September 28, 2020

Volume X, Number 272

September 28, 2020

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September 25, 2020

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Substantial Risk of Forfeiture: What Non-Profit and Governmental Employers Need to Know About IRS Guidance on Section 457 - Part 2

We're back with the second installment in our series on the IRS's Section 457 proposed rules. The first alert covered Section 457(f) basics and discussed the meaning of "deferred" compensation (if you missed it, you can read it here).

As discussed in the first alert, benefits subject to Section 457(f) will be taxed to the employee when the compensation is no longer subject to a substantial risk of forfeiture. This part of our series will consider what it means to have a “substantial risk of forfeiture.” 

Under the proposed rules, compensation will be considered “subject to a substantial risk of forfeiture” if:

  1. Entitlement to that amount is conditioned either (a) on future performance of substantial services; or (b) upon the occurrence of a condition that is related to the employee's performance of services for the employer, the employer's tax exempt or governmental activities, or organizational goals (i.e., the purpose of the compensation); and

  2. The possibility of forfeiture is substantial. 

Importantly, the second requirement means that an amount is not subject to a substantial risk of forfeiture if it is unlikely that the employer will actually enforce the forfeiture. In assessing the likelihood of enforcement, the IRS will take into account the employer's past practices, the level of control or influence the party responsible for enforcing the forfeiture has over the employee, and the enforceability of the provisions under applicable law.

Here are a couple of examples of how these rules may play out in practice:

Example 1: On November 1, 2016 an employee terminates employment and the employer agrees to pay the employee $200,000 on November 1, 2017, as long as the employee provides at least 50 hours of consulting services to the employer in the next year. The services provided are insubstantial when compared to value of the payment, and the compensation will be subject to taxation on November 1, 2016. In contrast, if the employer agrees to pay that amount only if the employee provides full-time consulting service for the employer until November 1, 2017, the compensation is subject to a substantial risk of forfeiture and will not be subject to taxation until November 1, 2017.

Example 2:  Each year an employer credits $10,000 to an executive’s account under the employer's Supplement Executive Retirement Plan (SERP). Under the terms of the SERP, the executive is entitled to receive the account balance only if he or she remains employed for at least 5 years. However, in the past the employer has paid out the SERP account balance even if the executive terminates employment with less than 5 years of service. The SERP credits are not subject to a substantial risk of forfeiture because under these facts it is unlikely that the employer will actually enforce the forfeiture. As a result, each amount is taxed to the executive when it is credited to his or her SERP account.

Be careful!  Although the new rules allow employers to continue using covenants not to compete to create a substantial risk of forfeiture, the plan must meet specific rules. Similarly, the new rules continue to allow the use of “rolling risks of forfeiture” (where an employee can elect to defer vesting), but add new requirements for those arrangements. As a result of these additional requirements, any plan that utilizes a rolling risk of forfeiture or a covenant not to compete, should be carefully reviewed to ensure it will meet the new requirements. These plans may have to be modified or redesigned to avoid unintentional early taxation of benefits. 

Up next: a look at the effect on severance, disability, death benefit, and sick leave and vacation leave plans.

© 2020 Poyner Spruill LLP. All rights reserved.National Law Review, Volume VI, Number 238


About this Author

Employers today face expanding and complex employment legislation as well as a growing body of regulatory requirements that govern the employment relationship. Lawsuits brought by employees also are steadily rising, as are enforcement actions and audits by government agencies responsible for enforcing employment laws, such as the Equal Employment Opportunity Commission, the U.S. Department of Labor, Immigrations and Customs Enforcement and the Office of Federal Contract Compliance Programs.  

In this environment, employers need experienced legal counsel capable of providing sound...

Kelsey H. Mayo, Employee Benefits Attorney, Poyner Spruill Law Firm

Kelsey Mayo has extensive experience working with governmental, non-profit, and for-profit employers on all aspects of qualified and non-qualified plans, welfare benefit plans, fringe benefit plans, and executive compensation plans.

Kelsey routinely represents clients before the Internal Revenue Service and Department of Labor in matters involving employee benefits.