Executive Compensation Arrangements for Tax-Exempt Organizations
(Posted on September 14, 2018 by )


Go to: Executive compensation considerations for tax-exempt entities | Reasonable compensation | Excise Tax on Excess Executive Compensation | Deferred compensation rules | Severance pay | Vacation and sick leave plans | Performance bonuses and other nonfixed payments | Fringe benefits

This practice note sets out important legal and tax considerations when developing executive compensation arrangements for tax-exempt organizations. It provides guidance on practical steps for attorneys advising their tax-exempt clients on various aspects of executive total compensation packages, including deferred compensation, incentive compensation, severance, vacation, and fringe benefits.

This practice note is divided into the following main topics:

Governmental organizations, churches, and qualified church-controlled organizations (QCCOs), whether or not also exempt from federal tax under I.R.C. § 501(c), are beyond the scope of this practice note. Governmental organizations are subject to quite different executive compensation rules than nongovernmental tax-exempt organizations. Churches and QCCOs are exempt from both the Employee Retirement Income Security Act (ERISA) (unless they elect otherwise) and the deferred compensation rules under I.R.C. § 457.

For additional information on private inurement and excess benefit transaction issues for tax-exempt entities, see Planning Tax-Exempt Organizations § 12.04. For additional information on I.R.C. § 457 deferred compensation plans, see Employee Compensation and Benefits Tax Guide ¶ 1407. For general executive compensation considerations primarily focused on taxable entities (including I.R.C. § 409A compliance issues), see Understanding, Drafting, and Negotiating Executive Compensation Agreements on Behalf of Employers and Understanding, Drafting, and Negotiating Executive Compensation Agreements on Behalf of Executives.

Executive Compensation Considerations for Tax-Exempt Entities

Deferred compensation and other executive compensation plans and arrangements for tax-exempt organizations often differ from those established for taxable (for-profit) entities. This is due in part to the tax consequences for nonqualified deferred compensation arrangements commonly provided to executives. Although executives benefit from delayed taxation under such arrangements, a for-profit organization cannot deduct the related compensation expense until the benefits are paid. However, a tax-exempt organization is unconcerned with the tax benefit of compensation deductions. Hence, they have less incentive to avoid deferred compensation arrangements, which can result in undue delay and manipulation from the government’s perspective. In addition, high levels of executive compensation in the nonprofit sector are a red flag area for violations of the private inurement prohibition applicable to tax-exempt entities. See 26 C.F.R. § 1.501(c)(3)-1(c)(2). Consequently, special rules were developed to stem the potential for abuse.

Executive compensation plans of tax-exempt organizations are subject to three principal sets of rules:

Reasonable compensation rules. This requirement is applicable to the aggregate of all compensation that the executive receives, but creates specific concerns in the case of:

  • Deferred compensation
  • Performance bonuses
  • Fringe benefits

Excise tax on excess tax-exempt organization executive compensation. A tax-exempt employer is liable for an excise tax on certain “excess compensation.” As with the reasonable compensation rules, this rule applies to the aggregate of all compensation that a covered executive receives, but creates specific concerns in the case of:

  • Deferred compensation
  • Performance bonuses
  • Fringe benefits

Deferred compensation rules. These rules apply based on:

  • ERISA coverage and exceptions
  • I.R.C. § 457 rules (governing deferred compensation for tax-exempt and state and local government entities)
  • I.R.C. § 409A rules (governing nonqualified deferred compensation for all entities)

Deferred compensation arrangements are also subject to special rules for Social Security and Medicare (FICA) taxes under I.R.C. § 3121(v)(2). However, because those rules are the same for tax-exempt organizations as for taxable organizations, this practice note does not discuss them. For a general discussion regarding I.R.C. § 3121(v)(2), see Employee Compensation and Benefits Tax Guide P 1404.6.

As discussed later in this practice note, many plans not commonly thought of as providing for deferred compensation can fall within the deferred compensation rules noted above, unless they meet certain exceptions, particularly:

  • Severance Plans
  • Vacation Pay
  • Performance Bonuses
  • Fringe Benefits

This practice note first reviews the reasonableness requirement and the deferred compensation rules as generally applicable to tax-exempt entities and then their application to specific types of plans.

Reasonable Compensation

The reasonableness of compensation paid to employees applies to for-profit entities and tax-exempt entities alike, and the tests for whether the compensation is reasonable are similar (though not identical) in both cases. Violations of the test of reasonableness are apparent only when looking at an employee’s total compensation, including:

  • Salary or wages
  • Contributions to retirement plans
  • Deferred compensation
  • Payment of the employee’s personal expenses
  • Personal use of the entity’s property or facilities

Although the reasonableness rule applies to both taxable and tax-exempt entities, it is especially relevant for tax-exempt entities. For a taxable organization, the only penalty for violating it is the limit on the deductibility of compensation to an amount that is reasonable. I.R.C. § 162; 26 C.F.R. § 1.162-7(b)(3). The penalties for a tax-exempt organization are far more onerous.

Penalties for Reasonableness Requirement Violations

Loss of Tax-Exempt Status

I.R.C. § 501(c) sets forth the rules for an organization to acquire and maintain tax-exempt status. For most kinds of tax-exempts, one of the requirements is that “no part of the net earnings . . . inures to the benefit of any private shareholder or individual . . ..” I.R.C. § 501(c)(3); 26 C.F.R. § 1.501(c)(3)-1(c)(2).

Mere payment of compensation to an executive is not necessarily considered inurement to the benefit of any private individual, and individuals operating charitable organizations have no duty to donate their services. They are entitled to reasonable compensation for their efforts. World Family Corp. v. Commissioner, 81 T.C. 958 (T.C. 1983). However, the emphasis is on reasonable compensation; an organization that pays unreasonable compensation may, in extreme cases, lose its tax exemption (e.g., Mabee Petroleum Corp. v. United States, 203 F.2d 872 (5th Cir. 1953)).

Excess Benefit Transaction Penalty Tax

Even if the IRS does not impose the extreme penalty of loss of tax-exempt status, it may impose penalty taxes on the organization under I.R.C. § 4958. This penalty tax on so-called excess benefit transactions seeks to avoid conflicts of interest between a tax-exempt organization and disqualified persons. The tax is imposed in two tiers:

  • First tier tax: 25% of the amount involved
  • Second tier tax: an additional 200% of the amount involved where the excess payment is not corrected before the earlier of:
    • The date of mailing an IRS notice of deficiency –and–
    • The date on which the tax imposed is assessed

I.R.C. § 4958(a)(1), (b).

A disqualified person who receives an excess benefit from a relevant transaction has liability for the tax. A disqualified person for this purpose includes any person who was in a position to exercise substantial influence over the affairs of the applicable tax-exempt organization. I.R.C. § 4958(f)(1); 26 C.F.R. § 53.4958-3. Thus, an executive of a tax-exempt organization receiving an unreasonable level of compensation may be a disqualified person subject to the penalty.

In addition, an organization manager who knowingly and willfully participates in an excess benefit transaction is subject to an excise tax equal to 10% of the amount involved (up to $20,000). I.R.C. § 4958(a)(2); 26 C.F.R. § 53.4958-1(d). Thus, a disqualified person who is both a manager who knowingly and willfully participates in the transaction and receives an excess benefit is subject to both excise taxes.

Information on how to correct an excess benefit transaction can be found at the IRS web page Intermediate Sanctions—Excess Benefit Transactions, and the IRS examination guidelines for excess benefit transactions penalties can be found under I.R.M. § 7.27.30.

Reasonable Compensation Testing

To ensure that compensation is reasonable, an employer must look at two aspects of the compensation, performing a substantive test and a procedural test.

Substantive Test

The substantive test has two prongs:

  • Amount test. This prong focuses on whether the total amount paid is excessive.
  • Purpose test. This prong examines whether the services for which the compensation was paid were necessary to carrying out the organization’s exempt purposes.

The second of these is mostly self-explanatory. A tax-exempt cannot, for example, pay an executive for services that benefit a private business rather than the tax-exempt itself. However, it comes up in the context of whether a performance bonus has impermissibly established a joint venture between the tax-exempt entity and the executive. (See further discussion below under Performance Bonuses and Other Nonfixed Payments)

The rules for determining whether the amount of compensation paid to an executive of a tax-exempt organization is excessive are identical to the ones used under I.R.C. § 162 to determine whether compensation paid by taxable organization is tax deductible as reasonable compensation. See Instructions to IRS Form 990, available at IRS, Current Form 990 Series—Forms and Instructions (hereafter, Form 990 Instructions). Under those rules, compensation is not excessive if it is “such [an] amount as would ordinarily be paid for like services by like enterprises under like circumstances.” 26 C.F.R. § 1.162-7(b)(3).

The IRS has no standard formula for determining when compensation is reasonable. Instead, market rate is determined by researching what someone in a similar position would earn at an organization that is of the same size and has a similar mission or field of activity. Because the IRS recognizes that tax-exempt entities are often in competition with taxable organizations for executives, tax-exempt organizations can look at for-profit compensation when determining market rate, as long as the job, organization size, and organization mission/purpose are comparable.

In assessing whether compensation is excessive, courts have applied two types of tests. In the context of profit-making businesses, many courts have applied an independent investor test, which looks to whether an inactive, independent investor would have been willing to pay the amount of disputed compensation on the basis of the facts of the particular case (e.g., Miller and Sons Drywall Inc. v. Commissioner, 2005 Tax Ct. Memo LEXIS 114). However, because this analysis would clearly not apply to a tax-exempt organization, we would look to an alternative multifactor test. In applying this test, 12 factors have been cited by the courts:

  • Amount of responsibility
  • Qualifications
  • Size of business in sales dollars
  • Contribution to profits
  • Intent
  • Ratio of salaries to net income
  • Compensation paid in prior years
  • Accumulated earnings
  • Expert testimony
  • Actual salaries paid
  • Number of owners
  • Number of related parties

See Englebrecht, Ted D., Holcombe, Calee Jo, and Murphy, Kristie, “An Empirical Assist in Determining Reasonable Compensation in Closely Held Corporations,” Vol. 30, No. 1, Journal of Applied Business Research, p. 233.

Clearly, some of these factors would be hard to apply in the case of a nonprofit, but in general, they may be of assistance on the substantive tests.

Procedural Test

The IRS will not rule on whether compensation to be paid to any particular employee is reasonable, since this involves a factual matter that cannot be determined in advance. Rev. Proc. 2018-3, 2018-1 I.R.B. 130, Section 3.01(28). However, if an organization follows certain procedures, as described below, the IRS can refute a presumption of reasonableness only if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body. Thus, you should advise tax-exempt employers to find and use contemporaneous persuasive comparability data when they authorize compensation and benefits that may be seen as excessive. Form 990 Instructions (Appendix G).

In order to rely on the presumption of reasonability, the following conditions must be met:

  • Evidence of compensatory intent. The organization must provide contemporaneous written substantiation of its intent to provide an economic benefit as compensation. This may be done by:
    • Producing a signed written employment contract
    • Reporting the benefit as compensation on a Form W-2, Form 1099, or Form 990 filed before the start of an IRS examination –or–
    • Reporting by the executive of the benefit as income on a Form 1040 filed before the start of an IRS examination

    See 26 C.F.R. § 53.4958-4(c).

  • Approval absent conflict of interest. The transaction must be approved by an authorized body of the organization (or an entity it controls) that is composed of individuals who do not have a conflict of interest concerning the transaction. Typically, an organization will have a policy that no member of the Executive, Human Resources, or other committee that sets compensation will be a staff member, the relative of a staff member, or have any relationship with staff that could present a conflict of interest.
  • Reliance on comparability data. Before making its determination, the authorized body must obtain and rely upon appropriate data as to comparability. Under a special safe harbor for small organizations having gross receipts of less than $1 million, appropriate comparability data includes data on compensation paid by three comparable organizations in the same or similar communities for similar services.
  • Documentation of determination. The authorized body must adequately document the basis for its determination concurrently with making that determination. The documentation should include:
    • The terms of the approved transaction and the date approved
    • The members of the authorized body present during deliberation and those who voted on it
    • The comparability data relied upon and how it was obtained –and–
    • Any actions by a member of the authorized body having a conflict of interest

    To be contemporaneous, ensure the documentation requirements are met before the later of the next meeting of the authorized body or 60 days after the final actions of the authorized body are taken, and that approval of records as reasonable, accurate, and complete occurs within a reasonable time thereafter.

26 C.F.R. § 53.4958-6(c); see also Form 990 Instructions (Appendix G, under “What Is Reasonable Compensation” and “Rebuttable Presumption of Reasonableness”).

Excise Tax on Excess Executive Compensation

Tax reform legislation signed into law in late 2017 (Pub. L. No. 115-97) and effective as of the 2018 tax year imposes new excise taxes on tax-exempt organizations for certain “excess” executive compensation arrangements under new I.R.C. § 4960. Pub. L. No. 115-97, § 13602. Note that the excise tax on excess compensation is separate from the penalty tax on excess benefit transactions discussed above under “Excess Benefit Transaction Penalty Tax.” Compensation can represent excess compensation whether or not it also constitutes an excess benefit transaction and vice versa.

Under the new law, tax-exempt organizations (and certain public entities, farmer’s cooperatives, and political organizations) are liable for a 21% excise tax (the corporate rate) on:

  • Any remuneration (other than an excess parachute payment) in excess of $1 million paid to a covered employee for a taxable year –and–
  • Any excess parachute payment paid to a covered employee

I.R.C. § 4960(a).

Definitions and Rules of Application

A covered employee is an employee (or former employee) of a tax-exempt organization if the employee is one of the five highest compensated employees of the organization for a taxable year beginning after December 31, 2016. Once someone becomes a covered employee, they remain one for life, even if they are no longer among the five highest compensated employees. I.R.C. § 4960(c)(2).

In general, remuneration includes all compensation reported on an individual’s Form W-2. This can include deferred compensation which has vested, even if it has not been paid (e.g., under a 457(f) plan, as discussed later in this practice note).

However, two types of compensation are exempt from the rule:

  • Roth contributions
  • Compensation attributable to medical services of licensed professionals, such as doctors, nurses, or veterinarians
    I.R.C. § 4960(c)(3), (4).

A parachute payment under these rules is a payment to a covered employee (subject to the exclusions noted below) if:

  • The payment is contingent on the employee’s separation from employment –and–
  • The aggregate present value of all such payments equals or exceeds three times the base amount.

However, parachute payments do not include payments:

  • To a qualified retirement plans, simplified employee pension plans, and SIMPLE IRAs
  • To a tax-deferred annuity or annuity contract exempt under I.R.C. § 403(a) and 403(b)
  • To an eligible deferred compensation plan under I.R.C. § 457(b)
  • For medical services provided by a licensed professional –or–
  • To an individual who is not a highly compensated employee under I.R.C. § 414(q) (i.e., annual compensation does not exceed the applicable threshold ($120,000 for 2018))

I.R.C. § 4960(c)(5)(B).

The base amount is the average annualized compensation includible in the covered employee’s gross income for the five taxable years ending before the date of the employee’s separation from employment. I.R.C. § 4960(c)(5)(D).

An excess parachute payment is the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment. Excess parachute payments are subject to the excise tax even if they do not exceed the $1 million limit applicable to other remuneration. Similar to the golden parachute rules under I.R.C. § 280G, the excise tax only applies if the total present value of all parachute payments exceeds 3x the base amount, but the tax applies to all excess parachute payments (i.e., parachute payment amounts exceeding 1x the base amount). I.R.C. § 4960(c)(5)(A).

An excess parachute payment is not counted in determining whether the $1 million limit on remuneration is exceeded. However, a single severance payment can trigger both the excise tax on excess compensation (other than excess parachute payments) and the excise tax on excess parachute payments.

For example, suppose that A is a covered employee and receives regular compensation of $600,000, plus a severance payment of $1.8 million, in 2018. A’s average annualized compensation for the five taxable years ending before the separation from service is $500,000 (the base amount). Since the severance payment is more than the three times the base amount, the excess parachute payment excise tax is triggered. The excess parachute payment amount is $1.3 million ($1.8 million minus the base amount). The other $500,000 of the severance payment is added to the $600,000 in regular compensation for the year to determine whether the $1 million in annual remuneration (other than excess parachute payment) limit is exceeded. That means that $100,000 ($600,000 + $500,000 – $1 million) is subject to the excise tax as excess compensation (other than excess parachute payments). The total amount subject to the excise tax is the $100,000 in excess compensation (other than excess parachute payments) plus the $1.3 million excess parachute payment, or $1.4 million.

Deferred Compensation Rules

The three main compliance concerns for the executive deferred compensation arrangements of a tax-exempt organizations are to ensure:

  • The value of the deferred compensation must, when added to the rest of the executive’s compensation package, represent reasonable compensation (as discussed in the previous section)
  • The deferred compensation is structured as a top hat plan under ERISA to avoid funding and other requirements –and–
  • The deferred compensation arrangement qualifies as a:
    • 457(b) plan –or–
    • 457(f) plan that meets (or is exempt from) the requirements of I.R.C. § 409A

Each of these considerations is described further below.

Valuation Issues for Deferred Compensation Reasonableness Testing

As noted above, you need to take account the value of deferred compensation in determining whether total compensation is reasonable. Thus, you need to have a mechanism to determine the value of the deferred compensation promise. You may want to look by analogy to the valuation principles used in the regulations under I.R.C. § 3121(v)(2). Those rules provide separate valuation methods for account balance plans versus non-account balance plans.

Account Balance Plans

An account balance plan is defined as:

[A] nonqualified deferred compensation plan under the terms of which a principal amount (or amounts) is credited to an individual account for an employee, the income attributable to each principal amount is credited (or debited) to the individual account, and the benefits payable to the employee are based solely on the balance credited to the individual account.

26 C.F.R. § 31.3121(v)(2)-1(c)(1)(ii)(A). This is the most common type of deferred compensation plan.

If an account balance is determined using a predetermined actual investment (whether as a notional bookkeeping account or an actual investment held in a rabbi trust) or a reasonable rate of interest, the value of deferred compensation payable under an account balance plan is generally the amount credited to the account. For example, suppose that the plan provides that the employer will put $5,000 into a rabbi trust, and the executive will get the value of that rabbi trust (including the earnings thereon) at the end of five years. The value of the deferred compensation today would be $5,000. See 26 C.F.R. § 31.3121(v)(2)-1(d). The same would be true in the absence of a rabbi trust, if the executive will get $5,000 plus interest calculated at a reasonable rate compounded quarterly at the end of five years.

The situation becomes more complicated if the deferred amount is credited with interest at an unreasonable rate. For example, if the employer promised a benefit of $5,000, plus interest at a rate of 50% a year, payable in five years, then the value could not be deemed to be only $5,000. In that situation, the value of the deferred compensation is equal to the amount credited to the participant’s account, plus the present value of the excess of the earnings to be credited under the plan over the earnings that would be credited during that period using a reasonable rate of interest. See 26 C.F.R. § 31.3121(v)(2)-1(d)(2)(iii).

Non-account Balance Plans

In some instances, a deferred compensation plan is not based on an account balance. For example, a plan might simply provide that the executive would receive a benefit of $10,000 in five years. Other examples might include plans providing for an annuity benefit based on a formula. For non-account balance plans, the value of the deferred compensation is the present value of the right to receive payment of the compensation in the future, taking into account the time value of money and the probability that the payment will be made. Prop. Treas. Reg. §§ 1.457-12(a)(2) and (c), 81 Fed. Reg. 40548 (June 22, 2016) (see Part IV.B of the preamble). This contrasts with the rules of I.R.C. § 3121(v)(2), under which discounts based on the probability that payments will not be made due to the unfunded status of the plan, the risk that the eligible employer or another party may be unwilling or unable to pay, the possibility of future plan amendments or changes in law, and other similar contingencies cannot be taken into account. 26 C.F.R. § 31.3121(v)(2)-1(c)(2).

Top Hat Plan ERISA Exemption

Under ERISA, a pension benefit plan (which, as defined under ERISA § 3(2) (29 U.S.C. § 1002(2)), includes many deferred compensation arrangements) must normally be funded. However, a funded plan that covers only one or more executives would give rise to a number of unfavorable tax consequences under I.R.C. § 402(b). To avoid this issue, a deferred compensation plan for an executive must be structured as a so-called top hat plan. These rules are the same that would apply for a taxable organization.

Top hat plans are not only exempt from ERISA’s funding rules, but also its participation, vesting, and fiduciary responsibility requirements. ERISA §§ 201(2), 301(a)(3), 401(a)(1) (29 U.S.C. §§ 1051(2), 1081(a)(3), 1101(a)(1)). They are also exempt from Form 5500 reporting and ERISA disclosure requirements, provided that the sponsor files a simple one-time notice with the Department of Labor (DOL). 29 C.F.R. § 2520.104-23. For more information on the DOL notice filing, see Understanding the Top Hat Plan Statement.

Two questions arise with respect to determining whether a plan is a top hat plan:

  • Is the plan unfunded?
  • Is the plan maintained primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees?

Top Hat Plan Funding – Rabbi Trusts

As discussed above, a top hat plan must be unfunded. However, some form of funding is desirable from the perspective of executives seeking assurance that the amount will ultimately be paid, even if changes in the organization’s board cause it to reconsider payment or if the organization’s finances make payment a hardship for the organization. In addition, as discussed above, valuing deferred compensation for purposes of the reasonable compensation test is difficult if the amount ultimately to be paid is not based on a fixed set-aside each year, plus earnings at a reasonable rate. Having the rate depend on the performance of a trust is one way to ensure that the rate is reasonable. The primary mechanism for achieving this goal is a rabbi trust.

