Section 403(b) Plan Design and Compliance
(Posted on December 5, 2018 by )


Go to: 403(b) Plan Overview | Eligible Employers and Employees | ERISA Coverage of 403(b) Plans | Qualification Requirements | 403(b) Plan Contributions | 403(b) Plan Distributions | Implementation and Operation | Correcting 403(b) Plan Errors | Terminating 403(b) Plans | EP Subcommittee Report: 403(b) Plan Issues and Recommendations | Advantages and Disadvantages of 403(b) Plans

This practice note discusses the rules that apply when eligible tax-exempt organizations (or their employees) establish tax-sheltered annuities, custodial accounts, or retirement income accounts, as described in Section § 403(b) of the Internal Revenue Code (403(b) plans). While all employers are eligible to set up a defined benefit plan, and most tax-exempt nongovernmental employers are eligible to set up 401(k) plans, 403(b) plans are another option for certain tax-exempt and governmental organizations. These organizations may establish a 403(b) plan (sometimes called a tax-sheltered annuity plan or a TSA), which can fulfill most of the functions of a qualified plan, including allowing for pre-tax employee elective contributions, while offering various advantages to employers over a traditional qualified plan design.
This practice note addresses the following topics:

For more information on 403(b) plans, see Employee Compensation and Benefits Tax Guide ¶ 502.14 and the IRS website resource for 403(b) plans.

403(b) Plan Overview

A 403(b) plan is a type of retirement plan providing for deferred taxation on certain contributions and earnings made by specific kinds of tax-exempt organizations (primarily, public schools and 501(c)(3) tax-exempt organizations) for their employees and by certain ministers. I.R.C. § 403(b)(1). For the participant, a 403(b) plan appears much like a 401(k) plan in that it provides for an individual account for each participant. However, 403(b) plan investment options are more limited. 403(b) plans are subject to some, but not all of the requirements that apply to 401(k) and other retirement plans qualified under I.R.C. § 401(a). A 403(b) plan can allow employees, the employer, or both to contribute to the plan. Also, like a 401(k) plan, a 403(b) plan can include a qualified Roth contribution program.

Although 403(b) plans have been around in some form for over 50 years, the Treasury Department only issued final regulations under I.R.C. § 403(b) in 2007, which generally became effective in 2009. 72 Fed. Reg. 41,127 (July 26, 2007).

Eligible Employers and Employees

Only certain types of employees are eligible to participate in a 403(b) plan, essentially restricting 403(b) plan sponsors to certain tax-exempt organizations, schools (including colleges and universities) sponsored by state and local governments, and ministers or their employers or deemed employers. If a plan permits ineligible employees to participate, the plan may lose its tax-favored status (unless a correction is made under the IRS Employee Plans Correction Resolution System (EPCRS); see Correcting 403(b) Plan Errors later in this practice note).

The following types of employees are eligible to participate in a 403(b) plan:

  • 501(c)(3) employees. Employees of tax-exempt organizations established under I.R.C. § 501(c)(3) and cooperative hospital service organizations (501(c)(3) organizations), as described further below.
  • School employees. Individuals who are (1) involved in the daily operations of a public school, college, or university that is sponsored by a state, local, or Indian tribal governmental body (public school systems), as described further below under “Public School Systems” or (2) civilian faculty and staff of the Uniformed Services University of the Health Sciences. See below for further discussion.
  • Ministers. Ministers described in I.R.C. § 414(e)(5), provided they are:
    • Employed by a 501(c)(3) organization
    • Self-employed –or–
    • Not employed by a 501(c)(3) organization, but functioning as a minister in their daily responsibilities with their employer, such as a chaplain for a state-run prison

I.R.C. § 403(b)(1)(A); 26 C.F.R. § 1.403(b)-2(b); I.R.S. Maintaining Eligibility to Sponsor a 403(b) Plan.

501(c)(3) Organizations

All 501(c)(3) organizations must be organized and operated exclusively for a purpose that is:

  • Charitable
  • Religious
  • Educational
  • Scientific
  • Literary
  • For public safety testing
  • For fostering national or international amateur sports competition –and/or–
  • For preventing cruelty to children or animals

I.R.C. § 501(c)(3).

Other 501(c)(3) organization requirements are that none of its earnings may inure to any private shareholder or individual, and the entity may not attempt to influence legislation as a substantial part of its activities nor participate in any campaign activity for or against political candidates. In addition, assets of the organization must be permanently dedicated to an exempt purpose and, upon dissolution, the assets must be distributed for a charitable purpose. 26 C.F.R. § 1.501(c)(3).

Most 501(c)(3) organizations (or their parent organizations) are required to have an IRS determination as to their status. There is an exception for filing for church and related organizations (and other I.R.C. § 508 excepted organizations) and entities organized before October 9, 1969. An online search tool providing a list of organizations with determination letters can be found on the IRS website at EO Select Check. Information regarding the application process is available in I.R.S. Publication 557, Tax Exempt Status for Your Organization.

A cooperative hospital service organization described in I.R.C. § 501(e) is treated as if it were a 501(c)(3) organization if it is organized and operated solely to perform on a centralized basis certain services for two or more tax-exempt or governmental hospitals. Rev. Rul. 72–329, 1972–2 C.B. 226.

Public School Systems

A public school system eligible to adopt a 403(b) plan is a state-sponsored educational organization that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. Included in this category are employees of public schools and state colleges or universities. 26 C.F.R. § 1.403(b)-2(b)(14).

The employer must be a state, a political subdivision of a state, or an agency or instrumentality of one of these. I.R.C. 403(b)(1)(A)(ii). Implementing regulations interpret “state” to include the District of Columbia and Indian tribal governments as provided under I.R.C. § 7871(a)(6)(B). 26 C.F.R. § 1.403(b)-2(b)(20).

Both faculty and nonacademic staff (e.g., custodial staff) performing services for the educational organization may be covered by the 403(b) plan, but elected or appointed officials (holding positions in which persons that are not education professionals may serve) are not eligible. Members of the school board and university regents or trustees are not eligible. 26 C.F.R. § 1.403(b)-2(b)(10). Additional guidance on this issue may be found in the I.R.S. 403(b) Plan Fix-It Guide.

Employers Not Permitted to Adopt 403(b) Plans

Adoption of a purported 403(b) plan by an organization not qualified to adopt one is a common violation of the I.R.C. § 403(b) rules. Correction under the IRS EPCRS program (discussed below) can preserve the tax-deferred status of contributions made prior to the discovery of ineligibility.

When analyzing employer eligibility, several special situations should be considered:

  • Non-501(c)(3) organizations, even if tax exempt. Only a 501(c)(3) organization can adopt a 403(b) plan. Organizations that are tax exempt under another subparagraph of I.R.C. § 501(c) are not eligible employers. Examples of ineligible employers are trade associations exempt under I.R.C. § 501(c)(6) and unions exempt under I.R.C. § 501(c)(5).
  • Governmental organizations other than public school systems. A governmental organization can adopt a 403(b) plan only if it is a public school system, as described above, with the following exceptions:
    • A governmental organization that is also a 501(c)(3) organization can maintain a 403(b) plan. An organization affiliated with government may qualify for I.R.C. § 501(c)(3) exemption if it is separately incorporated or formed to accomplish one or more exempt purposes. For example, a public hospital may receive 501(c)(3) status. However, an organization may not
      obtain 501(c)(3) status if it has governmental regulatory or enforcement powers that would be beyond those permitted by an organization described in I.R.C. § 501(c)(3).
    • A governmental organization can have mixed functions. For example, a prison would not normally be a public school, and therefore could not maintain a 403(b) plan for its employees. However, employees of the education section of a prison (designed to provide educational opportunities to prisoners) could participate in a 403(b) plan. I.R.S. General Couns. Memo. 38666 (Mar. 27, 1981).
  • Nonqualifying affiliates of a 403(b) plan authorized entity. An affiliate of an organization authorized to maintain a 403(b) plan cannot participate in the plan unless the affiliate also would be an eligible employer. For example, it is common for a private university described in I.R.C. § 501(c)(3) to own a taxable technology start-up to engage in commercialization of
    university-based research. Even though the technology company is wholly owned by the university, and its earnings are paid as dividends to the university, employees of the technology company cannot participate in a 403(b) plan. To the extent that some employees may divide their time between the university and its taxable affiliate, only their compensation from the
    university can be counted for purposes of the 403(b) plan.

ERISA Coverage of 403(b) Plans

Most private employer-sponsored 403(b) plans are subject to the Employee Retirement Income Security Act (ERISA), which has several requirements that parallel rules for qualified defined contribution and qualified defined benefit plans under the Internal Revenue Code, but don’t otherwise directly apply to 403(b) plans, including:

  • Vesting rules under ERISA § 203(a)(2)(B) (29 U.S.C. § 1053(a)(2)(B)) and I.R.C. § 411(a)(2)(B)
  • Asset transfer rules under ERISA § 208 (29 U.S.C. § 1058) and I.R.C. § 414(l)
  • Qualified joint and survivor annuity rules under ERISA § 205 (29 U.S.C. § 1055) and I.R.C. § 401(a)(11)
  • Anti-cutback rules as applied to transfers under ERISA § 204(g) (29 U.S.C. § 1054(g)) and I.R.C. § 411(d)(6)

So, 403(b) plans that are subject to ERISA must also comply with these rules as well as ERISA’s reporting and disclosure requirements, and—perhaps more significantly—such 403(b) plan sponsors are subject to ERISA’s fiduciary and prohibited transaction rules, unless an exemption applies.

For further information on ERISA reporting requirements, see Dep’t of Labor Field Assistance Bulletin 2009-02 (July 20, 2009) and Field Assistance Bulletin 2010-01 (Feb. 17, 2010) (hereinafter, FAB 2010-01).

ERISA fiduciary status may be a particular area of concern in light of recent litigation targeting several university 403(b) plans asserting breaches of fiduciary duty. E.g., Vellali, et al. v. Yale University, et al. 3:16-cv-01345 (D. Conn.), Sacerdote, et al. v. New York University 1:16-cv-06248 (S.D.N.Y.); Sweda, et al. v. The University of Pennsylvania, et al. 2:16-cv-04329 (E.D. Pa.); Clark, et al. v. Duke University, et al. 1:16-cv-1044 (M.D.N.C.); Munro, et al. v. University of Southern California, et al. 2:16-cv-06191 (C.D. Cal.).

Sponsor-Based Exemptions from ERISA Coverage

The ERISA rules do not apply to governmental plans or nonelecting church plans, which are generally exempt from ERISA. (Church plans may elect to be covered by ERISA.) ERISA § 4(b)(1), (2) (29 U.S.C. § 1003(b)(1), (2).

Non-ERISA 403(b) Plans

An exemption from ERISA Title I (governing reporting and disclosure, participation and vesting, funding, and fiduciary requirements) is available even for 403(b) plan sponsors that are subject to ERISA if the arrangement meets certain requirements that minimize employer involvement (non-ERISA 403(b) plans). A non-ERISA 403(b) plan is a program with limited employer involvement that provides for the purchase of annuity contracts or custodial accounts invested solely in mutual funds that is not recognized as an ERISA § 3(2)(A) employee pension benefit plan because it is not treated as “established or maintained by an employer.” 29 C.F.R. § 2510.3-2(f); see Dep’t of Labor Field Assistance Bulletin 2007-02 (July 24, 2007) (hereinafter, FAB 2007-02); FAB 2010-01.

