New Article: Nonqualified Deferred Compensation Rules for Tax-Indifferent Entities (Section 457A)
(Posted on October 26, 2018 by )


Nonqualified Deferred Compensation Rules for Tax-Indifferent Entities (Section 457A)
(Posted on October 26, 2018 by )


Lexis Practice AdvisorThis practice note explains the application of Internal Revenue Code Section 457A, which restricts the ability of certain tax-indifferent entities (so-called nonqualified entities) to defer compensation for services provided by their service providers. It provides guidance on practical steps for attorneys advising such entities on nonqualified deferred compensation plans.

This practice note is divided into the following topics:

Purpose of Section 457A

Section 457A of the Internal Revenue Code (the IRC) was enacted shortly after Section 409A, which both govern nonqualified deferred compensation. However, where Section 409A regulates the timing of the payment of nonqualified deferred compensation, Section 457A effectively eliminates the payment of nonqualified deferred compensation by so-called nonqualified entities. This is because Section 457A requires that the nonqualified deferred compensation be included in the employee’s (or other service provider’s) income either (1) as soon as it is no longer subject to a substantial risk of forfeiture (using the limited definition under Section 457A) if the amount is determinable at that time or (2) as soon as the amount becomes determinable after ceasing to be subject to a substantial risk of forfeiture, in which case, the service provider is subject to an additional 20% tax on the deferred amount plus an interest penalty. Section 457A, therefore, causes the service provider to pay tax on determinable amounts of nonqualified deferred compensation once the amount is nonforfeitable, so there is no advantage to defer payment. Moreover, the 20% tax and interest penalty provisions for arrangements where the amount is indeterminate at the time it becomes nonforfeitable are essentially strictly punitive.

The policy behind Section 457A is to limit the payment of nonqualified deferred compensation by entities that are indifferent to when they receive a deduction for the compensation expense (i.e., the so-called nonqualified entities). In a taxable entity, any benefit a service provider obtains by deferring compensation is mitigated by the fact that the deferral delays the entity’s tax deduction until the time of payment. Thus, deferral will be respected for income tax (although potentially not for FICA tax) purposes, provided that it complies with certain rules set forth in Section 409A of the IRC. However, in the case of an entity not subject to tax, this mitigation does not occur, and therefore the entity has no incentive to limit the payment of nonqualified deferred compensation. Section 457A is in many ways the analog of Section 457(f), which imposes similar (but not identical) rules on nonprofit and governmental entities.

A nonqualified entity, therefore, does not have as much freedom as most other entities to defer taxation through nonqualified deferred compensation arrangements. Ideally, nonqualified entities should structure their compensation arrangements so as to avoid Section 457A. To the extent a compensation arrangement is subject to Section 457A (a Section 457A arrangement), consideration must be given to the tax consequences to the service providers. Moreover, Section 457A arrangements must be carefully drafted to take into account not only Section 457A, but the nonqualified deferred compensation rules of Section 409A, the FICA tax rules of Section § 3121(v), and (in the case of a domestic partnership or other entity over which the U.S. has jurisdiction) the Employee Retirement Income Security Act (ERISA). Each of these concerns are addressed in this practice note.

Application of Section 457A

Section 457A applies to amounts paid:

  • By a nonqualified entity
  • To a service provider
  • Under a nonqualified deferred compensation plan

Such an amount becomes includible in income for tax purposes:

  • When it ceases to be subject to a substantial risk of forfeiture (i.e., when vested, as determined for Section 457A) –or–
  • If an amount is not determinable when vested, when it becomes determinable

In addition, if the amount of nonqualified deferred compensation is not determinable when vested, the service provider will be subject to (1) an additional 20% tax on the amount and (2) an interest penalty, determined at the underpayment rate plus 1% as if the amount had been included in income when vested. I.R.C. § 457A(a), (c). See Tax Effect of Section 457A for more details.

