457(f) and 409A

[Locust]

It looks to me that under the final 409A regulations, a noncompete condition will work to delay taxation under 457(f) and can be structured so it won't violate 409A.

For example, if an executive will be paid in 5 annual installments following separation from service provided he meets a noncompete provision that is a SRF under 457(f), he won't be taxed until each payment that coincides with the lapse of the SRF. The SRF delays taxation until lapse, and it meets 409A because the payments are fixed dates. The timing of taxation is determined under 457(f), and it meets the payment timing rules of 409A.

But it doesn't look like rolling vesting works unless the election to change the vesting date coicides with the 12 month/5 year change of election rules. So the executive who was to be vested in 2012 at the end of his employment contract can change the vesting date only if the new agreement is made by 2011 (12 months before vesting) and if the payment date is no earlier than 2017. [This assumes that rolling vesting is a valid concept under 457(f).] If the change is made under the 12 mon/5 year rule, it meets the payment timing rules of 409A. If it doesn't meet those rules, it violates 409A and taxation occurs under 409A even if it wouldn't have been taxed under 457(f).

Do you think this is the way that noncompetes and rolling vesting will work in an ineligible plan post-final 409A regulations?

[QDROphile]

Treas. Reg. section 1.409A-1(d):

An amount is not subject to a substantial risk of fofeiture merely because the right to the amount is conditioned, directly or indirectly, upon refraining from performance of services.

Rolling vesting is out, too. A risk that is added afterward is disregarded.

The IRS deliberately blocked the dirty tricks under 457(f).

[Guest mjb]

L: what is the basis in 457(f) for your conclusion that a non compete clause is an SRF? Reg 1.457-11(a)(1) doesnt provide for a SRF for a non compete.

[Locust]

mjb - The assumption before 409A was that the 83(b) definition of SRF would apply to 457(f). Reg. ss 1.83-3© defines SRF as including conditioning a benefit "upon the future performance (or refraining from performance) of substantial services." The parenthetical phrase is the basis for saying that a legitimate noncompete could be a SRF.

QDROphile - I don't think 409A changes the rules of 457(f) that say when deferred compensation of a nonprofit/governmental is taxed (unless 409A is violated). In other words the 409A definition of SRF does not change the 457 definition of SRF, and under the 457 definition a covenant not to compete might still be an SRF. As I mentioned, I think you could have rolling vesting, only it would have to meet the 12 mo/5 year rule applicable to changes in payment dates.

[Guest mjb]

Locust. That premise does not apply if only cash is deferred since section 83 only applies to transfers of property other than cash. Under reg. 1.83-3(e) a promise to pay money or an unfunded and unsecured promise to pay money or property in the future is not section 83 property. Compare transfer of property in examples 1-3 under reg 1.457-11(d)(2) with example 4 which discusses the taxation of cash comp not property, under 457(f). The 457 regs were finalized before 409A was enacted.

Requiring a non compete provision in a 457(f) plan will not defer taxation of the comp but will prevent the employee from receiving the comp until the non compete is signed.

[Locust]

mjb - I agree that there is nothing in 457(f) or the regulations that defines "substantial risk of forfeiture." However, application of the 83 definition, which was the only definition around when 457 was enacted, was the standard that was used. When 409A was enacted, Congress stated that the IRS should develop definition of SRF for 409A that was more rigid than the 83(b) definition, thus the rule under 409A that a condition requiring an employee to refrain from service will not be a SRF. As the 409A definition was supposed to be a change for 409A of the definition that had applied before, I don't think that definition will apply to 83 or 457(f), which will retain the current 83 definition until the IRS changes it. Also, the examples under 457 regs show is that if property is transferred, 83 applies, but they don't indicate that the SRF definition under 457 and 83 are different.

[Guest mjb]

There is an exception from the SRF in 457(f)(1)(A) for that portion of any 457(f) plan which consists of a transfer of property under IRC 83. IRC 457(f)(2)©. As previously noted property under IRC 83 does not include an unfunded promise to pay money in the future. I dont see any exception for non competes for a deferral of comp in a 457(f) plan as an SRF if a transfer of property is not involved because there is no statutory authority.