A rabbi trust is one in which any assets held by the trust will remain subject to the claims of the employer’s general creditors in the event of the employer’s insolvency. The IRS treats such trusts as being unfunded and, therefore, excluded from the rules of I.R.C. § 402(b), which generally governs the tax treatment of trusts under nonqualified plans. The DOL has stated its intention to look to the IRS rules governing rabbi trusts for purposes of determining funded status for the definition of a top hat plan. ERISA Advisory Opinion 90-14A; Dep’t of Labor Op. 90-14A.

For a form rabbi trust that is based on IRS model language in Rev. Proc. 92-64, 1992-2 C.B. 422, see Rabbi Trust. Because the IRS will not issue rulings on a rabbi trust, use of the model form is advisable to assure compliance with IRS requirements.

A rabbi trust does not have all of the benefits of a funded arrangement. In the event of the organization’s insolvency, the executive’s benefits may not be paid. However, a rabbi trust with an independent third-party trustee protects the executive in situations short of the organization’s insolvency, such as if a new board disagrees with the prior board’s decision to provide deferred compensation and refuses to make payment, if the organization is suffering cash flow issues short of insolvency, or if the organization has charitable purposes that are a higher priority for it than paying out deferred compensation.

For more information on this topic, see Understanding and Drafting “Rabbi” Trusts.

Top Hat Plan – Select Group

Top hat plans must be maintained “primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.” Although I.R.C. § 414(q) and 26 C.F.R. § 1.414(q)-1T set forth a definition of highly compensated employee for purposes of plan qualification requirements, case law clarifies that this definition cannot be used for purposes of determining top hat plan status. Instead, a four-part test is used, looking at the:

  • Percentage of the total workforce invited to join the plan
  • Nature of their employment duties
  • Compensation disparity between top hat plan members and non-members –and–
  • Actual language of the plan agreement

Bakri v. Venture Mfg., 473 F.3d 677, 678 (6th Cir. 2007); Cramer v. Appalachian Reg’l Healthcare, No. 2012 U.S. Dist. LEXIS 154624 (E.D. Ky. O2012).

The DOL takes the position that the term “primarily,” as used in the phrase “primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees,” refers to the purpose of the plan and not the participant composition of the plan. Therefore, a plan cannot include any employees who are not part of “a select group of management or highly compensated employees” without losing its status as a top hat plan. Dep’t of Labor Op. 90-14A.

Internal Revenue Code Deferred Compensation Rules

Deferred compensation plans of tax-exempt organizations are subject to two sets of rules:

  • Section 457 rules for tax-exempt organizations. In general, I.R.C. § 457(f) imposes income taxes on all nonqualified deferred compensation in the first year such amounts are no longer subject to a substantial risk of forfeiture, except to the extent that it is paid under a 457(b) plan as described in the next section. Moreover, when amounts are included in income under I.R.C. § 457(b) or (f), they are counted as remuneration in determining whether the excise tax on excess compensation applies. This tax timing rule applies even if the plan otherwise complies with I.R.C. § 409A, which substantially restricts nonqualified deferred compensation arrangements for nonprofits.
  • Section 409A rules for all employers, including tax-exempt organizations. I.R.C. § 409A sets forth rules allowing for the deferral of income recognition and income taxation of nonqualified deferred compensation until the amounts are paid, even if the amounts are no longer subject to a substantial risk of forfeiture. However, if the strict rules of Section 409A are not met, then two things happen for any amounts deferred under the plan that are no longer subject to a substantial risk of forfeiture:
    • Such amounts are included in the income of the employee (even if they are not yet payable under the terms of the plan).
    • The employee is subject to an additional 20% tax on such amounts, plus an interest penalty based on any underpayment of tax liability for an earlier year when the deferred amount should have been included in income.

Although both Section 457 and Section 409A potentially impose taxes at the point at which nonqualified deferred compensation ceases to be substantial risk of forfeiture, the meaning of “substantial risk of forfeiture” for purpose of the two sections is slightly different, as described in the discussions below.

On June 22, 2016, the Treasury Department issued proposed regulations under Section 457 (proposed 457 regulations) and Section 409A (proposed 409A regulations). 81 Fed. Reg. 40548 (June 22, 2016) (Section 457) and 81 Fed. Reg. 40569 (June 22, 2016) (Section 409A). These proposed regulations modified several long-standing rules and are taken into account for purposes of the discussion below. Although not yet finalized, taxpayers may rely on the proposed regulations until the applicability date.

Section 457

As noted in the previous section, Section 457 provides that deferred compensation paid by tax-exempt organizations is taxable at the time it is no longer subject to a substantial risk of forfeiture (i.e., vests), unless the plan is a 457(b) plan. I.R.C. § 457(f).

Thus, a deferred compensation plan other than a 457(b) plan that does not subject the amount deferred to a substantial risk of forfeiture would cause an executive to be taxable as soon as he or she obtained the legally binding right to a plan benefit, even though payment may not occur until years into the future. To avoid this, a deferred compensation plan for an executive of a tax-exempt organization must be structured so as either to be a 457(b) plan or to ensure that the compensation remains subject to a substantial risk of forfeiture during the period of deferral. The latter alternative is referred to as a 457(f) plan. As discussed later in this practice note, a 457(f) plan (but not a 457(b) plan) is subject not only to I.R.C. § 457(f), but also to I.R.C. § 409A.

Income Inclusion under Section 457

The amount recognized as taxable income under Section 457 is the present value of the amount that becomes vested during the tax year. If payment occurs in a later year, the employee may be subject to additional income tax under the annuity tax rules of I.R.C. § 72. The taxable amount in the year of payment would be any excess over the amount recognized as income in the year of vesting, which earlier amount is treated as an investment in the contract under the annuity rules. However, if income is included for a deferred amount that is never paid, because the right to the benefit was forfeited under the terms of the plan, the individual is entitled to a deduction for the tax year in which the forfeiture occurs. 26 C.F.R. § 1.457-11(a); see also Prop. Treas. Reg. § 1.457-12(c)(2), 81 Fed. Reg. 40565.

Section 457(b) Plans

I.R.C. § 457(b) provides an exception to Section 457’s general income recognition rule for unfunded plans of a tax-exempt organization that qualify as a so-called eligible deferred compensation plan. I.R.C. § 457(a). Eligible deferred compensation plans must meet all of the following requirements:

  • Only individuals who perform service for the employer may be participants.
  • The maximum amount that may be deferred under the plan for a year (other than rollover amounts) cannot exceed the lesser of certain dollar limits, as adjusted for inflation ($18,500 for 2018) or 100% of the participant’s compensation, subject to certain catch-up contributions.
  • Compensation can be deferred for any calendar month only if an agreement providing for such deferral has been entered into before the beginning of such month.
  • The plan will not distribute amounts earlier than the earliest of:
    • The calendar year in which the participant attains age 70½
    • The participant’s severance from employment with the employer –or–
    • An unforeseeable emergency
  • The plan meets certain minimum distribution requirements beginning on the participant’s death or attainment of age 70½, in accordance with I.R.C. § 401(a)(9).

I.R.C. § 457(b); see also 26 C.F.R. §§ 1.457-2–1.457-10.

A 457(b) plan provides certain flexibility as compared with other types of deferred compensation plans. For example, it can defer benefits until retirement or other termination of employment, rather than to a fixed date. And it can provide for the payment of benefits over a period of time, rather than in one lump sum. However, as with other deferred compensation plans, amounts deferred will be counted as remuneration in determining whether the excise tax on excess executive compensation applies at the time they are included in a covered executive’s taxable income. This can be an issue to the extent that amounts are deferred under a 457(b) over many years, but paid out in one year, potentially causing the compensation paid in the year of the payout to exceed $1 million.

The disadvantage of a 457(b) plan is that it permits only a relatively low level of deferrals. For example, in 2018, the maximum deferral for most participants is $18,500. Somewhat higher limits apply to those with long service or who are close to retirement. Nevertheless, the maximum amount that can be deferred under a 457(b) plan is much less than many organizations wish to provide for their executives. Thus, a tax-exempt organization will typically defer the maximum for an executive under the 457(b) plan, which amounts are fully vested, and then defer additional amounts that are subject to a substantial risk of forfeiture under a 457(f) plan.

Section 457(f) Plans

If a deferred compensation plan of a tax-exempt organization is not a 457(b) plan (or is not otherwise exempt), the general Section 457 income recognition rule applies and any amounts of compensation deferred are included in the executive’s gross income for tax purposes for the first taxable year in which there is no substantial risk of forfeiture of the rights to such compensation. The amount is also treated as part of remuneration for purposes of the excise tax on excess compensation in the first taxable year in which there is no substantial risk of forfeiture. Delaying distributions beyond the date that benefits will become taxable would mean that an executive would owe taxes on money he or she had not received. To avoid this, 457(f) plans are typically structured so as to ensure that amounts deferred are subject to a substantial risk of forfeiture during the entire period of deferral.

This differs from a nonqualified deferred compensation plan of a taxable organization, which can provide for deferred payment of vested amounts so long as the arrangement complies with Section 409A rules. For example, a taxable entity can offer an executive a retention bonus that will become vested if the executive remains employed for at least five years, but will not be paid (or recognized in income) until the executive reaches a specified retirement age. For a tax-exempt entity, this arrangement would result in the executive becoming taxed on the amount of the bonus in the year that the five-year vesting period is satisfied.

Exceptions to the Application of Section 457

Short-term deferrals. The proposed 457 regulations establish a short-term deferral rule based on the one under Section 409A. If an arrangement provides in writing that the payment must occur, under any circumstances, on or before March 15 of the year following the calendar year in which the right to the amount is no longer subject to a substantial risk of forfeiture (and the amount is paid by that date), the arrangement would not be a plan providing for a deferral of compensation to which I.R.C. § 457(f) applies. Although the March 15 date always works as a rule of thumb, where applicable, the applicable period extends to the 15th day of the third month following the end of the employer’s first taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture. Prop. Treas. Reg. § 1.457-12(d)(2), 81 Fed. Reg. 40562.

Qualified plan exemption. Qualified plans and other tax-favored deferral arrangements described in I.R.C. § 457(f)(2) (e.g., 401(k), 403(b), and 415(m) plans) are exempt from the Section 457 income inclusion rule. I.R.C. § 457(f)(2); 26 C.F.R. § 1.457-11(b).

Other exceptions. The following arrangements are also exempt or not considered to be deferrals of compensation for purposes of Section 457:

  • Severance pay plans (discussed further below)
  • Bona fide vacation and sick leave (discussed further below)
  • Compensatory time, disability pay, death benefit, and volunteer length-of-service award plans, and certain voluntary early retirement incentive plans
  • Certain recurring part-year compensation arrangements (e.g., where a teacher who does not work during the summer is nevertheless paid in substantially equal amounts throughout the year)
  • Taxable reimbursements of expenses, medical benefits, or in-kind benefits (based on parallel exemptions for such benefits from Section 409A)
  • Taxable educational assistance for an employee (but not a family member) under I.R.C. § 127(c)(1)

I.R.C. § 457(e)(11); Prop. Treas. Reg. §§ 1.457-11(c)(1), (2), 81 Fed. Reg. 40560; and Prop. Treas. Reg. § 1.457-12(d)(3), (4), 81 Fed. Reg. 40566.

Substantial Risk of Forfeiture under Section 457

Identifying when a substantial risk of forfeiture exists under Section 457 is important for structuring arrangements to comply with the short-term deferral exception to Section 457 and for identifying the year in which deferred amounts become taxable under I.R.C. § 457(f). Rights to deferred compensation are subject to a substantial risk of forfeiture if the executive’s rights to such compensation are conditioned upon the future performance of substantial services. I.R.C § 457(f)(3)(B). The proposed 457 regulations bring the Section 457 definition of substantial risk of forfeiture into closer alignment with the definition under the Section 409A final regulations by providing as follows:

  • Performance goals. An amount conditioned upon the occurrence of a condition that is related to a purpose of the compensation (e.g., a performance goal of the employee or organizational goal of the tax-exempt entity) is considered to be subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial.
  • Involuntary severance. Amounts whose payment are conditioned on an involuntary severance from employment without cause, or a bona fide voluntary termination for good reason (e.g., severance), are only considered subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial.
  • Noncompetes. Refraining from the performance of substantial services (e.g., pursuant to a covenant not to compete) may form the basis of a substantial risk of forfeiture, subject to the following conditions:
    • The covenant not to complete must be an enforceable written agreement.
    • The employer must make reasonable ongoing efforts to verify compliance with noncompetition agreements in general, and with the specific noncompetition agreement applicable to the employee.
    • The employer must have a substantial and bona fide interest in preventing the employee from performing the prohibited services.
    • The employee must have a bona fide interest in, and ability to, engage in the prohibited competition.
  • Likelihood of enforcement. In any case, a substantial risk of forfeiture will not be deemed to exist unless the facts and circumstances indicate that forfeiture provision is likely to be enforced.

Prop. Treas. Reg. § 26 C.F.R. § 1.457-12(e)(1), 81 Fed. Reg. 40567.

The proposed 457 regulations also contain special rules relating to elective deferred compensation arrangements, that is, arrangements in which the executive can elect (1) to defer the payment of compensation that is normally payable on a current basis (e.g., salary or commissions) with the addition of a payment condition that subjects the amount to a substantial risk of forfeiture, or (2) to extend the deferral period of an amount already deferred. The concern is that a rational executive who could get cash now would not agree to defer the money until later if there were any meaningful risk that he or she would never receive it. Thus, the proposed 457 regulations allow such initial elective deferrals and elections to extend a deferral period only if the election meets all of the following requirements:

  • The present value of the amount to be paid upon the lapse of the substantial risk of forfeiture (as extended, if applicable) must be materially (at least 25%) greater than the amount the employee otherwise would be paid in the absence of the substantial risk of forfeiture (or absence of the extension).
  • The initial or extended substantial risk of forfeiture must be based upon the future performance of substantial services or adherence to an agreement not to compete. It may not be based solely on the occurrence of other types of conditions (e.g., a performance goal for the organization). However, if there is a sufficient service condition, the arrangement can also impose other conditions. For example, the risk of forfeiture could continue until the later of two years or when a performance goal was met.
  • The period for which substantial future services must be performed may not be less than two years (absent an intervening event such as death, disability, or involuntary severance from employment).
  • The agreement subjecting the amount to a substantial risk of forfeiture must be made in writing before (1) the beginning of the calendar year in which any services giving rise to the compensation are performed in the case of initial deferrals, or (2) at least 90 days before the date on which an existing substantial risk of forfeiture would have lapsed in the absence of an extension. Special rules apply to new employees (but not to employees who are newly eligible to participate in a plan).

Prop. Treas. Reg. § 1.457-12(e)(2), 81 Fed. Reg. 40567–68.

Based on the above factors, a 457(f) plan must be structured in very different ways than a deferred compensation plan for a taxable organization:

  • Because of the need for an ongoing condition to payment to provide a substantial risk of forfeiture, it is difficult to design a 457(f) plan to effectively defer payment until retirement or to a post-retirement period, and many executives will balk at arrangements that require extended vesting periods.
  • Since any deferred amounts will become taxable in the year they cease to be subject to a substantial risk of forfeiture, a 457(f) plan cannot efficiently provide for payments over life, or over a period of years, following the date on which benefits become payable, but rather must be paid immediately to avoid a mismatch in the timing of taxation.
  • In most instances, a 457(f) plan must distribute benefits in a year in which the executive is still working (since a service-based requirement usually forms the basis for the substantial risk of forfeiture). Because an executive’s compensation tends to rise over time, the tax advantages of deferral may be offset by the executive being in a higher tax bracket at the time benefits are paid.

Section 409A

As noted above, Section 409A imposes a 20% additional tax and potential interest penalties on compensation deferred under a nonqualified deferred compensation plan that does not meet certain requirements, unless an exception applies. Because Section 409A applies separately and independently from Section 457, tax-exempt organizations must ensure their nonqualified deferred compensation arrangements are eligible for an exception from Section 409A (usually as a short-term deferral) or comply with the Section 409A rules. The interaction of the two statutes is discussed further below.

Section 409A Basics

All arrangements subject to Section 409A must:

  • Be in writing (and include any applicable provisions required by Section 409A for the specific arrangement, such as the six-month delay rule)
  • Provide for a time of payment upon one or more of the following permissible payment events, as specified in the original deferral agreement:
    • Separation from service
    • Disability
    • Death
    • A fixed payment date or schedule
    • A change in control of the business
    • An unforeseeable emergency
  • Where deferral elections are permitted, comply with the applicable rules, including requiring:
    • Initial elections to defer compensation to be made before the end of the year preceding the year in which the services are rendered (subject to certain exceptions) –and–
    • Subsequent elections to further defer the payment of compensation to be (1) filed more than 12 months before the first payment of the deferred compensation becomes due, (2) not take effect for 12 months, and (3) defer by at least five years the date for the commencement of the payment
  • Not be modified as to form or timing of payment, except as permitted under Section 409A –and–
  • Be operated in compliance with Section 409A (e.g., there can be no acceleration of the timing of payment before the permissible payment event)

Certain arrangements are exempt from Section 409A, including:

  • Short-term deferrals (described in the following section)
  • Qualified and other tax-favored plans (e.g., 401(k), 403(b), and 415(m) plans), including 457(b) plans
  • Certain severance benefits (discussed further below)
  • Bona fide vacation and sick leave plans (discussed further below)
  • Compensatory time, disability pay, and death benefit plans
  • Nontaxable welfare benefits

Note that these exceptions do not always line up with the exceptions to Section 457.

The Section 409A rules are extremely complex. For a full discussion of the requirements and applicable exceptions, see Understanding Nonqualified Deferred Compensation Arrangements and Internal Revenue Code Section 409A.

Interaction between Section 409A and Section 457 for Tax-Exempt Entities

As discussed earlier in this practice note, Section 457’s general rule requires employees to recognize as taxable income any deferred compensation amounts in the first year that they are vested. Therefore, unlike taxable entities not subject to Section 457, tax-exempt employers effectively cannot take advantage of Section 409A-compliant plans that operate to defer the taxation of vested compensation until payment in a later year. Nevertheless, Section 409A still applies to tax-exempt employers, so it is important to ensure that these entities’ deferral arrangements are eligible for an exception to Section 409A (or comply with the Section 409A rules if not exempt) to avoid the significant negative tax consequences of a Section 409A failure. 26 C.F.R. § 1.409A-1(a)(4).

Short-term deferrals and substantial risk of forfeiture. Most 457(f) plans are not nonqualified deferred compensation plans for purposes of Section 409A because they automatically fall under Section 409A’s short-term deferral exception. Section 409A does not apply if the deferred compensation must in all circumstances be paid no more than the first two and one-half months after the close of the tax year in which it ceases to be subject to a substantial risk of forfeiture. 26 C.F.R. § 1.409A-1(b)(4). Further, under 26 C.F.R. § 1.409A-1(a)(4), the inclusion in income of an amount in income under I.R.C. § 457(f) is treated as a payment for purposes of the short-term deferral rule. So, on first glance, one might think that I.R.C. § 409A would never apply to a 457(f) plan, because income inclusion necessarily occurs in the same year in which the substantial risk of forfeiture lapsed.

However, differences between the definitions of substantial risk of forfeiture for purposes of Sections 457 and 409A can make Section 409A a concern for a 457(f) plan in certain circumstances. The two most common are:

  • Extended deferral periods. As discussed above, an executive covered by a 457(f) plan can elect to extend the substantial risk of forfeiture for purposes of I.R.C. § 457(f) if certain conditions are met. However, for purposes of I.R.C. § 409A, the addition of any risk of forfeiture after the legally binding right to the compensation arises, or any extension of a period during which compensation is subject to a risk of forfeiture, is disregarded for purposes of determining whether such compensation is subject to a substantial risk of forfeiture.

    Moreover, once the present value of deferred compensation is included in income, imputed earnings under the plan are not taxable under I.R.C. § 457(f) until they are actually or constructively received, at which time they are taxable under the rules applicable to annuities. Nevertheless, the imputed earnings are subject to the rules of I.R.C. § 409A.

    26 C.F.R. § 1.409A-1(d)(1). Thus, if an executive extends the period of deferral under the 457(f) plan, the rules of I.R.C. § 409A must be followed in order to avoid 409A penalties.

  • Noncompete agreements. For a 457(f) plan, a covenant not to compete will be deemed to create a substantial risk of forfeiture under certain circumstances, as set forth above. However, for purposes of I.R.C. § 409A, “An amount is not subject to a substantial risk of forfeiture merely because the right to the amount is conditioned, directly or indirectly, upon the refraining from the performance of services.” 26 C.F.R. § 1.409A-1(d)(1).

To avoid the 20% additional tax and potential interest penalty, a 457(f) plan that is subject to Section 409A because of the mismatch of substantial risk of forfeiture definitions must meet all of the requirements for Section 409A compliance summarized in the section entitled “Section 409A Basics,” above, unless another Section 409A exception applies.

See the practice note Substantial Risk of Forfeiture for additional discussion on the different definitions of substantial risk of forfeiture under the Internal Revenue Code.