Department of Labor (DOL) regulations provide safe harbor rules for non-ERISA 403(b) plans. To qualify for the safe harbor, the 403(b) plan must satisfy the following requirements:

  • Voluntary participation. Participation in the plan must be completely voluntary for employees.
  • Employee enforceability. All rights under the arrangement are enforceable solely by the employee, a beneficiary of the employee, or an authorized representative of the employee or beneficiary.
  • Restricted employer involvement. The sole involvement of the employer must be limited to the following activities:
    • Permitting annuity contractors (including any agent or broker who offers annuity contracts or who makes available custodial accounts) to publicize their products to employees
    • Requesting information concerning proposed funding instruments or annuity contractors
    • Summarizing information on funding instruments or annuity contractors for employee review and analysis
    • Collecting contributions as required by salary reduction agreements or by agreements to forego salary increases, remitting such contributions to annuity contractors, and maintaining records of such amounts (i.e., no employer contributions are permitted)
    • Holding in the employer’s name one or more group annuity contracts (including the right to act as an employee representative for contract amendments)
    • Limiting the funding instruments made available to employees, or the annuity contractors who may approach employees, in a manner designed to afford employees a reasonable choice in light of all relevant circumstances (described further below)
  • No employer compensation. The employer receives no direct or indirect consideration or compensation, in cash or otherwise, except reasonable compensation to cover expenses properly and actually incurred in the performance of its duties pursuant to the salary reduction agreements or agreements to forego salary increases.

29 C.F.R. § 2510.3-2(f).

The circumstances that may be considered by an employer desiring to limit the non-ERISA 403(b) plan funding media or products or annuity contractors include (but are not limited to):

  • The number of employees affected
  • The number of contractors who have indicated interest in approaching employees
  • The variety of available products
  • The terms of the available arrangements
  • The administrative burdens and costs to the employer
  • The possible interference with employee performance resulting from direct solicitation by contractors

Id.

Note that the non-ERISA 403(b) plan safe harbor covers only arrangements that are limited to employee elective deferrals. There can be no employer contributions of any kind. 29 C.F.R. § 2510.3-2(f)(3)(iv). The DOL has provided guidance on other issues concerning the safe harbor, as discussed in the following sections.

Employer Administrative Reviews Permitted for Non-ERISA 403(b) Plans

Certain employer activities designed to ensure that a 403(b) plan continues to be tax compliant under I.R.C. § 403(b) are permissible activities that will not take a non-ERISA 403(b) plan out of the safe harbor. This is because employers have an interest separate from acting as their employees’ authorized representatives in ensuring that the 403(b) plan’s annuity contracts and custodial accounts are tax compliant. Specifically, for example, the employer can be liable to the IRS for potentially substantial penalty taxes, correction fees, and employment taxes on employee salary deferrals for noncompliance, even if the violation was caused by an employee or annuity contractor. Thus, an employer’s compliance monitoring activities are consistent with the safe harbor (including in correcting errors). FAB 2007-02; FAB 2010-01; Dep’t of Labor Information Letter (Feb. 27, 1996).

However, to clearly indicate the employer’s limited involvement in the plan, where the written plan document allocates responsibility for performing administrative functions to persons other than the employer, the relevant document(s) should identify the parties that are responsible for administrative functions, including those related to tax compliance. The documents should delineate the employer’s limited role in the activity and allocate discretionary determinations to the annuity provider or participant or other third party selected by the provider or participant. FAB 2007-02; FAB 2010-01.

Impermissible Employer Discretion in Non-ERISA 403(b) Plans

If the employer exercises discretion in administering the plan, it may be deemed to have taken over control as the plan sponsor, resulting in the loss of ERISA Title I exemption (unless it is a governmental or nonelecting church plan, exempt from Title I requirements). Such prohibited exercises of discretion include determinations authorizing, directly or indirectly through a third-party administrator:

  • Administering distributions, including hardship distributions, domestic relations orders, and processing participant loans
  • Satisfying applicable qualified joint and survivor annuity requirements –or–
  • Plan-to-plan transfers or contract exchanges

FAB 2007-02; FAB 2010-01; Dep’t of Labor Adv. Op. 94-30A (Aug. 19, 1994).

Thus, maintaining a non-ERISA 403(b) plan’s exemption from ERISA is practical only if the annuity and/or custodial account providers are willing to take on the bulk of administrative duties under the plan, and the employer is willing to concede control of most plan functions to them. As discussed below, this can lead to compliance issues because each vendor is typically unaware of what other vendors are doing.

Qualification Requirements

The following sections outline the qualification rules for all 403(b) plans to be eligible for tax-favored status under 26 C.F.R. § 1.403(b)-3:

  • Funding restrictions
  • Written document requirement
  • Nondiscrimination rules
  • Contribution and benefit rules and limitations
  • Rollover distribution requirements
  • Required minimum distribution rules
  • Nontransferability rule

These rules are separate from any requirements under ERISA, which would also apply to 403(b) plans that are subject to ERISA (see the discussion in the previous section, ERISA Coverage of 403(b) Plans, regarding non-ERISA 403(b) plans). See 403(b) Plan Distributions for further discussion on distribution requirements.

Funding Restrictions

There are only three categories of funding arrangements that can be used for a 403(b) plan:

  • Annuity contracts (26 C.F.R. §§ 1.403(b)-2(b)(2), -8(c)). Generally, 403(b) plan annuity contracts must be issued by a state-regulated insurance company and offer an annuity form of benefit.
  • Custodial accounts (I.R.C. § 403(b)(7) and 26 C.F.R. § 1.403(b)-8(d)). These are separate accounts that must be held by a financial institution described in I.R.C. § 401(f)(2) and:
    • Be invested solely in mutual funds
    • Comply with the 403(b) plan distribution limitations (described under 403(b) Plan Distributions below)
    • Be operated for the exclusive purpose of providing benefits for participants or their beneficiaries –and–
    • Meet the rules in 26 C.F.R. § 1.403(b)-8(d)(2) regarding distribution limitations
  • Church retirement income accounts (I.R.C. § 403(b)(9) and 26 C.F.R. § 1.403(b)-9). Church sponsors of 403(b) plans may use retirement income accounts to fund plan benefits, which allow for increased investment flexibility. They must:
    • Be maintained under a separate accounting
    • Limit benefits only to gains or losses on invested assets
    • Be operated for the exclusive purpose of providing benefits for participants or their beneficiaries

26 C.F.R. § 1.403(b)-8.

Unlike a qualified plan, a 403(b) plan (other than certain grandfathered self-insured state and local government 403(b) plans or a church retirement income account) cannot be funded through a trust that holds stocks, bonds, or other investments. See 26 C.F.R. §§ 1.403(b)-8(c)(3), -9.
The 403(b) plan must specify which specific contracts will be available under the plan. The issuers of such contracts are known as approved vendors.

Written Document Requirement

A 403(b) plan must be documented in a written defined contribution plan that satisfies certain regulatory requirements and be operated in compliance with the plan. Specifically, the written plan document must set forth all the material terms and conditions regarding the following:

  • Eligibility
  • Contributions and benefits
  • Contribution limitations
  • Contracts available under the plan (approved vendors) –and–
  • Time and form of benefit distributions (including rules for rollover and required minimum distributions)

26 C.F.R. § 1.403(b)-3(b)(3)(i).

The plan also may set forth certain optional features that are consistent with but not required under I.R.C. § 403(b). These include:

  • Hardship withdrawals
  • Plan loans
  • Plan-to-plan transfers (or from annuity contract to annuity contract) –and–
  • Acceptance of rollovers to the plan

Id.

As provided in the final regulations, the existence of a written plan facilitates the allocation of plan responsibilities among the employer, the issuer of the contract, and any other parties involved in implementing the plan. Without such a central document for a comprehensive summary of responsibilities, there is a risk that many of the important responsibilities required under the statute and final regulations may not be allocated to any party. Failure to adopt a written plan document, or to follow its terms, is a common plan defect that is correctable under the IRS EPCRS program. See Correcting 403(b) Plan Errors.

Multiple Documents

The written plan document can consist of more than one document. That is, plans are permitted to incorporate other documents, such as annuity contracts and custodial agreements. 26 C.F.R. § 1.403(b)-3(b)(3)(ii).

Considerations for Non-ERISA 403(b) Plan

Consider advising a tax-exempt employer that wishes to maintain non-ERISA 403(b) plan status to exclude from its written plan document any provisions concerning hardship withdrawal distributions, loans, plan-to-plan transfers, and acceptance of rollovers. Employer involvement in those activities can jeopardize the non-ERISA 403(b) plan status. These provisions may appear instead in the annuity contract, custodial account agreement, or other ancillary document prepared by the third party administering the relevant aspect of the arrangement. Under the safe harbor rules, the employer could presumably limit the funding media or products available to employees, or the annuity contractors who may approach employees, to ones that agreed to include and administer such provisions. 29 C.F.R. § 2510.3-2(f)(3)(vii); FAB 2007-02.

Model Language

The IRS has provided model language for 403(b) plans designed to satisfy requirements under I.R.C. § 403(b) for public school sponsors, which can be modified for other types of eligible employers. Rev. Proc. 2007-71, 2007-2 C.B. 1184 (see March 2015 revised version available on the IRS website). See also the section entitled “Pre-approved 403(b) Plans,” under Implementation and Operation below.

Nondiscrimination Rules

The section 403(b) nondiscrimination rules are designed to ensure that coverage under a 403(b) plan does not discriminate in favor of highly compensated employees. Church-sponsored 403(b) plans are exempt from these rules. I.R.C. § 403(b)(1)(D). Their application to other plans depends on whether the plan is maintained by a government or a private employer:

  • Governmental and private employer plans are subject to the universal availability rule for elective deferrals.
  • Private employer plans are also subject to similar nondiscrimination rules as defined contribution and defined benefit plans qualified under I.R.C. § 401(a).

Universal Availability for Elective Deferrals

Plans of governments and private employers (but not churches) that permit elective deferrals under their 403(b) plans must make them available to all employees, subject to the exceptions for excludable employees noted below. This is the case even if the employee has not met the plan’s age and service requirements for employer contributions. I.R.C. § 410(b)(12)(A)(ii); 26 C.F.R. § 1.403(b)-5.

Aggregation rules are as follows:

  • Individual 501(c)(3) organizations are treated separately, even if related to other 501(c)(3) entities.
  • Government employers are aggregated if they are part of a common payroll.
  • If an employer has historically treated geographically distinct units as separate for employee benefit purposes, then such units can be treated separately for universal availability but only if the unit is run independently on a day-to-day basis. An exception to this exception applies to units within the same Standard Metropolitan Statistical Area.

26 C.F.R. § 1.403(b)-5(b)(3).

Excludable Employees

Certain employee groups may be excluded (on a universally basis) from participation in a 403(b) plan without violating the universal availability rule:

  • Any employee not willing to contribute more than $200 per year
  • Employees who work less than 20 hours per week or any lower number stated in the plan document (I.R.C. § 403(b)(12)(A) (ii)), but only if:
    • The employer expects the employee to work fewer than 1,000 hours for the 12 months beginning on the date of hire, and
    • The employee does work fewer than 1,000 hours in each subsequent plan year (or, if the plan so provides, each subsequent 12-month period) thereafter
  • Employees eligible to make salary deferral contributions to another 403(b), government 457(b), or 401(k) plan of the employer
  • College work-study students described in I.R.C. § 3121(b)(10) –and–
  • Nonresident aliens with no U.S. source income

I.R.C. § 403(b)(12)(A); 26 C.F.R. §§ 1.403(b)-5(b)(3)(i), -5(b)(4)(ii).