Substantial Risk of Forfeiture

Compensation subject to Section 457A is taken into account for income tax purposes when it ceases to be subject to a substantial risk of forfeiture, assuming the amount is determinable at that time. In general, the rights of a service provider to compensation are treated as subject to a substantial risk of forfeiture only if the person’s rights to compensation are conditioned upon the future performance of substantial services by any individual.

Section 457A provides that, to the extent provided in future regulations, if compensation is determined solely by reference to the amount of gain recognized on the disposition of an investment asset, such compensation is to be treated as subject to a substantial risk of forfeiture until the date of such disposition. I.R.C. § 457A(d)(1)(b)(i). For this purpose, an investment asset means any single asset (other than an investment fund or similar entity):

  • Acquired directly by an investment fund or similar entity
  • With respect to which such entity does not (nor does any person related to such entity) participate in the active management of such asset (or if such asset is an interest in an entity, in the active management of the activities of such entity) –and–
  • Substantially all of any gain on the disposition of which (other than such deferred compensation) is allocated to investors in such entity

I.R.C. § 457A(d)(1)(b)(ii).

No such regulations have been promulgated to implement the above provision. However, the intent may have been to deal with “side pocket” and other identified investments. In a side pocket investment, a hedge fund will identify a specific illiquid asset, and will allocate it entirely to present participants in the hedge fund. Future investors do not receive any portion of the side pocket. And present investors do not receive any of its value when they cash out of the hedge fund, but only when the side pocket investment is liquidated. If the anticipated holding period of the side pocket investment is significantly longer than the vesting period, this could cause issues under Section 457A without further relief. In theory, this rule offers the opportunity for some relief for these kinds of arrangements if the IRS wants to give it. However, the absence of regulations to date means that such arrangements would be hazardous for the recipient.
Section 457A has a more restrictive definition of substantial risk of forfeiture than is provided in several other IRC sections that use the same term. For example, a substantial risk of forfeiture for purposes of Section 457A cannot be created by, for example, a provision that the payment will be made only if certain earnings goals are met, even though a substantial risk of forfeiture for purposes of Section 409A can in some instances be created by such an agreement. See Substantial Risk of Forfeiture under the IRC and Substantial Risk of Forfeiture Definition Comparison Chart for detailed comparisons of the definitions under the various IRC provisions.

Nonqualified Entities

Any entity that is determined to be a nonqualified entity is subject to Section 457A. The entity subject to the determination (and potential nonqualified entity status) is the entity that would be entitled to a compensation deduction under U.S. federal income tax principles if the entity paid the deferred amounts to the service provider in cash in the relevant taxable year. I.R.S. Notice 2009-8, 2009-1 C.B. 347, Q&A 14. The plan sponsor is typically, but not always, the employer of the service provider.

The rules governing nonqualified entities depend on whether the entity is a corporation or a partnership. Specifically, the tests turn on whether “substantially all” of an entity’s income is derived from certain sources (in the case of a corporation) or is allocated to (in the case of a partnership) specific kinds of parties. The rules are described in the sections that follow.

Corporations

Only foreign corporations (as defined in I.R.C. § 7701(a)(3)), (e.g., corporations, associations, joint-stock companies, and insurance companies that are not domestic (as defined in I.R.C. § 7701(a)(4))) may be nonqualified entities. I.R.S. Notice 2009-8, Q&A 7. A foreign corporation is a nonqualified entity unless substantially all of its income:

  • Is subject to U.S. tax due to being effectively connected with the conduct of a trade or business in the United States (see “Effectively Connected Income Test” below)
  • Is subject to a comprehensive foreign income tax (see “Comprehensive Foreign Income Tax Test” below) –or–
  • Is eligible for the benefits of a comprehensive income tax treaty between the applicable foreign country and the United States

I.R.C. §§ 457A(b)(1)(A), (B); 457(d)(2)(A).