Special accelerated payment rule for 457(f) plans. For 457(f) plans that are subject to Section 409A, there is a limited special exception to the Section 409A prohibition on accelerated payments. This rule allows the plan to provide (or be amended to provide) for a distribution of a portion of the amount deferred under the plan earlier than the stipulated permissible payment event if the deferred compensation is required to be included in income under I.R.C. § 457(f) because it becomes vested. The amount that may be distributed is capped at the maximum tax withholding triggered by the income inclusion for federal, state, and local taxes (note that this may be less than the actual tax liability). 26 C.F.R. § 1.409A-3(j)(4)(iv). This exception can ease the burden on an employee who becomes subject to a tax liability on amounts that will not be paid under Section 409A plan until a later time.

457(b) plans. Note that 457(b) plans are exempt from Section 409A, so such “eligible deferred compensation plans” will not raise any Section 409A issues so long as the 457(b) rules are satisfied. I.R.C. § 409A(d)(2)(B). Avoiding potential Section 409A failures is another reason for 457(b) plan sponsors to be vigilant about compliance, since loss of eligible deferred compensation plan status would subject the arrangement to Section 409A and potentially risk a violation of its strict deferred compensation rules.

Severance Pay

ERISA, Section 457, and Section 409A all provide similar, but not identical, coverage exceptions for severance plans. The consequences of a plan that provides for post-termination benefits (in the case of ERISA) or for deferred compensation (in the case of Sections 457 and 409A) failing to qualify for a severance plan coverage exception under each of these statutes is different:

  • ERISA. Unless it falls within the DOL safe harbor discussed below, a severance plan is likely to be considered an employee pension benefit plan under ERISA that must be structured as a top hat plan to avoid various ERISA requirements as discussed in the section entitled “Top Hat Plan ERISA Exemption” under Deferred Compensation Rules, above.
  • Section 457. Unless it qualifies as an exempt severance pay plan as discussed below, a severance plan would be subject to Section 457 such that amounts deferred under it will be taxable when they cease to be subject to a substantial risk of forfeiture within the meaning of I.R.C. § 457(f).
  • Section 409A. To the extent it does not qualify for the separation pay plan exception discussed below (or another exception to Section 409A), severance rights are subject to Section 409A’s strict requirements.

Each of the specific regulatory exceptions are described in the following sections. Note as a preliminary matter, however, that some severance plans do not defer compensation at all. Such plans do not present issues under Sections 457 or 409A.

A severance agreement will not defer compensation if either:

  • The severance compensation is paid in the same year in which the severance arrangement is entered into or within the first two and one-half months of the following year.
  • The severance plan specifies that the employer has the right to amend the agreement at any time before the employee terminates employment (and, if there is a separation of service without any modification, then the severance is paid either within the same year as the termination of employment or within the first two and one-half months of the following year).

A common example of the first type is a situation in which the executive’s employment contract did not provide for severance, but the employer offers severance at the time of termination (e.g., as consideration for the executive signing a general release of claims against the employer). One pitfall to beware of in this area is that if the employer develops a pattern or practice of offering similar severance arrangements to a class of executives at the time of their termination, the arrangement may ultimately be held to represent a contract with all such executives from the inception of their employment, which would make this alternative unavailable.

The second type is typical of broad-based severance plans covering a number of executives (and perhaps even rank-and-file employees). Since the employer can unilaterally alter or eliminate the severance benefit, or terminate the plan altogether, the covered employees do not have a legally binding right to receive the severance benefit.

Severance Plan Exceptions

Even if a severance plan is considered to defer compensation, it may nevertheless fall within an exception to the ERISA, Section 457, and/or Section 409A rules. However, as described under Excise Tax on Excess Executive Compensation above, because severance pay is based on separation from service, you will need to ensure that the benefits paid under it are not large enough to trigger the excise tax on excess parachute payments. And because a severance payment is often larger than normal annual compensation, you will also need to ensure that it does not cause the excise tax on excess compensation (other than excess parachute payments) to apply.

ERISA Severance Pay Plan Safe Harbor

A severance plan will not constitute an employee pension benefit plan under ERISA if it meets the following tests:

  • Payments are not contingent, directly or indirectly, upon the employee’s retiring.
  • The total amount of the payments does not exceed the equivalent of twice the executive’s annual compensation during the year immediately preceding the termination of service.
  • All payments are completed either:
    • In the case of an executive whose service is terminated in connection with a limited program of terminations, within 24 months after the termination date (or, if later, after the employee reaches normal retirement age) –or–
    • In the case of all other employees, within 24 months after the termination date
      29 C.F.R. § 2510.3-2.

A plan that does not meet the above rules will need to be structured as a top hat plan, as discussed in the section entitled “Top Hat Plan ERISA Exemption” under Deferred Compensation Rules, above. For more information on this topic, see ERISA Considerations for Severance Benefits Checklist.

Section 457 Bona Fide Severance Pay Plan Exception

The exception to Section 457 for severance arrangements applies to bona fide severance pay plans described in I.R.C. § 457(e)(11)(A)(i). Such arrangements are not considered to provide for the deferral of compensation for purposes of Section 457. Until issuance of the proposed 457 regulations, there was little guidance on what constituted a bona fide severance pay plan. Those rules establish the following criteria:

  • The plan is permitted to pay the benefit only upon involuntary severance from employment (or pursuant to a window program or voluntary early retirement incentive plan). A voluntary severance from employment for “good reason” may be treated as an involuntary severance from employment under certain conditions (and the regulations include a safe harbor for bona fide good reason provisions).
  • The amount of the severance benefit must not exceed two times the executive’s annualized compensation, based on the annual rate of pay for the calendar year preceding the year of termination (or the year of termination if the executive had no compensation in the preceding year), adjusted for any pay increases expected to continue indefinitely if the executive had not had a severance from employment.
  • The plan must provide in writing for payment of the entire severance benefit no later than the last day of the second calendar year following the year in which the termination occurs.

Prop. Treas. Reg. § 1.457-11(d), 81 Fed. Reg. 40,560–61.

Although these rules have not yet been finalized, tax-exempt entities may rely on them to structure arrangements that will be considered bona fide separation pay plans for purposes of Section 457.

A severance arrangement that does not meet the above requirements and provides for any payment later than the applicable short-term deferral period could result in current taxable income to the executive under Section 457 in the year the legally binding right to the severance is created, unless payment is subject to a substantial risk of forfeiture.

For example, if the severance benefits are contingent on an executive’s satisfaction of a covenant not to compete that meets the requirements described in the section entitled “Substantial Risk of Forfeiture under Section 457” above, the noncompete covenant should serve to create a substantial risk of forfeiture, thereby avoiding income inclusion through the end of the noncompete period.

Section 409A Separation Pay Plan Exception

The severance pay plan exclusion under the proposed 457 regulations is based in part on Section 409A’s separation pay plan exception under 26 C.F.R. § 1.409A-1(b)(9)(iii). For purposes of Section 409A, separation pay does not provide for a deferral of compensation to the extent that the separation pay, or a portion of the separation pay, provided under the plan is:

  • Payable only upon involuntary severance from employment (including pursuant to a bona fide “good reason” provision) or pursuant to a window program or voluntary early retirement incentive plan
  • Greater than the lesser of two times either (1) the executive’s annual rate of pay, based on the calendar year preceding the year of termination (or the year of termination if the executive had no compensation in the preceding year), or (2) the compensation limit under I.R.C. § 401(a)(17) for the year of termination ($275,000 for 2018) –and–
  • Paid under the terms of the plan, by the end of the executive’s second taxable year following the year in which the executive separates from service

If a plan does not meet the above requirements, or to the extent that the amount paid exceeds the limitation, it will be considered deferred compensation for purposes of Section 409A. The ability to apply the Section 409A separation pay exception to a partial amount under a severance arrangement differs from the Section 457 severance pay plan exception, which is all-or-nothing.

You must be careful when drafting separation agreements that do not qualify for the exception and are subject to Section 409A, particularly if payment is contingent on the executive’s execution of a general release of claims against the employer. As noted above, Section 409A has strict rules designed to minimize the ability to manipulate the timing of payments of nonqualified deferred compensation. However, when severance pay is contingent on the executive’s waiver of claims against the employer, it is sometimes possible for the executive to effectively choose between receiving payment in the year of termination or the following year. This occurs when the period for the executive to sign the waiver falls at the end of a calendar year such that the executive can execute the release promptly and receive the amount right away, or delay delivery of the release until after December 31 so that payment will occur in the next year. This de facto discretion on the part of the executive is a plan document violation under Section 409A, so the agreement must be drafted so as to avoid it. For details, see I.R.S. Notice 2010-80, 2010-2 C.B. 853, modifying I.R.S. Notice 2010-6, 2010-1 C.B. 275.

Vacation and Sick Leave Plans

Vacation and sick leave plans can give rise to deferred compensation concerns because many paid time off policies provide employees a cash-out of their accrued but unused paid time off upon termination of employment or at the end of a plan year. However, any bona fide vacation plan is exempt from Sections 457 and 409A409A (though not from the excise tax on excess compensation). I.R.C. §§ 457(e)(11)(A)(i), 409A(d)(1)(B).

The proposed 457 regulations do not provide any bright-line test as to when a vacation or sick leave plan will be considered bona fide. Instead, they use a facts and circumstances test to determine whether the primary purpose of the plan is to provide participants with paid time off from work due to sickness, vacation, or other personal reasons. The following factors are to be considered:

  • Whether the amount of leave provided could reasonably be expected to be used in the normal course by an employee (before the employee ceases to provide services to the eligible employer) absent unusual circumstances
  • The ability to exchange unused accumulated leave for cash or other benefits (including nontaxable benefits and the use of leave to postpone the date of termination of employment)
  • The applicable restraints (if any) on the ability to accumulate unused leave and carry it forward to subsequent years in circumstances in which the accumulated leave may be exchanged for cash or other benefits
  • The amount and frequency of any in-service distributions of cash or other benefits offered in exchange for accumulated and unused leave
  • Whether any payment of unused leave is made promptly upon severance from employment (or instead is paid over a period after severance from employment) –and–
  • Whether the program (or a particular feature of the program) is available only to a limited number of employees

Prop. Treas. Reg. § 1.457-11(f), 81 Fed. Reg. 40561–62.

The last factor may be a particular concern in instances in which an executive has a more generous vacation plan than is available to other employees.

The final regulations issued under Section 409A do not provide a definition of bona fide vacation or sick leave plans “because the definitions of these terms may raise issues and require coordination with the provisions of section 451, section 125, and, with respect to certain taxpayers, section 457.” 72 Fed. Reg. 19234 (April 17, 2017). However, the IRS stated that, until further guidance, taxpayers whose participation in a nonqualified deferred compensation plan would be subject to Section 457(f) may rely on the definitions of bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan applicable for purposes of Section 457(f) as also being applicable for purposes of Section 409A. I.R.S. Notice 2005-1, 2005-1 C.B. 274, Q&A 6 (reaffirmed in the final regulations).

Performance Bonuses and Other Nonfixed Payments

Performance bonuses and other nonfixed payments present two kinds of issues. First, special rules apply in determining whether they meet the reasonableness test described earlier under Reasonable Compensation. Second, care must be taken in structuring them so that they are not considered deferred compensation for purposes of Sections 409A and 457 (or otherwise comply with the applicable rules), and that they do not trigger the excise tax on excess compensation.

Reasonableness Testing Issues

Performance bonuses and other nonfixed payments present special issues under both the substantive and procedural reasonableness tests for reasonable compensation.

Reasonableness Issues – Substantive Test

As discussed under “Reasonable Compensation—Testing” in the Reasonable Compensation section above, in determining whether compensation is excessive, you look to the value of the compensation. But what about situations in which the value of the compensation cannot immediately be determined? For example, suppose the executive initially accepts a low salary (less than he or she is worth) with a start-up nonprofit, but is promised that the organization will make up for it (in effect, paying more compensation than the executive is worth in a future year), with the increase to be based on overall growth in the organization? Or what if an executive is promised a performance bonus the amount of which is based on specific performance targets?

Such situations involve two issues: First, how does one determine whether the bonus is excessive? And, second, does the bonus establish an impermissible joint venture between the executive and the tax-exempt organization?

The mere establishment of profit-sharing incentive compensation plans does not result in prohibited inurement or other private benefit that will cause a tax-exempt entity to lose its exempt status under I.R.C. § 501(c)(3). If the bonus reflects reasonable compensation for services performed to further the organization’s exempt purpose, it would be acceptable. However, as a substantive matter, the IRS and the courts consider three factors in determining whether compensation is reasonable in this situation:

  • If the compensation paid under an incentive plan, when considered with the other compensation paid to the executive, is determined to be unreasonable on examination, the exempt status under I.R.C. § 501(c)(3) will be jeopardized (e.g., I.R.S. Gen. Couns. Memo. 39674 (Oct. 23, 1987), 1987 GCM Lexis 80).
  • If the amount an executive earns under the compensation arrangement depends on net revenues, does the arrangement accomplish the organization’s charitable purposes, such as keeping actual expenses within budgeted amounts, where expenses determine the amounts the organization charges for charitable services?
  • The presence of a percentage compensation agreement will terminate the organization’s exemption under I.R.C. § 501(c)(3) where such arrangement transforms the principal activity of the organization into a joint venture between it and the executive or is merely a device for distributing profits to persons in control. Rev. Rul. 69-383, 1969-2 C.B. 113.

The last consideration could be an issue, for example, if a physician is the chief executive of an organization designed to provide medical services to patients needing medical attention, regardless of their ability to pay, but determines the fees for each patient that he or she sees. Lorain Avenue Clinic v. Commissioner, 31 T.C. 141 (1958).

Moreover, compensation can be “excess” for purposes of the excise tax even if it is “reasonable.” For example, suppose that an organization determines that because a covered executive has been underpaid for many years, they should be paid $1.5 million in the current year. Even if the IRS agreed with that determination, the amount in excess of $1 million in that year would be subject to the excise tax. Unlike the reasonable compensation determination, the excise tax is determined strictly on a year-by-year basis.

Reasonableness Issues – Procedural Test

As discussed under “Reasonable Compensation Testing” in the Reasonable Compensation section above, if certain procedural steps are followed, the tax-exempt organization will generally have established a rebuttable presumption that the amount of compensation is not excessive. However, in the case of a nonfixed payment, generally no rebuttable presumption arises until the exact amount of the payment is determined, or a fixed formula for calculating the payment is specified, and the requirements creating the presumption have been satisfied. 26 C.F.R. § 53.4958-6(d).

Nevertheless, if the authorized body approves an employment contract with an executive that includes a nonfixed payment with a specified cap on the amount, the authorized body can establish a rebuttable presumption as to the nonfixed payment when the employment contract is entered into by, in effect, assuming that the maximum amount payable under the contract will be paid, and satisfying the requirements giving rise to the rebuttable presumption for that maximum amount. 26 C.F.R. § 53.4958-6(d)(2); see also Form 990 Instructions. Thus, in the example of the executive paid a below-market salary during the start-up period of a tax-exempt organization, three mechanisms could be employed. First, the amount of the extra compensation could be specified in the initial employment agreement, but subject to a cap. Second, the amount of the additional compensation could be specified in the initial employment agreement, but determined under a fixed formula. Third, the organization could wait until the start-up period had ended, and then determine whether an additional payment to the executive was reasonable compensation, based on the executive’s having been undercompensated for past services.

The executive might be reluctant to accept a low initial salary based on an understanding that the authorized body would merely consider past undercompensated services, to the extent reasonable, at some unspecified future date. However, an arrangement to pay a fixed amount or an amount subject to a fixed formula raises deferred compensation issues, as discussed below.

Performance Compensation – Avoiding Deferred Compensation Rules

Often, bonuses are calculated based on results from a particular year, but can only be calculated after the end of that year. Employers commonly use one of two methods to avoid the application of Sections 457 and 409A on bonuses under these circumstances:

  • Pay the bonus by March 15 of the year following the year with respect to which the bonus is calculated.
  • Provide that the bonus will be paid on a specific date only if the executive is still employed on that date.

Both methods take advantage of the short-term deferral rules for deferred compensation arrangements. In most cases, this structure is necessary to avoid the mismatch of taxation and payment of vested deferred amounts under I.R.C. § 457(f).

However, performance compensation will not avoid the excise tax on excess compensation. For example, suppose that a covered executive is paid $500,000 in salary in year 1. In year 2, the executive receives a $500,000 bonus attributable to year 1, plus $600,000 in regular compensation. Thus, the compensation attributable to year 1 was $1 million and the compensation attributable to year 2 was $600,000. However, because the bonus attributable to year 1 was actually paid in year 2, it will trigger the excise tax on excess compensation in year 2.

Fringe Benefits

Fringe benefits provided to executives of tax-exempt entities raise two issues:

  • Taxable fringe benefits such as company cars must be valued and included in determining whether the executive’s overall compensation package is reasonable, and whether the excise tax on excess compensation applies.
  • Unless an exception applies, certain fringe benefits paid after termination of employment may be treated as deferred compensation.

Fringe Benefits – Special Reasonableness and Excise Tax Requirements

As noted earlier in the discussion of Reasonable Compensation, nontaxable fringe benefits do not have to be taken into account when determining whether an executive’s compensation package is reasonable. Moreover, because they are not part of W-2 compensation, they are not counted in determining the excise tax on excess compensation for a covered executive. However, some fringe benefits, although primarily provided in order to enable the executive to perform his or her job, may be in part taxable and thus are subject to reasonable compensation and excise tax analysis.

The most common example is a company car. An organization may want to provide an executive with a car, both to simplify business travel and to ensure that the executive is driving a car that is of high enough quality to impress potential donors. However, if the executive also uses the car for personal purposes (even if it is just to drive to and from work), a portion of the car’s value becomes taxable and thus a part of the compensation package for purposes of determining both reasonable compensation and excess compensation. The portion that is a taxable fringe benefit must be taken into consideration in determining whether the executive’s overall compensation package is reasonable, and whether a covered executive’s compensation constitutes excess compensation.

Fringe Benefits – Avoiding Deferred Compensation Rules

Fringe benefits that are paid or made available in a year later than the year in which the employee obtains the legally binding right to the benefit can fall under the nonqualified deferred compensation rules. However, Section 409A and the proposed 457 regulations specifically exclude certain fringe benefit reimbursement and in-kind benefit arrangements provided after termination of employment to the extent provided for a limited period of time, including:

  • Continuation of health insurance coverage, to the extent non-taxable to the employee (or other non-taxable welfare benefits) (Section 409A only, although such benefits could be exempt from Section 457 under a bona fide severance pay plan)
  • Reimbursement of expenses that the service recipient could otherwise deduct as business expenses incurred in connection with the performance of services for expenses incurred up to the end of the second year following termination, so long as payment is provided by the end of the third year following termination
  • Reimbursement of reasonable outplacement or moving expenses directly related to the termination of services including the reimbursement of all or part of any loss incurred due to the sale of a primary residence for expenses incurred up to the end of the second year following termination, so long as payment is provided by the end of the third year following termination
  • Reimbursement of medical expenses otherwise deductible under I.R.C. § 213 (without regard to the 7.5% of adjusted gross income limitation) provided during the period that COBRA continuation coverage would apply under a group health plan of the employer
  • De minimis separation benefits, defined as aggregating less than the I.R.C. § 402(g) limit for contributions to 401(k) plans ($18,500 in 2018) (e.g., estate planning or tax-preparation assistance), provided by the end of the second year following termination (Section 409A only, although such benefits could be exempt from Section 457 under a bona fide severance pay plan)

26 C.F.R. §§ 1.409A-1(a)(5), 1.409A-1(b)(9)(v)(A)–(D); Prop. Treas. Reg. 1.457-12(d)(4)(i), 81 Fed. Reg. 40566.

Section 457 present valuation determinations for fringe benefits. The proposed 457 regulations provide that the rules in the Section 409A proposed income inclusion regulations (Prop. Treas. Reg. § 1.409A-4(b)(4), 73 Fed. Reg. 74380 (Dec. 8, 2008)) apply for purposes of determining the present value of reimbursement and in-kind benefit arrangements for fringe benefits that must be included in income under I.R.C. § 457(f) because an exclusion is not available. Prop. Treas. Reg. § 1.457-12(c)(1)(viii), 81 Fed. Reg. 40565.

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New article: Pre-approved Plan Design and Compliance
(Posted on August 13, 2018 by )


Lexis Practice AdvisorWith the IRS cutting back on determination letters for individually designed plans, more and more employers are switching to pre-approved plans. An article recently published in the Lexis Practice Advisor discusses practical considerations involved with such plans. Topics include:

Pre-approved Plan Design and Compliance
(Posted on August 13, 2018 by )


Go to: Pre-approved Plan Designs and Favored Regulatory Status | General Advantages and Disadvantages of Pre-approved Plans | Types and Requirements of Pre-Approved Plans | Limitations on Plans That May Be Pre-approved | Pre-approved Plan Providers | Implementing Pre-Approved Plans | Obtaining IRS Opinion Letters

This practice note describes the requirements for implementing pre-approved plans and advantages, disadvantages, and best practices concerning the implementation and legal review of pre-approved plans. A pre-approved plan document can be used for most types of plans qualified under section 401(a) of the Internal Revenue I.R.C. (I.R.C.) (qualified plans). Tax-sheltered annuities or custodial accounts described in I.R.C. § 403(b) (403(b) plans) can also take the form of pre-approved plans, but the procedures are rather different and are described in a different practice note. See Pre-approved 403(b) Plans.

