Apart from one brief regulation issued several years ago, the Internal Revenue Service (IRS) has never issued comprehensive guidance for 457(f) plan sponsors. Comprehensive guidance has been discussed and was expected to be issued in 2011, but did not occur (click here to see Client Alert Restrictive IRS Guidance for 457(f) Plans Likely to be Issued in 2011). However, new guidance is anticipated within the next few months in the form of proposed regulations. Upon issuance of the regulations, the IRS will grant a "comment period" during which the public will be able to review, and suggest changes to, the regulations. The guidance will likely cover the following key areas, according to informal IRS comments:

  • Vesting — Vesting triggers taxation under 457(f) plans. The IRS intends on describing exactly which triggers are valid vesting events, and which are not. IRS officials have emphasized that they want to use the same definition of vesting under both Sections 457(f) and 409A of the Code to the fullest extent possible. This means, for example, that the concept of a "rolling risk of forfeiture" will no longer work. Similarly, noncompetes won't delay vesting, and pure salary deferral plans (without a substantial match) won't delay taxation. On the other hand, 457(f) plan sponsors will (for the first time) have official approval for using the concept of a "constructive termination."
  • Bona Fide Severance and Bona Fide Vacation Plans — These two sorts of arrangements have always been exempt from Section 457(f), but the IRS has never provided a clear definition. The upcoming guidance is expected to change that. Among other things, the guidance will describe the extent to which vacation and sick-leave conversion plans are subject to Section 457(f). IRS officials have informally stated that the key to the "bona fide vacation plan" exemption will be whether the amount eligible for conversion is "reasonable" and available to a broad cross-section of the employer's workforce. They have also noted that bona fide vacation plans will still be subject to the rules of "constructive receipt."
  • Present Value — Upon vesting, the present value of a 457(f) benefit is taxed, but the IRS has never described exactly how present value is calculated for this purpose. For example, it has never described what sort of mortality assumptions and interest rates should be used, or how contingent events such as death should be factored into the calculation. Upcoming guidance is expected to fill this gap.
  • "Menus" — It has become increasingly common for tax-exempt employers to offer terminating executives a choice between things such as nontaxable retiree health coverage and a taxable lump sum cash payment (e.g., for employees who already have retiree health coverage through their spouses). IRS officials have expressed concern that this choice could trigger application of Section 457(f). The guidance is expected to address this risk.
  • What is "Deferred Compensation?" — Tax-exempt employers administering deferred compensation plans are obligated to address the interplay of 457(f) and 409A, as 457(f) plans are already subject to the requirements of 409A. The regulations under Code Section 409A provide an extremely broad definition of "deferred compensation," and include such things as employer payment of taxable medical premiums, in-kind benefits and legal fees. In contrast, practitioners have always taken the view that 457(f) only covers the deferral of elective or non-elective cash compensation. The upcoming guidance may broaden the reach of Section 457(f), as part of an IRS attempt to create a uniform set of rules among non-profit and for-profit sponsors.
  • Grandfathering — The IRS will likely offer some sort of transition relief for existing 457(f) plans, but IRS officials have informally stated that any grandfathering provision will be based on the facts and circumstances. Stated differently, it is highly unlikely that all plans in existence before the date of the guidance will be given a blanket exemption — particularly if they contain a provision that was arguable even under prior law (e.g., a vesting provision based on a very weak non-compete requirement). IRS officials have stated that this sort of blanket grandfather would essentially shut down their audits of pre-existing plans, and thus could not be allowed.

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