Universal availability rule compliance is an issue for many 403(b) plans. For example, a school often hires substitute teachers whose work schedule is unpredictable. The employer may initially not permit elective deferrals based on an expectation they will work less than 20 hours per week and will not exceed 1,000 hours for they year (a permissible exception, as noted above). However, if this is done, the employer needs to carefully track actual hours to ensure that a substitute that ceases to qualify for an exempt category is given the opportunity to participate. As an alternative, many employers simply permit all employees, regardless of hours worked, to make elective deferrals.

In the past, several 403(b) plans misapplied the part-time employee exclusion by extending it to employees for any plan years where an employee did not meet the hours threshold during the immediately prior year, even if they had been permitted to contribute to the plan previously. The IRS has offered limited relief for such plans to bring their plans into compliance under the 403(b) remedial amendment period if they timely amend the plan in accordance with the transition relief and operate the plan in a manner compliant with the once-in-always-in rule for exclusion years beginning on or after January 1, 2019. I.R.S. Notice 2018-95, 2018 IRB LEXIS 617.

Notice Requirement

There is a notice component to the universal availability rule. Employers must provide all eligible employees with an annual notice concerning the opportunity to make salary deferrals to a 403(b) plan offering elective deferrals. The notice must also advise employees how they can make or change the amount designated for salary deferral purposes. I.R.C. § 403(b)(12)(A); 26 C.F.R. § 1.403(b)-5(b)(2).

No Contingent Benefits

Finally, the universal availability rule prohibits 403(b) plans from making an employee’s right to receive any employee benefit contingent on his or her decision to make an employee elective deferral contribution to the 403(b) plan (other than matching contributions, plan loan benefits relating to a deferral amount, or alternative benefits, credits, or cash under a cafeteria plan available in lieu of the 403(b) plan contribution).

Universal Availability Rule Compliance Review

Following are steps for universal availability compliance and monitoring:

  • Review the 403(b) plan document and administrator’s practices and procedures concerning universal availability.
  • Review eligibility rules generally for 403(b) plan compliance. Remember that employers cannot exclude employees based on job classifications, such as visiting professors or adjuncts, student workers or interns, substitute teachers, seasonal or temporary employees, administrative workers, bus drivers, custodial staff, cafeteria workers. Only individuals falling in a permissible excludable class under the terms of the plan can (and must) be excluded.
  • If part-time employees are excluded, establish procedures for determining excludable status and implement periodic testing to ensure the 20-hour-per-week and 1,000-hour-per-year rules continue to be satisfied for all excluded individuals.
  • Ensure the annual notice provides an accurate description of the 403(b) plan eligibility requirements and is distributed each year.

For a thorough discussion of issues relating to universal availability compliance, see the 2015 report by the Employee Plans Subcommittee of the IRS’s Advisory Committee on Tax Exempt and Government Entities (ACT), available at ACT, 2015 Report of Recommendations, pp. 28-38.

Other Nondiscrimination Rules

The plans of private employers, but not governments or churches, are subject to the same as the rules that apply to qualified plans under I.R.C. §§ 401(a)(4) (nondiscrimination in contributions and benefits), 401(a)(17) (compensation limit), 401(m) (matching and after-tax contributions), and 410(b) (minimum coverage). 26 C.F.R. §§ 1.414(c)-5(a)(1).

Unlike the universal availability rule, these nondiscrimination requirements apply on a related-entity basis under the employer aggregation rules of I.R.C. §§ 414(b), (c), (m), and (o), rather than just to the employer maintaining the plan. On their face, I.R.C. §§ 414(b) and (c), which define “controlled group,” apply only to controlled groups of corporations and two or more trades or businesses under common control. However, regulations take the position that these rules apply to tax-exempt organizations as well (other than churches) and provide rules for determining controlled group status in the case of tax-exempt organizations. 26 C.F.R. §§ 1.414(c)-5(a)(4), -5(b)(3).

Contribution and Benefit Rules and Limitations

Benefits under a 403(b) plan are based on contributions made and earnings thereon. The written plan document must specify the types of contributions allowed. 403(b) plan contributions are also subject to limitations, like other qualified plans. In the case of a private employer, such contributions must satisfy certain nondiscrimination requirements, as discussed in the previous section. As with employer contributions under a qualified plan, employer contributions, including those made by the employee under a salary reduction agreement, and earnings are not included in the employee’s income until distributed (except for after-tax and Roth contributions). I.R.C. § 403(b)(1).

A 403(b) plan can permit any or all of the following types of contributions, but the plan must specify which types are permitted:

  • Elective deferrals
  • Employer contributions (including matching, discretionary, and/or mandatory contributions)
  • Roth contributions
  • After-tax contributions
  • Rollover contributions

Each of these are described in the 403(b) Plan Contributions section below. A 403(b) plan may also provide for automatic enrollment. I.R.C. § 414(w).

Contribution Limits

Similar to contributions under 401(k) plans, contributions to 403(b) plans are subject to:

  • Maximum annual limits under I.R.C. § 402(g) on elective deferrals and Roth contributions
  • Maximum annual additions under I.R.C. § 415 on all types of contributions (other than rollovers)

Annual Limit on Elective Deferrals and Catch-Up Contributions

Elective deferral limit. The normal annual limit on elective deferrals plus contributions under an eligible Roth contribution program to a 403(b) plan is determined under the I.R.C. § 402(g) threshold, as adjusted for inflation ($18,000 in 2017), the same limit that applies to elective contributions under a 401(k) plan. I.R.C. §§ 402(g)(1)(A), 402A(c)(2); 26 C.F.R. § 1.403(b)-3(c). See the paragraph captioned “One-time election to exceed 402(g) limit” in the above discussion of elective deferrals for a special rule allowing a new 403(b) plan participant to exceed the annual limit. I.R.C. §§ 402(g)(3), 403(b)(12).
Timing rules for the return of any excess deferral resulting from a failure to comply with the elective deferral limit are found in 26 C.F.R. §§ 1.403(b)-4(f)(4).

Catch-up contribution rules. There are two catch-up contribution opportunities for eligible employees to increase the elective deferral limit for a year:

  • Age 50 catch-up –and–
  • 15-years-of-service catch-up

Age 50 catch-up contribution. If permitted by the 403(b) plan, employees who are age 50 or over at the end of the calendar year can also make catch-up contributions up to the statutory catch-up limit under I.R.C. § 414(v), as adjusted for inflation ($6,000 in 2017). The amount cannot exceed the employee’s compensation for the year. I.R.C. § 414(v); 26 C.F.R. § 1.403(b)-4(c)(2).
If an employee covered by a 403(b) plan is also covered by a 401(k) plan (or a simplified employee pension or SIMPLE retirement account), the plans are combined in applying the annual limit on elective deferrals and the age-50 catch-up limit. 26 C.F.R. § 1.402(g)-1(b).

15-years-of-service catch-up contribution. A special rule for 403(b) plans under I.R.C. § 402(g)(7) allows plans to provide for a separate catch-up right for employees having at least 15 years of service with a:

  • Public school system
  • Hospital
  • Home health service agency
  • Health and welfare service agency
  • Church –or–
  • Convention or association of churches (or associated organization)

26 C.F.R. § 1.403(b)-4(c)(3)(ii).

If permitted under the plan, this catch-up rule increases the annual limit otherwise applicable by the least of:

  • $3,000
  • $15,000, reduced by the amount of additional elective deferrals made in prior years under this rule
  • $5,000 times the number of the employee’s years of service for the organization, minus the total elective deferrals made for
    earlier years –or–
  • The participant’s compensation for the year (as defined in 26 C.F.R. § 1.403(b)-2)

26 C.F.R. § 1.403(b)-4(c)(3)(ii).

Special rules for determining years of service for this purpose are given in 26 C.F.R. § 1.403(b)-4(e). Several examples applying the catch-up rules are given in 26 C.F.R. § 1.403(b)-4(c). See also I.R.S. Publication 571, Tax-Sheltered Annuity Plans (403(b) Plans), §4.
When both catch-up opportunities are available (because a qualifying individual is age 50 or older by year-end), the employee may utilize both, but regulations require the additional amounts to be applied first to the 15-years-of-service catch-up and then to the age 50 catch-up. 26 C.F.R. § 1.403(b)-4(c)(4).

Due to its complexity and the subsequent introduction of the age-50 catch-up rules, many employers have eliminated the 15-years-of-service catch-up from their 403(b) plans. The I.R.S. 403(b) Plan Fix-It Guide identifies allowing this catch-up to an employee who does not have the required 15 years of full-time service with the same employer as a common plan defect.

Limit on Annual Additions under I.R.C. § 415

The annual additions limit that applies to qualified defined contribution plans also applies to the aggregate of all contributions to a 403(b) plan, other than rollover contributions and age-50 catch-up contributions. I.R.C. § 403(b)(1); 26 C.F.R. § 1.403(b)-4(b).

The limit is the lesser of:

  • The statutory limit, adjusted for inflation under I.R.C. § 415(d) ($54,000 for 2017 limitation years) –or–
  • 100% of includible compensation (as defined in 26 C.F.R. § 1.403(b)-2)

I.R.C. § 415(c)(1); 26 C.F.R. § 1.403(b)-4(b)(2); see also 26 C.F.R. §§ 1.415(b)-1(b)(2), (c) for special application rules relating to 403(b) plans.

It is important to establish a separate account to hold excess contributions to prevent commingling with 403(b) plan-eligible contributions. Failure to do so could taint the tax-qualified status of the entire 403(b) plan. 72 Fed. Reg. 41,136; 26 C.F.R. §§ 1.403(b)-3(b)(2), -4(f).

Special rule for former employee contributions. Where contributions continue for a former employee, the former employee’s compensation for this purpose is based on the amount earned during the most recent year of service for up to the next five taxable years. 26 C.F.R. 1.403(b)-4(d). Thus, it is possible for nonelective employer contributions to a 403(b) plan to continue for up to five years in the case of a retired or terminated participant. See 26 C.F.R. §§ 1.403(b)-3(b)(4), -4(d).

Special rule for Church employees. In lieu of the Section 415 limit, a church employee can choose to use $10,000 a year as the limit on annual additions. This is only useful if the employee’s includible compensation is less than $10,000 and if the total contributions will exceed 100% of the employee’s includible compensation. Moreover, total contributions over the employee’s lifetime under this choice cannot be more than $40,000. See 26 C.F.R. § 1.403(b)-9(b).

Aggregation of contributions under separate plans. Normally, an employee who participates in a 403(b) plan and a qualified defined contribution plan, simplified employee pension, defined benefit plan that provides for employee after-tax contributions, or individual medical benefit account that is part of a pension or annuity plan need not combine contributions made to the 403(b) plan with contributions to the other types of plans for purposes of the Section 415 limit. However, the plans must be combined if the other plan is maintained by a corporation, partnership, or sole proprietorship over which the employee has more than 50% control. I.R.C. § 415(k)(4).

For example, if a tax-exempt organization maintains both a qualified plan and a 403(b) plan, up to the lesser of $54,000 (in 2017) or 100% of compensation could be contributed to each plan. However, if a doctor employed by a tax-exempt hospital also has a qualified plan for his or her own private medical practice, the 403(b) plan of the hospital would have to be combined with the qualified plan of the private medical practice in applying the limit.

Incidental Benefit Rule

Requirements imposed on qualified plans under 26 C.F.R. § 1.401-1(b)(1)(ii) regarding the extent to which incidental life or accident or health insurance benefits may be provided as plan benefits also apply to 403(b) plans. 26 C.F.R. §§ 1.403(b)-3(a)(8), -6(g).

