Par. 11. Newly-designated § 1.457-12 is revised to read as follows:
(a) Tax treatment of an ineligible plan under section 457(f) —(1) In general. Pursuant to section 457(f)(1), if an eligible employer provides for a deferral of compensation under an ineligible plan, amounts will be included in income in accordance with paragraphs (a)(2) through (4) of this section, except as otherwise provided in this paragraph (a) or paragraph (b) of this section. See § 1.457-11 for plans that are not subject to section 457 or are not treated as providing for a deferral of compensation for purposes of section 457.
(2) Income inclusion. The present value of compensation deferred under an ineligible plan is includible in the gross income of a participant or beneficiary under section 457(f) on the applicable date. For this purpose, the applicable date is the later of the first date on which there is a legally binding right to the compensation or, if the compensation is subject to a substantial risk of forfeiture, the first date on which the substantial risk of forfeiture (within the meaning of section 457(f)(3)(B) and paragraph (e) of this section) lapses. Paragraph (c) of this section provides rules for determining the present value of the compensation deferred under the plan, including a requirement that the amount of compensation deferred under an ineligible plan as of an applicable date includes any earnings on the compensation as of that date.
(3) Treatment of earnings after income inclusion. Earnings credited on compensation deferred under an ineligible plan after the date on which the compensation is includible in gross income under section 457(f)(1) pursuant to paragraph (a)(2) of this section are includible in the gross income of a participant or beneficiary when paid or made available to the participant or beneficiary.
(4) Income inclusion when compensation is paid or made available. Amounts paid or made available to a participant or beneficiary under an ineligible plan are includible in the gross income of the participant or beneficiary under section 72, relating to annuities. For this purpose, an amount is paid or made available if there is actual or constructive receipt (within the meaning of § 1.451-2) of any taxable or nontaxable benefit, including a transfer of cash, a transfer of property includible in income under section 83, any other event that results in the inclusion in income under the economic benefit doctrine, a contribution to (or transfer or creation of a beneficial interest in) a trust described in section 402(b) at a time when contributions to the trust are includible in income under section 402(b), or inclusion of an amount in income under section 457A. An amount is also paid or made available for this purpose if there is a transfer, cancellation, or reduction of an amount of deferred compensation in exchange for benefits under a welfare benefit plan, a fringe benefit excludible under section 119 or section 132, or any other benefit that is excludible from gross income.
(5) Investment in the contract. For purposes of applying section 72 to amounts that are paid or made available as described in paragraph (a)(4) of this section, a participant is treated as having an investment in the contract to the extent that compensation has been included in gross income by the participant in accordance with paragraph (a)(2) of this section. An amount is treated as included in income for a taxable year only to the extent that the amount was properly includible in income and the participant actually included the amount in income (including on an original or amended federal income tax return or as a result of an IRS examination or a final decision of a court of competent jurisdiction).
(b) Exceptions —(1) In general. Section 457(f)(1) and paragraph (a) of this section do not apply to a plan or a portion of a plan described in this paragraph (b). The determination of whether a plan or a portion of a plan is described in this paragraph (b) is made as of the date on which the legally binding right to an amount arises. However, a plan or portion of a plan will cease to be a plan that is described in this paragraph (b) on the first date that it no longer meets the requirements described in this paragraph (b).
(2) Certain retirement plans. Annuity plans and contracts described in section 403 and plans described in section 401(a) are not subject to the provisions of section 457(f)(1) and paragraph (a) of this section.
(3) Section 402(b) trusts —(i) Section 402(b). The portion of a plan that consists of a trust to which section 402(b) applies is not subject to the provisions of section 457(f)(1) and paragraph (a) of this section.
(ii) Example. The provisions of this paragraph (b)(3) are illustrated in the following example:
Example.