Effectively Connective Income Test

Substantially all of the income of a foreign corporation is treated as effectively connected with the conduct of a trade or business in the United States only if, for the taxable year of the foreign corporation ending with or within the service provider’s relevant taxable year, at least 80% of the gross income of the foreign corporation is effectively connected with the conduct of a trade or business in the United States under I.R.C. § 882 that is not exempt from U.S. federal income tax pursuant to a treaty obligation of the United States (e.g., because the income is not attributable to a permanent establishment). I.R.S. Notice 2009-8, Q&A 9.

Comprehensive Foreign Income Tax Text

Substantially all of the income of a foreign corporation is subject to a comprehensive foreign income tax if, for the taxable year of the foreign corporation ending with or within the service provider’s relevant taxable year (as described under “When to Determine Nonqualified Entity Status” below), such foreign corporation:

  • Is not taxed by the foreign corporation’s country of residence under any regime or arrangement that is materially more favorable than the corporate income tax otherwise generally imposed by such country –and–
  • Either:
    • Is eligible for the benefits of a comprehensive income tax treaty between its country of residence and the United States –or–
    • Demonstrates that it is resident for tax purposes in a foreign country that has a comprehensive income tax

I.R.S. Notice 2009-8, Q&A 8(a).

Notwithstanding the above test, substantially all of the income of a foreign corporation will not be treated as subject to a comprehensive foreign income tax if the foreign corporation’s:

  • Taxable income (determined under the laws of its country of residence) excludes, in whole or in part, nonresidence source income realized by the foreign corporation –and–
  • Aggregate amount of nonresidence source income that is excluded for the relevant taxable year exceeds 20% of the gross income of the foreign corporation

I.R.S. Notice 2009-8, Q&A 8(b).

Partnerships

A partnership (as defined in I.R.C. § 7701(a)(2)) is a nonqualified entity unless substantially all of its income is allocated to persons other than:

  • Tax-exempt organizations –or–
  • Foreign persons with respect to whom such income is not either
    • Subject to a comprehensive foreign income tax –or–
    • Eligible for the benefits of a comprehensive income tax treaty between the applicable foreign country and the United States

I.R.C. § 457A(b)(2).

Substantially all of a partnership’s income is treated as allocated to eligible persons with respect to a taxable year only if at least 80% of the gross income of the partnership for such taxable year is allocated to eligible persons. I.R.S. Notice 2009-8, Q&A 11(a).
Note that while a corporation can be subject to Section 457A only if it is a foreign corporation, a partnership need not be a foreign partnership in order to be subject to that section. A domestic partnership can be subject to Section 457A based on having either tax haven or tax-exempt partners.

S Corporations

It would appear that an S corporation would be treated as a partnership rather than a corporation due to I.R.C. § 1372. While the language is not entirely clear (Section 1372 refers to “fringe benefits,” and it is unclear whether deferred compensation should be treated as a fringe benefit or cash), treatment of an S corporation as a partnership would appear to be appropriate, given an S corporation’s pass-through status.

When to Determine Nonqualified Entity Status

The determination of whether a plan sponsor is a nonqualified entity is made as of the last day of each of the service provider’s taxable years in which the nonqualified deferred compensation is no longer subject to a substantial risk of forfeiture and remains deferred. Whether a partnership is a nonqualified entity as of the last day of the service provider’s taxable year is determined based on the allocations (or deemed allocations) of gross income by the partnership for the partnership’s taxable year ending with or within the service provider’s taxable year. If a partnership does not yet have a taxable year that has ended or ends on the last day of the service provider’s taxable year, a reasonable, good faith estimate of such allocation (or deemed allocation) of the partnership for its current taxable year must be used to determine whether it is a nonqualified entity. I.R.S. Notice 2009-8, Q&A-13.

Service Providers

The term service provider includes nonemployee service providers as well as employees. A service provider subject to Section 457A may be:

  • An individual
  • A corporation
  • A subchapter S corporation
  • A partnership
  • A personal service corporation
  • A noncorporate entity that would be a personal service corporation if it were a corporation

I.R.S. Notice 2009-8, Q&A-5.

