SCOTT E. GALBREATH, September 28, 2023
On July 14, 2023, the Internal Revenue Service (the “IRS”) issued Notice 2023-54 (the “Notice”), providing much-welcomed guidance and transition relief relating to certain required minimum distributions (RMDs). Specifically, the Notice provides the following:
Tax exempt organizations have unique considerations when it comes to compensating executives. The most obvious is the fact that they are not motivated by getting a tax deduction for compensation paid or contributions made to employee benefits plans as are for-profit employers. Tax exempt organizations generally do not pay income tax. Therefore, a deduction is worthless to them. These organizations are motivated by other factors, such as competing with private employers for available human capital in the workforce. In addition, being tax-exempt, they cannot offer equity in the organization as compensation (such as restricted stock, stock options, or phantom stock) to tie an employee’s performance and remuneration to the performance of the employer. As a result, a primary purpose of a deferred compensation plan for these organizations is to provide compensation to the employee in the future and avoid it being taxed currently.
Likewise, many tax exempt organizations (i.e., section 501(c)(3) charitable organizations, section 501(c)(4) social welfare organizations and section 501(c)(6) trade associations) must be concerned with the Internal Revenue Code’s (Code) prohibition against private inurement which is a requirement for their exempt status. Additionally, charitable organizations and social welfare organizations may be subject to excise taxes if compensation paid to any one individual is deemed excessive under the excess benefit transactions rules of Code section 4958. Further, under Code section 4960, a 21% excise tax is imposed on any organization that is tax-exempt under Code section 501(a) on the amount of “excess compensation” paid to a “covered employee” in any one year. Excess compensation is compensation above $1,000,000. A covered employee is one of the top 5 highest paid employees.
When looking at providing deferred compensation for executives of tax exempt organizations the starting point is Internal Revenue Code section 457 (Section 457). Section 457 is one of the most interesting and complex sections of tax law due to its breadth, nuances, and history. Addressing the tax consequences of unfunded deferred compensation of employees of both State and local governmental entities and tax exempt organizations, yet treating them differently, adds to its complexity. Likewise, providing for the favorable tax consequences for “eligible” plans that meet the requirements under Code section 457(b), as well as the less favorable consequences for “ineligible” plans that fail to meet such requirements that are taxed under Code section 457(f), demonstrates its breadth. The fact that “ineligible” plans are also subject to Code section 409A only adds to the complexity.
Part 1 of this article will discuss many of the requirements for eligible 457(b) plans sponsored by tax exempt organizations and how they differ from 457(b) plans sponsored by state or local governmental entities. It will also discuss areas where mistakes can easily be made. To read about common mistakes in 457 plans, see my article on The Benefit of Benefits blog: “Ten Common Mistakes In 457 Plans of Tax Exempt Organizations” Part 1. Part 2 of this article will take a closer look at ineligible 457(f) plans and how they must comply with Code section 409A. It will also discuss the application of the excess benefit transaction rules and Code section 4960 excise tax to deferred compensation.
To (b) or To (b) — There Is No Question!
Section 457 generally separates deferred compensation of eligible employers into two classifications, eligible plans known as “457(b)” plans (457(b) Plans) and plans that are not eligible plans, known as “457(f)” plans (457(f) Plans). As one would suspect, 457(b) Plans generally have better tax consequences than 457(f) Plans.
In addition, Section 457 generally provides that there are two types of eligible employers: a State, political subdivision of a State, and any agency or instrumentality of a State or political subdivision of a State (State & Local governments, referred to below as S&L); and any other organization, other than a governmental unit, exempt from tax (Exempt Organization, referred to below as EO).
Code section 457(b) sets forth the definition of an “eligible deferred compensation plan.” It begins with the pre-condition that it must be a plan maintained by an “eligible employer” and then sets forth numerous conditions of eligibility, such as a requirement that participants must only be individuals providing services to the employer, limitations on the amount that can be deferred, required minimum distribution requirements, etc. An S&L 457(b) Plan is much closer to a 401(k) plan in that it can cover all employees, its assets must be held for the exclusive benefit of the employees, it can have age 50 catch-up contributions, participant loans, in-service distributions, Roth deferrals, and it can permit rollovers to and from other types of plans. EO 457(b) Plans cannot have any of these provisions.
Take It to the Limit
There is also a dollar limit on the amount that can be credited to an employee for a year under a 457(b) Plan regardless of whether it is from employee salary reduction elective deferrals or from nonelective employer contributions. Currently, that amount is $22,500 for 2023, but the limit is adjusted upward for inflation, similar to the limit on 401(k) deferrals. Some EOs wish to provide executives with deferred compensation above the annual limit allowed under a 457(b) Plan. For example, the contribution limit may not be enough to provide sufficient replacement retirement income for a well-paid executive. In such case, a 457(f) Plan can be used to supplement the 457(b) Plan. Compensation deferred into an EO 457(b) Plan will only be taxed to the executive when paid or otherwise made available. However, Section 457(f) provides that compensation deferred under a plan not meeting the requirements of Section 457(b) will be taxed to the participant on the later of when the legal right to such compensation arises or when such right is no longer subject to a substantial risk of forfeiture (or vested). A plan that permits deferred compensation in excess of the annual limit for a 457(b) Plan would be an ineligible plan subject to Section 457(f).