Nonforfeitability/Vesting

In theory, contributions under a 403(b) plan must be nonforfeitable. 26 C.F.R. § 1.403(b)-3(a)(2). As a practical matter, though, there is a workaround build into the regulations whereby forfeitable contributions are treated as not having been made to the 403(b) plan, but rather to a separate I.R.C. § 403(c) annuity (or a tax-exempt employee trust where a custodial account is used), when they are made. (Forfeitable contributions are required to be kept in a separate bookkeeping account than nonforfeitable contributions.) Then, as amounts become vested, and assuming all of the 403(b) plan conditions (other than nonforfeitability) are met for those contributions, those amounts are retroactively treated as having been made to the 403(b) plan for purposes of the maximum limits on contributions when they become nonforfeitable. 26 C.F.R. § 1.403(b)-3(d)(2).

In this way, many 403(b) plans subject employer matches, employer discretionary contributions, and/or employer mandatory contributions to a vesting schedule (vesting for employee elective deferrals would be permissible in non-ERISA 403(b) plans, but is highly unusual).

For example, a plan might provide that an employee would be 20% vested after two years, 40% after three years, 60% after four years, 80% after five years, and 100% (nonforfeitable) after six years. If an employee left after two years with an employer contribution account balance of $5,000, the employee would receive only $2,000. The remaining $3,000 in the account would, depending on the plan terms, be used for plan administrative expenses, divided among the accounts of other employees, or used to reduce future employer contributions.
To avoid participants becoming immediately subject to taxation upon a termination of the plan, however, a 403(b) plan that allows for any type of forfeitable contribution should provide for automatic full vesting upon plan termination (as would be mandatory for a traditional qualified plan).

Vesting Requirements for Plans Subject to ERISA

For 403(b) plans that are subject to ERISA, any vesting schedule must be at least as favorable as is required under ERISA. Thus, such 403(b) plans can subject employer contributions to three-year cliff vesting or six-year graded vesting, as described in the example given above (or more liberal vesting schedules). ERISA § 203(a)(2)(B) (29 U.S.C. § 1053(a)(2)(B)) (parallel provisions under I.R.C. § 411(a)(2)(B)).

Rollover Distribution Requirements

If a participant or beneficiary in a 403(b) plan is entitled to a distribution from the plan, the plan must give the participant or beneficiary the option to have the amount directly transferred to another plan rather than being paid to the participant or beneficiary. The qualified plan rollover rules under I.R.C. §§ 401(a)(31) and 402(c) and (f) apply (other than inherited IRA rules). Thus, 403(b) plan rollovers may be made to qualified plans, other 403(b) plans, and eligible governmental 457(b) plans (including to designated Roth accounts) as well as to I.R.C. § 403(a) annuity plans and traditional and Roth IRAs. I.R.C. § 403(b)(8), (10); 26 C.F.R. §§1.403(b)-3(a)(7), -7(b).

The qualified plan automatic cashout rules also apply, so if a plan calls for certain small benefits in excess of $1,000 to be paid to a participant without the participant’s election, the amount must be automatically directly transferred to an IRA unless the participant elects to the contrary. See I.R.C. § 401(a)(31).

Note that although rollovers out of the plan are required, accepting rollovers into a 403(b) plan is not.

Required Minimum Distributions

A 403(b) plan is treated as an individual retirement plan for purposes of satisfying the required minimum distribution (RMD) rule sunder I.R.C. § 401(a)(9). 26 C.F.R. §§ 1.403(b)-3(a)(6), -6. Special rules of application for 403(b) plans, including treatment of grandfathered benefits accruing before 1987, are found in 26 C.F.R. § 1.403(b)-6(e). Generally, 403(b) plan annuity contracts are treated like individual retirement accounts for purposes of the RMD rules. For further information on RMDs, see Employee Benefits law § 3A.02[m].

Nontransferability

Except in the case of a contract issued before January 1, 1963, 403(b) plan contracts must be nontransferable. Thus, an employee could not sell the contract to a third party. I.R.C. § 401(g); 26 C.F.R. § 1.403(b)-3(d)(2). Nor can a creditor of the employee seize the contract as payment for a debt, even in a bankruptcy situation. 11 U.S.C. § 541(b)(7). Special rules relating to the exchange of annuity contracts within a 403(b) plan and plan-to-plan transfers are considered in the discussion on distributions further below.

403(b) Plan Contributions

This section describes the different types of contributions permitted under a 403(b) plan.

Elective Deferral Contributions

Similar to 401(k) plan deferrals, these contributions to a 403(b) plan are made under a salary deferral agreement on a pre-tax basis and reduce the income shown on the employee’s Form W 2. I.R.C. §§ 402(e)(3), 403(b)(1)(E), 402(g)(3)(C). For example, if an employee whose salary is $50,000 gross contributes $5,000 to the 403(b) plan as an elective deferral, the wages reported on the Form W 2, Box 1, will be $45,000 rather than $50,000.

403(b) plan elective deferrals are subject to the following rules:

  • Annual limit. 403(b) plan elective deferrals are subject to the same annual limit as for 401(k) plans, determined on an aggregate basis for the individual, including the additional amounts for catch-up contributions, discussed further below. I.R.C. § 402(g).
  • One-time election to exceed 402(g) limit. A special rule allows plans to let an employee make a one-time irrevocable election at the time of initial eligibility in a 403(b) plan to contribute without regard to the elective deferral limitation. I.R.C. §§ 402(g) (3), 403(b)(12); I.R.S. Rev. Rul. 2000-35, 2000-2 C.B. 138.
  • Social Security/Medicare taxes apply. Like elective deferrals to a 401(k) plan, elective deferrals to a 403(b) plan are subject to applicable Social Security and Medicare taxes. I.R.C. § 3121(a)(5)(D).
  • Additional tax relief for retired public safety officers. While elective deferrals and earnings thereon from a 403(b) plan are generally all taxable when distributed. However, eligible retired public safety officers may use a distribution of up to $3,000 made directly from a 403(b) plan to pay premiums on accident, health, or long-term care insurance, without including the amount in taxable income. The premiums can be for the employee or the employee’s spouse or dependents. I.R.C. § 402(l) (3)(B).

Employer Contributions

A 403(b) plan may provide for employer matching, discretionary, or mandatory contributions. I.R.C. § 403(b)(1), (7). However, a 403(b) plan that provides for employer contributions cannot be a non-ERISA 403(b) plan. 29 C.F.R. § 2510.3-2(f)(3)(iv). Several types of employer contributions are possible:

  • Employer matching contributions. For matching contributions, the plan states the formula for matching contributions made by the employer based on the amount of the employee’s elective deferrals. For example, the employer may contribute an amount equal to 50% of elective deferrals (or, in some cases, elective deferrals and after-tax contributions). Typically, the
    match will be subject to a cap (e.g., that only contributions equal to the first 6% of an employee’s compensation will be matched).
  • Employer discretionary matching contributions. With a discretionary match, the employer decides how much to contribute toward the match. However, the plan terms must specify how the match is to be divided among employees. For example, it could specify that the match would not apply to contributions that exceeded the first 6% of an employee’s compensation, but
    that the percentage match would depend on the amount the employer chose to contribute for that year.
  • Employer discretionary contribution. With a discretionary contribution, the plan could specify that the employer may decide each year how much to contribute to the 403(b) plan, but the plan terms must set forth how the amount is to be allocated among employees (e.g., in proportion to compensation).
  • Employer mandatory contributions. With a mandatory contribution, the plan document states the amount to be contributed by the employer. For example, an employer may contribute to the 403(b) plan 5% of employee compensation each year.
  • Special rule for former employees. Subject to the limits in 26 C.F.R. § 1.403(b)-4(d), an employer may continue to make contributions on behalf of a former employee for up to five years after the year employment ends.

After-tax Employee Contributions

After-tax employee contributions do not give the employees an immediate tax benefit. However, earnings on the contributions are tax deferred until distributed from the plan, which could positively affect investment returns. I.R.S. 403(b) Plan Basics.

Roth Contributions

A 403(b) plan is recognized as an applicable retirement plan that may include a qualified Roth contribution program. I.R.C. § 402A(b), (e)(1)(B). Thus, 403(b) plans may allow employees to make elective Roth contributions. These contributions must be maintained separately from pre-tax and after-tax elective contributions and, like after-tax contributions, are treated as an elective deferral, but are not excludable from the employee’s gross income. However, for qualified distributions made from a Roth account, the earnings on the contributions are tax free, not merely tax deferred as for pre-tax or after-tax contributions. I.R.C. § 402A(d)(1); 26 C.F.R. § 1.403(b)-3(c) (incorporating rules under 26 C.F.R. § 1.401(k)-1(f)(1), (2)).

To be a qualified Roth distribution, the distribution from the 403(b) plan must be made, and must be:

  • Made at least five years after the employee first contributes to the Roth account –and–
  • Meet one of the following criteria:
    • Occur on or after the date the employee becomes age 59½
    • Be made to a beneficiary, or to the employee’s estate, after the death of the employee
    • Be attributable to the employee’s being disabled (as defined under I.R.C. § 72(m)(7)) –or–
    • Be used to pay for qualified first-time homebuyer expenses (as defined under I.R.C. § 72(2)(F))

I.R.C. § 402A(d)(2).

Rollover Contributions

A 403(b) plan can (but is not required to) permit rollovers from:

  • A qualified plan
  • Another 403(b) plan
  • A governmental 457(b) plan –or–
  • An IRA from which an employee is receiving a distribution

I.R.C. § 402(c)(1), (8).

Such rollovers continue the tax deferral on the amounts from the other plan. Id.

403(b) Plan Distributions

This section describes 403(b) plan distribution rules, describing when benefit distributions are generally permitted and special distributions rules for plan terminations, domestic relations orders, and plan loans. Certain permitted exchanges and transfers that are not treated as distributions are also discussed.

General Distribution Restrictions

A 403(b) plan’s distribution provisions must limit distributions to take into account limitations under I.R.C. § 403(b)(10) similar to defined contribution qualified plans. Certain distributions that are permitted will give rise to penalties on the plan participant. A plan may, but is not required to, limit distributions to avoid penalties on the participant.

Generally, a 403(b) plan can permit a distribution to be made only once the employee:

  • Reaches age 59½
  • Has a severance from employment
  • Dies
  • Becomes disabled (within the meaning of I.R.C. § 72(m)(7)
  • Encounters financial hardship, but only for elective deferral contributions (excluding income), as described below –or–
  • Is eligible for a qualified reservist distribution

26 C.F.R. §§ 1.403(b)-6(b) to (d).

26 C.F.R. §§ 1.403(b)-6(b) to (d).

However, the restrictions above do not apply to after-tax contributions. Id. Rollover contributions are also exempt. 26 C.F.R. § 1.403(b)-6(i). Thus, for example, a plan can permit in-service withdrawals of such amounts, even if the employee has not attained age 59½.

Hardship distribution rules. To be a hardship distribution, the same rules apply as under the qualified plan distribution rules. They are only permissible for an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need. The need of the employee includes the need of the employee’s spouse or dependent. IRS regulations provide certain safe harbors under which a distribution will be assumed to meet these tests. 26 C.F.R. § 1.403(b)-6(d)(2); see 26 C.F.R. § 1.401(k)-1(d)(3). For additional compliance information, see Hardship and Unforeseeable Emergency Distribution Checklist.