This practice note discusses the following topics:

For information on the extent to which pre-approved plan documents may be used for various types of retirement plans, see Pre-approved Plan Eligibility Checklist.

Pre-approved Plan Designs and Favored Regulatory Status

Pre-approved Plan Designs

Pre-approved plans are retirement plans that an entity (Provider) creates for adoption by a number of unrelated employers. In contrast, individually designed plans are retirement plans that an employer sponsor or a law firm creates usually for exclusive use by the employer sponsor (and members of its controlled group).

Pre-approved plans fall into one of two categories: standardized and non-standardized plans. In both cases, the plan’s Provider submits the plan document to the Internal Revenue Service (IRS) to review and opine on whether the written form of the plan satisfies the legal requirements for qualified status. After the IRS pre-approves the plan, the Provider offers the plan to employers to adopt.

Favored Regulatory Status of Pre-approved Plans

Regulatory agencies favor pre-approved plans because they:

  • Are efficient to produce
  • Are relatively easy to implement (compared to individually designed plans)
  • Reliably reflect the many and ever-changing provisions required by the Employee Retirement Income Security Act of 1974 (ERISA) and the I.R.C.

The favored status of pre-approved plans has increased over time. Most recently, the IRS generally restricted the ability of individually designed plans to obtain favorable determination letters except upon the plan’s establishment or termination. I.R.S. Announcement 2015-19, 2015-2 C.B. 157; I.R.S. Rev. Proc. 2016-37, 2016-2 C.B. 136. By eliminating an individually designed plan’s ability to receive interim approval of the plan’s form, federal regulators have tacitly endorsed pre-approved plans as the model for future plan implementations. See, also, I.R.S. Notice 2016-03, 2016-1 C.B. 278; I.R.S. Rev. Proc. 2016-37, 2016-2 C.B. 136, Section 18 (extending the deadline for adoption of pre-approved plans in certain instances in recognition of the abolition of the remedial amendment program for individually designed plans).

General Advantages and Disadvantages of Pre-approved Plans

Use of a pre-approved plan has advantages both for the adopting employer and for the plan Provider over adoption of an individually designed plan. However, you should weigh these advantages against the disadvantages and limitations applicable to the various pre-approved plan types. Advantages, disadvantages, and certain other concerns from the perspective of the employer are discussed in the sections that follow. Also discussed are the advantages for the plan Provider.

Advantages, Disadvantages and Other Concerns from the Employer’s Perspective

Advantages for Employers

For employers, the major advantages of a pre-approved plan are simplicity, cost, and assurances of IRS approval. An employer can adopt a pre-approved plan merely by selecting among available options (any of which will satisfy IRS requirements), having the documents approved by the board of directors or other person(s) having authority, and signing. Thus, the employer saves the cost of having a plan drafted and obtaining an IRS determination letter on its qualification.

Simplicity in Form

As mentioned above, because pre-approved plans are submitted for IRS approval prior to their adoption by an employer, they are to a certain extent set in form. Nevertheless, they still allow adopting employers to make certain customization decisions. For example, the employer will decide whether to allow plan loans or provide for matching contributions, and how long a vesting schedule to provide. After the adopting employer makes these elections electronically, software systems generate the documents required for the plan.

IRS Approval

The sponsor of a new individually designed plan must apply for a determination letter in which the IRS opines on the plan’s qualified status (in form). In addition, under the revised determination letter program, such sponsor can no longer get IRS assurances on the plan between inception and termination. However, a pre-approved plan Provider gets an IRS opinion letter on the pre-approved plan, and the adopting employer can generally rely on this letter. Moreover, the Provider can get a new letter on the pre-approved plan every six years, to reflect changes in the plan and changes in applicable statutes, regulations, and other guidance.

Bundled Third Party Administrative Services

A pre-approved plan is often part of “one-stop shopping” for the employer. The plan Provider or an affiliate may also be providing investment choices under the plan, third party administrative services, etc. This saves the employer from having to find different vendors for each of the functions under the plan. Particularly for a small employer, the simplicity of a pre-approved plan is often what enables the employer to adopt a plan at all without undue expense and use of employer personnel.

Disadvantages for Employers

The major disadvantage of a pre-approved plan is that it limits the employer’s flexibility for design options. Following are examples as to why an employer might generally prefer to sponsor its own (individually designed) plan over a pre-approved plan:

  • Limited ability to implement stand-alone amendments. Employers adopting pre-approved plans generally have to completely restate the plan (and make sure that existing benefit structures are preserved) when moving to a new investment provider.
  • Limited ability to vary coverage among participants. Employers adopting pre-approved plans generally cannot have different groups of employees covered by different plans or benefit structures.
  • Inflexibility of options for certain types of plans. Many employers prefer to provide a type of plan (e.g., many cash balance and stock bonus plans) that is eligible to use pre-approved plan documents. (See Types and Requirements of Pre-Approved Plans, for more information.
  • Additional costs due to plan document inflexibility. One typical example where an employer adopting a pre-approved plan may incur an additional cost is where the pre-approved plan document requires employer contributions for all participants who have completed at least 500 hours of service during the plan year, even if they terminate employment before year end. The expense of providing contributions for individuals who are no longer working for the employer (and thus for whom the employer’s cost for the contributions is not justified by the plan’s advantages in attracting and retaining employees) may outweigh the cost savings of having a pre-approved plan, in which case the employer may prefer to design its own plan instead.

The difficulties discussed above are most often a concern to larger employers who may want to adopt more complex plans or to handle investments in-house, and who have greater costs associated with their large numbers of plan participants. However, a smaller employer that wants to maximize benefits for the owners may also prefer an individually designed plan.

Other Considerations for Employers

Two major cost-related considerations for employers are (1) whether the employer intends to purchase bundled and/or additional services (one-stop shopping) and (2) the extent to which legal review of a pre-approved plan may be necessary.

Effectiveness of One-stop Shopping

First, to the extent an employer chooses a pre-approved plan for the purpose of one-stop shopping, the plan may be less effective than anticipated. Employers must consider the following:

  • Variability of fiduciary-related costs. Though pre-approved plan providers may provide certain bundled services, they will typically not be fiduciaries within the meaning of ERISA (for ERISA plans), or relevant state law (for governmental and non-electing church plans). This means that employers may incur unexpected costs associated with necessary delegations of fiduciary duties (e.g., the prudent selection and monitoring of investments in cases where the employer does not have investment expertise). See What Your Prototype Plan Provider Doesn’t Tell You by Carol Buckmann, Cohen & Buckmann, P.C.
  • Desirability of Provider investment platforms. Pre-approved plan Providers often provide an investment platform for the plan as an additional service to employers. Employers will evaluate the cost of this (and any other bundled) services, the availability of investment options in potential Providers’ platforms, and the risk evaluation performed on these investments. Based on these considerations, an employer may decide that the potential Providers do not provide enough investment alternatives or may simply prefer to manage investments in-house.
  • Lack of substantive legal review. The plan Provider (other than a law firm that provides pre-approved plans for its employer-clients) will typically not be an attorney or authorized to provide legal advice. While the plan documents will typically specify that legal advice should be sought, many employers nevertheless just sign the documents without any legal review.

Need for Legal Review

Even without legal review, an adopting employer has assurances that a pre-approved plan meets qualification requirements. However, this does not eliminate the need for legal review. Some issues that may come to light in connection with a legal review (apart from documentary qualification issues) include:

  • Provider issues. These include issues with indemnification, responsibilities, and resolution of claims against the Provider. For example, the plan may provide that such claims must be resolved through arbitration rather than lawsuits, or that lawsuits must be filed in the plan Provider’s home state (which may be far from where the employer is located). If reviewing a pre-approved plan, you should ensure that your client is aware of the existence of any such provisions and has taken them into consideration when choosing the particular plan.
  • Insufficiency of plan provisions to protect the employer. While the opinion letter on a plan will generally provide comfort that the plan is qualified in form, it may omit crucial protections for the employer. For example, if the plan document does not give the employer the right to interpret the terms of the plan, a court may hold that provisions have a meaning quite different from that which the employer assumed. In addition, the plan may either omit a statute of limitations on bringing claims for benefits or provide one that is shorter than the maximum statute of limitations available under state law. You should explain any existing issues of this type to the adopting employer.
  • Foreign trust situs. A qualified plan must have a U.S. domestic trust. If the Provider has only executives located outside of the U.S., this requirement may not be met in operation, even if the trust document requires it. You should advise clients considering adoption of such a plan that this is a key element that they must investigate.
  • Poor plan communications. Many lawsuits are based on plan communications. You should ensure, therefore, that the summary plan description (SPD) of the plan and all other employee communications accurately describe the essential provisions of the pre-approved plan.

Advantages from the Perspective of the Provider

For Providers of pre-approved plans, the use of pre-approved plans is primarily a marketing decision. An investment company, payroll provider, insurance company, or third-party administrator may sponsor a pre-approved plan so that it can sell its services by providing the employer with a quick and inexpensive way to get the plan set up. If the sponsor had to provide an individually designed plan for each employer, the up-front cost would make the transaction less profitable to the sponsor.

Law firms may provide pre-approved plans for use by their clients as a plan that has received legal review, but is less costly than an individually designed plan and can receive IRS assurances on its status.

Types and Requirements of Pre-Approved Plans

Requirements Applicable to All Pre-Approved Plans

In some respects, the rules for standardized and non-standardized plans are similar. Both are plans that are designed by a Provider for use by adopting employers (per adoption agreements). Both types of plans must include a procedure for Providers to amend a plan on behalf of an adopting employer. Rev. Proc. 2017-41, 2017–29 I.R.B. 92, Section 5.03. In addition, pre-approved plans are subject to the following requirements:

  • Prohibition on incorporation of certain I.R.C. sections by reference. Pre-approved plans cannot incorporate by reference the I.R.C. § 415 limitations on benefits and contributions), the average deferral percentage test under I.R.C. § 401(k)(3), or the average contributions percentage test under I.R.C. § 401(m)(2), I.R.S. Rev. Proc. 2017-41, Sections 6.03(11) and (12). Plan Providers often wish to incorporate I.R.C. sections by reference, so as to avoid lengthy provisions in the plan of the required provisions and to avoid needing to amend the plan if the I.R.C. section is amended. However, the IRS is concerned that the absence of the full provision in the plan may lead to inattention to the provisions in administering the plan.
  • Preclusion of form flexibility that would violate qualification requirements. Any blanks or fill-in provisions for the employer to complete must have parameters that preclude the employer from completing the provisions in a manner that could violate the qualification requirements. I.R.S. Rev. Proc. 2017-41, Section 6.03(17).
  • Inclusion of USERRA compliance provisions. All pre-approved plans must contain language within the underlying plan document (as opposed to the adoption agreement) to comply with the Uniformed Services Employment and Reemployment Rights Act of 1994, 38 U.S.C. §§ 4301-4335. I.R.S. Rev. Proc. 2017-41, Section 5.14.
  • Inclusion of trust provisions. All pre-approved plans must include a trust or custodial account document separate from the plan document, unless the plan uses an annuity as a funding method. Rev. Proc. 2017-41, Section 4.10.

Differences among the Various Types of Pre-approved Plans

Single or Multiple Funding Media

In some pre-approved plans, each employer that adopts the plan uses a single funding medium (for example, a trust or custodial account document) as all other employers who adopt the same plan. In others, each employer who adopts the plan has a separate funding medium.

Differences between Standardized and Non-standardized Plans

There are two subsets of pre-approved plans: standardized and non-standardized. I.R.S. Rev. Proc. 2017-41. The difference between them is the method by which they comply with the rules preventing discrimination in favor of highly compensated employees.

A standardized pre-approved plan is designed so that it is impossible by its terms for it to violate any of the tests of I.R.C. § 401(a)(4) and (5) (relating to discrimination in benefits), and I.R.C. § 410(b) (relating to discrimination in plan coverage). Together, these rules constitute the I.R.C.’s non-discrimination rules. (An employer must still ensure that 401(k) contributions meet the actual deferral percentage (ADP) test of I.R.C. § 401(k)(3) and that employer matching contributions and employee after-tax contributions meet the actual contribution percentage (ACP) test of I.R.C. § 401(m).) A non-standardized plan requires the employer to monitor the plan to ensure that, as applied to its employees, the plan satisfies the I.R.C.’s non-discrimination rules.

Structure of Pre-approved Plans

A pre-approved plan can consist of a single plan document, or a basic plan document plus an adoption agreement. A pre-approved plan must also have a trust or custodial agreement, separate from the plan document(s). However, the IRS will no longer rule on whether a trust agreement for a pre-approved plan is tax-exempt under I.R.C. § 501(a).

In the case of a pre-approved plan that consists of a basic plan document plus an adoption agreement, the basic plan document provides all provisions that could possibly apply to the plan, while the adoption agreement permits the employer to select among such provisions. For example, the basic plan document for a profit-sharing plan might provide for 401(k) contributions, matching contributions, and/or contributions that are the same percentage of compensation for all employees. The adoption agreement could allow an employer to choose to have the plan provide for only contributions that are the same percentage of compensation for all employees, only 401(k) contributions, only 401(k) and matching contributions, or all three types of contributions.

A single plan document can be structured so as to have alternative versions of certain provisions, so that a particular employer’s plan can omit provisions inapplicable to that employer.

An adopting employer cannot vary the provisions of a pre-approved plan at all, beyond the options provided in the single plan document or the adoption agreement, except:

  • Amendments to the plan to add or change a provision (including choosing among options in the plan) and/or to specify or change the effective date of a provision, provided the employer is permitted to make the modification or amendment under the terms of the Pre-approved Plan as well as under § 401 or 403(a), and, except for the effective date, the provision is identical to a provision in the Pre-approved Plan
  • Sample or model amendments published by the IRS that specifically provide that their adoption will not cause such plan to fail to be identical to the Pre-approved Plan
  • Amendments that adjust the limitations under §§ 415, 402(g), 401(a)(17), and 414(q)(1)(B) to reflect annual cost-of-living increases, other than amendments that add automatic cost-of-living adjustment provisions to the plan
  • Plan language completed by the employer if such language is necessary to satisfy § 415 or 416 because of the required aggregation of multiple plans under these sections
  • Interim amendments or discretionary amendments that are related to a change in qualification requirements
  • Amendments that reflect a change of a Provider’s name, in which case the Provider must notify the IRS, in writing, of the change in name and certify that it still meets the conditions to be a Provider –and–
  • Amendments to the administrative provisions in the plan (such as provisions relating to investments, plan claims procedures, and employer contact information), provided the amended provisions are not in conflict with any other provision of the plan and do not cause the plan to fail to qualify under I.R.C. § 401

Rev. Proc. 2017-41, Section 8.03.

Standardized Plans

To ensure that it meets the I.R.C.’s non-discrimination rules for any employer that adopts it, a standardized plan is limited in the options it can provide. For a qualified plan:

  • The plan must cover all employees, other than those who have less than one year of service (YOS), who are under age 21, who are covered by a collective bargaining agreement, or who are nonresident aliens with no U.S.-source income. However, in the case of employees acquired through an asset or stock acquisition, merger, or other similar transaction involving a change in the employer of the employees of a trade or business, the plan can exclude them until the last day of the first plan year beginning after such transaction.
  • Some or all of the otherwise excludible employees as described in the preceding paragraph can be included only if the criteria for excluding such employees apply uniformly to all employees.
  • The plan may deny an accrual or allocation to an employee based on hours of service or participation on the last day of the plan year only if the employee both has less than 500 hours of service and has terminated employment before the last day of the plan year.
  • Allocations of contributions or benefits must be based on total compensation (i.e., a definition that constitutes a safe harbor definition under I.R.C. § 414(s)). I.R.S. Rev. Proc. 2011-49. (For additional information, see Compensation Definition Rules for Qualified Retirement Plans.)
  • Unless the plan is a target benefit plan or a § 401(k) and/or 401(m) plan, the plan must, by its terms, satisfy one of the design-based safe harbors to ensure compliance with I.R.C. § 401(a)(4) and (5).
  • All benefits, rights, and features under the plan (other than those, if any, that have been prospectively eliminated) are currently available to all employees benefiting under the plan.
  • Any past service credit under the plan must meet the 401(a)(4) safe harbor.
  • Section 401(k) plans that provide for in-service hardship distributions must only provide for safe-harbor distributions. (See discussion of hardship distributions, below.)

I.R.S. Rev. Proc. 2017–41, Section 5.16.

Non-standardized plans

A non-standardized plan does not contain the above provisions that ensure that the plan will meet the I.R.C.’s non-discrimination rules, except that such plan:

  • May (but is not required to) contain the requirement that hardship distributions under a 401(k) plan must be limited to safe-harbor distributions –and–
  • May (but is not required to) give the adopting employer the option to select total compensation as the compensation to be used in determining allocations or benefits

Rev. Proc. 2017-41, Section 5.15. If a non-standardized plan permits non-safe-harbor hardship distributions, such distributions must be subject to nondiscriminatory and objective criteria contained in the plan. Rev. Proc. 2017-41, Section 6.03(14).

Thus, except in the case of a governmental or nonelecting church plan, inappropriate selections regarding coverage or benefits can cause a non-standardized plan to lose the protection of IRS pre-approval. However, pre-approval still provides assurances that the plan will meet IRS requirements other than the Non-discrimination Rules.

Limitations on Plans That May Be Pre-approved

Not all types of plans eligible for qualified status can be pre-approved. The IRS sets forth certain types which are allowed, and excludes plans with certain features, as described below. I.R.S. Rev. Proc. 2017-41.

Plans Permitted

Pre-approved plans can include plans qualified under Internal Revenue I.R.C. (I.R.C.) § 401(a) or 403(a) (qualified plans), including plans that permit employee pretax salary deferral contributions (also known as (401(k) contributions or elective deferrals).

Most pre-approved qualified plans are profit-sharing plans. To the extent that they provide 401(k) contributions, they are known as 401(k) plans. However, most other types of qualified plans can also be pre-approved. Qualified plans eligible for the pre-approved form include:

  • Money purchase plans (which may be combined with a 401(k) or other profit sharing plan in the same plan document)
  • Defined benefit plans, including cash balance plans (but the types of cash balance plans permitted are limited)
  • Effective February 1, 2017, employee stock ownership plans within the meaning of I.R.C. § 4975(e)(7) (ESOPs), other than ESOPS that
    • Are a combination of a stock bonus plan and a money purchase plan –or–
    • Provide for the holding of preferred employer stock

Restrictions on Plans

Certain types of qualified plans cannot be pre-approved plans:

  • Multiemployer plans
  • Collectively bargained plans (although a pre-approved plan can cover collectively bargained employees, so long as its terms are not modified by the collective bargaining agreement)
  • Stock bonus plans other than ESOPs
  • ESOPs that are a combination of a stock bonus plan and a money purchase plan
  • ESOPs that provide for the holding of preferred employer stock
  • Group trusts described in I.R.S. Rev. Rul. 81-100, 1981-1 C.B. 326, as modified by later guidance
  • Statutory hybrid plans other than cash balance plans
  • Cash balance plans that contain a variety of provisions prohibited by Rev. Proc. 2017-41, or fail to contain a variety of provisions mandated by that revenue procedure
  • Any defined benefit plan that provides a benefit derived from employer contributions that is based partly on the balance of the separate account of a participant
  • Target benefit plans, other than plans that satisfy the 401(a)(4) safe harbors
  • Governmental defined benefit plans that include “deferred retirement option plan” (DROP) features, or similar provisions in which a participant earns additional benefits for continued employment post-normal retirement age in the form of credits to a separate account under the same plan
  • Fully-insured § 412(e)(3) plans (plans funded by individual insurance contracts), other than non-statutory hybrid plans that by their terms satisfy the safe harbor in § 1.401(a)(4)-3(b)(5)
  • Plans that provide for medical accounts under I.R.C. §§ 401(h) or 105
  • Eligible combined (defined benefit/defined contribution) plans
  • Variable annuity plans and plans that provide for accruals that are determined in whole or in part based on the value of or rate of return on identified assets, including plan assets
  • Plans that include so-called fail-safe provisions for I.R.C. § 401(a)(4) or the average benefit test under I.R.C. § 410(b)

Rev. Proc. 2017-41, Section 6.03.

Pre-approved plans can include governmental plans and church plans that have not elected to be covered by ERISA (non-electing church plans). However, because such plans are exempt from ERISA and from many of the I.R.C. qualification requirements, but are subject to special requirements under state law, the plan documents used for governmental plans and nonelecting church plans must be separate from each other, and also separate from the documents used for ERISA-covered plans. Rev. Proc. 2017-41, Section 9.06.

Pre-approved Plan Providers

Plan Providers

The IRS provides different procedural requirements to apply for an opinion letter, depending on whether the plan is or is not a “mass submitter” plan as described below. Mass submitters usually have reduced procedural requirements and get expedited treatment from the IRS, because of the high volume of Providers they represent, and the number of identical or near-identical plans they submit to the IRS. This makes it easier and more efficient for review purposes. “Substantially identical” plans may receive expedited review, even if they are not mass submitter plans.

Provider. A Provider of a pre-approved plan must be a U.S. business that has at least 15 employer-clients that it reasonably expects to adopt the sponsor’s lead basic plan document. A sponsor that meets the 15 employer-clients requirement can request opinion letters for a number of additional basic plan documents and adoption agreements provided it has at least 30 employer-clients in the aggregate, each of which is reasonably expected to adopt at least one of the Provider’s basic plan documents. Although there is no specific deadline for having the 15 or 30 employer-clients adopt the plan, the IRS reserves the right at any time to request from the Provider a list of the employers that have adopted or are expected to adopt the Provider’s pre-approved plans, including the employers’ business addresses and employer identification numbers.