However, an independent contractor is not a service provider subject to Section 457A if an arrangement with respect to the independent contractor would be excluded from coverage under 26 C.F.R. § 1.409A-1(f)(2) (generally excluding arrangements with independent contractors having multiple unrelated clients, but not excluding arrangements with such independent contractors that provide management services). Id.

Note that to the extent a Section 457A arrangement covers service providers of an entity subject to U.S. law (typically, a domestic partnership), it will typically have to be structured as a plan for a select group of management and highly compensated employees (i.e., a top hat plan), to avoid various requirements under ERISA. For more information, see Top Hat Plan Statement Filing Rules and Procedures.

Nonqualified Deferred Compensation Plans

The definition of nonqualified deferred compensation plan under Section 457A and the exceptions from such definition are very similar to those under Section 409A, with certain important differences. In many places terms defined under Section 409A are incorporated by reference.

General Rule

With certain exceptions, an arrangement is a nonqualified deferred compensation plan for purposes of Section 457A if the arrangement:

  • Is described in I.R.C. § 409A(d) (generally, an arrangement where the service provider has a legally binding right to compensation that is or may be payable in a future tax year) –or–
  • Provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient

I.R.C. § 457A(d)(3). This is true regardless of whether the arrangement is a formal plan, or a less formal arrangement (e.g., part of an employment contract with a single individual).

With regard to equity arrangements, Section 457A does not apply to restricted stock includable in income under I.R.C. § 83. However, stock appreciation rights (other than those discussed in “Exempt Equity Arrangements,” below (and presumably, comparable rights in a noncorporate entity) would be subject to Section 457A unless they qualified for the short-term deferral exemption, even though they would not be subject to Section 409A. See I.R.S. Notice 2009-8, Q&A 2. See “Exempt Equity Arrangements,” below, for a more complete listing of the types of equity arrangements covered.

Short-Term Deferral Exceptions

Section 457A provides for two so-called short-term deferral exceptions from the general rule, as follows:

  1. The service provider actually receives payment within 12 months after the end of the taxable year of the service recipient (for this purpose, the entity for which the service provider is directly providing services) during which the right to the payment of such compensation is no longer subject to a substantial risk of forfeiture.
  2. The arrangement qualifies as a short-term deferral under 26 C.F.R. § 1.409A-1(b)(4) applied using the definition of substantial risk of forfeiture under Section 457A.

I.R.C. § 257A(d)(3)(B); I.R.S. Notice 2009-8, Q&A 4.

As earlier noted in the section entitled Substantial Risk of Forfeiture, the IRS is authorized to implement special rules for compensation based on the appreciation of a specified investment asset, extending the period in which such amounts are subject to a substantial risk of forfeiture until the disposition of the asset. If those rules are put in place, the 12-month short-term deferral rule under (1) above will not be available for those arrangements (although they may still be exempt from Section 457A if the Section 409A short-term deferral rule requirements as described in (2) are satisfied). I.R.C. § 457(d)(1)(B)).

Example (short-term deferral (1)). Suppose that Bob, a calendar year taxpayer, is an employee of X Corporation, which has a taxable year ending June 30. Under an agreement with X Corporation, Bob has a legally binding right to receive a bonus payment on June 30, 2022 based on his performance in the year ending June 30, 2019, provided that his employment continues until at least July 1, 2020. If payment is timely made, the arrangement will not be subject to Section 457A because the payment became nonforfeitable July 1, 2020, which was in X Corporation’s taxable year ending June 30, 2021, and was made within 12 months after the end of that taxable year.