Distributions Subject to Penalties

As with distributions from qualified plans, two sorts of penalties can apply to distributions from a 403(b) plan, even if the withdrawals are permitted under the plan:

  • 10% additional tax (in addition to normal income taxes) on early withdrawals under I.R.C. § 72(t) –and–
  • Loss of the special tax treatment for Roth contributions distributed within the five-year nonexclusion period under I.R.C. § 402A(d)(2)(B)

Because these limitations apply to the participant, they need not be included in the plan document. However, some plans attempt to limit plan distributions to those that will not give rise to the penalties. The 10% additional tax applies only to the amount of the distribution that is subject to income tax. For example, it would not apply to a distribution to the extent it consisted of after-tax employee contributions, but it would apply to the portion of the distribution that consisted of earnings on those contributions. It also does not apply to the extent that taxes are deferred by rolling the distribution over to another plan. The additional tax applies unless one of the exceptions under I.R.C. 72(t) is met.

For example, a 30-year-old employee could be permitted to take a distribution of elective deferrals from a 403(b) plan upon termination of employment or hardship. However, unless the distribution was rolled over, it would generate normal income taxes plus the 10% additional tax.

Distributions upon Plan Termination

Distributions can be made regardless of the above limitations upon termination of the 403(b) plan. However, if the 403(b) plan contains elective deferrals or is funded through custodial accounts, termination of the plan and the distribution of accumulated benefits is permitted only if the employer (taking into account all entities that are treated as the employer under I.R.C. §§ 414(b), (c), (m), and (o) on the date of the termination) does not make any contributions to any 403(b) plan that is not part of the terminating plan during the period beginning on the date of plan termination and ending 12 months after distribution of all assets from the terminated plan. An exception to this rule exists when less than 2% of eligible employees are eligible under the other 403(b) plan during the restricted period. 26 C.F.R. § 1.403(b)-10(a)(1).

See also Terminating 403(b) Plans below for other issues in terminating a 403(b) plan.

Domestic Relations Orders

The 403(b) regulations include a specific exception to the distribution limitation rules for domestic relations orders. 26 C.F.R. 1.403(b)-10(c). A domestic relations order is defined as any judgment, decree, or order (including approval of a property settlement agreement) that:

  • Relates to the provision of child support, alimony payments, or marital property rights to a spouse, former spouse, child, or other dependent of a participant –and–
  • Is made pursuant to a state domestic relations law (including a community property law)

I.R.C. § 414(p)(9).

A governmental or nonelecting church plan can comply with any domestic relations order (and may be subject to state domestic relations laws regarding distributions). Other plans can comply only if the order is a domestic relations order that meets certain requirements for qualified domestic relations orders (QDROs) under I.R.C. § 414(p) and ERISA § 206(d)(3) (29 U.S.C. § 1056(d)(3)). See Rev. Proc. 2007-71.

Remember that sponsors of non-ERISA 403(b) plans should not conduct any discretionary administration of the plan’s domestic relations order distributions.

Plan Loans

Loans from 403(b) plans are permissible, depending on the facts and circumstances of the loan arrangement, including whether there is a fixed repayment schedule, the reasonability of the interest rate, and the presence of repayment safeguards that a prudent lender would rely on. As for 401(k) plan loan programs, the prohibited transaction exemption requirements under ERISA § 408(b)(1) (29 U.S.C. § 1108(b)(1)) apply for ERISA-governed plans, and tax treatment is governed by I.R.C. § 72(p).

The plan document (or ancillary document) must contain material terms and conditions for the loans and identify the person responsible for administering the program. If the participant fails to repay a 403(b) plan loan, the participant’s account under the plan can be used for repayment similar to other qualified plan loans. 26 C.F.R. § 1.403(b)-6(f); see also 29 C.F.R. § 2550.408b-1 and 26 C.F.R. § 1.72(p)-1.

The taking out of a loan is not treated as an impermissible distribution. A loan that is in default is generally treated as a taxable distribution from the plan of the entire outstanding balance of the loan (a deemed distribution). A deemed distribution is treated as an actual distribution for purposes of determining the tax on the distribution, including any early withdrawal penalty. However, a deemed distribution is not treated as an actual distribution for purposes of determining whether a plan satisfies the limitations on in-service distributions. 26 C.F.R. §§ 1.403(b)-7(d), 1.72(p)-1, Q&A12, 13.

For more information on the rules for qualified plan loans, see Plan Loan Program and Plan Loan Program Checklist.

Exchanges and Transfers Not Treated as Distributions

Subject to applicable requirements, three types of in-service exchanges or transfers, described further in the following sections, are permitted without violating the 403(b) plan distribution (or nontransferability) rules:

  • Contract exchanges
  • Plan-to-plan transfers –and–
  • Asset transfers to governmental plans for purchase of permissive service credit

26 C.F.R. § 1.403(b)-10(b)(1); see also I.R.S. Retirement Plans FAQs regarding 403(b) Tax-Sheltered Annuity Plans.

Such exchanges and transfers are distinguished from rollovers (even direct rollovers from one plan to another). As discussed in the section entitled “Rollover Distribution Requirements” under Qualification Requirements above. Rollovers are available only when a distribution event has occurred. Remember that sponsors of non-ERISA 403(b) plans should not undertake any discretionary actions concerning such exchanges or transfers.

Contract Exchanges

A 403(b) annuity contract or custodial account can be exchanged for (1) another 403(b) contract or custodial account issued by an approved vendor under the same plan that receives plan contributions, or (2) another 403(b) contract or custodial account issued by a vendor that is not expressly authorized by the 403(b) plan terms (an unapproved vendor). However, an unapproved vendor exchange is permitted only if:

  • The 403(b) plan permits exchanges with unapproved vendors
  • The amount of the transferred accumulated benefit after the exchange is at least the same as before the exchange
  • The unapproved vendor’s contract is subject to distribution restrictions at least as stringent as the plan’s terms –and–
  • The 403(b) plan sponsor and the unapproved vendor enter an agreement to share information for tax reporting and plan compliance purposes (including information under 26 C.F.R. § 1.403(b)-10(b)(2)(i)(C))

26 C.F.R. § 1.403(b)-10(b)(2); Rev. Proc. 2007-71.

Plan-to-Plan Transfers

A 403(b) plan may transfer a contract or custodian account to a different employer’s 403(b) plan (e.g., on behalf of transferring employees upon a corporate transaction), subject to the following conditions:

  • The participant whose assets are being transferred is an employee (or former employee) of the employer (or business of the employer) sponsoring the receiving plan (or the assets belong to a beneficiary of such a participant)
  • The terms of both plans allow for such plan-to-plan transfers
  • The amount of the accumulated benefit after the transfer is at least the same as before the transfer
  • The receiving plan imposes distribution restrictions on the transferred assets that are at least as stringent as the transferring plan’s rules –and–
  • If the transferred assets are not the participant’s entire interest in the plan, then the receiving plan treats the amount transferred as a continuation of a pro rata portion of their interest in the transferring plan (e.g., with respect to pre-tax versus after-tax contributions)

26 C.F.R. § 1.403(b)-10(b)(3); Rev. Proc. 2007-71.

Certain Contract-to-Plan Transfers to Governmental Plans

A 403(b) plan may transfer assets held in the plan to an I.R.C. § 414(d) governmental defined benefit plan in three circumstances:

  • Purchase of permissive service credit. A governmental plan that allows participants to make voluntary contributions (in addition to any employee contributions required under the plan) to acquire deemed service credit that will be used for purposes of calculating plan benefits (so-called permissive service credit, described in I.R.C. § 415(n)(3)) may accept such
    additional permissive service credit contributions through the transfer from a 403(b) plan. 26 C.F.R. § 1.403(b)-10(b)(4)(ii)(A). This is an exception from the general rule prohibiting assets transfers between 403(b) plans and plans qualified under I.R.C. § 401(a) or eligible governmental deferred compensation plans under I.R.C. § 457(b). 72 Fed. Reg. 41,132.
  • Repayments of contributions. The assets from a 403(b) plan account can be transferred to a governmental plan where the amount is treated as a repayment of contributions for an amount previously refunded upon a forfeiture of service credit under the plan, as described in I.R.C. § 415(k)(3). 26 C.F.R. § 1.403(b)-10(b)(4)(ii)(B).
  • Rollovers. Participants may choose to roll over any eligible rollover distribution from a 403(b) plan to a governmental defined benefit that accepts rollovers. I.R.C. § 403(b)(8).

Implementation and Operation

To receive and maintain tax-favored treatment, 403(b) plans must comply in form and operation with the requirements described in this practice note. For plan document compliance, employers who adopt prototype and volume submitter pre-approved plans are able to rely on the IRS determination letter program established for pre-approved plans, described below under “Pre-approved 403(b) Plans.“ By contrast, sponsors of individually designed plans have no way to receive IRS blessing on their 403(b) plans, since the IRS decided not to adopt a determination letter program for such plans. See Rev. Proc. 2013-22, 2013-1 C.B. 985.

Adopting a pre-approved plan simplifies 403(b) plan administration for employers since the sponsor of the pre-approved plan is responsible for plan updates, among other things. Individually designed 403(b) plan sponsors must remain vigilant regarding required plan amendments due to changes to the Internal Revenue Code, Treasury Regulations, or other guidance published by the IRS.

All 403(b) plan sponsors (whether directly or via a third-party administrator) must ensure that the day-to-day operational requirements concerning eligibility, nondiscrimination, contributions, funding vehicles, and distributions continue to be satisfied. Non-ERISA 403(b) plan sponsors may take an active role in ensuring compliance (including facilitating corrections of noncompliance) without jeopardizing the plan’s safe harbor status. FAB 2007-02; Dep’t of Labor Information Letter (Feb. 27, 1996).

ERISA Considerations

If ERISA applies to the 403(b) plan (see ERISA Coverage of 403(b) Plans above), the plan must satisfy the disclosure and reporting obligations under ERISA Title I, such as:

  • Providing updated summary plan descriptions and, as needed, summaries of material modifications to participants for amendments
  • Making plan-related documents available
  • Filing Form 5500 annual reports
  • Meeting ERISA fiduciary responsibilities and avoiding prohibited transactions

For a summary of ERISA responsibilities, see ERISA Title I Fundamentals.

Pre-approved 403(b) Plans

The IRS has established a pre-approved 403(b) plan program for prototype and volume submitter plans. The sponsors of such pre-approved plans can obtain opinion or advisory letters on their plan designs, providing reassurance that their plan documents meet the necessary requirements. I.R.S. Announcement 2009-34, 2009-1 C.B. 916. The determination letter application procedures are found in Rev. Proc. 2013-22, as modified by Rev. Proc. 2014-28, 2014-1 C.B. 944, and Rev. Proc. 2015-22, 2015-1 C.B. 2015-11. Rev. Proc. 2019-4, 2019-1 I.R.B. 146.

For more information, see Pre-approved 403(b) Plans. See also IRS, 403(b) Pre-approved Plan Program – Key Provisions. The initial remedial amendment period for 403(b) plans will be March 31, 2020. This means that employers who adopt a pre-approved plan by that date can obtain retroactive relief for qualification defects arising since 2010. Rev. Proc. 2017-18, 2017-5 I.R.B. 743.

