowed). 457(f) plans would be subject to both. This could cause administrative problems if someone is taxed under the 409A rules but under the terms of the plan is not paid out until there the risk is gone for 457(f) purposes, etc. I don't know if I'm stating the issue exactly as it was posed, so someone correct me. But I know that some bad situations have been discussed.

The concern is that you need to know and understand both definitions and when they apply.

[Guest LeeNunn]

Sections 83 and 457(f) use the same definition of substantial risk of forfeiture. Section 409A generally uses a more narrow definition, as you point out.

Neither the Service nor Treasury agree with many of the 457(f) techniques being used out there, but Treasury has had its hands tied because of the 1978 moratorium. 409A has given Treasury an opportunity to indirectly address some of the 457(f) abuses it perceives. To quote Dan Hogans at Treasury, "why would anyone defer compensation if there were a substantial risk of forfeiture?" In Treasury's mind, a 457(f) elective deferral is an oxymoron.

[E as in ERISA]

The scenario I'm describing was discussed by Treasury in events that it participated in after it issued guidance. In those discussions, it appeared to recognize that 457(f) does not specifically utilize the 83 definition of substantial risk of forfeiture. They acknowledged that covenants, rolling risk, etc. are used under 457(f)s. That shocked me. But I haven't worked with 457(f)s recently. And I'm not sure that they actually recognized them as valid under 457(f) -- just recognized that they were being used under 457(f) plans and would cause taxation under 409A. And there might be some slippage.

[mbozek]

I doubt that treasury will create an exception from taxation under 409A of amounts deferred under 457(f) plans with abusive provisions. IRS position for at least the last 10 years is that rolling vesting, covenants, etc are not valid methods to avoid taxation under 457(f). But NP still adopt such programs based on opinions from tax advisors.

[E as in ERISA]

What they said today is that both 409A and 457(f) apply and they are not necessarily identical. The plan's taxation would have to be separately analyzed under both rules.

An SRF is strictly defined under 409A and "fancy conditions" would not be SRFs. However, an SRF may not be as clearly defined under those 457(f). So the point of taxation might be different under those rules.

A plan would have to comply with 409A distribution rules to the extent that there was any deferral beyond the date of vesting for purposes of 409A. Or there would be a 409A violation.

If a plan complies with 409A and 457(f), it's possible that vesting for 409A could occur in Yr A, vesting and taxation for 457(f) could occur in Yr B, and distribution and taxation for 409A could occur in Yr C.

A new issue raised was old grandfathered 457 plans (pre-457(f)) that might have to be subjected to 409A. If they are not vested, then they might not be grandfathered under 409A. They would have to be updated. But then that might be a material modification for the 457 grandfathering...

[mbozek]

I thought the Notice permits payment of taxes due in a 457(f) plan upon the occurance of a vesting event under 409A. Q-15(d) & (f). What I dont understand is when would the amounts deferred under the 457(f) plan be taxed under 409A because of the failure to meet the SRF definition in 409A. For example, if a participant's benefit under a 457f plan is subject to rolling vesting where the benefits become non forefitable on 1/1/07 in the absence of an agreement to extend the risk of forefeiture, will the deferred amounts be included in income tax on 1/1/05 because rolling vesting is not a SRF under 409A or will it occur on 1/1/07 when the rolling vesting expires.

[E as in ERISA]

My understanding:

It depends on whether the plan includes the 409A distribution terms, etc.

If the plan terms comply with 409A provisions, the amount will be vested for purposes of 409A on 1/1/05. However, it is not taxed because it complies with 409A. Assuming that the rolling risk is a valid 457(f) SRF (which they would not answer), then 457(f) would tax it on 1/1/07. The plan could have a distribution event that allows payment of taxes at that time per Q 15. I don't think that the 409A penalties would ever apply.

If the plan does not have 409A provisions, then the amount is vested for purposes of 409A on 1/1/05. It is not paid at that time, so it is a deferral of compensation subject to 409A. It is in violation of those rules. Therefore it is subject to tax and penalties at that time.

[E as in ERISA]

I think that you're suggesting that taxation under 457(f) could occur at 1/1/05 because a rolling risk of forfeiture is invalid as an SRF under 457(f)? (And I don't necessarily disagree. Especially when you consider how the Treasury skirts that question in 409A discussions)

But even so, vesting is not a taxable event under 409A for a plan that is compliant. So Q 15 could permit you to have a distribution to pay taxes at that time without subjecting you to tax under 409A until the actual distribution.