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July 2016 Benefits News

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IRS Issues Proposed Regulations Under Code Section 457 for Tax-Exempt and Governmental Plans

Evan Giller

After many years of anticipation, the IRS has finally issued proposed new rules governing non-qualified deferred compensation plans for tax-exempt and governmental employers under Code section 457. These rules were needed, in part, to clarify certain important definitions under section 457 and also to explain the relationship between 457(f) and another Code section that applies to deferred compensation plans, 409A. These new regulations address some important questions that affect how an employer can design a 457(f) plan.

Code section 457 generally governs non-qualified deferred compensation plans established by most tax-exempt and governmental employers (plans established by qualifying churches are exempt). A plan under 457(b) is an “eligible plan” and is subject to certain rules, including a limit on contributions. If a plan does not meet the rules under 457(b), it is considered an “ineligible” plan and is subject to 457(f). Amounts deferred under a 457(f) plan on behalf of a plan participant are not included in the participant’s income so long as the amounts are subject to a “substantial risk of forfeiture”. There are also a number of plans that defer compensation but are specifically exempt from the rules of 457, such as bona fide severance plans and sick leave and vacation leave plans. The proposed regulations cover many issues relating to the design and operation of 457(b) and 457(f) plans. In this article, we are going to focus on some of the rules that apply to 457(f) plans and how these rules may affect the design of these plans going forward.

Substantial Risk of Forfeiture

The proposed regulations provide that an amount to which an employee has a legally binding right under a 457(f) plan is generally includible in gross income on the later of the date the employee obtains the legally binding right to the compensation or the date the substantial risk of forfeiture lapses. An amount is subject to a substantial risk of forfeiture only if the employee must perform substantial services for the employer in the future, or upon the occurrence of a condition that is related to a purpose of the compensation, as long as the possibility of forfeiture is substantial. This means that a substantial risk of forfeiture provision can be established as requiring a number of years of substantial service for the employer, or requiring that the employee meet certain performance goals. However, the performance goals must be significant enough to create a substantial risk. If an employee does not provide the required number of years of service or meet the performance goals, his or her account will be forfeited. However, the IRS warned in the preamble to the regulations that if the employer has a pattern of not enforcing the forfeiture provision, it will not recognize a provision as creating a substantial risk. The regulations also make clear that a valid substantial risk of forfeiture provision can provide that the employee be entitled to payment if the employee experiences an involuntary severance from employment without cause, as long as the possibility of forfeiture is substantial.

Non-Competition Agreements

In the past, some 457(f) plans were designed so that a substantial risk of forfeiture existed as long as an employee complied with a non-competition agreement. Unlike the rules under Code section 409A, the proposed 457(f) regulations provide that requiring an employee to comply with a non-competition agreement can create a substantial risk of forfeiture, as long as the following conditions are met:

  1. The right to receive the compensation must be conditioned on a written non-competition agreement that is enforceable under applicable law;

  2. The employer must make regular efforts to validate compliance with the non-competition agreement;

  3. The facts and circumstances must show that the employer has a substantial and bona fide interest in preventing the employee from performing the prohibited services and that the employee has a bona fide interest in engaging, and an ability to engage, in the prohibited services.

Elective Deferrals and “Rolling Risk of Forfeitures”

Previous IRS guidance suggested that section 457(f) plans could not allow an employee to contribute elective deferrals to a plan. Similarly, the guidance generally did not permit a “rolling risk of forfeiture”, or extending the forfeiture period from the original lapse date to some date in the future. The proposed regulations provide specific rules under which these designs may be permitted. First, the present value of the amount that the employee will receive when the substantial risk of forfeiture lapses must be at least 125% of the amount that the participant would have otherwise have received absent the elective deferral or the extension of the forfeiture period. As a practical matter, this means that if a 457(f) plan is going to allow an employee to electively defer compensation, the plan will need to have an employer contribution (such as a matching contribution) as well. Second, the initial or extended substantial risk period must be based upon the future performance of substantial services or adherence to an agreement not to compete and must be for a period of at least two years. Finally, there must be an agreement in writing entered into prior to the year that the services will be performed or within 90 days of the lapse of an existing substantial risk period. This rule is not the same as the rule under 409A, and the regulations advise that there is to be no implication that this rule applies to 409A.

Bona Fide Severance Pay Plans

While Code section 457(e)(11) exempts a bona fide severance pay plan, there had never previously been a definition of such a plan in the regulations. The proposed regulations fill that gap by generally (although not completely) adopting the definition for similar plans in Code section 409A:

  1. The benefits provided under the plan must be payable only upon a participant’s involuntary severance from employment or pursuant to a window program (defined as a program, offered for a limited period of time typically no longer than 12 months, that provides severance pay in connection with an impending severance from employment) or a voluntary early retirement incentive plan;

  2. The amount payable under the plan with respect to a participant must not exceed two times the participant’s annualized compensation;

  3. The severance benefits must be paid no later than the last day of the second calendar year following the calendar year in which the severance from employment occurs.

Bona Fide Sick Leave and Vacation Leave Plans

The regulations generally provide that a sick leave or vacation leave plan will be treated as bona fide, and not subject to 457(f), if the facts and circumstances show that the primary purpose of the plans is to provide employees with sick time or vacation leave. But the regulations suggest that a plan might not be considered as bona fide if it provides for an excess amount of leave time to be accumulated, or if the plan provides that the payment of unused sick or vacation leave is not made promptly upon severance from employment (or, instead, it is paid over a period of time after severance from employment), and whether the plans are available only to certain employees.

Relationship to Code Section 409A

The regulations make clear that deferred compensation arrangements under 457(f) are also subject to Code section 409A. This means that these plans must be designed to meet the requirements of both sections of the Code. While these regulations will eliminate some of the variations between the two sections, there are still some important differences and plans need to be drafted carefully to make sure that they comply with all the applicable rules. For example, while a 457(f) plan may create a substantial risk of forfeiture based on a non-competition clause, that same clause will generally not qualify as a substantial risk of forfeiture under 409A. That means that such a plan will need to comply with the different rules under each statute, increasing the complexity of its design and operation.

Effective Date

Generally, the proposed regulation will apply to compensation deferred under a plan for calendar years beginning after they are finalized. However, the regulations may rely on the proposed regulations before that date. There does not appear to be any transitional rules available for existing plans that do not comply with these regulations.


The new proposed regulations under Code section 457 contain many important changes and clarifications that will have an impact on the design on non-qualified deferred compensation plans under 457(f), including many that we have not addressed in this article. The proposal may also affect the operation of existing plans. Sponsors of 457(f) plans should review their plans to determine whether they will meet the new requirements and whether any steps need to be taken to ensure that they remain in compliance.


Form 5500 Updates

The United States Department of Labor has just proposed major changes to the Form 5500 (the form that is required to be filed by most employee benefit plans), some of which take effect as early as 2016 (i.e., effective for filings in 2017 with respect to the 2016 plan year). We will be providing more information and analysis of these changes in future issues of this newsletter as they are finalized. In the meantime, more information can be found at the following website:

Copyright ©2016 Boutwell Fay LLP. All rights reserved. This newsletter is for informational purposes only and does not constitute legal or tax advice.


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