Restrictive IRS Guidance for 457(f) Plans Likely to be Issued in 2011

By David L. Wolfe, Esq., and Joshua J. Waldbeser, Esq.  

Drinker Biddle & Reath LLP, Chicago, IL


After a lengthy period of silence, it appears that the IRS is getting ready to issue the long-anticipated regulations governing Internal Revenue Code ("Code") §457(f) plans. As a reminder, 457(f) plans are nonqualified deferred compensation plans that may be sponsored by tax-exempt and governmental entities, and provide for greater tax deferral opportunities than are available under 457(b) plans (which generally limit deferrals to $16,500 annually, plus certain catch-up contributions).

Status of the Regulations 

On a number of recent occasions, Cheryl Press, Senior Counsel in the IRS Office of Chief Counsel, has addressed the issuance of the regulations. While no official publication date has yet been announced, Ms. Press confirmed, in an April 11 webcast sponsored by the National Association of Government Defined Contribution Administrators (NAGDCA), that the regulations are in the "clearance" process at the IRS and Treasury Department, and could be published by NAGDCA's 2011 annual conference, which falls in September of this year.

Expected Regulatory Changes 

Recent comments by Ms. Press also verify practitioners' expectations that the regulations will be a significant piece of guidance that will preclude a number of plan features and practices that have historically been used widely by 457(f) plan sponsors. As discussed in Drinker Biddle's  (August 2007 Client Memorandum), the IRS previously described, in Notice 2007-62, several of the expected provisions, which are designed to synchronize 457(f) requirements with those of Code §409A, including:

  • Post-severance "non-compete" clauses will not create a "substantial risk of forfeiture" of 457(f) benefits, and accordingly, will not operate to defer taxation of previously-vested amounts.
  • Severance arrangements will only be considered "bona fide" severance pay plans, which are exempt from Code §457 requirements, to the extent they (i) are payable only upon involuntary severance from employment, (ii) limit distributions to two times the lesser of the employee's annual compensation or the Code §401(a)(17) compensation limit that applies to qualified retirement plans ($245,000 in 2011), and (iii) require distributions to be completed by the end of the second taxable year following the year in which the employee separated from service. These requirements mirror those of an "involuntary separation pay plan" that is exempt from §409A.
  •  Elective deferrals of salary are not permitted to be made to a 457(f) plan. Because employees have a current right to receive salary, the IRS's position is that a deferral of such amounts would only reasonably occur where an employee seeks to avoid taxation by exposing it to a purported "substantial risk of forfeiture" that does not, in fact, exist. As an alternative, the IRS may permit elective salary deferrals only if they are "matched" by the employer, or if the present value of the amounts, if deferred, otherwise significantly exceeds the present value of the salary.
  •  Further extensions of vesting periods made subsequent to an employee's initial election (so-called "rolling vesting") will be disregarded, and therefore, will not further defer the taxation of vested 457(f) deferred compensation.

Ms. Press' recent comments indicate that the IRS's position on these issues has likely remained unchanged, and practitioners should therefore continue to expect that these provisions will be included in the regulations. She has also acknowledged that the IRS recognizes a significant degree of regulatory "confusion" on the part of 457(f) plan sponsors, which may (hopefully) indicate that the regulations will include some manner of "grandfathering" or transitional relief for existing 457(f) accounts. The regulations may well be published in proposed format, with a comment period before they are finalized.

Additional issues to be addressed in the regulations that have only recently been identified by Ms. Press in informal communications, include the following:

  • Unused, accrued vacation and sick leave pay cannot be transferred to a 457(f) plan. Such amounts may be cashed out, or in some cases, contributed to a 401(k) or 403(b) plan.
  • The present value of a participant's 457(f) account balances may be determined on an annual, as opposed to daily, basis.

Likely Impact on Plan Sponsors 

In anticipation of the regulations' release, some 457(f) plan sponsors have already amended their plans to comply with the guidance provided in Notice 2007-62, 2007-32 I.R.B. 311, described above, while others have chosen to wait until the regulations' publication. Plans that have already been amended may, in some cases, require additional amendments to reflect regulatory provisions that were not previously described in Notice 2007-62. The extent to which 457(f) plan document provisions and practices will need to be changed will also depend on the extent of the "grandfathering" or other transitional relief, if any, that is provided for existing accounts in the regulations.

 For more information, in the BNA Tax Management Portfolios, see Brisendine, Veal & Drigotas, 385 T.M., Deferred Compensation Arrangements,  and in Tax Practice Series, see ¶5710, Nonqualified Deferred Compensation. 

© Drinker Biddle & Reath LLP 2011