Providers must make reasonable and diligent efforts to ensure that adopting employers of the Provider’s plan have actually received and are aware of all plan amendments.

Mass submitter. A “mass submitter” is a U.S. business that submits opinion letter applications on behalf of at least 30 unaffiliated Providers that have “word-for-word identical” basic plan documents to the mass submitter’s lead plan. In addition, if the mass submitter has additional plans, it can submit applications regardless of the number of Providers for the mass submitter’s other plan(s).

Mass submitters who have met the “30 Provider” requirement can submit additional applications for Providers with identical plans and Providers that have “minor modifications” to the mass submitter’s plan. The IRS will review submissions with respect to minor modifications on an expedited basis and opinion letters will be issued to the Provider as soon as possible.

Mass submitters usually have reduced procedural requirements and get expedited treatment from the IRS, because of the high volume of Providers they represent, and the number of identical or near-identical plans they submit to the IRS. This makes it easier and more efficient for review purposes.

All of these terms have specific meanings. For example, the term “word-for-word identical plan” includes a “flexible” plan. This feature permits the prototype’s Provider to remove certain sections of a mass submitter’s plan because they do not apply or because the financial institution offering the plan does not offer the provision. If the prototype’s Provider does not offer loans, for example, then the section in the plan and the adoption agreement that refers to loans is removed and generally replaced with “reserved.” Plans can have as many as six administrative flexible provisions and six investment flexible provisions.

A “minor modification” is a minor change to an otherwise word-for-word identical plan of the mass submitter that does not require an in-depth technical review. For example, a change from five-year 100% vesting to three-year 100% vesting is a minor modification. On the other hand, a change in the method of accrual of benefits in a defined benefit plan would not be considered a minor modification. A minor modification must be submitted by the mass submitter on behalf of the Provider that will adopt the modified plan.

Implementing Pre-Approved Plans

At minimum, implementing a pre-approved plan requires multiple documents. For a plan taking the form of a basic plan document plus an adoption agreement, it requires a:

  • Basic plan document containing non-elective provisions, which also explains the elections made in the adoption agreement
  • Trust agreement that describes requirements for plan asset segregation and management in a separate document –and–
  • Adoption agreement in which the employer adopting the plan selects elective provisions

Alternatively, the plan can take the form of a single plan document plus a trust or custodial account document.

For either type of plan, the following additional documents are also required:

  • SPD. In the case of an ERISA plan, the SPD must conform with the requirements of ERISA §§ 101(a), 102(a)(1) and 104(b), and 29 C.F.R. §§ 2520.104b-1 and 2520.107. While a non-ERISA plan is not required to have an SPD, most do in order to provide a simplified method for participants to understand the basic terms of the plan.
  • Resolution. Corporate resolution by which the employer adopts the plan.

The plan Provider will also need to provide each adopting employer with a copy of the opinion letter applicable to the pre-approved plan.

Additional requirements for these documents are provided below.

Basic Plan Document or Single Document

A Provider’s document system will generate the basic plan document or specimen plan, and a copy of the opinion letter by which the IRS approved the written form of the plan. (See below regarding IRS approval.) Neither document allows for customization, but both are essential to the plan.

A basic plan document reflects the regulatory requirements for all plans that are covered by the pre-approved plan document, even if all the features discussed in the basic plan document are not elected in the adoption agreement. For example, a basic plan document may incorporate both profit sharing and 401(k) plan statutory requirements, even a specific employer elects in the adoption agreement to provide only profit sharing features but not 401(k) features. Essentially, the basic plan document reflects all the regulatory basis for every possible election in the adoption agreement.

Alternatively, a plan can elect to use a single plan document that incorporates only those features that a specific adopting employer elects. In the case of a plan with this form, all references to the adoption agreement below should be read as referring to the single plan document.

General Information Required Of All Adopting Employers

All document systems require certain information about the employer adopting the plan, the plan itself, and the document being generated. General information includes:

  • Employer name, address, fiscal year, Employer Identification Number, NAICS I.R.C. that identifies industry subtypes;
  • Plan design type (i.e., DC or defined benefit), employer’s plan number (because employers may have multiple plans), plan name, effective date;
  • Pre-approved document type (profit-sharing only, 401(k))
  • The preferred style of document (such as a “check-the-box” style adoption agreement, or a single plan document that emulates an individually designed plan)

After drafting the adoption agreement or the single plan document, the system user must register the document in the Provider’s system. Registration enables the Provider to notify adopting employers when plan revisions are required by law, or simply to adopt such revisions itself. Without such automated “upkeep” of implemented plans, the plan’s pre-approval can essentially expire for failure to have updated the plan as laws, regulations, or other guidance changes.

Shared Information for Plan Documents, Administration, Reporting and Disclosure

Often, companies that provide plan document systems also offer plan administration and plan reporting systems. Such systems work together, culling data from one system for use in the others. For example, the information provided to the document system about the adopting employer will be reflected in the plan’s annual tax return. Such shared information includes:

  • Plan trustees and contact information (captured in SPD);
  • Adopting employer information (captured in the plan’s annual tax return for which the employer is responsible);
  • Whether the plan employer is part of “commonly controlled group” of corporations, or an “affiliated service group” of corporations (captured by plan administration system for nondiscrimination testing purposes).

Since the same information has multiple applications, there is inherent risk that erroneous information may compromise related plan service systems. In practice, such risks may be minimized before the plan goes into operation—via diligent review by Providers, plan administrators, and adopting employers.

Adoption Agreement

Eligibility and Service Provisions

Every plan must define when an employee will become eligible to participate. The selection of eligibility and service provisions, including eligibility exclusions, is often a function of the demographics of the employer’s workforce (provided the selected eligibility and service requirements adhere to I.R.C. requirements, and ERISA requirements in the case of an ERISA plan, and are applied consistently). For additional information on coverage and minimum participation requirements see ERISA § 202 (29 U.S.C. § 1052); I.R.C. § 410; 26 C.F.R. § 1.401(a)(26)-6(b). Governmental and church plans are exempt from statutory eligibility and participation rules, but plan documents for them must still specify what eligibility and participation rules will apply.

Eligible Employees

An employer may exclude from the definition of “eligible employee” any employee who:

  • Does not meet the plan’s minimum age and/or service requirements
  • Is a nonresident alien who receives no earned income from sources within the United States –or–
  • Is covered by a collective bargaining agreement between that employer and a union

I.R.C. §§ 401(a)(26)(B) and 410(b); 26 C.F.R. §§ 1.401(a)(26)-6(b) and 1.410(b)-6.

However, the employer may elect in the adoption agreement to include nonresident aliens and collectively bargained employees described above, provided the inclusion is consistently applied. 26 C.F.R. §§ 1.401(a)(26)-6(a) and 1.410(b)-6(b)(3).

In a non-standardized plan, an employer may choose to exclude certain classifications of employees based upon the plan’s design. Such “design-based” exclusions include:

  • Leased employees (defined in I.R.C. § 414(n))
  • Key employees (defined in I.R.C. § 416(i))
  • Highly compensated employees (HCEs) defined in I.R.C. § 414(q)
  • HCEs who are key employees
  • Self-employed individuals defined in I.R.C. § 401(c)
  • Employees paid solely in commissions
  • Employees paid on an hourly basis
  • Employees paid on a salaried basis, regardless of the number of hours they work
  • Employees ineligible for employer-provided health and welfare benefits
  • For collectively bargained plans, and if applicable to the collective bargaining agreement, employees whose compensation does not include prevailing wage payments –and–
  • Other exclusions designed for the employer, provided that such exclusions do not cause the plan to cover only those non-HCEs who are the lowest paid or who have the shortest periods of service, and who represent the minimum number of non-HCEs necessary for the plan to pass annual coverage testing under I.R.C. § 410(b)

Some large employers sponsor different plans for different employment classifications, i.e., hourly, salaried, commissioned salespeople, collectively bargained employees and partners/owners. Employees may also be excluded on the basis of being employed by a separate line of business (as defined in I.R.C. § 414(r)) for the purpose of nondiscrimination testing under I.R.C. § 410(b)(6)(C).

Employers often permit their entire full-time workforce to participate after satisfying the plan’s age and/or service requirements – but may wish to exclude part-time employees. Part-time employees cannot be excluded based solely on their part-time status: if they satisfy the plan’s service requirements they must be permitted to enter the plan. I.R.C. § 410(a). Conversely, the adoption agreement may allow exclusions based on other criteria that may also apply to part-time employees (such as ineligibility for employer-paid health and welfare benefits).

Service Requirements and Entry Date

ERISA covered plans reference YOS to determine much about an employee’s rights in a plan. YOS serves many purposes, including as:

  • A requirement to participate in the plan
  • The measure by which a participant’s employer-funded contributions (i.e., profit sharing or matching contributions) vest and become non-forfeitable –and–
  • The basis for determining whether a break in service has occurred that may cause the participant to forfeit benefits previously earned

In a non-ERISA plan, service can be based on years of employment, years of participation, or other creditable years of service as defined in the plan document.

To apply service requirements consistently, the plan must also define the terms used to calculate plan service, including:

  • The required amount of service. This must be based on YOS, defined as a maximum of 1,000 hours of service (HOS) either in the first year of employment, or by the end of a defined computation period.
  • Service-counting. Counting service can be accomplished by counting the hours actually worked during a year (known as “counting/actual hours method”) and extrapolating whether a YOS has been satisfied by assuming a certain number of HOS for every day, week, two-week or month worked, or by determining YOS based on the years of service (YOS) and fractional YOS (known as “elapsed time method”).
  • Variation. YOS definitions will vary for different plan purposes – such as service for eligibility purposes, versus, service for vesting purposes.
  • Prior service recognition. Whether service with a prior employer or predecessor plan will be counted must be clear, and the purposes for which such service will be considered. This election often arises as the result of corporate acquisitions of other employers.

Each type of contribution permitted in a plan can be subject to uniform or varied eligibility requirements. Examples of varied eligibility requirements include:

  • Elective deferrals (funded by employees) that have no requirement other than employment
  • Employer-funded profit sharing and matching contributions that require one YOS
  • Age requirements (up to age 21) –and–
  • Eligibility requirements less restrictive than the statutory maximum waiting periods

After satisfying the plan’s eligibility requirements, the eligible employee becomes a plan participant on the plan’s “entry date.” Like eligibility requirements, entry date can vary for different types of contributions. Entry dates may be:

  • After the eligibility requirements are satisfied, whether semiannually, quarterly, monthly, or the next plan year
  • The first or last day of the plan year nearest satisfaction of eligibility requirements
  • The plan’s defined anniversary date –or–
  • Immediate upon satisfaction of the requirements

For more information about participation requirements generally, see I.R.C. §§ 401(a)(26), 410(a) and 410(b); for 401(k) plans see I.R.C. § 401(k)(2).

Plan Date Provisions

ERISA and I.R.C. compliance is often date-driven. Dates that are crucial to plan administration (but of little interest to employers and participants) include:

  • “Anniversary date” which is often defined as the first or last day of the plan year, but any day of the plan year may be elected in the adoption agreement
  • “Valuation date” to determine the value of the assets in plan accounts and the plan’s trust or custodial account, which may be the last day of the plan year, semiannual on the last of each six month period, the last day of each quarter or month
  • “Limitation year” which is used to determine compliance with maximum allocations under I.R.C. § 415, and which may be the plan year, the calendar year coinciding with or ending within the plan year; a 12-consecutive month period ending on a specified date; the employer’s fiscal year ending with or within the plan year; or a designated 12-month period

Because these dates impact plan administration, the employee benefits practitioner is advised to consult with the plan administrator, the third-party plan administrator (if any) and/or the plan’s actuary to determine an appropriate dates and periods.

The dates of greatest interest to employers and participants involve retirement. Except in the case of a governmental plan, “normal retirement age” (NRA) although not a calendar date, must be elected in the plan. A pre-approved can, for example, provide NRA options of:

  • Age 65 or the 5th anniversary of participation in the plan (the statutory NRA, which is also the latest NRA permitted by ERISA for ERISA plans)
  • A younger age (but not less than 55)
  • Age between 55 and 65, plus a selected number of YOS or years of participation (YOP)
  • Combined age and YOS or YOP that equals a fixed number
  • Age and the sum of age and YOS or YOP equaling a fixed number
  • Age and a defined anniversary of employment or participation in the plan –or–
  • Another formula, provided it does not result in NRA later than the statutory NRA.

Whatever NRA is selected must be applied consistently. Additional information about retirement ages can be found at 26 C.F.R. § 1.401(a)-1(b); ERISA § 3(24) (29 U.S.C. § 1002(24)); I.R.S. Notice 2012-29, 2012-1 C.B. 872.

The normal retirement date (NRD) is the date on which a participant who has terminated employment can begin taking unreduced retirement distributions. In some instances, the plan will also permit in-service distributions beginning on NRD, or permit a participant to delay distributions beyond NRD until they are mandated (soon after the later of termination of employment or turning age 70½). Except in the case of a governmental plan, the adoption agreement must designate the NRD because rights and obligations toll from that date. The employer designates the plan’s NRD by reference to the NRA:

  • Actual date NRA is attained; month in which NRA is attained; month following NRA
  • Anniversary date of plan year in which NRA is attained; anniversary date nearest NRA; anniversary date following NRA
  • Last day of month NRA is attained; last day of month nearest NRA; last day of month coincident with or next following NRA.

A plan may, but is not required, to permit an “early retirement age” (ERA) – and corresponding “early retirement date (ERD),” at which an employee who has terminated employment can receive actuarially reduced benefits. If selected by the employer, ERA can be:

  • A designated age that does not exceed NRA
  • An age, plus a YOS or YOP requirement
  • A number of years before NRA
  • Sum of age and YOS or YOP that equals a designated number
  • Age and the sum of age plus YOS or YOP equaling a selected number
  • A number of YOS or YOP, without an age requirement
  • An age and a designated anniversary of employment or plan participation

For large employers, ERA/ERD may be used to promote succession, or to provide early retirement windows when a company finds itself top-heavy with senior employees. Early retirement benefits are relatively rare among small employers, and if permitted, are typically in plans that cover few employees other than the business owner and his immediate family.

Some plans elect to provide retirement benefits in the event the participant becomes disabled before attaining retirement age. If so, the adoption agreement must define “disability” that permits payment of benefits before ERA or NRA is attained. Disability retirement options include:

  • Suffering from a medically determinable impairment expected to result in death or last for at least 12 or more months
  • Determination by the Social Security Administration that the participant is eligible to receive Social Security disability benefits –or –
  • The participant has begun to receive payments under the employer’s long term disability program

Compensation Provisions

Compensation is among the most complex topics under ERISA and the I.R.C. Like service provisions, compensation is a concept used for several plan purposes, including:

  • Contribution allocations – to determine the amount contributions that will be allocated to participants’ accounts
  • Maximum benefit limitations – to ensure that plan allocations do not exceed maximum allocation limitations (I.R.C. § 415) and additional allocations will be required if higher paid and key employees disproportionately benefit under the plan (I.R.C. § 416)
  • Safe harbor contributions – to ensure that requirements of this feature (which enables employers to avoid complex nondiscrimination testing) have been satisfied.

In a non-standardized plan, compensation can also be variously defined. Nevertheless, a non-standardized plan must give the adopting employer the option to select total compensation as the compensation to be used in determining allocations or benefits. The differences between types of compensation are subtle when read, but significant in application. The adoption agreement should designate a compensation definition that is appropriate to how compensation is paid to plan participants. Optional compensation definitions include:

  • W-2 compensation, which is wages, tips and other compensation entered on Box 1 of Form W-2
  • I.R.C. § 3401(a) compensation, which is used for FICA purposes
  • I.R.C. § 415(c)(3) compensation
  • Simplified I.R.C. § 415(c)(3) compensation, as defined in 26 C.F.R. § 1.415(c)-2(d)(2)

The compensation definition can be further modified by applying certain exclusions from compensation. Generally, employee deferrals to other plans sponsored by the employer can be excluded from the definition of compensation. Possible exclusions include deferrals to:

  • Simplified Employee Pensions under I.R.C. § 402(h)(1)(B);
  • Cafeteria plans under I.R.C. § 125;
  • Transportation plans under I.R.C. § 132(f)(4);
  • I.R.C. §§ 401(k) and 403(b) plans;
  • I.R.C. § 457(b) plans;
  • Simple Retirement Accounts under I.R.C. § 402(k).

In a non-standardized plan an employer can also choose to exclude types of pay from the plan’s definitions of compensation, including overtime, commissions, discretionary bonuses, bonuses, taxable employee benefits, compensation in excess of a specified dollar amount, and a designated exclusion that does not discriminate in favor of HCEs. Other possible inclusions/exclusions can be selected for salary paid in the first few weeks of the next limitation year; for salary continuation during military leave or for disabled participants; or for post-severance compensation.

The adoption agreement must also designate the “computation period” for compensation, for each purpose to which the compensation definitions apply. Computation periods can be an entire plan year; the plan’s limitation year; the calendar year ending with or within the plan year; a pay period, monthly, bi-monthly, quarterly, semi-annually, bi-weekly, or weekly; or a 12-month period ending on a designated date.

As with any administrative provisions, the employee benefits practitioner should consult the plan administrator before selecting compensation definitions.

For a further discussion on permissible definitions of plan compensation, see Compensation Definition Rules for Qualified Retirement Plans.

Contributions and Benefits

For a defined contribution plan, the adoption agreement must specify the type of contributions allowed. For example, in a 401(k) plan, there might be any or all of elective deferrals, matching contributions, and profit-sharing, Roth contributions, employee after-tax contributions, deemed IRA contributions. The employer’s contribution may be required at a specified rate under the terms of the plan, or may be determined by the employer each year. Safe harbor contributions may be provided in order to ensure than a 401(k) plan satisfies the ADP and ACP tests. Elective deferrals may be limited to the statutory limitations that apply to elective deferrals under I.R.C. §§ 402(g), 415, 401(k)(3) and 416, or the plan may permit catch-up contributions to the extent permitted by law. (401(k) plans permit catch-ups under I.R.C. § 414(v)). The plan must set forth special contribution rules in case the plan becomes top-heavy.

A defined contribution plan must also specify how contributions are allocated. For example, are profit-sharing contributions allocated strictly in proportion to compensation, or are they coordinated with Social Security under the I.R.C. § 401(l) permitted disparity rules? Are matching contributions allocated in proportion to all employee contributions, or do they match just elective deferrals? Are there maximum limits on the contributions that will be matched?

A defined benefit plan (including a cash balance plan) must specify the benefit formula to be applied. For example, a defined benefit plan might provide that the benefit is X% of final average compensation times years of service. The rate of contributions would then not be specified under the plan, but determined based on actuarial computations of what contributions were necessary to fund the benefits.

Vesting Provisions

“Vesting” refers to the extent to which portions of employer-funded contributions become nonforfeitable over time. Most often, a designated percentage becomes vested in each year of the stated vesting period. The unvested portion of employer contributions can be forfeited, i.e., removed from the participant’s account balance, if the participant terminates employment before satisfying the vesting schedule (although certain service reinstatement rules can prevent forfeiture). In contrast, employee-funded contributions are always fully vested and can never be forfeited by the participant.

Vesting Schedules and Events

If the plan provides employer contributions, the adoption agreement must specify their vesting periods. A plan can designate a single vesting schedule for all employer-funded contributions, or individual vesting schedules for each type of employer contribution. ERISA and the I.R.C. limit the time over which employer contributions can vest. For an ERISA plan, the longest permissible graded vesting period is six years. Cliff vesting cannot require more than three vesting YOS. For additional information on minimum vesting requirements, see I.R.C. § 411(a)(2); 26 C.F.R. § 1.411(a)(1); 26 C.F.R. §§ 1.411(a)-3T.

Permissible vesting schedules in an ERISA plan include:

  • Cliff vesting – 100% vesting upon completion of designated years of vesting service
  • Immediate vesting – 100% upon participation in the plan
  • nother vesting schedule designated by the employer – provided that 100% vesting occurs not later than completion of the sixth year of vesting service

Top-heavy contributions to an ERISA plan are subject to special vesting requirements. Foremost, the vesting schedule for top-heavy contributions must be at least as favorable as the vesting schedule for other employer contributions. In practice, plans that provide a vesting schedule for non-safe harbor employer contributions often designate the same vesting schedule for top-heavy contributions.

Certain contributions are also subject to statutory vesting schedules. For example:

  • Employee contributions (including employee deferral contributions after-tax contributions) must vest immediately, never to be forfeited by the participant.
    •Safe harbor nonelective (SHNE) contributions (contributions designed to help a 401(k) plan to meet ADP requirements) and safe harbor matching (SHM) contributions (contributions designed to help a 401(k) plan other than a nonelecting church plan to meet ACP requirements) must also vest immediately.
  • Plans that require two years of service before a participant can enter the plan must immediately and fully vest employer contributions.