After receipt of the favorable opinion or advisory letter from the IRS, the pre-approved plan sponsor for a prototype plan or volume submitter plan must take the steps below to maintain compliance:

  • Amend plan for legal changes. Amend the plan pursuant to changes in the Internal Revenue Code, Treasury Regulations, or other guidance published by the IRS.
  • Document adopting employers. Maintain a written record of the eligible employers that have adopted the prototype plan or volume submitter plan. The list must include the names, addresses, and employer identification numbers of all eligible employers that, to the best of the plan sponsor’s knowledge, have adopted the plan. The plan sponsor must present the list
    to the IRS, if requested.
  • Disclose plan-related documents. Provide to the adopting employers the plan document, any restatements thereof, all amendments, and all opinion or advisory letters, in electronic or hard copy form, and comply with the notice requirements under the program or other written guidance.
  • Adopt notification procedures. Establish a procedure to notify adopting employers of plan amendments and restatements and of the need to timely adopt the plan and any plan restatements and the consequences for failing to do so or failing to operate the plan in accordance with plan changes.
  • Meet obligations upon discovery of noncompliance. Upon determining that a 403(b) preapproved plan as adopted by an employer may no longer satisfy the requirements of 403(b) (in a manner that is not or cannot be corrected by the preapproved plan sponsor under the EPCRS):
    • Notify the employer that the plan may no longer satisfy I.R.C. § 403(b)
    • Advise the employer that it may incur adverse tax consequences –and–
    • Inform the employer about the availability of the EPCRS

Rev. Proc. 2013-12, as modified by Rev. Proc. 2014-28 and Rev. Proc. 2015-22.

Pre-approved Plan Document Must Prevail over Conflicting Investment Arrangement

In the event of any conflict between the terms of the pre-approved plan and the terms of investment arrangements under the plan (or of any other documents incorporated by reference into the plan), the terms of the pre-approved plan must govern. An eligible employer may not rely on an opinion or advisory letter issued for a 403(b) pre-approved plan if any investment arrangement under the plan provides that the terms of the investment arrangement govern in the event of a conflict. Rev. Proc. 2013-12, § 4.01(9).

Limited Reliance

Even for pre-approved plans, however, the opinion or advisory letter addresses whether the plan document complies with I.R.C. § 403(b). It does not address ERISA requirements (if applicable), investment arrangement terms, other documents incorporated by reference, or whether the plan operates in a compliant fashion.

For general information on pre-approved plans, see
Pre-approved Plan Design and Compliance.

Correcting 403(b) Plan Errors

EPCRS for Qualification Errors

The Employee Plans Compliance Resolutions System (EPCRS) is the IRS correction program to address noncompliance issues in tax-favored retirement plans, including 403(b) plans. IRS guidance issued in 2013 substantially expanded the program’s application to 403(b) plans. The most recent iteration of EPCRS is found in I.R.S. Rev. Proc. 2018-52, 2018 IRB LEXIS 524 (effective as of January 1, 2019, updating Rev. Proc. 2016–51, 2016-2 C.B. 466), which incorporates intervening guidance regarding pre-approved 403(b) plans. See IRS, Updated Retirement Plan Correction Procedures for an overview.

The EPCRS can resolve 403(b) plan operational and documentation failures within one of the three EPCRS units:

  • Self Correction Program (SCP)
    • No filing with the IRS or penalty is involved, but the sponsor or administrator must have reasonably designed compliance practices and procedures in place.
    • Available for unintentional (1) operational violations that are either insignificant, or (2) nonegregious significant failures that are timely addressed (generally before the end of the year after the year the violation occurred).
    • Not available for documentation errors.
  • Voluntary Correction Program (VCP)
    • Formal filing with the IRS along with the payment of a penalty is required.
    • Available for (1) documentation errors (i.e., failing to have, or follow the terms of, a compliant plan document), and (2) operational failures.
    • Results in a compliance statement showing IRS approval of proposed correction method.
  • Audit Closing Agreement Program (Audit CAP)
    • Program for plans under IRS audit.
    • Involves negotiated correction of an identified failure and the payment of a sanction varying depending on nature and severity of the error.

Common 403(b) plan errors corrected under SCP include failures to follow the terms of the plan document, to permit eligible employees to make salary deferrals in violation of the universal availability rule, and to comply with the annual addition limits in I.R.C. § 415. The VCP must be used for documentation errors, including to unwind a plan upon discovery that the employer is not eligible to sponsor a 403(b) plan, to correct a plan document that fails to satisfy the applicable requirements, and to correct a failure to follow the plan document or a significant operational failure after the SCP timeliness limit.

Significance of an error is based on the facts and circumstances, taking into consideration factors such as the extent, scope, and duration of the violation, the percentage of plan assets involved and number/percentage of participants affected, the timeliness of correction, and the reason for the failure.

Fiduciary Violations

Common 403(b) plan errors corrected under SCP include failures to follow the terms of the plan document, to permit eligible employees to make salary deferrals in violation of the universal availability rule, and to comply with the annual addition limits in I.R.C. § 415. The VCP must be used for documentation errors, including to unwind a plan upon discovery that the employer is not eligible to sponsor a 403(b) plan, to correct a plan document that fails to satisfy the applicable requirements, and to correct a failure to follow the plan document or a significant operational failure after the SCP timeliness limit.
Significance of an error is based on the facts and circumstances, taking into consideration factors such as the extent, scope, and duration of the violation, the percentage of plan assets involved and number/percentage of participants affected, the timeliness of correction, and the reason for the failure. 71 Fed. Reg. 20135 (April 19, 2006); Dep’t of Labor, Voluntary Fiduciary Correction Program.

General IRS Correction Guidance

The I.R.S. 403(b) Plan Fix-It Guide also serves as a quick reference for practitioners handling potential 403(b) plan mistakes. This guide contains information on how to identify and avoid errors, along with corrective actions. The Guide contains links to other relevant IRS resources on 403(b) plan rules and compliance topics.

Terminating 403(b) Plans

The 403(b) plan regulations explicitly permit employers to terminate their plans. 26 C.F.R. § 1.403(b)-10(a)(1); see also Rev. Rul. 2011-7, 2011-1 C.B. 534 (analyzing the termination of 403(b) plans and an annuity benefit money purchase plan).

In some circumstances, however, plan termination is not possible. As a precondition to termination, all plan assets must be distributed. Id. However, in some cases, plan sponsors cannot distribute some custodial accounts because the participants have not cooperated. The regulation states that “delivery of a fully paid individual insurance annuity contract is treated as a distribution,” but does not refer at all to a custodial account. 26 C.F.R. § 1.403(b)-10(a)(1). And vendors of custodial accounts often take the position that because the contracts are owned by the participants, the plan sponsor has no right to force a distribution of cash without participant consent. In some cases, participants with custodial accounts cannot be cashed out because they cannot be located or refuse to consent to the distribution. This issue was highlighted in ACT, 2015 Report of Recommendations, pp. 43-48.

The inability to terminate a 403(b) plan extends the obligations of the sponsor (e.g., if covered by ERISA, it must continue to file an annual Form 5500). A sponsor that attempts to terminate a plan without fully complying with the rules risks tainting the termination and invalidating any rollover distributions made to participants who would not have had a distribution event were it not for termination of the plan.

EP Subcommittee Report: 403(b) Plan Issues and Recommendations

A 2015 report by the Employee Plans (EP) Subcommittee of the IRS’s Advisory Committee on Tax Exempt and Government Entities (ACT), titled “Employee Plans: Analysis and Recommendations Regarding 403(b) Plans,” analyzes several issues affecting 403(b) plans and their sponsors. ACT, 2015 Report of Recommendations, pp. 15-83. The report identifies specific areas of widespread noncompliance and recommends enhanced IRS formal or “soft” guidance and educational outreach. These areas of concern include the following:

  • Universal availability nondiscrimination rule. As discussed above, many employers, particularly those with many short-term or part-time personnel, struggle over interpreting or implementing the universal availability rule regulations. Others are simply unaware of its existence. But the consequences of noncompliance are severe (disqualification of the plan in its entirety). The subcommittee recommended steps to increase awareness of the rule and singled out employee exclusion rules as an area deserving further clarification.
  • Orphan 403(b) contracts. The 403(b) regulations required written plans to be in place generally by 2010, and for available contract vendors to be listed in the plan documentation. Plan sponsors are also required to coordinate plan administration with the vendors of former contracts via information-sharing agreements if any further contributions were to be made during
    or after 2008. 26 C.F.R. § 1.403(b)-10(b). So-called orphan contracts, issued before 2009 and frozen to new contributions (as described in Rev. Proc. 2007-71) raise some compliance questions not directly addressed in the regulations. For example, there is uncertainty as to whether operational compliance under an employee’s orphan contract could taint the status of his
    or her active 403(b) plan contracts and accounts.
  • 403(b) plan terminations. The EP Subcommittee raised the issue discussed above under Terminating 403(b) Plans wherein some employers intending to terminate a 403(b) plan are unable to because of participant or vendor noncooperation or due to missing participants. Recommendations include further clarification of the current IRS position and, if possible, creation of a good faith or de minimis rule allowing employers to treat their 403(b) plans as terminated.

The EP Subcommittee also had several recommendations to improve the EPCRS program as it relates to 403(b) plans:

  • Expand the SCP to allow corrections of certain plan loan errors.
  • Extend the availability of the DOL’s VFCP Earnings Calculator to compute lost earnings in more circumstances.
  • Develop new VCP schedules focused specifically on common 403(b) plan problems.
  • Consider lower fees for 403(b) plan sponsors due to their nonprofit status.

ACT, 2015 Report of Recommendations, pp. 49–55.

Advantages and Disadvantages of 403(b) Plans

Compared with a qualified plan such as a 401(k) plan, a 403(b) plan has several advantages:

  • Simplicity. Often vendors will fulfill most functions.
  • No nondiscrimination testing required. A 403(b) plan avoids the actual deferral percentage (ADP) test applicable to elective contributions in 401(k) plans and merely requires that elective contributions be universally available. This simplifies testing for the employer and means that highly compensated employees will not have their contributions limited because lower paid employees make low or no contributions.
  • Plan language available. The IRS provides prototype language that can be used directly by preapproved plans and as a guide for individually designed plans.
  • Generous catch-up contributions. Catch-up limitations on elective deferrals are more favorable than for 401(k) plans.
  • Limited excise taxes. Excise taxes on excess contributions apply only if the 403(b) contract is a custodial account described in I.R.C. § 403(b)(7), as opposed to an annuity contract.
  • Excess contributions do not disqualify plan. If excess contributions are made, only the amount in excess of the contribution limits is taxable, as opposed to disqualifying the entire plan due to the separate accounting rules under 26 C.F.R. § 1.403(b)-3.
  • Ability to avoid ERISA for nongovernmental/nonchurch employers. By adopting a non-ERISA 403(b) plan, an eligible 403(b) plan sponsor that would normally be subject to ERISA can avoid ERISA coverage.

Notwithstanding the advantages noted above, 403(b) plans have some disadvantages compared with qualified plans that need to be considered:

  • Employees, particularly those who have not previously worked for tax-exempt or governmental employers, may have less familiarity with 403(b) plans.
  • Hardship withdrawals are available only for elective deferrals themselves, not for income on them as they would be under a 401(k) plan.
  • In-service withdrawals are available for employer contributions only upon attainment of age 59½. This contrasts with a 401(k) plan, which can provide for in-service withdrawals of employer contributions as early as:
    • Five years after the employee begins plan participation –or–
    • Two years after the money is contributed to the plan (Rev. Rul. 1968-24, 1968-1 C.B. 150; Rev. Rul. 71-295, 1971-2 C.B. 184)
  • Some states (e.g., New Jersey and Pennsylvania) impose income taxes on all 403(b) contributions.
  • Fewer providers and more limited types of providers for 403(b) plans may result in relatively higher fees.