Under the short-term deferral rule described in (2) above, an amount is not subject to the rules of Section 409A (and therefore is not subject to the rules of Section 457A) if the amount is required by the arrangement to be, and is actually (or constructively) received, by the later of the date that is:

  • 2½ months after the end of the service provider’s first taxable year in which the compensation is no longer subject to a substantial risk of forfeiture –or–
  • 2½ months after the end of the first taxable year of the service recipient in which the compensation is no longer subject to a substantial risk of forfeiture

26 C.F.R. § 1.409A-1(b)(4)(i)(A).

Obviously, this short-term deferral rule will in most cases be superfluous because the applicable 2½ month period will end before 12 months after the end of the taxable year of the service recipient in which the substantial risk of forfeiture lapsed. However, there are at least two circumstances where the Section 409A short-term deferral rule could play a role.

First, if the IRS implements the special substantial risk of forfeiture rules for compensation based on appreciation of a specified investment asset, the Section 409A short-term deferral rule will be the only short-term deferral rule available for those arrangements.
The second situation involves extensions of the Section 409A short-term deferral rule’s applicable period. The applicable 2½ month period can be extended for any of the following reasons:

  • It was administratively impracticable for the service recipient to make the payment by the end of the applicable 2½ month period for a reason that was not foreseeable when the arrangement was entered into.
  • Making the payment by the end of the applicable 2½ month period would have jeopardized the service recipient’s ability to continue as a going concern, provided further that the payment is made as soon as administratively practicable or as soon as the payment would no longer have such effect.
  • The service recipient reasonably anticipates that a deduction for the payment would not be permitted under I.R.C. § 162(m) for a reason that was not foreseeable when the arrangement was entered into.
  • The payment would violate Federal securities laws or other applicable law.

26 C.F.R. § 1.409A-1(b)(4)(ii); Prop. Treas. Reg. § 1.409A-1(b)(4)(ii)) (81 Fed. Reg. 40,569, 40,578–79 (June 22, 2016)).

Thus, in the rare instances where one of these exceptions are triggered, an arrangement may be exempted from Section 457A by reason of the short-term deferral rule of Section 409A.

Example (short-term deferral (2)). Suppose that Susan is supposed to receive a bonus from Corporation Y before March 15, 2020, based on work performed in 2019. The bonus is nonforfeitable as of December 31, 2019. Both Susan and Corporation Y are on a calendar year. However, due to reasons unforeseeable at the time the arrangement was entered into, payment of the amount before March 15, 2020 would jeopardize Corporation Y’s ability to continue as a going concern. The first time the payment can be made without having that effect is July 1, 2021. That is more than 12 months after the end of Corporation Y’s taxable year in which the payment became nonforfeitable. However, because the arrangement is excluded from coverage under Section 409A due to its extended short-term deferral rules, it will not be treated as covered by Section 457A.

Exempt Plans

Section 457A does not apply to certain arrangements which receive special tax benefits, including the following:

  • A qualified plan described in I.R.C. § 401(a)
  • A qualified annuity (as described in I.R.C. § 403(a))
  • Any tax-sheltered annuity or account (as described in I.R.C. § 403(b))
  • Any simplified employee pension (within the meaning of I.R.C. § 408(k))
  • Any simple retirement account (within the meaning of I.R.C. § 408(p))
  • Certain grandfathered pension plans to which only employees make contributions (as described in I.R.C. § 501(c)(18))
  • Any eligible deferred compensation plan of a government or tax-exempt employer (within the meaning of I.R.C. § 457(b))
  • An excess benefit plan (as described in I.R.C. § 415(m))
  • Certain pension, etc., plans created or organized in Puerto Rico (as described in ERISA § 1022(i)(2))
  • Any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan

See I.R.C. § 409A(d) (incorporated by reference in I.R.C. § 457A(d)(3)(A)).