For a governmental plan, the IRS provides a safer harbor for vesting at least as favorable as the following schedule:

  • Fifteen year cliff vesting. 100% vesting upon 15 years of creditable service (service can be based on years of employment, years of participation, or other creditable years of service).
  • Twenty year graded vesting. A participant is fully vested based on a graded vesting schedule of five to 20 years of creditable service (service can be based on years of employment, years of participation, or other creditable years of service).
  • Twenty year cliff vesting for qualified public safety employees. A participant is fully vested after 20 years of creditable service (service can be based on years of employment, years of participation, or other creditable years of service). This safe harbor would be available only with respect to the vesting schedule applicable to a group in which substantially all of the participants are qualified public safety employees (within the meaning of I.R.C. § 72(t)(10)(8)).

The plan’s selected vesting schedule notwithstanding, the employer can choose whether to “accelerate” vesting upon a participant’s attainment of early retirement age, death, or disability. The employer can also choose to count a participant’s time of disability toward their vesting service (as though s/he was still employed). Like all adoption agreement provisions, however, the administrator must apply vesting acceleration on an equal and nondiscriminatory basis.

Prior and Transferred Assets Vesting Schedules

After a corporate merger, acquisition or spin-off, an employer may require a new plan or amendment of its existing plan, to provide plan coverage to employees of the entity that was the subject of the corporate transaction. For example, an employer that acquires another business can cover the acquired employees in the employer’s existing plan, or may sponsor a new plan for the acquired company. If the acquired company has a pre-existing plan, the employer may become the sponsor of the acquired plan, may sponsor a new plan for the affected employees, or may merge the prior plan into an existing plan.

ERISA’s provisions relating to mergers and acquisitions exceed the scope of this note. But in relevant part, affected employees may not lose the benefits allocated to them under a prior employer’s plan: each affected participant is entitled to receive a benefit after a corporate transaction that is at least equal to the benefit the participant would have received before the transaction. I.R.C. §§ 401(a)(12) and 414(l); 26 C.F.R. §§ 1.401(a)-12, 1.414(l)-1. For additional information on ERISA’s requirements regarding retirement plans involved in mergers & acquisitions, see Retirement Plan Issues in Corporate Transactions.

When implementing (or amending) a pre-approved plan that will cover acquired employees, the adoption agreement must indicate:

  • Whether a prior vesting schedule exists for affected participants prior account balances
  • Whether the vesting schedule that applied to prior account balances (“old money”) is more or less generous than the vesting schedule for new contribution allocations (“new money”) –and–
  • The vesting schedule under the prior plan

In summary, old money must vest at least as quickly as it would under the prior plan, but new money can vest at the existing plan’s schedule, whether slower or faster than the former plan’s vesting schedule.

Similarly, if two plans merge and assets are transferred from the acquired plan into a new or existing plan, the transferred assets must continue to vest at the same or faster rate as they would have under the former plan. The adoption agreement will require you to designate each account type that is the source of transferred assets, i.e., non-elective contribution account or matching contribution account, and the vesting schedule that applied to the transferred assets.

Breaks in Service and Reemployment

An account balance in an ERISA plan that becomes forfeitable is not immediately forfeited: the participant must attain a designated number of years of “breaks in service” before the balance is deducted from the participant’s employer contribution account. If the participant returns to service before the maximum break in service is completed, then the participant’s account balance attributed to unvested employer contributions can be reinstated. (But compare employer contributions that are fully and immediately vested, which can never be forfeited.)

In order to permit forfeitures, an adoption agreement must indicate the service rules that apply to forfeitures, including how breaks in service are counted (by incorporating HOS and YOS – both of which are defined in “Service Requirements and Entry Date” above under “Eligibility Requirements”). The most typical break in service and reemployment provisions are:

  • A “one-year break in service” is a plan year during which the participant failed to complete a designated number of HOS up to 500 hours –and–
  • YOS completed after a break in service can be disregarded for vesting purposes unless the participant is reemployed within five years

Some plans (more typically defined benefit plans) apply a “rule of parity” that allows a plan to disregard YOS completed before a break in service, if the number of consecutive one-year breaks equals or exceeds the greater of five, or the participant’s years of service before the break began. In contrast, although relatively rare, employers can choose to count all service toward vesting, including service completed after a break in service, regardless of the length of the break in service.

Governmental plans are not subject to statutory rules regarding forfeitures, but must nevertheless specify what forfeiture rules are being used.

Forfeitures

Forfeitures are the result of a participant’s failure to complete the plan’s vesting schedule. For example, if a plan has three-year cliff vesting, employer contributions will vest when the participant completes three years of service, but if the participant terminates employment after two years, the account balances become forfeitable.

The adoption agreement must reflect the plan’s rules for how forfeitures will be deducted from participants’ accounts. A plan can permit forfeitures to occur at:

  • Various dates tied to other plan definitions (such as valuation date, the designated number of consecutive breaks in service)
  • Upon certain distribution events (such as distribution of the entire vested interest, or pro-rata as the vested interest is distributed over time)

Consult the trustee (or trust custodian charged with valuing account balances) before electing these provisions. For additional information on forfeitures, see I.R.C. §§ 411(a)(6).

Forfeited assets cannot revert to the employer; therefore the adoption agreement must detail when and how forfeitures of employer contribution accounts will be applied in the plan. Once forfeited, unvested employer non-elective and matching contributions can be used by the employer to:

  • Reduce administrative expenses (to pay permissible plan expenses)
  • Restore forfeited account balances of rehires (to replace forfeitures previously taken from an account if the participant is reemployed by the employer)
  • Reduce employer contributions (to fund current employer contributions with forfeited balances)
  • Supplement employer contributions (to give additional contributions to participants)

Asset Distribution Provisions

End-of-Service Distributions

Plans must permit distribution of benefits (if requested by the participant or beneficiary) as the result of retirement, termination of employment or death. If elected in the adoption agreement, a plan may treat a participant’s full disability (as defined in the plan) as a distribution event.

In all cases, the adoption agreement must designate the forms of distribution permitted by the plan. Options include:

  • Lump sum in cash (the minimum form required of all DC plans)
  • Partial non-periodic ad hoc distributions paid at times and in amounts requested by the participant or beneficiary
  • Installment payments made in substantially equal annual, quarterly or monthly installments over a number of years designated in the adoption agreement, or over a period of years selected by participant that is less than her life expectancy, or another schedule designated in the adoption agreement
  • Annuities (payments made by purchasing an annuity contract providing for equal periodic payments for the life of participant, and possibly after participant’s death for the life of a designated beneficiary or spouse)

For additional information on permitted distribution types, see I.R.C. §§ 401(a)(15), 401(a)(11), 411(d)(6). More varied distribution types are permitted in governmental and nonelecting church plans, which are not subject to those I.R.C. sections.

If permitted by the employer’s election (and if later elected by the participant) a plan can provide joint and survivor annuities, which pay for the life of the participant, and at participant’s pre-death election, continue payments to a designated beneficiary a fixed proportion of the annuity contract value for a specified period.

Pre-approved plans may permit various annuity options, and those provided in support of annuity products often provide extensive ones. In a defined benefit plan, the normal form of benefits must be a qualified joint and survivor annuity for the participant and spouse if the participant is married, and otherwise a life annuity for the participant. A preretirement survivor annuity in favor of the spouse must also be provided if the participant dies before termination of employment. If a married participant wants to elect a different form of benefits, the election is possible only if the spouse consents.

Depending on the annuity options provided by the pre-approved plan’s provider, the adoption agreement may require decisions on:

  • The periods permitted for annuities
  • Whether they will carry over from the participant’s life to another’s life
  • The designated percentage payable to the non-spouse beneficiary or surviving spouse
  • Whether payments will be guaranteed for a period of years

For additional information on statutory annuity requirements, see I.R.C. §§ 401(a)(11), 417; 26 C.F.R. § 1.401(a)(20).

In-Service Distributions

Plans are not required, but may in some circumstances permit, participants to access portions of their account balances while still employed by the adopting employer. For participants, the availability of in-service distributions is a double-edged sword: they calm employees’ fears that money saved for retirement will be inaccessible until retirement, but removing assets and losing investment income reduces retirement readiness. Notably, although a plan can permit premature distributions (taken before the plan’s earliest retirement date) a 10% penalty tax will be deducted from the premature distribution.

Once elected, the ability to remove in-service distributions is limited. The availability of in-service distributions are “protected benefits”: once provided, they must always be available for account balances that exist before the removal of the protected benefit. Although subsequent allocations are not subject to an eliminated protected benefit, the plan will incur additional administration costs to administer a protected benefit for portions of participants’ account balances. See I.R.C. § 411(d)(6) for additional information on protected benefits.

In-service distributions can be provided only if the adoption agreement provides for them. Distributions of employee deferrals under a 401(k) plan can be permitted only on or after a participant’s attaining an age specified by the employer that is no earlier than 59½, or upon hardship (see below).

The adoption agreement may also apply non-age requirements to access account balances that would be used for in-service distributions. Additional requirements can include:

  • The participant’s attainment of early or normal retirement age under the plan
  • Assets having been allocated for at least two years
  • Participation in the plan for at least five years –or–
  • A combination of both allocation and participation requirements

In a defined benefit plan, in-service distributions can be permitted only upon attainment of the earlier of age 62 or normal retirement age under the plan. Various rules limit the normal retirement age that can be specified for this purpose.

The adoption agreement must also specify the accounts from which in-service distributions can be deducted. If elected, in-service distributions of 401(k) elective deferrals can be made from accounts holding:

  • Employee non-elective contributions (i.e., employee deferrals)
  • Matching contributions
  • SHNE and SHM contributions
  • Various types of rollover accounts (in which employees place distributions from a prior employer’s plan)
  • Employee voluntary contribution accounts

For additional information on in-service distributions, see I.R.C. §§ 401(k)(2)(B)(i)(III), 401(k)(10).

Hardship Distributions

For a 401(k) plan, another permissible in-service distribution is the hardship distribution. Hardships distributions must be granted on the basis of immediate and heavy financial need, which must be defined in the plan. The single plan document or adoption agreement must designate the accounts from which hardships can be paid. Like in-service distributions, the availability of hardships is a protected benefit. Hardship distributions are also subject to the 10% premature distribution penalty.

Most pre-approved plans define “hardship” as meeting the “safe harbor hardship” standards of 26 C.F.R. § 1.401(k)-1(d)(2)(iv). If a safe harbor hardship is elected in the single plan document or adoption agreement, the safe harbor’s “deemed hardship” criteria cannot be changed, and any distribution paid on this basis will be deemed necessary to satisfy the participant’s immediate and heavy financial need. Safe harbor distributions can be used to pay:

  • Deductible medical expenses
  • A down payment on the purchase of a principle residence
  • Tuition and related educational needs
  • Amounts required to prevent eviction or foreclosure
  • Funeral or burial expenses –and–
  • Significant repair costs arising from a catastrophic event

In addition, before obtaining a safe harbor hardship, a participant must have obtained all other distributions and plan loans that are available under the plan and must have ceased elective deferrals and voluntary employee contributions for six months.

Although atypical in a pre-approved plan, in lieu of the safe harbor standards, an employer can define its own non-safe harbor criteria for hardship distributions. However, a unique definition must be consistently applied, and the employer should expect the plan’s review, approval and recordkeeping processes to invite stricter scrutiny in a financial or agency audit of the plan. See I.R.C. § 401(k)(2)(B)(i)(IV) for additional information on hardship distributions.

Plan Loans

Although not technically an in-service distribution, a defined contribution plan can permit plan loans that enable participants to access their account balances before terminating employment. Plan loans are paid from the participant’s accounts, and must be repaid with interest. Plan loans that have not been repaid are deducted from the participant’s accounts; there is no premature distribution penalty associated with plan loans. For a plan covered by ERISA, married participants must provide their spouse’s consent to obtain plan loans.

If plan loans are permitted, the adoption agreement must specify the number, frequency, minimum and maximum amounts permitted, applicable interest rate and default provisions relating to plan loans. For information on plan loans see I.R.C. § 72(p)(2).

Other Administrative Provisions

Besides statutory and design options, the adoption agreement must specify how plan asset and trust or custodial account provisions will apply. These include:

  • The date as of which earnings on contributions will be credited to a participant’s account
  • Whether the plan’s forfeiture account will be subject to trust earnings
  • Whether plan participants may make their own investment choices from a slate of investment alternatives that have been vetted by the plan trustees
  • If the plan permits participant-elected investments, to which accounts a participant’s investment control will apply
  • Whether life insurance can be purchased as a form of benefit
  • The extent to which the plan will accept rollover contributions from other plans (if at all) –and–
  • How many trustees are required to take action on behalf of all trustees

Additional Documents Required to Implement a Pre-Approved Plan

Other documents required to generate a pre-approved plan may also require some additional information.

Trust Agreement

If plan assets are held in trust (as opposed to an annuity contract), either the basic plan document or a separate trust agreement must set forth the trust provisions. The trust agreement enumerates ERISA’s fiduciary requirements that apply to trustees’ management of plan assets. “Named trustees” are generally employees of the adopting employer, who exercise some discretion in the administration of the plan. Most typical in pre-approved plans, named trustees select the plan investments that a participant can apply to his individual accounts. Conversely, some pre-approved plans require trustees to make all investment decisions for the plan’s aggregated accounts. For additional information on trust requirements, see ERISA § 403 (29 U.S.C. § 1103).

In either case, the trust agreement must specify the names of the plan’s trustees, and since circumstances (such as retirement) cause trustees to change, the trust agreement will require periodic amendment.

Summary Plan Description

In brief, the SPD describes the plan’s benefits and participant rights in “plain English” intended to be understood by the average plan participant, including eligibility, contributions, vesting/forfeiture, distributions, where to get additional information about the plan.

Choices elected in the adoption agreement will also be captured in the system-generated SPD. However, additional plan policies may need to be completed to enable the document system to generate a complete (and ERISA compliant, in the case of an ERISA plan) SPD. Additional policies that would impact the SPD include the plan’s:

  • Loan policy (if the plan permits loans)
  • Expense policy (denoting administrative expenses charged to participant accounts, such as to apply for a plan loan) –and–
  • Insurance policy (describing how contribution accounts can be applied to life insurance premiums)

Detailed information about ERISA’s requirements for SPDs is located at ERISA § 102 (29 U.S.C. § 1022); 29 C.F.R. § 2520.102-3. While non-ERISA plans are not subject to statutory or regulatory requirements for SPDs, they will nevertheless typically provide a plan summary to inform employees of the essential plan terms.

Corporate Resolution

The corporate resolution is the instrument with which the employer adopts the plan and approves the plan documents. The information required for the resolution is usually captured from the employer’s general information that was entered into the adoption agreement.

However, some situations will require either unique or multiple resolutions. Besides allowing you to select certain routine resolutions (i.e., appointing and/or removing a plan trustee), the resolution module should allow you to draft unique resolutions that are not pre-programmed as a module option (such as allocating contributions to specified ineligible employees to correct cross-testing failures under 26 C.F.R. § 1.401(a)(4)-11(g)).

Notices to Participants and Beneficiaries

Many plan provisions that can be elected by the employer also require special disclosures to plan participants. For example, SHNE and SHM contributions, as well as automatic deferral contributions, each require the administrator to provide annual notice to participants. Certain events, such as plan mergers, cause a transfer of investments between investment platforms and a “blackout period” during which participants cannot access their accounts or change their investments. The plan administrator must provide detailed blackout notices to participants and beneficiaries well before the blackout begins.

Some document systems generate such participant notices but only after you provide relevant event-specific information. When the notice relates to plan features, the relevant information is captured from the adoption agreement. But when a notice relates to an event that isn’t a plan feature – such as a plan merger – additional information is required to generate a compliant notice.

Obtaining IRS Opinion Letters

The IRS issues opinion letters on pre-approved plans. The opinion letter explains the:

  • Scope of the IRS’s pre-approval of the plan that is being used by the employer
  • Body of law and certain assumptions that are basis for the pre-approval –and–
  • Extent to which the adopting employer is protected by pre-approval of plan

The IRS announces the date by which employers must adopt pre-approved plans for each six-year cycle.

For instructions on how to apply for an opinion letter, see Pre-Approved Plan Submission Procedures. For a detailed discussion on determination letter applications (including information on how to apply), see Determination Letter Application Procedures.

If a mass submitter files on behalf of a flexible plan, it must bracket and identify the optional provisions when submitting such plan, and must also provide the IRS a written representation describing the choices available to Providers and the coordination of optional provisions. Thus, such a representation must indicate whether a Provider’s plan may contain only one of a certain group of optional provisions, may contain only a specific combination of provisions, or may exclude the provisions entirely. Similarly, if the inclusion (or deletion) of a specific optional provision in a Provider’s plan will automatically result in the inclusion (or deletion) of any other optional provision, this must be set forth in the mass submitter’s representation.

Adopting employers that have made minor modifications to the terms of the pre-approved plan may request a determination letter using Form 5307. Examples of minor changes include: changing the effective date of a provision, adopting IRS model or sample amendments, the adoption of an interim or discretionary amendment in accordance with Revenue Procedure 2007-44, or the adoption of amendments to obtain reliance for §§ 415 and 416 given the required aggregation of plans. Adopting employers that have not made any changes to the terms of the pre-approved plan (except to select among options under the plan) should not submit Form 5307. These employers may rely on the opinion letter issued for the plan.

This excerpt from Lexis Practice Advisor®, a comprehensive practical guidance resource providing insight from leading practitioners, is reproduced with the permission of LexisNexis. Reproduction of this material, in any form, is specifically prohibited without written consent from LexisNexis.

New Immigration Rules Create Issues for Employer Health Plans
(Posted on August 9, 2018 by )


Department of Homeland SecurityA leaked draft of Proposed Department of Homeland Security (“DHS”) regulations indicates that certain non-US citizens may be disadvantaged in extending or adjusting their immigration status if they obtain health insurance coverage through the Health Insurance Marketplace (“Marketplace”) set up under the Patient Protection and Affordable Care Act (“ACA”) or Medicaid, or obtain benefits under the Children’s Health Insurance Program (“CHIP”) for their dependents (even US citizen dependents). From an employee benefits perspective, the proposed rules have three effects on employers:

  1. Employees may have questions about whether they can or should switch coverage from the Marketplace or CHIP to the employer’s health plan.
  2. Employers are required to give notices to employees on hiring about the availability of health insurance through the Marketplace, and annually about the availability of CHIP. Employers may want to consider adding information to these notices regarding the potential impact on immigration of accepting either of these benefits.
  3. Employers that wish to retain non-US citizen employees may wish to improve health benefits (particularly for dependents) to discourage use of the Marketplace or CHIP.

The change in regulations would have a number of effects on employers who hire non-US citizens, particularly in instances in which the employer is sponsoring them (such as for an H-1B visa or a green card) which are beyond the scope of this post. However, this post discusses the specific impact on employee benefits of the proposed regulations, and potential employer responses to them. Read more.

New Article: Substantial Risk of Forfeiture
(Posted on July 25, 2018 by )


Lexis Practice AdvisorAn article recently published in the Lexis Practice Advisor, Substantial Risk of Forfeiture, discusses the concept of substantial risk of forfeiture (SRF) under sections 83, 409A, 457(f), 457A, and 3121(v)(2) of the Internal Revenue Code and the different consequences of the failure to achieve a SRF under each such section.

Topics covered are:

It is accompanied by a Substantial Risk of Forfeiture Comparison Chart, which summarizes the rules.

Substantial Risk of Forfeiture
(Posted on July 25, 2018 by )


Go to: Significance of SRF under the Various I.R.C. Sections | Definition of SRF | Conditions that Generally Support the Existence of a SRF and Related Requirements | Conditions that Generally Do Not Support the Existence of a SRF | Other rules relating to SRF

This practice note discusses the concept of substantial risk of forfeiture (SRF) under sections 83, 409A, 457(f), 457A, and 3121(v)(2) of the Internal Revenue Code (I.R.C.) (referred to hereafter as Section 83, Section 409A, etc.) and the different consequences of the failure to achieve a SRF under each such section. SRF is the standard that the I.R.C. and Treasury Regulations apply to determine when an employee’s or an independent contractor’s deferred compensation (or transfer of compensatory property) vests, and therefore (depending upon the particular I.R.C. section) may be includable in income for the individual (or deductible for the employer or other controlled group member granting the compensation).

The Internal Revenue Service (IRS) recently issued proposed regulations that help clarify the similarities and differences among the SRF definitions. 81 Fed. Reg. 40,569 (June 22, 2016) (regarding Section 409A); 81 Fed. Reg. 40,548 (June 22, 2016) (regarding Section 457(f)). To properly analyze SRF-related issues, you must be aware of the overall rules and the details about the differences among the different definitions.

The practice note is divided into the following main topics:

For a chart summarizing the main points contained in this practice note, see Substantial Risk of Forfeiture Definition Comparison Chart.

Significance of SRF under the Various I.R.C. Sections

As discussed further in the next section, SRF generally exists with respect to deferred compensation (or compensatory property governed by I.R.C. § 83) where the right to receive such compensation is subject to a condition—e.g., a requirement that the grantee provide substantial services to the grantor. Also, the lapse of a SRF (or vesting of the compensation) may mean that the compensation is subject to taxation and inclusion in income at that time, depending upon the rules under the applicable I.R.C. section. Finally, the existence of a SRF is an important factor in determining whether the short-term deferral exception to Section 409A applies to an amount that would otherwise be treated as nonqualified deferred compensation (and a similar concept used in analyzing compensation subject to Section 457(f) under the proposed regulations).

