Interplay of 409A and 457(f)

[Guest curious jorge]

Notice 2005-1 is confusing me as to 457(f) plans (among others!). What is the effect if 457(f) sponsor rolled risk of forfeiture prior to enactment of 409A, but next vesting date is at point after 1/1/05 (under 457(f) and 409A)? What can be done to mitigate problems to the extent there are any?

Thanks.

[QDROphile]

There are no problems. If the amount is not already taxable, it will become taxable at the time scheduled for the risk to lapse.

[Guest curious jorge]

Even though A-10 of 2005-1 seems to indicate rolled vesting dates don't work?

[E as in ERISA]

The rolling risk would not be a substantial risk of forfeiture for 409A. So if the plan does not pay until the risk lapses, there will be deferral of compensation and the plan will be subject to 409A. It has to comply with the 409A deferral and distribution rules. The timing of the distribution has to be set in stone in advance -- with the possibility of five year delay. It would be potentially be taxed at distribution under 409A.

However, 457(f) simultaneously applies. Assuming that the rolling risk is valid there, then it will be taxed at the lapse of the risk under 457(f).

That may be sooner or later than the taxation under 409A at distribution. They haven't clarified how those rules coordinate and what you tax at the time that the later of the two rules applies. Whether you cut off taxation of earnings on the amount taxed earlier or whether you capture them at the later date...

[QDROphile]

Curious:

You misunderstood my statement. You don't get to continue the roll (assuming you could do it in the first place - which is doubtful). When the restriction lapses according to the schedule in effect in 2004, the amount is taxable. Or maybe before. No problems does not mean no taxes. No problems means that the outcome is rather clear. Confusion (which drew you to the board) is a problem. Thinking that such a scheme was workable in the first place is a problem. Now you have no problems.

[E as in ERISA]

409A does not generally tax at vesting. It taxes at distribution. Vesting is generally irrelevant for 409A. There is an exception is if distribution occurs at the time of lapse of a risk of forfeiture that is valid for 409A. In that case, vesting is relevant because it excepts you from the definition of deferral of compensation and you are not subject to 409A. No requirement to comply with limits on timing of distribution.

It doesn't sound like you meet the exception. You have no valid risk of forfeiture for 409A. So you have a deferral of compensation and are subject to the limits on timing of distribution. The plan needs to be amended to comply.

If you don't bring the plan into compliance with 409A, then you probably have taxation and penaltes at January 1, 2005, under 409A.

If you bring it into compliance with 409A, then you defer taxation under 409A until distribution. But in the meantime you could have taxation under 457(f).

And as QDROphile notes, the rolling risk is probably questionable under 457(f). But that's a different discussion.

[Guest curious jorge]

Katherine:

1. am I reading your post correctly to say that, for example, if a participant's one and only vest date is set to occur in 2006 (and is not result of a prior roll), participant actually works until and separates on that date, and plan distributes soon after separation, the payment would not be considered a deferral subject to 409A b/c it meets an exception (I'm assuming of the 2 1/2 month short-term deferral variety)?

2. in a situation where there is an attempted rolling vesting date situation (e.g.., it is decided, perhaps inappropriately, that vesting should be rolled from 2006 until 2008), would it be correct to say (assuming no 457(f) vesting occurred) that to the extent the plan otherwise complies with 409A, there would be no tax imposed under 409A until distribution in 2008, even though a 409A vest occurred in 2006?

[E as in ERISA]

Yes. That's my understanding -- for 409A purposes.

1. Yes, if the terms of vesting are a valid risk of forfeiture for 409A.

Under Q&A-4 of Notice 2005-1, there is no deferral of compensation/the plan is not subject to 409A if it pays out shortly after there becomes a legally binding right to it and/or a valid risk of forfeiture lapses. See Q&A-10 for risk of forfeiture definition.

2. Yes. Vesting is not a taxable event under 409A. As long as the plan satisfies 409A, you don't tax until the distribution.

This works for participants who plan to terminate or retire. It might not work for participants who aren't certain of termination.

The bigger risk is under 457(f). The IRS could audit the plan and say the rolling risk is not valid for 457(f). Therefore, it's taxable in 2006 -- under 457(f). Then its not clear what part is taxable for 409A in 2008 (nothing because already taxed, additional earnings)

[Alf]

409A does not generally tax at vesting. It taxes at distribution.

Of course, it is impossible to generalize this broadly, but isn't this more off than it is on? It sounds to me like this is the old constructive receipt rule. I would say that 409A causes taxation at vesting UNLESS you meet the requirements of 409A.

Anyway. I thought that QDROphile nailed it imo. This plan isn't grandfathered (b/c not vested), so shouldn't taxation apply at vesting, which is when the original rolling risk lapses?

[E as in ERISA]

I'm just piggybacking off the way the IRS is discussing it. They are indicating that vesting is a fairly irrelevant event for 409A plans. People seem to be getting confused about that since there is a lot of discussion about vesting -- particularly for grandfathering and now the definition of deferral of compensation and rule on short term deferrals. So they're trying to drive the point home that for a plan that is subject to 409A and complies with the rules, it is distribution not vesting that is important. The bottom line is that, yes, compliant NQ plans (non-457(f)) will be taxed like they were under the old rules. Frankly, I don't think that the rules are that different than the way that the IRS and conservative practitioners thought that people should be operating their plans all along. They've just been codified -- and complicated with transition rules and grandfathering.

