457(f) Substantial Risk of Forfeiture

I have been presented with a 457(f) plan that relies on a noncompete provision to satisfy the SROF requirement.  I understand that unlike the 409A rules, the 457(f) rules do permit the use of a non-compete as a SROF.  This particular plan's SROF restricts the participant from working for a competing business while employed with the sponsor of the 47(f) plan.  But the participant vests upon a separation from service for any reason.  The participant is  not subject to a post-employment non-compete obligation.  As such, the participant is only subject to a forfeiture if they work for a competing business prior to separating from service from the sponsor of the 457(f) plan.  I am also troubled by the fact that the payment is to be made "within 3 months after separation from service and the appropriate distribution paperwork is submitted to the employer."  This would not appear to be exempt from Section 409A as a short term deferral and it lacks the required specified time for distribution.   

For an ineligible deferred compensation plan, a participant’s compensation counts in her gross income for her first tax-accounting year in which there is no substantial risk of forfeiture of her right to the compensation. I.R.C. (26 U.S.C.) § 457(f)(1)(A).

Section 457(f)(3)(B) defines: “The rights of a person to compensation are subject to a substantial risk of forfeiture if such person’s rights to such compensation are conditioned upon the future performance of substantial services by any individual.”

If one doubts that the conditions IM4ERISA describes result in a substantial risk of forfeiture, how one acts (or refrains from acting) on such a doubt might turn on whether one is the tax-exempt organization, a participant, or some third person with some role about the plan.

Likewise, if one is a lawyer, certified public accountant, or other adviser, how one advises one’s client or other advisee turns on the client’s or advisee’s rights, duties, obligations, and other interests.

For example, a participant might like lax conditions on her right to the deferred compensation plan—even if that means tolerating some risk that the compensation counts in income before it becomes payable. A participant might reason that the employer won’t tax-report the deferred compensation if the employer assumes that the conditions are substantial. Why burden one’s right to compensation with any more restraint than is necessary?

But a tax-exempt organization (or a person the IRS or another tax agency might find was or is a “responsible party”) might dislike lax conditions if that could result in a liability exposure for having failed to tax-report deferred wages.

A practitioner might dislike lax conditions if someone might assert that the practitioner did not meet a lawyer’s standard of care to inform one’s advisee about all the risks. That’s especially a risk exposure if the someone might plausibly assert that it or she was the adviser’s client or otherwise was invited to rely on the practitioner’s advice.

The Treasury department has made no rule interpreting what is a § 457(f)(3)(B) substantial risk of forfeiture.

Some might consider the Treasury’s proposal. Deferred Compensation Plans of State and Local Governments and Tax-Exempt Entities [notice of proposed rulemaking], 81 Federal Register 40548-40569 (June 22, 2016), https://www.govinfo.gov/content/pkg/FR-2016-06-22/pdf/2016-14329.pdf. The notice states: “Taxpayers may rely on these proposed regulations until the applicability date [of a final rule].”

A tax-exempt organization’s select-group executive who evaluates her own participation under a deferred compensation plan should get her lawyer’s or other IRS-recognized practitioner’s advice.

This discussion is not advice to anyone.

I haven't come across anything like this before, but I think it's (at a minimum) a very aggressive interpretation. The current and proposed 457(f) rules both at least implicitly contemplate post-employment restrictions in order to delay vesting. Under the proposed regulations, one of the factors in determining whether a non-compete constitutes a SROF is the employee's bona fide interest in, and ability to, engage in future competitive services. I'm not sure the IRS would consider an employee getting a second full-time job with a direct competitor to meet this standard (although I don't know the specific dynamics at issue with your situation). 

Thanks Peter and EBECatty.  I posted this question because I have never encountered this type of non-compete provision.  This plan has been in place for a number of years.  I would not have been comfortable drafting the plan in this manner.   

The IRS seems to be content with remaining ambiguous about 457(f) rules rather than being prescriptive which leaves the consideration of facts and circumstances as a primary tool for determining the validity of the deferral of compensation.  Fundamentally, they do not seem to be able to get their head around what would motivate an employee to agree to put compensation at a substantial risk of forfeiture unless the employee was reasonably certain that the risk was not substantial.

The Proposed Regs 1.457-12(e) and in particular subsection (iv) provide some insight into IRS-think about SROF and non-compete provisions, and the sort of facts and circumstances the IRS may consider.  You may wish to point the client to this section for their own enlightenment.

And if one looks to the proposed rule, some might read it to call not only that the noncompete must be real but also that the period for which the employee must perform the services against which she must not compete is itself “substantial.”

On 3/21/2024 at 3:13 PM, IM4ERISA said:

But the participant vests upon a separation from service for any reason. 

So what you're really saying, I think, is that they are vested, unless the prohibition on working currently (i.e., while employed for the first employer) for a second competing employer is enough to prevent vesting, which is a determination based on facts and circumstances, but seems doubtful.

On 3/21/2024 at 3:13 PM, IM4ERISA said:

I am also troubled by the fact that the payment is to be made "within 3 months after separation from service and the appropriate distribution paperwork is submitted to the employer."  This would not appear to be exempt from Section 409A as a short term deferral and it lacks the required specified time for distribution.   

Under 457(f) proposed regs, if the benefit is payable within the short-term deferral period, actually or constructively, it becomes subject to IRC 409A. So if it takes longer than 2-1/2 months after the end of the year in which vested (see above as to substantial questions regarding when vested), you might want to include on W-2 so that "constructively" received. Frankly, I found the proposed regs somewhat confusing on the point of "constructive payment."

If the participant vests on a separation from service for any reason, then the benefit is already vested.  While a noncompete can prevent vesting, that happens only if the person has to avoid competing for some defined period of time.  If the person can get out of the noncompete by separating from service, it would be just like any other situation in which someone gets the benefit regardless of when they terminate.

Thank you all for your responses.  It is the case that the individual is fully vested upon a separation from service for any reason.  The only way to forfeit the benefit is to work with a competitor prior to separating from service.  I suspected that this would not constitute a substantial risk of forfeiture.