Sections 83, 409A, 457(f), 457A, and 3121(v)(2) all deal with compensatory arrangements, as follows:

  • Section 83 governs transfers of compensatory property (such as restricted stock).
  • Section 409A governs nonqualified deferred compensation.
  • Section 457(f) governs deferred compensation paid by tax-exempt and state and local government employers payable to participants under a deferred compensation plan that is not an eligible plan under I.R.C. § 457(b).
  • Section 457A governs deferred compensation payable by nonqualified entities (i.e., certain tax-haven organizations that do not benefit from a U.S. federal tax deduction for deferred compensation amounts paid/included in income by the payee).
  • Section 3121(v)(2) governs when nonqualified deferred compensation is subject to Social Security (FICA) taxation.

Section 83—Transfers of Property and Funded Deferred Compensation Plans

Section 83 governs three situations:

  • If an employer transfers property to an employee as compensation (e.g., restricted stock), the employee owes taxes on the fair market value of the property (minus the amount the employee paid for it, if any) for the year the employee’s rights in the property become either (1) transferable, or (2) not subject to a SRF (whichever occurs earlier), unless the individual elects for immediate income recognition at the time of transfer from the employer under I.R.C. § 83(b). I.R.C. § 83.
  • For purposes of I.R.C. § 280G, dealing with excess parachute payments, a payment is considered made at the same time as under Section 83 (i.e., the earlier of the time the employee’s rights in the property become transferable or the SRF lapses), without regard to any section 83(b) election. 26 C.F.R. § 1.280G-1, Q&A-12
  • If an employer contributes to a trust insulated from the claims of the employer’s creditors to fund a retirement plan that that is not a qualified plan (within the meaning of I.R.C. § 401(a)), the transfer is treated as if it were a transfer of property within the meaning of Section 83. I.R.C. § 402(b)(1). A plan that involves contributions to such a trust is referred to as a funded plan. (Similar treatment occurs for assets designated to pay deferred compensation under a nonqualified deferred compensation plan (within the meaning of I.R.C. § 409A(d)(1)) in certain situations, regardless of whether the trust is insulated from the employer’s creditors. I.R.C. § 409A(b)(1)–(3).)

Virtually all plans covered by Section 83 involve transfers of property with deferred vesting rather than funded nonqualified plans. Employers almost never intentionally offer funded nonqualified plans. Such plans typically arise only accidentally (e.g., if a plan meant to be a qualified plan fails to satisfy the requirements for qualified status). Similarly, employers typically structure parachute payments to avoid the harsh penalties of I.R.C. §§ 280G and 4999, so they are seldom concerned about its timing rules. Thus, this practice note focuses on transfers of property subject to I.R.C. § 83.

The value of property transferred for purposes of Section 83 is determined without taking into account any restrictions on the property, other than restrictions that by their terms will never lapse. However, if a forfeiture is certain to occur (e.g., property must be returned whenever the employee terminates employment for whatever reason), the property will not be considered to have been transferred, so the concept of SRF does not apply. 26 C.F.R. § 1.83-3(a)(3).

As noted above, an employee can prevent tax at the time the SRF lapses by electing to include in income the value of the property (less any amount paid for it) for the year of the transfer. I.R.C. § 83(b). Since in this case the taxation occurs at the time the employee receives the property, the SRF concept does not affect the timing of taxation.

Section 409A—Nonqualified Deferred Compensation Plans

Section 409A generally governs the taxation of nonqualified deferred compensation, subject to certain exceptions and exemptions. Unlike Sections 457(f) and 457A, which apply only to specific types of employers, Section 409A applies to all employers. (For more information on Section 409A, see, generally, Section 409A Fundamentals.)

SRF is important in three areas under Section 409A (each as discussed below):

  • Determining whether the plan provides for deferred compensation under the short term deferral rule
  • Determining the date on which deferred amounts must be included in income, and additional interest and penalty taxes applied, if the rules of Section 409A are not met
  • Determining whether payments under the plan are made on a fixed payment date or schedule, or whether payments may be accelerated or further delayed

Short-term deferral rule. Under the short-term deferral rule (exception to Section 409A), a plan does not provide for deferred compensation if payment is made no later than the 15th day of the third month following the end of the employee’s or employer’s taxable year (whichever ends later) in which a SRF lapses. 26 C.F.R. § 1.409A-3(d). Therefore, the timing of the SRF of deferred compensation that qualifies for the short-term deferral rule exception is critical to determining the schedule of payment for amounts that are not subject to Section 409A’s rules.

Section 409A penalties. If a deferred compensation arrangement that is not exempt from Section 409A fails to meet the rules of Section 409A, two things happen at the point that amounts deferred under the plan are no longer subject to a SRF:

  • The employee must include the amounts deferred under the plan in income for tax purposes.
  • The employee is subject to a 20% additional tax on the deferred compensation required to be included in income, plus an interest factor applied to any underpayment of taxes that should have been paid on the deferred amount from the time of income inclusion based on the IRS underpayment rate plus one percentage point (premium interest tax).

I.R.C. § 409A(a)(1)(B).

Scheduling of payments, deferrals and accelerations. Unlike Section 83 compensatory property, a compliant Section 409A arrangement does not automatically result in tax liability when the SRF lapses. A deferred compensation plan can avoid the tax consequences of Section 409A if it meets the following conditions:

  • With some exceptions, including for performance-based compensation and new hires, elections to defer compensation must be made before the end of the year preceding the year in which the services related to the compensation are rendered. I.R.C. § 409A(a)(4)(B)(i).
  • Nonqualified deferred compensation generally may only be paid upon a fixed payment date (or schedule) or upon certain limited, permissible payment events (under I.R.C. § 409A(a)(2)(A)) specified in the original deferral agreement.
  • Any acceleration of payment or further deferral of compensation may only be made in accordance with limited special rules. I.R.C. § 409A(a)(3); 26 C.F.R. § 1.409A-3(j); I.R.C. § 409A(a)(4)(C).

A payment will, nevertheless, be considered to be made on a fixed payment date or permissible payment event if it is made in accordance with a fixed schedule that is objectively determinable based on the date the SRF lapses, provided that the schedule must be fixed on the date the time and form of payment are designated. 26 C.F.R. § 1.409A-3(i)(1)(i). For example, suppose that a deferred compensation plan provides for payment contingent on the performance of three years of service, except that the service requirement will be waived in the event of an initial public offering (which is not one of the enumerated permissible payment events under Section 409A). A payment schedule that provides for substantially equal payments on each of the first three anniversaries of the date the SRF lapses will be considered a fixed payment schedule, even though an initial public offering will accelerate the lapse of the SRF and therefore will accelerate the payments.

Effect of other I.R.C. sections. Note that the fact that an arrangement is subject to Section 83, 457(f), or 457A will not preclude such arrangement from being subject to Section 409A. You must analyze the arrangement under both sets of rules (e.g., nonqualified deferred compensation arrangements with tax-exempt or government employers are subject to both Section 409A and Section 457).

Note in this regard that the SRF analysis under each I.R.C. provision will not always be identical because of the differences in the definitions of SRF for purposes of each of the sections.

Section 457(f)—Unfunded Deferred Compensation Plans of Tax-Exempt or Governmental Employer

Section 457(f) applies to unfunded deferred compensation plans of tax-exempt and governmental employers that are not eligible 457(b) plans. I.R.C. § 457(f)(1). The basic rule under Section 457(f) is that amounts of deferred compensation payable by relevant employers are included in income in the first year in which the amount is not subject to a SRF. Eligible 457(b) plans are not subject to this rule, but they are limited as to the amount of annual compensation participants may defer and other restrictions. Qualified plans, funded plans, and certain other arrangements are excluded by reason of I.R.C. § 457(f)(2).

The rationale for Section 457(f) is that in the case of a taxable employer, the employee’s desire to defer taxes is balanced by the employer’s desire for an immediate deduction, but similar balancing does not apply in the case of employers that are not subject to tax. In the case of a tax-exempt employer or a nonqualified entity, Section 457(f) essentially subjects an unfunded plan to rules similar to those that would apply under Section 83 if it were a funded plan, imposing a tax as soon as there is no longer a SRF (or, if later, on the date the employee receives a legally binding right to the compensation).

So (by comparison), as discussed above, compensation governed by Section 83 is taxed upon the lapse of the SRF or earlier (e.g., if the property becomes transferable or if the employee makes a section 83(b) election to be taxed on the initial transfer), and the taxation of compensation governed by Section 409A can be deferred beyond the lapse of the SRF if the plan meets certain criteria. However, if Section 457(f) applies to the employer, the I.R.C. automatically imposes tax upon the lapse of the SRF, regardless of any other factors.

Short-term deferral rule. Note, however, that the proposed regulations under Section 457(f) apply a similar short-term deferral rule (exception) as under Section 409A by incorporating Section 409A’s regulations as applied to the Section 457(f) plan (with Section 457(f)’s definition of SRF). See 81 Fed. Reg. 40,555. Therefore, deferred compensation payable within 2 1/2 months following the end of the employer’s or employee’s taxable year (whichever ends later) in which the SRF lapses is not subject to Section 457(f)’s income inclusion rules. 81 Fed. Reg. 40,555.

Section 457A—Unfunded Deferred Compensation Plans of Tax Haven Employers

Section 457A is similar to Section 457(f), providing for immediate income inclusion in the first year where there is no SRF, except that it applies to so-called nonqualified entities. The following entities are nonqualified entities:

  • Any foreign corporation, unless substantially all of its income is:
    • Effectively connected with the conduct of a trade or business in the United States (within the meaning of I.R.C. § 457A(b) (1)(A)) –or–
    • Subject to a comprehensive foreign income tax (within the meaning of I.R.C. § 457A(d)(2))
  • Any partnership, unless substantially all of its income is allocated to persons other than:
  • Foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax –and–
  • Organizations which are exempt from tax

I.R.C. § 457A(b).

In other words, Section 457A applies to employers whose income avoids tax due to tax havens, rather than due to tax-exempt or governmental status. Section 457A provides an exception to its general rule that taxation will occur when the SRF lapses if the value of the deferred amount cannot be determined at that time. In that case, the employee is subject to normal income taxes, an interest factor, and a 20% penalty on the deferral when the value becomes determinable. I.R.C. § 457A(c)(1). Otherwise, if Section 457A applies to the employer, the employee is taxed upon the lapse of the SRF, regardless of any other factors. I.R.C. § 457A(a).

Short-term deferral rule. Like Sections 409A and 457(f), Section 457A also contains a short-term deferral rule (exception) based on the date of the lapse of the SRF (as defined under the more limited definition of SRF provided under Section 457). However, the rule applies to deferred compensation payable within 12 months following the end of the employer’s taxable year in which the amount is no longer subject to the SRF. I.R.S. Notice 2008-9, 2008-1 C.B. 277, Q&A 4.

Section 3121(v)(2)—FICA Taxes on Deferred Compensation Plans

Section 3121(v)(2) determines when Social Security and Medicare (FICA) taxes are imposed on an amount deferred under a nonqualified deferred compensation plan (funded or unfunded). The basic rule is that such amounts are taken into account as of the later of:

  • When the services are performed –or–
  • When there is no SRF of the right to such amount

I.R.C. § 3121(v)(2)(A).

Section 3121(v)(2) applies to a 403(b) plan or a 457(b) plan, as well as to plans that do not have any special tax status. (I.R.C. § 3121(v) (1) imposes similar rules on 401(k) and 414(h) elective contributions, but since those contributions are always fully vested, the SRF analysis does not apply to them.)

Unlike Section 83, Section 3121(v)(2) does not permit an employee to accelerate the time of taxation by making a special election. Unlike Sections 457(f) and 457A, Section 3121(v)(2) applies to all employers, not just those with a special tax status. And unlike Section 409A, an employer cannot defer Section 3121(v)(2) beyond a lapse of SRF simply by structuring a plan appropriately.

Nevertheless, except in the case of a governmental or church plan, or a private school or university, Section 3121(v)(2) typically has minimal effect on an employee’s taxes. To avoid constraints imposed by ERISA, other employers typically only offer unfunded deferred compensation plans to a select group of managers and highly compensated employees. Such employees typically have salaries in excess of the Social Security wage base, so Section 3121(v)(2) imposes only the 1.45% Medicare tax on employers and employees. See I.R.C. § 3121(v)(2)(B).

Even for a governmental plan, Section 3121(v)(2) has minimal effect on an employee’s taxes if the employment is not subject to Social Security. I.R.C. § 3121(a)(5)(E); I.R.C. § 3121(v)(3). About one-fourth of all public employees are not subject to Social Security, so Section 3121(v)(2) applies only to Medicare taxes.

Definition of SRF

Although the general concept of SRF (and the statutory definition) is the same for each of Sections 83, 409A, 457(f), 457A, and 3121(v)(2), implementing regulations have varied the definitions as applied to each of the I.R.C. sections. This section sets forth the varying definitions pursuant to the regulations.

Statutory Definition of SRF

SRF has the same statutory definition for Sections 83, 409A, 457(f), 457A, and 3121(v)(2), as follows:

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.

I.R.C. §§ 83(c)(1), 409A(d)(4), 457(f)(3)(B), and 457(d)(1)(A). I.R.C. section 3121(v)(2) does not define SRF, but 26 C.F.R. § 31.3121(v) (2)-1(e)(3) provides that the definition will be the same as for Section 83.

So, for purposes of Sections 83, 409A, 457(f), 457A, and 3121(v)(2), whether compensation is subject to a SRF generally involves two components:

  • The amounts will be forfeited if certain conditions do or do not occur –and–
  • The risk of such forfeiture is substantial

The substantiality of the risk is measured in two ways:

  • Likelihood of the occurrence
  • Likelihood of enforcement

A simple example of a SRF involves a deferred compensation plan in which an employment contract provides that the employer will put aside $5,000 today. The amount will be put into a trust (either one insulated from the claims of creditors, in the case of a funded plan, or a rabbi trust, in the case of an unfunded plan). The amount is payable only if the employee remains employed for the entire five years, and the employer routinely enforces this condition. In this situation, there is a risk of forfeiture (because the employee will lose the deferred compensation in the event he or she does not stay for five years), and that risk is substantial (because the employee has no guarantee that employment will continue). Conversely, a SRF does not exist if the amount, though deferred for five years, is payable regardless of any continuing service requirement or any other conditions.

Sections 83 and 3121(v) SRF Definition

Based on legislative history, the regulations under Section 83 expand the statutory definition of SRF, treating compensation contingent on the following conditions as subject to a SRF:

  • Performing substantial services (i.e., a service condition)
  • Refraining from performing services (e.g., a covenant not to compete)
  • The occurrence of a condition related to a purpose of the transfer

26 C.F.R. § 1.83-3(c). These conditions (and related requirements) are discussed below under Conditions that Generally Do Not Support the Existence of a SRF.

Section 409A SRF Definition

The Section 409A regulations treat only compensation contingent on the following as subject to a SRF:

  • Performing substantial services
  • The occurrence of a condition related to a purpose of the transfer 26 C.F.R. § 1.409A-1(d)(1).

Unlike for Sections 83 and 3121(v)(2) (and the proposed Section 457(f) regulations), compensation contingent on refraining from the performance of services is not subject to a SRF for purposes of Section 409A. 26 C.F.R. § 1.409A-1(d); 81 Fed. Reg. 40,574.

Section 457(f) SRF Definition

Until 2016, there was no formal regulatory definition of SRF for purposes of Section 457(f), although some guidance existed in the form of a 1997 EO CPE article, Section 457 Deferred Compensation Plans of State and Local Government and Tax-Exempt Employers, I.R.S. Notice 2007-62, 2007-2 C.B. 331, and some private rulings (e.g., I.R.S. Priv. Ltr. Rul. 200321002, 2003 PLR LEXIS 201 (Feb. 11, 2003), and I.R.S. Priv. Ltr. Rul. 199943008, 1999 PLR LEXIS 1173 (July 20, 1999)). Thus, the proposed regulations provided much needed guidance on the issues involved.

The Section 457(f) proposed regulations treat compensation contingent on the following as subject to a SRF:

  • Performing substantial services
  • Refraining from performing services, but only if certain conditions are met
  • The occurrence of a condition related to a purpose of the transfer

Prop. Treas. Reg. §§ 1.457-12(e)(1)(i), 1.457-12(e)(1)(iv), 81 Fed. Reg. 40,548, 40,567 (June 22, 2016).

Section 457A SRF Definition

The Section 457A definition is narrower than under any of the other sections. Only compensation contingent on the performance of substantial services is subject to a SRF for purposes of Section 457A. I.R.C. § 457A(d)(1)(A). Compensation contingent on either the occurrence of a condition that is related to a purpose of the compensation or refraining from the performance of services will not be considered subject to a SRF. I.R.S. Notice 2009-8, 2009-9-1 C.B. 347, Q&A 3(a).

Conditions that Generally Support the Existence of a SRF and Related Requirements

Service Condition

As mentioned above, for purposes of all of the relevant I.R.C. sections, a SRF exists where the right to the compensation is conditioned upon the performance of (future) substantial services. For this purpose, two factors must be considered: whether the services themselves are substantial (e.g., a requirement of an hour a week is not sufficient) and the duration of services. 26 C.F.R. §§ 1.83-3(c) (2), 1.409A-1(d); 31.3121(v)(2)-1(e)(3). For purposes of the duration component of the test, the IRS has treated a period of at least two years of service as substantial for purposes of Sections 83, 457(f), and 3121(v)(2). 26 C.F.R. § 1.83-3(c)(4), Example (1); I.R.S. Priv. Ltr. Rul. 9713014, 1996 PLR LEXIS 2336 (Dec. 24, 1996); I.R.S. Priv. Ltr. Rul. 9723022, 1997 PLR LEXIS 334 (Mar. 7, 1997); I.R.S. Priv. Ltr. Rul. 9211037, 1991 PLR LEXIS 2582 (Dec. 17, 1991); I.R.S. Tech. Adv. Mem. 199903032, 1998 PLR LEXIS 1828 (Oct. 2, 1998).

Consulting Agreements

A requirement of future consulting services (as requested for a period of time) will create a SRF for purposes of Section 83, 457(f), or 3121(v)(2) where the employee is in fact expected to perform services that are substantial relative to the payment. 26 C.F.R. § 1.83¬3(c)(2); Prop. Treas. Reg. § 1.457-12(e)(3), Example 1, 81 Fed. Reg. 40,568. While there is no guidance under Section 409A or 457A on this point, it appears likely that the IRS would take a similar approach for purposes of those sections.

Condition Related to a Purpose of the Transfer or Compensation

For purposes of Section 83, a condition related to the purpose of the transfer can create a SRF. Two examples:

  • Stock is transferred to an underwriter prior to a public offering and the full enjoyment of such stock is expressly or impliedly conditioned upon the successful completion of the underwriting
  • An employee receives property from an employer subject to a requirement that it be returned if the total earnings of the employer do not increase

26 C.F.R. § 1.83-3(c)(2). The regulations provide several other examples of conditions. See 26 C.F.R. § 1.83-3(c)(4). However, not all limitations based on such conditions will give rise to a SRF. The likelihood the forfeiture conditions will occur (and will be enforced) must be taken into account. The preamble to the proposed (now finalized) Section 83 regulations stated that no SRF would likely exist where a plan provided that stock would be forfeited if gross receipts of the employer fall by 90% over the next three years at a time when there is no indication that any fall in demand is anticipated. Notice of Proposed Rulemaking 2012-1 C.B. 1028.

For purposes of Section 409A, a condition relating to the purpose of the compensation will give rise to a SRF if the possibility of forfeiture is substantial. The purpose of the compensation, however, must relate to either (1) the employee’s performance for the employer, or (2) the employer’s business activities or organizational goals (e.g., the attainment of an earnings goal). 26 C.F.R. § 1.409A-1(d)(1).

The proposed Section 457 regulations do not specifically discuss a condition relating to earnings, presumably because employers subject to that section are nonprofit or governmental employers, and thus are not focused on overall profitability. However, they recognize an employer’s governmental or tax-exempt activities (as applicable) or organizational goals as potential conditions related to the purpose of the compensation. Prop. Treas. Reg. 26 C.F.R. § 1.457-12(e)(iii), 81 Fed. Reg. 40,567.

Conditioning compensation on a condition relating to the purpose of the transfer will not create a SRF for purposes of Section 457A, as only a condition based on future services sufficesfor purposes of that section. I.R.S. Notice 2009-8, Q&A-3(a).

Likelihood of Enforcement

Even if an employment agreement or deferred compensation plan contains provisions that would otherwise give rise to a SRF, no SRF will exist if the employer is unlikely to enforce the forfeiture condition. Of particular concern is a situation in which the employee has such influence over the employer that the forfeiture condition is likely to be waived. If an employee owns a significant amount of the total combined voting power or value of all classes of stock of the employer or its parent, the following factors will be taken into account in determining the likelihood of enforcement:

  • The employee’s relationship to other stockholders and the extent of their control, potential control, and possible loss of control of the corporation
  • The position of the employee in the corporation and the extent to which he or she is subordinate to other employees
  • The employee’s relationship to the officers and directors of the corporation
  • The person or persons who must approve the employee’s discharge
  • Past actions of the employer in enforcing the provisions of the restrictions

26 C.F.R. § 1.83-3(c)(3); 26 C.F.R. § 1.409A-1(d)(3)(i); 26 C.F.R.§ 1.457-12 (e)(1)(v); I.R.S. Notice 2009-8, Q&A-3(c).

Due to the inherently factual nature of the problems involved and other reasons, the IRS will not issue letter rulings on whether a restriction constitutes a SRF if the employee is a controlling shareholder of the employer under Section 83. Rev. Proc. 2016-3, 2016-1 C.B. 126.