For 457(f) plans its more complicated, because plans are subject to taxation under both sets of rules and the definitions of substantial risk of forfeiture appear to be different (409A is very clearly limited; 457(f) is just not well-defined so plans are using more aggressive SRFs).

The answers to these questions are very fact specific. I read the original question as indicating that the risk had already been rolled once ("What is the effect if 457(f) sponsor rolled risk of forfeiture prior to enactment of 409A"). If that is true, then the money was probably vested for 409A purposes at 1/1/05, because a rolling risk of forfeiture is not a valid SRF for 409A purposes. When cj indicated that there had been no roll yet, then the answer changed (assuming the original SRF was valid).

[Guest curious jorge]

Is it as simple as saying then that 409A, if complied with (and therefore not triggered), never actually imposes a tax, even at distribution ? In other words, a 457(f) plan in compliance with 409A in form and operation would be taxed under 457(f) in all cases.

[QDROphile]

A rolling risk of forfeiture, as it is known under 457(f) arrangements, is not compliant with 409A. See Notice 2005-1 Q&A 10: "*** any extension of a period during which compensation is subject to a substantial risk of foreiture is disregarded ***."

[Guest curious jorge]

Doesn't mean it doesn't comply with 409A. It only means for purposes of determining SROF, an extention of srof is not respected.

[QDROphile]

Which means the amount will become taxable at the time the risk lapses for 409A purposes. To me, that means that the arrangement is not compliant if you try to give effect to it the same as you would under the terms of the 457(f) arrangement, if you believe that rolling risk works under 457(f) in the first place.

[Guest curious jorge]

Let's assume (right or wrong) that 457(f) would permit another roll like #2 in my prior post. Even though 409A says SROF lapses for purposes of 409A in 2006, if plan otherwise is in compliance with 409A, haven't we established that 409A vesting is a nonevent -- meaning there would be no tax as result of SROF lapse until 2008 (again assuming no 457(f) vest in 2006)? My thought is that 457(f) would operate to tax, whether in 2006 or 2008, not 409A.

No problems, as you say.

[QDROphile]

I think amounts become taxable in 2006 when the restriction lapses for purposes of 409A. I think Notice 2005-1 was intended to make it very clear that rolling risk of forfeiture is not permitted. The IRS has never bought into it as currently used (or abused) and took its opportunity in Notice 2005-1 to put and end to the arrangement.

I think you misunderstand the IRS position on vesting. Look at the example in the Notice. The vesting is irrelevant because the established deferral period exceeded the vesting period. A change in the vesting did not affect the deferral. It may have changed whether or not the employee actuall got any compensation, but not when or in what form the compensation, if any, would be paid. The deferral was compliant with 409A. It does not work that way under 457(f) because there is no separate deferral under 457(f). 457(f) works on risk of forfeiture alone. 409A says you can't extend the period for risk of forfeiture, with an express exception.

I heard the IRS comments about vesting and a lot of people came away confused, perhaps including me. I don't think they were saying anything different from what is in the Notice.

[Guest curious jorge]

Exactly where is the example to which you refer?

This is straight from what 2005-1 Q&A-1 says, with my added emphasis: "Section 409A provides that all amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income, unless certain requirements are met." The Notice also makes clear that 409A does not alter or affect the application of any other code section or common law.

It seems clear then that the SROF definition set out explicitly for 409A cannot automatically be read to be the same under other SROF-driven provisions such as 457(f). If that were true, the IRS would have specified as such.

I read Q&A-1 to mean if you meet those "certain requirements" of 409A (i.e., as to timing and form of distribution, etc., etc.), then it doesn't matter when SROF lapses b/c 409A has not been violated and therefore won't result in taxation, additional tax and penalties. 457(f) operates on a separate track and a separate determination outside of 40A should therefore be made as to SROF.

[card]

Katherine: to complicate things a little more, you said earlier: "If that is true, then the money was probably vested for 409A purposes at 1/1/05, because a rolling risk of forfeiture is not a valid SRF for 409A purposes."

Actually, for determining which dollars are grandfathered, the definition of SRF in Section 83 applies, not the definition in Section 409A. See Question 16(b).

But I thought this entire issue was fairly straightforward:

457(f) plans are generally subject to both sections 409A and 457(f).

A rolling risk of forfeiture works (presumably still) for 457(f) but not 409A.

If a 457(f) plan complies with section 409A's substantive requirements (elections, distributions, etc.) the issue of a substantial risk of forfeiture as defined under Section 409A is irrelevant (except for the 2 1/2 month rule), and the plan continues as it always has under section 457(f) (including RRF's)

If a 457(f) plan fails to satisfy section 409A's election or distribution requirements, then the definition of SRF in section 409A applies, the rolling risk of forfeiture is ignored, and there is immediate taxation under 409A. If a 457(f) plan fails to satisfy Section 409A's funding requirements then a transfer under Section 83 is deemed to occur (and SRF as defined in Section 83 applies).

SRF's are important under 409A for three reasons:

1. Benefits under noncompliant plans are taxed when the SRF lapses. (409A definition for election and distribution failures, section 83 definition for funding failures.)

2. Determining the grandfathered benefit. (section 83 definition)

3. Determining if the 2 1/2 month rule in Q4© applies. (409A definition- so RRF would be ignored for this purpose, and you would have a deferral of compensation subject to 409A)

[edited to clarify that a violation of the funding rules creates a transfer of property under Section 83.]

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