What is “Substantial Risk of Forfeiture” in section 457?
“The definition of ‘substantial risk of forfeiture’ in section 457 is very similar to the definition of the same term in Code section 83. Consistent with the regulations under section 83, the IRS has ruled under section 457(f) that an amount deferred under a noneligible deferred compensation plan will be considered to be subject to a substantial risk of forfeiture where the employee’s right to the amount is conditioned upon the continued service of the employee to a specified termination date or, if earlier, to the date of the employee’s death, disability, or termination of employment by the employer other than for cause. If the employee terminated employment voluntarily or was dismissed for cause, in each case before the specified retirement date, the benefit must be forfeited.”
-Section 409A Handbook, Substantial Risk of Forfeiture, at Ch.3.
In addition, the 2016 457 regulations allow for a substantial risk of forfeiture to continue under a noncompete agreement, provided the noncompete (1) must be written, (2) is verifiable, and (3) the employer has a substantial and bona fide interest in preventing the employee from competing and the employee has an interest in engaging in competing.
How does the excise tax of 4960 apply to a 457(f) plan?
Tax-exempt organizations are now subject to IRC Section 4960 added by the Tax Cuts and Jobs Act (TCJA). “Tax-exempt organizations will be taxed 21% on compensation paid over $1 million, which includes amounts in 457(f) plans. Plan sponsors need to be cognizant of any large payments coming out of 457(f) plans that may be taxable to them”.
The tax is applied to total compensation earned in the year. This includes base and incentive compensation and also amounts paid out until 457(f) accounts. As an example if an employee has base compensation of $500,000 and bonus compensation of $100,000 in the year of retirement. Additionally, there is a $2 million payout from the 457(f) plan then the organization would be subject to a tax of 21% on amounts over $1 million. ($500,000 + 100,000 + 2,000,000 – 1,000,000) x 21% = $336,000 tax.