Substantial Risk of Forfeiture Under Sec. 457(f)

By Barbara Josefowicz, J.D., LL.M., CPA, New York, NY

Editor: Greg A. Fairbanks, J.D., LL.M.

Sec. 457(f) deals with non qualified deferred compensation (NQDC) plans of governmental and other tax-exempt employer sponsors. Specifically, Sec. 457(f) applies to plans classified as ineligible plans to distinguish them from Sec. 457(b) plans, which are called eligible plans.

Sec. 457(b) plans have a contribution dollar limit ($15,500 for 2008) but do not generate taxable income to the participant until the nonqualified deferred compensation is paid or made available to the participant. Sec. 457(f) plans, on the other hand, have no contribution limit but cause the participant to have taxable income in the first tax year in which there is no substantial risk that the participant will forfeit the nonqualified deferred compensation. In other words, the participant could have income inclusion before the deferred compensation is paid or made available. Under Sec. 457(f)(3), a substantial risk of forfeiture exists when the participant’s rights to the deferred compensation are conditioned on the future performance of substantial services by any individual.

Impact of Sec. 409A

In addition to the requirements of Sec. 457(f), governmental and tax-exempt sponsors of Sec. 457(f) ineligible plans must also deal with Sec. 409A. Sec. 409A, which generally became effective in 2005, provides for three categories of restrictions that apply to most NQDC plans, including Sec. 457(f) ineligible plans. The three types of restrictions under Sec. 409A are restrictions on the election to defer compensation, on funding, and on distributions.

Under Sec. 409A, the event that produces taxable income to the participant is failure to comply with Sec. 409A. Under Sec. 457(f), by contrast, the event that produces taxable income to the participant is the cessation of the substantial risk of forfeiture.

Income inclusion under Sec. 409A encompasses all deferred compensation that vests after 2004 plus interest thereon. There is also an additional 20% penalty imposed on the participant as well as interest on the income taxes that would have been due had the deferred compensation been reported in income (rather than deferred) in prior years (Sec. 409A(a)(1)(B)(i)(II)). The interest rate on such income is the appli cable underpayment rate plus 1% (Sec. 409A(a)(1)(B)(ii)).

Caution: Deferrals that are not yet subject to income inclusion under Sec. 457(f) could violate Sec. 409A, there by causing a taxation impact to the participant that is far more severe than income inclusion alone under Sec. 457(f).

Recent IRS Announcement on Sec. 457(f)

On July 23, 2007, the Service issued Notice 2007-62, which announced the Service’s intent to issue guidance re garding a substantial risk of forfeiture for purposes of Sec. 457. This guidance, according to Notice 2007-62, will be prospective in application and will generally follow the rules under Sec. 409A, which also embodies a substantial-risk-of-forfeiture concept.

Considerations for Sponsors of Sec. 457(f) Plans

There are three practices that tax-exempt organizations have frequently built into their Sec. 457(f) ineligible NQDC programs. These are briefly discussed below, together with the impact of Secs. 457(f) and 409A.

Under the first practice, the em ployee elects to defer salary and agrees to make the deferral subject to a vesting schedule in order to avoid current income taxation under Sec. 457(f). Notice 2007-62 points out that unless the amount to be received in the future is substantially greater than the amount that the participant can currently re ceive, the participant would have no reason to agree to the vesting schedule except to avoid current income taxation. In the Service’s view, no realistic substantial risk of forfeiture exists. Under Sec. 409A, the vesting schedule is ignored, and Sec. 409A applies when the employee makes the election to defer. According to Notice 2007-62, future guidance will present the same analysis under Sec. 457(f).

Under the second practice, the em ployer, the employee, or both agree to a series of extensions of the original vesting period in order to avoid current income taxation. This practice is sometimes referred to as a rolling risk of forfeiture. Notice 2007-62 points out that for Sec. 409A purposes, only the initial vesting date is respected and any extension of the date is disregarded. The same rationale will most likely be used by the Service in future guidance under Sec. 457(f).

The third practice under Sec. 457(f) aimed at creating a substantial risk of forfeiture is to include a noncompetition clause in a terminating executive’s employment agreement. Under this practice, there would be no income inclusion under Sec. 457(f) until the noncompete period ends. For Sec. 409A purposes, however, Notice 2007-62 makes it clear that the noncompetition clause is disregarded. According to the notice, conditions that would create a valid substantial risk of forfeiture under Sec. 409A must relate to the participant’s performance for the service recipient. An example is the service recipient’s attainment of an earnings level. The Service has asked for comments on whether future guidance under Sec. 457(f) should take the same approach.

Action Step

Practitioners who serve the tax-exempt industry should review NQDC plans instituted under Sec. 457(f). While such plans may still create a substantial risk of forfeiture for Sec. 457(f) purposes, they may generate income taxation and penalties under Sec. 409A.


Greg A. Fairbanks, J.D., LL.M., works for Grant Thornton LLPWashington, DC

Unless otherwise indicated, contributors are members of or associated with Grant Thornton LLP.

If you would like additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or

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