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New article: Section 403(b) Plan Design and Compliance
(Posted on December 5, 2018 by )


Lexis Practice Advisor articleA new article, Section 403(b) Plan Design and Compliance, discusses the rules that apply when eligible tax-exempt organizations establish tax-sheltered annuities, custodial accounts, or retirement income accounts, as described in Section 403(b) of the Internal Revenue Code (403(b) plans).

This article addresses the following topics:

Read more.

New Article: Pre-Approved 403(b) Plans
(Posted on November 29, 2018 by )


Internal Revenue ServiceIn March 2017, the Internal Revenue Service (IRS) began issuing advisory and opinion letters to the first preapproved retirement programs described in Internal Revenue Code (I.R.C.) § 403(b) (403(b) plans). A new article, Pre-Approved 403(b) Plans, discusses preapproved 403(b) plans, including their advantages, legal pitfalls, and other issues that an eligible employer may consider when determining whether to convert its existing 403(b) plan into a preapproved plan.

The major topics are:

Read more.

Preapproved 403(b) Plans
(Posted on November 29, 2018 by )


Go to: What Is a 403(b) Plan?|What Is a Pre-approved 403(b) Plan?|What Are the Advantages of a Pre-approved 403(b) Plan?|What Are the Legal Pitfalls of a Pre-approved 403(b) Plan?|What Operational Issues Can Arise for a Pre-approved Plan?|What Practical Issues Can Arise for a Pre-approved Plan?|When Should an Employer Adopt a Pre-approved 403(b) Plan?|Can the Employer Cure Past Plan Issues by Adopting a Pre-approved 403(b) Plan?|What Should an Employer Do If It Did Not Comply with the Written Plan Document Requirement in the Past?

This practice note discusses pre-approved Internal Revenue Code (I.R.C.) § 403(b) plans (403(b) plans), including their advantages, legal pitfalls, and other issues that an eligible employer may consider when determining whether to convert its existing 403(b) plan into a pre-approved plan. In March 2017, the Internal Revenue Service (IRS) began issuing advisory and opinion letters to the first pre-approved retirement programs described in I.R.C. § 403(b).

This practice note discusses:

For discussion of 403(b) plan requirements, design, and operation, see Section 403(b) Plan Design and Compliance. For discussion of 403(b) plans in general, see Employee Compensation and Benefits Tax Guide P 502, 502.14.

What Is a 403(b) Plan?

A 403(b) plan is a type of retirement plan providing for deferred taxation on certain contributions and earnings made by specific kinds of tax-exempt organizations (primarily, public schools and I.R.C. § 501(c)(3) tax-exempt organizations) for their employees and by certain ministers. I.R.C. § 403(b)(1). 403(b) plans are defined contribution plans, with the exception of certain grandfathered church defined benefit plans. 26 C.F.R. § 1.403(b)-10(f)(1).

For the participant, a 403(b) plan appears much like a 401(k) plan in that it provides for an individual account for each participant (except in the case of grandfathered church defined benefit plans). However, 403(b) plans are funded by an annuity contract with an insurance company, a custodial account, or a retirement income account—as opposed to a trust—and investment options are more limited. In addition, 403(b) plans are subject to some, but not all of the requirements that apply to 401(k) and other retirement plans qualified under I.R.C. § 401(a).

Public schools and universities and I.R.C. § 501(c)(3) nonprofit organizations have for many years maintained 403(b) plans, sometimes referred to as tax-deferred annuities or tax-sheltered annuities. When I.R.C. § 403(b) was enacted, its provisions were fairly simple. However, over time, 403(b) plans have become more complex, both in the types of plans available and in the legal requirements applicable to them. For example, prior to December 31, 2009, 403(b) plans were not subject to the plan document requirement, which was imposed by regulations issued in 2007. 72 Fed. Reg. 41,128 (July 26, 2007) (the effective date of which was delayed by I.R.S. Notice 2009-3, 2009-1 C.B. 250). Today, they resemble the better-known 401(k) plans.

For more information on the I.R.C. requirements applicable to 403(b) plans, see Section 403(b) Plan Design and Compliance.

Requesting IRS Ruling Letters for 403(b) Plans

As the requirements for 403(b) plans have become more complex, employers have often sought assurances from the IRS that their plans meet the legal requirements. At one time, employers would typically obtain ruling letters from the IRS. However, in Rev. Proc. 2013-22, 2013-1 C.B. 985, the IRS announced that it would no longer issue such letters to individual employers. Instead, it would issue only advisory or opinion letters to sponsors of pre-approved plans.

The guidance on requesting advisory or opinion letters on pre-approved plans is contained in Rev. Proc. 2013-22, as modified by Rev. Proc. 2014-28, 2014-1 C.B. 944, and clarified by Rev. Proc. 2017-18, 2017-5 I.R.B. 743, and Rev. Proc. 2015-22, 2015-11 I.R.B. 754. See also IRS, 403(b) Pre-Approved Plan Program FAQs.

What Is a Pre-approved 403(b) Plan?

A pre-approved plan is a form plan document developed by a plan sponsor for use by at least 15 different employers, except that a church-related organization is eligible to sponsor a 403(b) prototype plan that is intended to be a retirement income account under I.R.C. § 403(b)(9) without regard to the number of eligible employers that are expected to adopt the plan. Rev. Proc. 2014-28, Section 3.02; Rev. Proc. 2013-22, Section 11.01. The plan document will include certain required provisions, but allow for an employer to choose various permissible options. Rev. Proc. 2013-22, Sections 8.04-8.10 and 4.01. A pre-approved 403(b) plan may take one of three forms, and can generally be adopted by any eligible employer for any type of 403(b) plan, with certain exceptions, as discussed in the following sections.

What Types of Pre-approved 403(b) Plans Are Available?

Employers may choose among three types of pre-approved 403(b) plans. Pre-approved 403(b) plans may take one of three forms:

  • Standardized prototype plans
  • Nonstandardized prototype plans
  • Volume submitter plans

A prototype plan receives an opinion letter from the IRS if it is found to meet the 403(b) requirements. For a volume submitter plan, the letter is referred to as an advisory letter.

Standardized and Nonstandardized Prototype Plans

A prototype plan (standardized or nonstandardized) takes the form of a basic plan document and an adoption agreement. The basic plan document contains all provisions that are the same for all employers. The adoption agreement contains choices regarding certain plan features and the employer checks boxes to indicate which features it wants to adopt. For example, the basic plan document might provide for the investment choices available but the adoption agreement might allow the employer to choose to allow for employee pretax deferrals, employee after-tax contributions, Roth contributions, employer matches, employer mandatory contributions, employer discretionary contributions, or some combination.

In the case of a prototype plan, the employer may not make any changes to the plan or the plan will be treated as an individually designed plan. The employer would then lose the protection of the IRS opinion letter issued to the plan sponsor. In some instances, a plan sponsor chooses the prototype form specifically for this reason. For example, a firm that provides an investment platform for the plan may offer a prototype plan document specifying that only the investment options provided in that platform are permissible options for investment by the plan. As another example, a third-party administrator may find administration more efficient if all of its employer clients have the same plan document.

Difference between Standardized and Nonstandardized Plans

A standardized 403(b) prototype plan allows employee salary deferrals. If it allows other types of contributions, the plan must:

  • State they will be made for all eligible employees
  • Make all benefits, rights, and features of the plan available to all benefiting employees
  • Have provisions for allocating employer nonelective contributions that meet I.R.C. § 401(a)(4) design-based safe harbor provisions
  • Define compensation in a way permissible under:
    • I.R.C. § 415(c)(3) (disregarding I.R.C. § 415(c)(3)(E) (i.e., elective deferrals under I.R.C. § 402(g)(3) and employer contributions not includible in the employee’s gross income by reason of I.R.C. §§ 125, 132(f)(4), or 457))) –or–
    • 26 C.F.R. § 1.414(s)–1(c)

Rev. Proc. 2013-22, Section 6.01.

A nonstandardized 403(b) prototype plan is a plan that doesn’t meet the requirements to be a standardized plan. One example of such a plan would be a 403(b) prototype plan that allows the adopting employer to select (in the adoption agreement) a method for allocating nonelective employer contributions that isn’t an I.R.C. § 401(a)(4) design-based safe harbor, and therefore must meet the I.R.C.’s nondiscrimination testing rules (except in the case of the plan of a public school or university or a church, who are exempt from such testing).

Volume Submitter Plan

A volume submitter plan is based on a sample plan, known as a specimen plan, which can take the form of a basic plan document and an adoption agreement, as with prototype plans. In the alternative, it can take the form of a single plan document from which all provisions not selected by the employer are removed. The latter approach takes more work on the part of the plan sponsor but may be less confusing to the employer.

The major advantage of a volume submitter plan is that an employer is permitted to make changes to the plan, so long as they are not material, without having the plan lose its status as a volume submitter plan. In many instances, a law firm or consultant will offer a volume submitter plan in order to give adopting employers the most flexibility in individualizing the plan.

Employers must take care to ensure that any amendments are not material, so as not to jeopardize the plan’s pre-approved status. An employer that makes minor changes to a volume submitter plan can request a determination letter on the modified plan.

Which Types of 403(b) Plans May Use a Pre-approved Plan Document?

A 403(b) plan can be a pre-approved plan unless it is one of the following types of grandfathered plans:

  • Church 403(b) defined benefit plans. Section 251(e)(5) of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), P.L. 97-248, permitted certain arrangements established by a church-related organization and in effect on September 3, 1982 (TEFRA church defined benefit plans) to be treated as I.R.C. § 403(b) contracts even though they are defined benefit arrangements, though such arrangements cannot be pre-approved plans.
  • Self-insured state and local governmental 403(b) plans. Rev. Rul. 82-102, 1982-1 C.B. 62, reversed previous rulings that had permitted certain arrangements that were neither annuities nor custodial accounts to be treated as 403(b) plans. However, it provided that the revenue ruling would not be applied to an arrangement established by an employer on or before May 17, 1982, if (1) the contract(s) issued pursuant to the arrangement (including self-insured arrangements) would have met the requirements of I.R.C. § 403(b) except that the contract(s) was not purchased from an insurance company, and (2) the arrangement only covered current and future employees of that employer. Such arrangements can be individually designed 403(b) plans, but cannot be pre-approved plans.

Rev. Proc. 2013-22, Section 13.04. In the case of self-insured state and local governmental 403(b) plans, the employer may wish to modify the plan to provide for investment in annuities or custodial accounts, at least going forward.

If a church wishes to continue to offer a 403(b) defined benefit plan, it will likely have to do so without an IRS approval letter. Even if it already has a ruling on its plan document, it will have to monitor carefully future changes in law, regulations, or administrative guidance to ensure that its plan does not go out of compliance.

What Organizations Sponsor Pre-approved Plans?

A wide variety of organizations, ranging from law firms to church benefit boards, sponsor plans. A complete list of those plan sponsors that have applied for IRS opinion or advisory letters can be found here.

What Are the Advantages of a Pre-approved 403(b) Plan?