Conditions that Generally Do Not Support the Existence of a SRF

Transfer Restrictions on Section 83 Property

Restrictions on transfers of property (alone) typically do not constitute a SRF of the right to such property for purposes of Section 83, with two exceptions:

  • I.R.C. § 83(c)(3)provides that a SRF exists if the employee’s sale of the compensatory property at a profit could subject him or her to a lawsuit under section 16(b) of the Securities Exchange Act of 1934 (Exchange Act), until the end of the 16(b) period. 26 C.F.R. § 1.83-3(j).
  • Property is subject to SRF and is not transferable so long as the property is subject to a restriction on transfer to comply with the Pooling-of-Interests Accounting rules set forth in Accounting Series Release 130. 26 C.F.R. § 1.83-3(k). However, this rule is obsolete due to FASB Statement No. 141, which eliminates the pooling of income accounting method.

The Section 83 rules treating a 16(b) trading restriction as generating a SRF are interpreted narrowly. For example, the purchase of shares in a transaction not exempt from section 16(b) of the Exchange Act prior to the exercise of a stock option that would not otherwise give rise to section 16(b) liability, would not defer the taxation of the stock option at exercise. 26 C.F.R. § 1.83-3(j)(2), Example 4.

Transfer restrictions other than under Exchange Act section 16(b) will also not create a SRF. 26 C.F.R. § 1.83-3(c)(4). Transfer restrictions which do not represent a SRF would include:

  • Lock-up agreements
  • Insider-trading compliance programs
  • Rule 10b-5 insider-trading restrictions

The concept of transfer restrictions applies only to the SRF analysis for Sections 83 and 3121(v)(2), as the other sections involve unfunded deferred compensation, not transferred property.

Termination for Cause or Crimes, or Clawbacks

In general, a provision that deferred compensation or unvested property will be forfeited in the event of termination for cause, committing a crime, or as a result of a clawback due to securities violations, does not constitute a SRF. The likelihood of such a termination is not “substantial.” 26 C.F.R. § 1.83-3(c)(2). The same rule applies for purposes of Section 457(f). See I.R.S. publication Section 457 Deferred Compensation Plans of State and Local Government and Tax-Exempt Employers (C. Press and R. Patchell, 1997), p. 205 (hereafter Section 457 Plans 1997). It would most likely apply for purposes of Sections 409A and 457A as well, although the proposed Section 409A regulations discuss the issue only in the context of determining whether a stock right that provides for a clawback is treated as deferred compensation, and I.R.S. Notice 2009-8 concerning Section 457A does not discuss it at all.

However, at least one case, Austin v. Commissioner, 141 T.C. No. 18 (Dec. 16, 2013), has treated a forfeiture-for-cause provision as creating a SRF. In that case, the employment agreement defined cause to include “failure or refusal by Employee, after 15 days of written notice to Employee, to cure by faithfully and diligently performing the usual and customary duties of their employment and adhere to the provisions of this Agreement.” The court held that while a requirement to forfeit the money for serious (akin to criminal) misconduct did not impose a SRF, a requirement to forfeit it for what amounted to the employer’s decision to fire an at-will employee did.

Other Risks Considered Not Substantial for SRF Purposes

For ruling purposes, the IRS takes the position that a risk of forfeiture based upon the employee’s death, living to a specified age, or the employer’s insolvency fall short of the Section 83 and 457(f) requirements. Section 457 Plans 1997, p. 206. It is likely that the IRS would take the same position for Sections 409A and 457A.

However, as discussed later in this practice note, an acceleration provision that allows for payment upon the employee’s death will not negate a SRF arising from an otherwise applicable service-based condition to payment.

Non-compete Agreements

Non-competes and SRF under Sections 83 and 3121(v)

The presumption is that non-compete agreements will not result in a SRF, but this presumption can be overcome based on facts and circumstances. Factors to be considered are:

  • The age of the employee
  • The availability of alternative employment opportunities
  • The likelihood of the employee’s obtaining such other employment
  • The degree of skill possessed by the employee
  • The employee’s health
  • The practice (if any) of the employer to enforce such covenants

26 C.F.R. § 1.83-3(c)(2).

Non-competes and SRF under Sections 409A and 457A

A non-compete agreement will never create a SRF for purposes of Section 409A (26 C.F.R. § 1.409A-1(d); 81 Fed. Reg. 40,574) or Section 457A (I.R.S. Notice 2009-8, Q&A-3(a)).

Non-competes and SRF under Section 457(f)

The proposed Section 457(f) regulations provide that a non-compete agreement will result in a SRF only if all of the following conditions are satisfied:

  • The covenant not to compete must be an enforceable written agreement.
  • The employer must make reasonable ongoing efforts to verify compliance with non-competition agreements in general, and with the specific non-competition agreement applicable to the employee.
  • The employer must have a substantial and bona fide interest in preventing the employee from performing the prohibited services.
  • The employee must have a bona fide interest in, and ability to, engage in the prohibited competition. Prop. Treas. Reg. 26 C.F.R. § 1.457-12(e)(iv), 81 Fed. Reg. 40,567.

Other Rules Relating to SRF

Effect of Employee’s Election to Receive or Defer Compensation on SRF

An employee’s election to receive current compensation or to defer receipt until a later date presents special issues in determining whether a SRF exists. For example, the IRS takes the position that salary reduction plans must be placed under closer scrutiny because few employees would voluntarily accept subjecting their compensation to a SRF as an acceptable alternative to current compensation, unless perhaps they are very near retirement and feel secure in their jobs. See, e.g., Section 457 Plans 1999, pp. 188-89. IRS guidance on this issue under Sections 409A, 457A, and 457(f) is discussed below.

Extension of SRF under Sections 409A and 457A

The Section 409A regulations and Section 457A guidance make clear that an employee can be permitted to choose between receiving an amount of compensation either on a current basis or at a later time in a manner so that the deferred payment option would still be considered to be subject to a SRF, but only if there is additional consideration paid for the extension. The rules state that an amount cannot be subject to a SRF beyond the time that the employee could have elected to receive it, unless the present value of the amount subject to the SRF is materially greater (disregarding the risk of forfeiture) than the present value of the current compensation the recipient could have elected to receive without the SRF. The regulations do not provide guidance on the meaning of “materially greater.” 26 C.F.R. § 1.409A-1(d)(1); I.R.S. Notice 2009-8, Q&A-3 (a). Also note that the agreement to the deferral would have to be made prior to the time the amount was paid or made available to the employee to avoid immediate taxation under constructive receipt principles.

As an example, consider a bonus plan that permits a participant to elect to receive either (1) a cash payment payable at the end of the performance period, or (2) restricted stock units (RSUs) having a materially greater present value than the cash payment, provided that the RSUs will only be paid if and after the employee remains in continuous service with the company for a period of years. Even though the employee could have elected to receive the cash payment when bonuses are normally paid, the full amount of the RSU award would generally be considered to be subject to a SRF during the retention period. On the other hand, a straightforward salary deferral election to have compensation that is earned in one year be paid in a later year cannot be made subject to a SRF and would be subject to the rules for nonqualified deferred compensation under Section 409A (and Section 457A, if applicable). Id.

It is not clear whether an employer and employee could agree to further extend a SRF for current compensation amounts that have already been deferred once in accordance with the rules discussed in the preceding paragraphs. However, any such arrangement would at a minimum have to (1) occur before the compensation was paid or made available so as to avoid taxation under constructive receipt principles pursuant to I.R.C. § 451, and also (2) meet the materially greater value requirement as compared to the amount the employee currently has a right to receive.

Addition or Extension of SRF under Section 457(f)

The proposed Section 457(f) regulations explicitly allow for the addition or an extension of a SRF, subject to certain conditions.

For an initial addition of SRF on an amount of compensation not otherwise subject to a SRF, all of the following requirements must be met:

  • The present value of the amount to be paid upon the lapse of the added SRF must be materially (at least 25%) greater than the amount the employee otherwise would be paid in the absence of the additional SRF. Note that the IRS has indicated that this provision does not imply that same materiality standard applies for purposes of determining whether an elective deferral could give rise to a SRF under Section 409A as described in the previous section. 81 Fed. Reg. 40,557.
  • The SRF must be based upon the future performance of substantial services, or adherence to an agreement not to compete (in accordance with the rules noted above under “Non-competes and SRF under Sections 409A and 457A”), for a period of at least two years after the employee could have received the compensation had there been no additional SRF. Note:
    • The SRF may not be based solely on the occurrence of other types of conditions (e.g., a performance goal for the organization). However, if there is a sufficient service condition, the arrangement can also impose other conditions. For example, the SRF could continue until the later of two years or when an organizational goal was met.
    • Notwithstanding the two-year minimum, the service condition may lapse upon the employee’s death, disability, or involuntary severance from employment.
    • If the foregone current compensation is allocable to separate payments (e.g., a percentage of each semi-monthly payroll amount during a designated period), then the two-year minimum is measured from the time each payment would otherwise have been made.
  • The agreement subjecting the amount to a SRF must be made in writing before the beginning of the calendar year in which any services giving rise to the compensation are performed, subject to a special rule for recent hires:
    • If the employee was not providing services to the employer within 90 days prior to the addition of SRF, then the written agreement may be entered into as late as the 30th day after hire, but only with respect to compensation related to services provided after the agreement date.

Prop. Treas. Reg. § 1.457-12(e)(2), 81 Fed. Reg. 40,567-68.

For a second or subsequent extension of a SRF, the following rules apply:

  • The materially greater value and two-year minimum forfeiture period apply, as described above (i.e., the new amount must be at least 25% more than the current amount and the extended SRF must be based on an additional two years of performing (or refraining from performing) substantial services) –and–
  • A written agreement reflecting the new SRF must be entered into at least 90 days before the lapse of the existing SRF, subject to the same special rule for recent hires as noted above for an initial deferral

Id.

The regulations clarify that the same rules apply for substitution arrangements, that is, where an amount of compensation is forfeited or relinquished and is replaced (in whole or in part) by a right to receive another amount (or benefit) that is subject to a risk of forfeiture, as a substitution for the first amount. Unless the above conditions are met, any SRF on the substituted amount will be ignored and, consequently, the amount may be subject to tax for the year in which the substituted right arises. Prop. Treas. Reg. § 1.457-12(e)(2)(v), 81 Fed. Reg. 40,568.

Extending or Modifying SRF in Connection with a Corporate Transaction under Section 409A

One exception to the rule that second or subsequent extension of a SRF must meet the written agreement, materially greater value, and two-year minimum forfeiture period requirements described above is found in 26 CFR § 1.409A-3(i)(5)(iv)(B). Under that regulation, an extension of vesting otherwise due to occur upon a change in control is permissible without meeting those tests, if:

  • The transaction constituting the change in control event is a bona fide arm’s length transaction between the service recipient or its shareholders and one or more parties who are unrelated to the service recipient and employee –and–
  • The modified or extended condition to which the payment is subject would otherwise be treated as a substantial risk of forfeiture for purposes of section 409A

Vesting Acceleration Provisions that Do Not Negate SRF

An amount can be considered to be subject to a SRF based on a requirement to provide future substantial services despite the fact that the compensation arrangement contains certain common provisions that allow for an accelerated payment in certain circumstances. Specifically, agreements that provide for all or a portion of an amount of compensation to be paid (or all or a portion of unvested property to become vested) in the event of the employee’s death, disability, or involuntary termination without cause can still be considered to be subject to a SRF, even though the service-based conditions are not fulfilled.

A number of private letter rulings support this position for Section 457(f) purposes. I.R.S. Priv. Ltr. Rul. 200321002, 2003 PLR LEXIS 201 (Feb. 11, 2003) and I.R.S. Priv. Ltr. Rul. 199943008, 1999 PLR LEXIS 1173 (July 20, 1999).

In addition, the proposed Section 457(f) regulations explicitly provide that a right to receive compensation conditioned on an involuntary severance from employment without cause (including a voluntary termination for good reason) is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial. Prop. Treas. Reg. § 1.457-12(e)(1)(i), 81 Fed. Reg. 40,567. This approach is consistent with the Section 409A rule for involuntary separations from service without cause under 29 C.F.R. § 1.409A-1(d)(1). The terms involuntary severance from employment (Section 457) and involuntary separation from service (Section 409A), as well as what constitutes a good-reason termination, are defined in the respective regulations. Although the Section 457A guidance is not explicit, the determination of the period over which a substantial risk of forfeiture is considered to exist for purposes of a transition rule indicates that the same rules would apply in this context. I.R.S. Notice 2009-8, Q&A 23(a)(c).

Similarly, the preamble to final regulations under Section 83 clarifies that a provision that accelerates vesting upon an involuntary separation from service without cause (or separation from service as a result of death or disability) will not cause a service-based requirement that constitutes a SRF to fail to qualify as such so long as the facts and circumstances do not demonstrate that an involuntary separation from service without cause is likely to occur during the service period. 79 Fed. Reg. 10,663 (Feb. 26, 2014).

This excerpt from Lexis Practice Advisor®, a comprehensive practical guidance resource providing insight from leading practitioners, is reproduced with the permission of LexisNexis. Reproduction of this material, in any form, is specifically prohibited without written consent from LexisNexis.

Substantial Risk of Forfeiture Definition Comparison Chart
(Posted on May 29, 2018 by )


The chart that follows compares the circumstances in which a person’s rights to compensation are subject to a substantial risk of forfeiture (SRF) for purposes of income taxation under each of sections 83, 409A, 457, and 457A of the Internal Revenue Code (I.R.C.), Social Security and Medicare (FICA) taxation under I.R.C. § 3121(v)(2), and excise taxes under I.R.C. § 4960. As a practitioner drafting or advising on compensation arrangements—especially arrangements involving non-qualified (or ineligible), unfunded deferred compensation (referred to herein as NQDC)—you must be able to correctly interpret these I.R.C. sections and distinguish the concepts of SRF expressed therein to ensure that an employer understands and achieves the tax goals for which its arrangements’ are designed. Read more.

Sample Subrogation and Reimbursement Clauses for Summary Plan Description Now Available
(Posted on May 25, 2018 by )


Lexis Practice AdvisorA new article by Carol V. Calhoun, published by Lexis Practice Advisor, provides sample subrogation and reimbursement clauses to be used in a summary plan description. Such clauses are typically used in an instance in which an employer’s health or disability plan wants to avoid a situation in which a participant gets a double recovery for the same illness or injury. For example, an employee covered by both the employer’s health plan and a spouse’s health plan should not have the same medical expenses paid by both plans. Or an individual who is hit by a car, and recovers lost wages from the driver’s insurance company, should not also be able to receive disability benefits for the same period.

You can see a copy of the piece at this link.

Subrogation and Reimbursement Clause (Summary Plan Description)
(Posted on May 25, 2018 by )


Drafting Notes= Drafting Notes

Alternate & Optional Clauses= Alternate & Optional Clauses

Subrogation and Reimbursement Rights
The Plan has a right to be reimbursed for the amount of any benefits it pays out to you if you receive, directly or indirectly, any money from a third party (such as a person responsible for an injury or an insurance company) on account of the same injury, illness or condition for which the Plan has paid benefits (any such money is referred to here as a “recovery”). Therefore, as a condition of receiving benefits from the plan for medical or other expenses, you agree that if you receive any recovery from a third party on account of an injury, illness, or condition for which the Plan has paid benefits, you will pay to the plan the amount of that recovery, up to the total amount of benefits paid to you by the plan. For example, if you are injured in an auto accident and either your insurance company or the other driver’s insurance company settles with you, you must reimburse the plan for the benefits the plan provided to you for your medical expenses resulting from that accident, but only up to the amount of your settlement.

If you decide not to pursue a claim relating to any injury, illness or condition for which the Plan has paid benefits, the Plan shall be subrogated to your right to pursue such claim. The Plan may assert a claim, in its discretion, to collect a recovery directly from any third party against whom you have any rights in any court of competent jurisdiction, or in any tribunal or other proceeding. You agree not to object to the jurisdiction of any such court or venue and otherwise cooperate in pursuing the recovery.

In connection with the Plan’s rights of subrogation and reimbursement, you are required to:

  • notify the Plan within thirty (30) days of the date when any notice is given to any party, including an attorney, of your intention to pursue or investigate a claim to recover damages or obtain compensation due to any injury, illness, or condition for which the Plan has paid benefits;
  • promptly notify the Plan of any recovery paid as a result of any injury, illness or condition for which the Plan has paid you benefits that you become aware of, by any person from any source;
  • fully cooperate with the Plan’s efforts to enforce its rights of subrogation and reimbursement;
  • complete all forms and provide all information requested by the Plan, including completing and submitting any applications or other forms or statements the Plan may reasonably request;
  • cooperate in all efforts to pursue the recovery, including in the preparation and execution of any case or otherwise, and by attendance or giving testimony at depositions and in court, or as otherwise may be necessary; and
  • do nothing to prejudice or impede the Plan’s rights of subrogation and reimbursement, including by making any settlement or recovery that attempts to reduce or exclude the full cost of the benefits provided by the Plan, except as reasonably agreed to by the Plan.

Please note the following regarding the Plan’s right of reimbursement:

  • The source and timing of the recovery do not matter. The Plan has the right to be reimbursed for whether that recovery is made to or on behalf of the covered person; made in a single payment or over a period of time; or collected by action at law, judgment, settlement, or otherwise.
  • The Plan will automatically have a lien against the recovery in the amount of any benefits the Plan provided as a result of the injury, illness, or condition for which the recovery is collected.
  • The plan may enforce the lien with any court or agency with jurisdiction over the matter against the covered person, an insurance company acting on behalf the covered person, o the third party or its agent, or with anyone who is in possession of the recovery.
  • The lien may be enforced by any claims administrator or other person acting as the Plan’s delegate or as a provider of administrative services to this Plan.
  • The Plan, or other person acting as the Plan’s delegate or provider of administrative services to this Plan, has the sole authority and discretion to decide whether to pursue any right of recovery in favor of the Plan.
  • The Plan’s recovery rights are a first priority claim against all responsible parties and are to be paid to the Plan before any other claim against the recovery.
  • The Plan’s lien on the recovery is not dependent upon whether or not:
    • the recovery is insufficient to make the covered person whole or otherwise compensate the covered person for the injury, illness, or condition;
    • the Plan participates in or assists in claims made to obtain the recovery;
    • the Plan bears any court costs or attorney fees in furtherance of claims seeking the recovery;
    • any liability for payment is admitted by anyone;
    • the recovery identifies the benefits provided by the Plan; or
    • the recovery identifies payment, in whole or in part, as for pain and suffering or for non-economic damages.

This excerpt from Lexis Practice Advisor®, a comprehensive practical guidance resource providing insight from leading practitioners, is reproduced with the permission of LexisNexis. Reproduction of this material, in any form, is specifically prohibited without written consent from LexisNexis.

Drafting Note to First Paragraph
This form addresses the circumstances which may result in a subrogation or reimbursement claim by the plan against a participant. ERISA requires that a summary plan description (SPD) provide a clear statement of any right to recovery (including by subrogation or reimbursement) that could affect the benefits that a participant (or beneficiary) might otherwise reasonably expect to receive from the plan. 29 C.F.R. § 2520.102-3(l).

Under ERISA, a plan fiduciary may seek reimbursement to the plan of specifically identifiable funds (i.e., the amount of a participant’s duplicative recovery from a third party) in the form of an “equitable lien by agreement” under ERISA § 502(a)(3) (29 U.S.C. § 1132(a)(3)). Sereboff v. Mid Atlantic Medical Services, 547 U.S. 356, 364 (2006). Further, in U.S. Airways v. McCutchen, 133 S. Ct. 1537 (2016), the Supreme Court held that equitable defenses (such as unjust enrichment) could not override an explicit subrogation right provided for in the plan documents. So plans that wish to establish subrogation and reimbursement rights should incorporate provisions into the plan document and SPD. Recently, the Supreme Court clarified that such an equitable lien right cannot be enforced if the participant spends the entire damages award on non-traceable items. Montanile v. Bd. of Trs. of the Nat’l Elevator Indus. Health Ben. Plan, 136 S. Ct. 651 (2016). Therefore, plans should act promptly to enforce these rights.

Any costs, expenses, or attorney’s fees that you pay in connection with obtaining any recovery will not reduce the amount you are required to reimburse the Plan as described in the preceding paragraph, unless the plan agrees to such reduction.
Drafting Note to Third Paragraph
This language is intended to establish a traditional subrogation right, whereby the plan obtains the right to “step into the shoes” of the participant to assert a claim directly against a third party.
Drafting Note to Fourth Paragraph
This language can be used, as stated or in modified form, to explicitly provide for specific terms of the subrogation and reimbursement rights that might otherwise be inferred.
Drafting Note to Fifth Paragraph
This paragraph anticipates and attempts to undermine several defenses upon which an equitable lien might be challenged.

Carol V. Calhoun quoted in “Will the Nick Sabin tax apply to Nick Sabin?”
(Posted on March 26, 2018 by )


Tax Notes TodayCarol V. Calhoun was quoted in a March 12, 2018 article in Tax Notes, dealing with the issue of whether the new excise taxes on excess compensation and excess severance benefits will apply to public colleges and universities. The wording of the law makes it unclear whether the law should apply to the very governmental entities most likely to have employees that would otherwise be affected by it.

Read the article.