Exempt Equity Arrangements

Certain equity arrangements are exempt from Section 457A, as follows:

  • Restricted stock or other restricted property taxable under I.R.C. § 83
  • A stock appreciation right which by its terms at all times must be settled in service recipient stock, and is settled in service recipient stock (and otherwise meets the requirements of 26 C.F.R. § 1.409A-1(b)(5)(i)(B))
  • Nonstatutory stock options on service recipient stock issued with an exercise price not less than fair market value at the date of grant and with no other deferral feature
  • Incentive stock options

By contrast, the following equity arrangements are subject to Section 457A, unless an exception (such as a short-term deferral exception (discussed above under “Short-Term Deferral Exceptions”)) applies:

  • Nonstatutory stock options that do not have a readily ascertainable fair market value
  • Nonstatutory stock options issued with an exercise price less than fair market value at the date of grant
  • Stock appreciation rights not described in the list of exempt arrangements, above
  • Restricted stock units

See I.R.S. Notice 2009-8, Q&A 2.

Tax Effect of Section 457A

The timing of income inclusion for nonqualified deferred compensation under Section 457A depends on whether the amount of such compensation is determinable at the time when it is no longer subject to a substantial risk of forfeiture.

Income Inclusion for Determinable Amounts

The calculation of the amount to be included in income is consistent with the rules under Section 409A, which are currently in the form of a notice and proposed regulations. See Notice 2008-115, 2008-2 C.B. 1367; Prop. Treas. Reg. 1.409A-4 (73 Fed. Reg. 74,380). The IRS has stated that taxpayers may rely on this guidance until further guidance is issued. I.R.S. Notice 2009-8, Q&A 16.

For determinable amounts, the amount deferred is subject to tax under Section 457A when it is no longer subject to a substantial risk of forfeiture. I.R.C. § 457A(a). The earnings on that amount are subject to tax on an annual basis, to the extent they are nonforfeitable. However, the service provider is entitled to a loss deduction if the right to the nonqualified deferred compensation is later forfeited. I.R.S. Notice 2009-8, Q&A 15, 16, 18.

Example. Wanda is promised an amount equal to $10,000, plus compounded interest at a rate of 4%, on attainment of age 65. The amount is nonforfeitable. Assuming that 4% is a reasonable rate of interest, she will immediately be taxed on $10,000 because there is no substantial risk of forfeiture. In year 2, she will be taxed on the interest accrued for that period, 4% of $10,000, or $400. In year 3, she will be taxed on 4% of the total accrued principal ($10,000 + $400), or $416. This will continue through the final year of interest accrual.

If no interest is credited, or the rate of interest is not reasonable, the initial amount will be adjusted to reflect the present value of the future deferred compensation, and then imputed interest based on a reasonable rate will be credited each year. I.R.S. Notice 2009-8, Q&A 15.

Example (no interest credited). George is promised a flat amount of $100,000 in 10 years. The amount is nonforfeitable. Again, assume that 4% is a reasonable rate of interest throughout the entire period. He will be taxed on the present value of $100,000 (which would be $67,556.42) this year. In each subsequent year, he will be taxed on the interest on $67,556.42, at a 4% rate of interest.

Example (excessive interest credited). Meredith is promised $20,000, plus interest at a rate of 25% a year, after 10 years. Thus, the total amount that will be paid is $186,264.51. The amount is nonforfeitable. Assume that 4% is a reasonable rate of interest. Instead of being taxed this year on $20,000, Meredith will be taxed this year on the present value of $186,264.51, or $125,833.63. She will then be taxed on each subsequent year on the earnings on $125,833.63 at a 4% rate of interest.

Income Inclusion and Interest and Penalty Taxes for Indeterminable Amounts

If the amount deferred under Section 457A is not determinable at the time the substantial risk of forfeiture lapses, it will be included in income as soon as it becomes determinable. In addition, the service provider is subject to:

  • An additional 20% income tax –and–
  • Interest at the underpayment rate (as determined under I.R.C. § 6621) plus 1% on the underpayment of federal taxes that would have occurred if the amount had been included in income when no longer subject to a substantial risk of forfeiture

I.R.C. § 457A(c).