The fact that an employee can be fully vested in contributions to a 457(b) Plan and not pay income tax until actually receiving the deferred compensation makes the tax consequences of the 457(b) Plan better than that of a 457(f) Plan. Therefore, a 457(b) Plan should always be adopted to provide these better tax consequences up to the annual limit. The executive could participate in the 457(b) Plan up to its limit on deferrals and participate in a 457(f) Plan for amounts above the annual limit. In designing a deferred compensation plan, an EO must decide whether to have just a 457(b) Plan or also a 457(f) Plan. However, it is highly recommended that an EO never establish a 457(f) Plan alone without establishing a 457(b) Plan first to defer the annual limit. That is, an EO could maintain a 457(b) Plan alone but should not only have a 457(f) Plan.
Get Your Top Hat On
A major difference between S&L 457(b) Plans and EO 457(b) Plans is that an S&L 457(b) Plan must be funded with a trust, custodial account, or annuity contract for the exclusive benefit of the employees, similar to a 401(k) plan. On the other hand, Section 457 requires that the title to the assets of an EO 457(b) Plan must remain in the name of the employer and subject to its creditors. If the assets are made available to the participant, by being set aside in an exclusive benefit trust, it will be taxable to the participant.
Additionally, because EO 457(b) Plans are subject to Title I of the Employee Retirement Income Security Act of 1974 (ERISA), such a plan must be a “top hat” plan that is designed primarily for a “select group of management or highly compensated employees.”1 Top hat plans avoid the requirement of Title I that the assets of a retirement plan must be held in an exclusive benefit trust. Thus, the only way for an EO 457(b) Plan to meet both the requirement that plan assets remain owned by the employer and also comply with Title I of ERISA is to be a top hat plan for a select top hat group. It cannot allow all employees of the organization to participate.
Unlike a 401(k) plan, elective deferrals under an EO 457(b) Plan are only valid for a given month if the deferral election was made by the participant in writing prior to the beginning of the month. This means one cannot make an annual deferral election for the year in January before the first payroll and have it effective for January. Such an election would not be valid until February. In order to make it valid for January, it would have to be executed in December of the prior year. The SECURE 2.0 Act eliminated this requirement for S&L 457(b) Plans but not those sponsored by EOs. This is an area where mistakes can be made with annual election forms. An “evergreen” annual election that remains in force until changed is permitted, but it won’t be effective until the month following the month made. The same is true for any changes to the election.
Contributions to a 457(b) Plan only count against the annual contribution limit in the year they are vested. Employee elective deferrals are always fully vested. This can be a trap if the plan provides for employer contributions subject to a vesting schedule (e.g., no vesting until 100% vested after 5 years) because it may cause an excess deferral in the year of vesting. For example, if an employee receives an annual contribution of $10,000 which doesn’t vest until year 5 if still employed — and in year 5, $50,000 vests — this amount will likely be over the contribution limit for year 5, and the excess will have to be distributed back to the executive.
The Sky’s the Limit
Importantly, contributions to a 457(b) or 457(f) Plan are not subject to the contribution limit under Code section 415 like other plans, currently $66,000 in 2023. Thus, to the extent the employer also maintains a 401(k) or 403(b) plan, which are subject to the 415 limits, 457 plan contributions will not reduce the annual additions available under those plans. Additionally, the total amount of compensation that may be taken into account under a 457 plan in a year is not capped by the Code like it is for a 401(k) plan, currently $330,000 for 2023. However, as mentioned above, both elective deferrals and employer contributions are subject to a single annual contribution limit ($22,500 in 2023) for a 457(b) Plan.
A Rabbi Can Provide Some Security
Though the assets of an EO 457(b) Plan must be titled in the employer and subject to its creditors, the assets can be held in a Rabbi Trust to help secure the benefits of participants by preventing the employer from using such assets for other purposes while it is solvent. It is called a “rabbi” trust simply because the first IRS ruling approving the tax consequences of the technique involved the deferred compensation plan o f a rabbi established by his synagogue. Basically, a Rabbi Trust is an irrevocable grantor trust of the employer whereby the trustee holds the assets of the trust and can only use the assets for two purposes: first, to pay benefits under the plan when they become due; second, should the employer become insolvent, the trustee must stop paying any benefits under the plan and hold the assets to be distributed to the creditors of the employer, if necessary. Thus, provided the employer is solvent, the participant(s) in the plan will get their benefits. The trust prevents the employer from using the plan assets for other purposes, such as to pay other expenses or for expansion projects while solvent. However, since the assets are still subject to the employer’s creditors, the contributions to the trust are not taxable to the employee.
But Wait, There’s More
Part 1 of this article has introduced the considerations EOs must think about in designing deferred compensation plans for executives and discussed the unique characteristics of 457(b) Plans. Part 2 of this article, which will be issued in October, will discuss 457(f) Plans in more detail, including how they must comply with Code section 409A. It will also discuss how the Code section 4958 excess benefit transaction rules, and Code section 4960 excise tax, apply to deferred compensation.
1 It is important to note that for Top Hat group purposes the term “highly compensated employees” is not the same as the defined term for qualified plan purposes under Code section 414(q), which provides employees earning compensation over a specific dollar threshold will be considered highly compensated. For Top Hat group purposes, to be highly compensated one must be one of the highest paid employees in the organization when comparing compensation to all other employees. This is another area that can cause operational errors.