The primary advantages of pre-approved 403(b) plans over individually designed plans are:

  • Cost. Drafting one plan document for 15 or more employers costs less per employer than drafting a plan just for one employer. The reduction in cost typically gets passed on to the adopting employers. In some instances, a plan sponsor may even offer the plan document free for those employers that use other bundled services (e.g., investment services or third-party administration services).
  • Reliance. An advisory or opinion letter from the IRS provides assurances that a plan meets IRS requirements. Even if the IRS later changes its interpretation of a particular legal requirement, it will typically provide retroactive relief to plans that have obtained such letters. In contrast, there is no determination letter program for individually designed 403(b) plans.
  • Ability to correct retroactively. If an employer amends its plan document to take the form of a pre-approved 403(b) plan, the IRS will allow it to correct certain past errors without penalty. Rev. Proc. 2017-18, Section 3. Because there is no determination letter program for individually designed 403(b) plans, there is no provision for retroactive correction.
  • Updates. A plan document must be revised to reflect new legislative, regulatory, and administrative requirements as they are created. As with the initial plan drafting, plan sponsors can amend pre-approved plan documents at less cost per employer as compared to the cost associated with drafting amendments for many individual employers.
  • Bundled third-party services. A pre-approved plan is often part of “one-stop shopping” for the employer. The plan sponsor or an affiliate may also provide investment choices under the plan and third-party administrative services. This saves the employer from having to find different vendors for each of the functions under the plan. In addition, the vendors may be able to operate more efficiently if they need to become familiar with only one plan document, instead of a different one for each employer.

In many instances, employers adopting a pre-approved plan assume that if the plan is issued by a well-established sponsor and has an IRS opinion or advisory letter, the employer need not obtain any kind of legal review of the plan. However, as discussed in the following sections, there are a number of legal and practical issues that may arise even if the plan document itself is pre-approved.

What Are the Legal Pitfalls of a Pre-approved 403(b) Plan?

There are legal pitfalls of a pre-approved 403(b) plan. An advisory or opinion letter on a pre-approved plan will not cover certain issues:

  • The advisory or opinion letter will not cover whether investment agreements such as annuity or custodial account agreements meet all legal requirements, even if they are incorporated into the 403(b) plan document. This issue arose when participants in retirement plans for 12 major universities sued plan fiduciaries asserting breaches of fiduciary duty arising from allegedly excessive fees for administrative and investment management services, imprudent selection and monitoring of recordkeepers and investment options, underperforming plan investment options, and the offering of too many investment options (leading to decision paralysis on the part of the participants). See Doe v. Columbia Univ. et al (S.D.N.Y. filed Aug. 16, 2016).
  • The advisory or opinion letter will not address whether the plan is subject to the Employee Retirement Income Security Act (ERISA) and, if so, whether it meets ERISA’s requirements.
  • The advisory or opinion letter will not cover whether the plan operates in such a way as to meet the I.R.C.’s requirements (as opposed to just the plan document meeting such requirements).

Moreover, the advisory or opinion letter merely assures that the plan meets I.R.C. requirements. It does not assure that the plan will meet a particular employer’s objectives or that the terms of the plan are understandable or easy to apply. In many instances, employers assume that if a plan is pre-approved, they need not obtain any kind of review of the plan before adopting it. This can be risky if, for example, the terms of a plan are not what the employer intended or are so unclear that the employer unwittingly violates IRS or Department of Labor (DOL) rules in operating the plan.

What Operational Issues Can Arise for a Pre-approved Plan?

The IRS has identified some common issues that may occur, even if the plan language meets legal requirements. These operational issues include:

  • Adoption by an ineligible employer. Nonprofits other than those described in I.R.C. § 501(c)(3), such as unions or trade associations, cannot sponsor 403(b) plans. These failures sometimes occur due to a change in the employer, such as when a private nonprofit hospital that maintains a 403(b) plan is taken over by a governmental entity that is ineligible to maintain the 403(b) plan.
  • Excess contributions, including:
    • Violating the 15-year catchup rule under I.R.C. § 402(g)(7) (which permits certain additional 403(b) contributions by employees of an adopting employer who have at least 15 years of full-time service with the same employer if the employer is an educational organization, hospital, home health service agency, health and welfare service agency, church, or convention or association of churches) –and–
    • Violating the maximum aggregate limit on employer and employee contributions (the annual additions limit) under I.R.C. § 415(c)

    Violation of these limits frequently occurs when an employee participates in more than one 403(b) plan and the employer fails to take account of contributions to one plan when determining the limits on contributions to the other(s).

  • Excluding eligible employees from participation:
    • Eligible employees include part-time employees that would qualify to participate. With very limited exceptions (e.g., employees who normally work less than 20 hours per week), all employees must be permitted to make pretax contributions to a 403(b) plan if any employee is permitted to make such contributions. I.R.C. § 403(b)(12)(i). This is known as the universal availability rule. Compliance with the universal availability rule is especially an issue with casual employees such as substitute teachers, as the hours they will work are impossible to know in advance.
    • Contributions other than pretax (or Roth, if permitted) employee contributions must be tested to ensure the employer does not impermissibly discriminate in favor of highly compensated employees under the nondiscrimination rules. I.R.C. § 403(b)(12)(ii). If the employer excludes certain individuals from the calculation of the number of eligible employees under the plan, this will skew the nondiscrimination testing.

    Churches are exempt from both the universal availability rule and the nondiscrimination rules by reason of I.R.C. § 403(b)(1)(D), and governmental employers are exempt from the nondiscrimination rules by reason of I.R.C. § 403(b)(12)(C).

    Issues with either the universal availability rule or the nondiscrimination rules can arise, for example, if an employer excludes individuals, it believes to be independent contractors from the plan and the IRS later determines that such individuals are employees.

  • Plan loan issues. Plan loan issues arise when (1) participants fail to make required payments when due, resulting in default of the entire loan; (2) loans are poorly documented; and (3) when loans from multiple vendors result in the aggregate of plan loans to one participant exceeding permissible limits. (I.R.C. § 72(p) provides limits on the maximum amount of loans, and I.R.C. § 72(p)(2)(D) provides that all plans of an employer and its controlled group are aggregated for purposes of applying the limits.)
  • Hardship withdrawal issues. These include failure to obtain documentation of the hardship or distributions from multiple vendors that exceed the amount necessary to relieve the hardship. (I.R.C. § 403(b) requires that distributions not begin before age 59½, severance from employment, death, or disability, except in the case of hardship. 26 C.F.R. § 1.401(k)-1(d)(3) requires that the determination of the existence of an immediate and heavy financial need and of the amount necessary to meet the need must be made in accordance with nondiscriminatory and objective standards set forth in the plan, and that the amount cannot exceed the amount necessary to relieve the hardship.)

For further discussion of issues related to 403(b) and 457 plans, see Top Ten Issues For IRC 403(b) and 457 Plans.

What Practical Issues Can Arise for a Pre-approved Plan?

Even if a 403(b) plan meets all IRS requirements, certain provisions may cause practical pitfalls for the employer. Counsel employers to be mindful of the following issues:

  • Plan provider issues. These include issues with responsibilities, indemnification, and resolution of claims against the plan provider. For example, the plan may call for the provider to handle certain administrative requirements. However, if those requirements are not handled in an acceptable manner, participants may sue the employer, but the plan may not give the employer any recourse against the provider or indemnification against liability that the employer may have to participants. Or the plan may provide that such claims must be resolved through arbitration rather than lawsuits or those lawsuits must be filed in the plan sponsor or practitioner’s home state (which may be far from where the employer is located).
  • Insufficiency of plan provisions to protect the employer. While the advisory or 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.
  • Poor plan communications. Many lawsuits are based on plan communications. An employer with a 403(b) plan subject to ERISA should ensure that the Summary Plan Description (SPD) and all other employee communications accurately describe the essential provisions of the pre-approved plan. See, e.g., Burstein v. Retirement Account Plan for Employees of Allegheny Health Education and Research Foundation, 336 F.3d 365 (3d Cir. 2003), in which the court found that when an SPD conflicted with the terms of a plan, the terms of the SPD controlled. In the case of a plan of a public school, the formal SPD requirements do not apply but the public school maintaining the plan typically uses some form of summary to communicate plan features to participants.
  • Failure to correctly identify whether the plan is subject to ERISA and to adopt an appropriate document. Governmental plans (403(b) plans of public schools or universities) are exempt from ERISA. Church plans are exempt from ERISA unless they have made an election to be covered by it. ERISA § 4 (29 U.S.C. § 1003). The 403(b) plans of other nonprofits are subject to ERISA unless they provide only for employee deferrals and have minimal levels of employer involvement. 29 C.F.R. § 2510.3-2(f).
    Use of a non-ERISA 403(b) plan document for an ERISA plan, or use of an ERISA plan document for a non-ERISA plan, can create problems for the employer. An ERISA 403(b) plan is subject to a variety of reporting, disclosure, fiduciary, and prohibited-transaction rules. If an employer adopts a plan document designed for a non-ERISA plan when its plan is subject to ERISA, it may not be aware of the ERISA requirements with which it needs to comply. Conversely, if an employer adopts a plan document designed for an ERISA plan when its plan is not subject to ERISA, it may contractually subject itself to requirements with which it would not otherwise be required to comply. This can be a particularly serious issue in the case of the prohibited transaction requirements of ERISA § 406 (29 U.S.C. § 1106). Prohibited transactions requirements prohibit certain transactions between a plan and certain closely related entities. A plan that is subject to such requirements under ERISA can apply for an exemption from the DOL, whereas a plan that is subject to them under contract may be unable to escape them at all.

    For a checklist describing ERISA prohibited transactions, see Prohibited Transaction and Parties in Interest Checklist (ERISA Rules).

When Should an Employer Adopt a Pre-approved 403(b) Plan?

The IRS issued the first opinion and advisory letters on pre-approved plans in March 2017. Rev. Proc. 2017-18, 2017-05 I.R.B. 743, announced that employers have until March 31, 2020 to convert their 403(b) plans to pre-approved form.

Best Practice Is to Adopt a Pre-approved 403(b) Plan Early

There are advantages to adopting early. A 403(b) plan is required to operate in accordance with IRS requirements, even if the plan document has not yet been amended to incorporate such requirements. To prevent the confusion that can result if the rules under which the plan must operate differ from what is stated in the plan document, an employer will typically want to use the pre-approved document as soon as possible.

Can the Employer Cure Past Plan Issues by Adopting a Pre-approved 403(b) Plan?

Rev. Proc. 2013-22, as clarified by Rev. Proc. 2017-18, announced relief for an employer that adopted a formal written document in order to satisfy the written plan requirements in the 403(b) regulations by the later of January 1, 2010, or the plan’s effective date. Such an employer can retroactively correct defects in the form of its plan by either adopting a 403(b) pre-approved plan or otherwise amending its 403(b) plan on or before March 31, 2020.

What Should an Employer Do If It Did Not Comply with the Written Plan Document Requirement in the Past?

If the organization did not have a written plan document by the deadline, the IRS will permit the issue to be corrected using the principles of the Employee Plans Compliance Resolution System (EPCRS). The details of EPCRS can be found in Rev. Proc. 2018-52, 2018 IRB LEXIS 524.

For further discussion of correction of 403(b) plan errors under EPCRS, see Section 403(b) Plan Design and Compliance — Correcting 403(b) Plan Errors.

Consult Legal Counsel to Avoid IRS and DOL Scrutiny

Pre-approved 403(b) plans can provide significant advantages to nonprofit employers and public schools and universities. However, they do not provide complete assurances that the plan will in operation meet IRS requirements or that it will meet employer needs. Legal advice is still critical to avoid both IRS and DOL scrutiny and potential participant lawsuits.

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


Lexis Practice AdvisorTax-exempt organizations face special legal challenges in developing compensation packages for their executives. A new article published in the Lexis Practice Advisor provides practical guidance on developing benefits for executives of nonprofits.

This article is divided into the following main topics:

Read more.

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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