An amount is determinable if it is paid under an account balance plan (i.e., a plan under which a specific amount is deferred, and credited with earnings thereafter). If not, it will be considered not to be determinable if it is a formula amount unknown at the end of the taxable year because it is based upon factors that remain variable as of the end of such year. For example, an amount based on future profits of the service recipient would not be determinable.

I.R.S. Notice 2009-8, Q&A 19; Prop. Treas. Reg. § 1.409A-4(b)(2)(iv) (73 Fed. Reg. 74,380, 74,396 (Dec. 8, 2008)).

Relationship between Section 457A and FICA Taxes

In theory, a determinable amount subject to Section 457A is subject to income taxes when it ceases to be subject to a substantial risk of forfeiture, and also to FICA taxes when it ceases to be subject to a substantial risk of forfeiture under I.R.C. § 3121(v). Nevertheless, the amount subject to tax may be different for income and FICA tax purposes. For purposes of income taxes, the amount deferred is taxed when the substantial risk of forfeiture lapses. If the amount is not paid immediately, future earnings on the deferred amount are subject to income tax on an annual basis. By contrast, FICA taxation applies only to the initial deferral, not to earnings thereon.
Moreover, an amount may be subject to income tax in one year, and FICA tax in another, due to differences in how the term substantial risk of forfeiture is defined for purposes of Sections 457A and 3121(v). For example, suppose that an amount is subject to forfeiture if a former employee does not comply with the terms of a noncompetition agreement. FICA taxation may be delayed until the noncompetition agreement ends, while income taxation may apply immediately. For further details, see Substantial Risk of Forfeiture under the IRC.

Relationship between Sections 457A and 409A

When drafting an arrangement subject to Section 457A, it is also important to consider the impact of Section 409A. While the details of Section 409A are beyond the scope of this practice note, that section imposes a 20% penalty on any nonqualified deferred compensation arrangement that does not meet its rules (plus an interest penalty, where applicable). Regulations clarify that Section 409A applies to nonqualified deferred compensation plans (as defined therein) separately and in addition to the rules under Section 457A. 26 C.F.R. § 1.409A-1(a)(4). Thus, it is critical that a Section 457A arrangement be drafted so as either to avoid coverage by, or meet the terms of, Section 409A. For further details on Section 409A, see Section 409A Fundamentals.

Being subject to Section 457A will not in itself make a deferred compensation arrangement exempt from Section 409A. However, most arrangements subject to Section 457A provide that compensation will be paid as soon as it ceases to be subject to a substantial risk of forfeiture, because there is no tax advantage in deferring it beyond that point. Such arrangements will typically not be subject to Section 409A due to the short-term deferral rule described above.

Moreover, an arrangement that provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient (e.g., a stock appreciation right that does not meet the exemption discussed on “Exempt Equity Arrangements,” above) may be subject to Section 457A, but not to Section 409A.

However, to the extent that an arrangement is structured to avoid Section 457A by paying the deferred compensation no later than 12 months after the end of the taxable year of the service recipient during which the right to the payment of such compensation is no longer subject to a substantial risk of forfeiture, the arrangement will still be subject to Section 409A if amounts are payable beyond the applicable 2½ month short-term deferral period under Section 409A.

Conversely, if payment of deferred compensation is dependent on the service recipient’s meeting certain earnings goals, the compensation will be considered subject to a substantial risk of forfeiture under Section 409A, but not under Section 457A (due to the difference in how each section defines the term). As a result, the amount deferred would be immediately taxable under Section 457A if the amount were not paid by the end of the service recipient’s taxable year following the taxable year in which the amount was deferred (i.e., when the right to the compensation became legally binding since the amount was never subject to a substantial risk of forfeiture for purposes of Section 457A). Nevertheless, the arrangement may be subject to Section 409A rules that will prevent the amount from being paid at the time it is subject to tax under Section 457A without triggering the Section 409A interest and penalty taxes. These rules can create hardships if an agreement is not properly structured.