[QDROphile]

Locust: You are really going to enjoy a new IRS notice about 457(f).

[Locust]

Thanks QDROphile - it looks like the IRS is going to define SRF for 457 consistently with 409A - so the rule will be clear then. Here is an excerpt from the notice you mention Q -

Excerpt from 2007-62

"The Service and Treasury anticipate that upcoming guidance under section 457(f) will generally adopt the rules relating to substantial risk of forfeiture that are contained in section 1.409A-1(d)."

I guess that settles it, unless I were to argue that this notice simply indicates an intent to change the rule - let's not go there.

Thanks for the learned discussion.

[MPLSLAW]

If neither of you will, I will. The new notice 2007-62 clearly states that the new definition of "substantial risk of forfeiture" for 457(f) purposes will be "prospective". "No inference should be made" with respect to prior periods. The notice requests comments as to appropriate "transition guidance" and what that should include.

My interpretation is that prior to the new regulations, it will be facts and circumstances with the burden being on the employer to prove that the non-compete restriction is a substantial restriction on the employee's right to employment in his or her field and that the employer intends to enforce the restriction to the result of a complete forfeiture. As long as the plan satisfies the fixed payment date and restrictions on elections contained in 409A, a 457(f) plan can comply with 409A. I would not rely on the 83 regulations for a new 457(f) plan however....

[Guest mjb]

MP etc:

Q1 Are you referring to a 457(f) plan which provides for a transfer of property or a deferral of compensation, e.g., a promise to pay compensation in the future.

Q2 why are facts and circumstances relevant on distributions made prior to the issue of new regs?

Q3 are facts and circumstances applied under the current 457-11 regs for a deferral of compensation that does not involve a transfer of property or is the deferral taxed when there is no requirement to perform substantial futrure services?

[Locust]

mpslaw - that's a good point. I haven't looked at the language that closely (that's obvious) but I would think the relevant date would be the date of the publication of the Notice - sometime shortly after July 24. I wouldn't want to count on the availability of the old SRF standard for elections made after that date - in other words you couldn't add a noncompete or extend a vesting period after that date. But maybe that is being too conservative - I suppose you could tell the client to try for it in this period before the rules are actually issued with the caveat that he or she may have to give it up. L

[QDROphile]

Somebody seems to have forgotten that 409A overlays 457(f) already. Proceed at your peril. The IRS sent a pretty clear message that it will remove the tools of the knaves who persist in the same mischief under the 457(f) regulations that helped bring us 409A in the first place.

[Locust]

Q - Your characterization of those who were aggressive as knaves is overly harsh. Some might charactize them as smart and helpful. With 457 and deferred compensation generally there was no IRS guidance as to what these various terms meant and no real enforcement. A certain percentage of taxpayers in this situation will want to be aggressive. In retrospect the aggressive taxpayer was rewarded and in a sense was "right" because the grandfather rules of 409A have pretty much approved everything that was done before 2005, and the grandfather rules of 457 will likely approve everything that was done before some date in 2007.

[QDROphile]

As a practical matter, you are correct that the IRS is not likely to go after arrangements before 2005. That does not justify them or make them any less improper. Many arrangements proceeded with the understanding that enforcement was unlikely, for various reasons. Although it took the shock of Enron to move the mountain, the improper "smart and helpful" behavior is why we got 409A, which is so far reaching that it presents problems for some common and innocuos arrangements. I still say knaves, and I am unimpressed with your defense of those who simply did not get caught in the enterprise of making themselves money while leading others astray. Actually, I am impressed that even in hindsight the bad behavior is recognized for what it was and the echoes of that bad behavior are evident in the current efforts to twist and get around the rules rather than understand and comply with them.

[Locust]

Q - So you knew exactly what 457 meant when it used the term "substantial risk of forfeiture," even though there was no definition (other than the ss 83 definition that is different from your understanding) and no IRS guidance and no IRS enforcement? Wow! I salute your extraordinary abilities! You ought to be picking stock. L

[QDROphile]

I knew that noncompetes were almost certainly bogus and rolling risk of forfeiture was bogus the way that most people were doing it.