The “Perfect Storm” Article

            In the prior article describing the “perfect storm” that is swamping compensatory split-dollar arrangements, we reviewed the changes to the law applicable to all split-dollar plans that had intersected to apply to all compensatory split-dollar arrangements.  Those changes included the issuance of IRS Notices 2002-8 and 2007-43, and the adoption of the Final Split-Dollar Regulations, and the adoption of Section 409A by Congress.  That article defined compensatory split-dollar arrangements, reviewed the income tax rules applicable to both pre-final regulation split-dollar arrangements and those entered into after the effective date of the final regulations (or modified thereafter), and distinguished between the income tax treatment of post-final regulation split-dollar arrangements taxed under the economic benefit regime and those taxed under the loan regime.  That article concluded by providing that a follow-up article reviewing the extra layer of complexity compensatory split-dollar arrangements entered into between tax-exempt employers and their executives added to the mix.  This is that article.

Section 457 Plans

            Section 457, which has been in effect for over 20 years, addresses deferred compensation plans of state and local governments and tax-exempt organizations.  The Code Section distinguishes between “eligible” deferred compensation plans and those deferred compensation plans to which Section 457 applies which are “not eligible” (commonly known as “ineligible” plans).

            Eligible plans are similar to the type of plans that are described in Section 401(k), namely, the amount of contributions are capped at a certain amount which are adjusted each year, but the amounts are not includable in the employee’s taxable income until distributed from the plan.  Plans that are not eligible under Section 457 are described in Section 457(f), and although the amount of contributions to these plans is not subject to any cap (other than the requirements of reasonable compensation imposed on employees of tax-exempt organizations), these ineligible plans will be includable in the employee’s income, unless those contributions are subject to a “substantial risk of forfeiture”. 

            A substantial risk of forfeiture is defined in Section 457(f)(3) as the requirement that the employee’s rights to such amounts are conditioned on the future performance of substantial services – that is, the employee’s rights in those amounts are non-vested (they will be lost if the future services aren’t provided).

The Impact of Section 457(f) on Pre-Final Regulation Split-Dollar Plans

 The general rule applicable to deferred compensation arrangements entered into by for - profit employers and their employees has been that any amount to which the employee was entitled under deferred compensation plan would be includable in employee’s income only when actually or constructively received, not when promised to the employee, even if the employee is vested in that promised amount. 

            That is, taxable employers and their employees have been able to enter into deferred compensation arrangements, whether a “true” deferral arrangement (under which the employee agreed to defer some part of his or her compensation), or a “supplemental benefit” plan (under which the employer agreed to provide supplemental amounts to the employee at his or her retirement), with no current income tax consequence to the employee, even if there were no risk of forfeiture (meaning that, he or she could be fully vested in the benefit with no current tax consequences).  The flip side of that was that there was no income tax deduction available to the employer until the amount was actually paid to the employee.  Because of that, it seemed to make sense to allow taxable employers and their employees to negotiate deferred compensation arrangements on an arm’s length basis, since the employer and the employee had different interests – the employee might want to defer receipt of the income until retirement, while the employer would want to accelerate the deduction of the compensation into an earlier year.

            For employers which are exempt from income taxation, however, there is no such built-in conflict – they won’t care when amounts are includable in their employee’s income, since there won’t be a corresponding compensation deduction.  Because of that, Section 457 (which, again, applies only to tax-exempt employers and their employees), requires that as to any amount of promised deferred compensation in which an employee of a tax-exempt employer is vested (that is, which is not subject to substantial risk or forfeiture), the employee will be taxed immediately, despite the fact that the payment of that compensation might not take place until retirement or some other later triggering event.  Accordingly, traditional ineligible deferred compensation arrangements of tax-exempt employers have provided only non-vested benefits for their employees.

            However, many tax-exempt employers and their executive employees have traditionally used split-dollar arrangements to provide a form of deferred compensation to those employees in a way that was arguably not subject to a risk of forfeiture, by relying on the death benefit only exception of Section 457.  In those plans, the executive owned the policy (and its cash values), and was therefore vested in the arrangement.  The employer was only entitled to a return of its premiums, so if cash values eventually exceeded premiums, the executive owned that excess, and it was intended that the executive would borrow against or withdraw from those values to create a stream of retirement income, arguably without any income tax consequences. 

            Whatever the correct tax result of those plans was under prior law, to the extent that Section 409A and the new rules described in the prior article apply to those plans, those plans cannot qualify for the death benefit only exception from either Section 457(f) or Section 409A, since they provide lifetime benefits as well as a death benefit.  That will mean that the employee will be taxed on any cash value to which he or she has access after retirement.

What Should Tax-Exempt Plan Sponsors of Such Plans Do Now?

            Tax-exempt employers should review all split-dollar arrangements  that are subject to Section 409A and Section 457(f) and identify all provisions which may violate the new rules; those plans need to be amended prior to the end of 2008, to avoid the application of penalties on the employee imposed under Section 409A.