Example. Suppose that Adrian is to receive deferred compensation after 10 years, assuming that certain earnings goals are met for the first five years. He will be taxed on the amount deferred immediately under Section 457A, because the amount is considered nonforfeitable. However, he may not have the money to pay that tax immediately. And the arrangement cannot be modified to permit him to be paid immediately (either the whole amount, or even an amount necessary to pay the tax) without triggering the 20% tax and interest penalty under Section 409A, except as permitted under certain transitional relief described in the next section.
In addition, as described in the next section, Section 409A may be a concern with respect to arrangements adopted before the effective date of Section 457A.

Effective Date and Transitional Rule

Section 457A was added by Section 801(a) of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, Div. C of Pub. L. No. 110-343 (TEAMTRA). It generally applies to amounts deferred that are attributable to services performed after December 31, 2008.

Under a transitional rule, deferred amounts attributable to services performed before January 1, 2009 are includible in gross income in the later of:

  • The last taxable year beginning before 2018 –or–
  • The first taxable year in which there is no substantial risk of forfeiture of the rights to such compensation

TEAMTRA § 801(d).

Obviously, arrangements adopted before TEAMTRA were not structured with Section 457A in mind. This has created issues, as described below, for coordinating Section 457A and Section 409A.

Deferrals Made and Vested before 2005

Section 409A does not apply with respect to amounts deferred and vested in taxable years beginning before January 1, 2005, if the arrangement under which the deferral is made is not materially modified after October 3, 2004. 26 C.F.R. § 1.409A-6. However, Section 457A applies to such pre-2005 deferrals, subject to the transitional rule above.

In many instances, the sponsor of an arrangement subject to Section 457A, but grandfathered under Section 409A, wanted to modify the arrangement to provide that amounts will be paid out at the time such amounts are subject to tax. Under the transitional rule of Section 457A, the amounts (being already vested) would be taxable in the last taxable year beginning before 2018. I.R.S. Notice 2017-75, 2017-52 I.R.B. 602, provided that modifying the plan to pay the amounts out when they became taxable would not be treated as a material modification for purposes of 26 C.F.R. § 1.409A-6.

Example. Susan deferred amounts in 2003, and those amounts were immediately vested. Those amounts were originally supposed to be paid when she attained age 65, which will not be until 2023. However, under the transitional rule to Section 457A, she was taxable on those amounts in 2017. Her employer was permitted to modify the arrangement to pay those amounts in 2017, without that modification being considered a material modification that would subject the plan to Section 409A and thus trigger the 20% penalty and interest that would apply to accelerations of benefits.

2005 through 2008 Deferrals and Pre-2005 Deferrals That Vested in 2005 or Later

Plans set up between 2005 and 2008 were generally set up to comply with Section 409A. However, under the transitional rule to Section 457A, benefits from those years will be includible in gross income in the later of:

  • The last taxable year beginning before 2018 –or–
  • The first taxable year in which there is no substantial risk of forfeiture of the rights to such compensation

In general, Section 409A does not permit the acceleration of benefits. However, I.R.S. Notice 2017-75 permits acceleration of benefits in order to pay the tax due under Section 457A.

Note that the rules for pre-2005 deferrals are different from the rules for 2005 through 2008 deferrals. For the former, the entire amount can be paid at the time taxes are imposed. For the latter, only an amount necessary to pay the taxes can be paid at that time.

Example. Jordan was covered by an arrangement in 2005 under which, if he remained in employment until 2020, he would receive payment beginning at age 65 (which would occur in 2030). Under the transitional rule to Section 457A, he is taxable on those amounts in 2020. If his employer were to accelerate the entire amount of deferred compensation, he would be subject to the 20% penalty plus the interest penalty under Section 409A. However, I.R.S. Notice 2017-75 permits the employer to accelerate just that portion of the payment necessary to pay the tax due in 2020.

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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).

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