(i) Facts. On October 1, 2017, an eligible employer establishes an ineligible plan covering only one participant (a highly compensated employee under section 414(q)) under which the participant obtains an unconditional right to be paid $150,000 (plus interest at a specified reasonable rate) on October 1, 2021. As part of the plan, the employer simultaneously establishes a trust described in section 402(b) in the United States for the sole benefit of the participant. Under the terms of the plan and trust, the assets of the trust are also payable to the participant on October 1, 2021, and the amount that the employer is otherwise obligated to pay under the plan will be reduced (offset) by the amount paid to the participant from the trust. Section 402(b)(4) applies to the trust, and the trust has assets of $98,000 on October 1, 2017 and $100,000 on December 31, 2017.
(ii) Conclusion. Section 457(f) and this section apply only to the portion of the plan that is not funded through the section 402(b) trust. Thus, the participant has income under section 457(f) equal to the present value of the portion of the compensation deferred under the plan that is not funded through the section 402(b) trust on the date on which there is a legally binding right to the compensation (October 1, 2017). This present value is equal to $52,000 ($150,000—$98,000), which is included in the participant's gross income on October 1, 2017. The participant must also include $100,000 in gross income on December 31, 2017 pursuant to section 402(b)(4)(A).
(4) Qualified governmental excess benefit arrangements under section 415(m). A qualified governmental excess benefit arrangement described in section 415(m) is not subject to the provisions of section 457(f)(1) and paragraph (a) of this section.
(5) Nonqualified annuities under section 403(c) —(i) Section 403(c) annuities. The portion of a plan in which premiums are paid by an employer for an annuity contract to which section 403(c) applies is not subject to the provisions of section 457(f)(1) and paragraph (a) of this section.
(ii) Examples. The provisions of this paragraph (b)(5) are illustrated by the following examples:
Example 1.
(i) Facts. A tax-exempt entity pays a premium for an annuity contract (described in section 403(c)) for the benefit of a participant. The annuity contract has a value of $135,000, and the participant is substantially vested (as defined in § 1.83-3(b)) at the time the premium is paid. The participant includes the full value ($135,000) in income under section 403(c) in the year the employer pays the premium.
(ii) Conclusion. Although the participant has a legally binding right to payments under the annuity contract that will be made in a subsequent taxable year, the participant's interest in the annuity contract is not subject to section 457(f)(1) and paragraph (a) of this section.
Example 2.
(i) Facts. The facts are the same as in Example 1 of this paragraph (b)(5), except the participant's rights in the annuity contract are not substantially vested (as defined in § 1.83-3(b)) at the time the premium is paid and do not become substantially vested until a future taxable year. The participant does not include the full value of the contract in income under section 403(c) in the year the employer pays the premium.
(ii) Conclusion. Neither the payment of the premium nor the participant's interest in the annuity contract is subject to section 457(f)(1) or paragraph (a) of this section.
(6) Transfer of property under section 83 —(i) Section 83. The portion of a plan that consists of a transfer of property to which section 83 applies is not subject to the provisions of section 457(f)(1) and paragraph (a) of this section. Specifically, section 457(f)(1) and paragraph (a) of this section do not apply if, on or before the first date on which compensation deferred under a plan is not subject to a substantial risk of forfeiture (within the meaning of section 457(f)(3)(B) and paragraph (e) of this section), the amount is paid through a transfer of property described in section 83. However, section 457(f)(1) and paragraph (a) of this section do apply if the first date on which compensation deferred under a plan is not subject to a substantial risk of forfeiture (as defined in section 457(f)(3)(B) and paragraph (e) of this section) precedes the date on which the amount is paid through a transfer of property described in section 83. If deferred compensation payable in property is includible in gross income under section 457(f)(1)(A), then, as provided in section 72, the amount includible in gross income when that property is later transferred or made available to the participant or beneficiary is the excess of the value of the property at that time over the amount previously included in gross income under section 457(f)(1)(A).
(ii) Examples. The provisions of this paragraph (b)(6) are illustrated by the following examples:
Example 1.
(i) Facts. On December 1, 2017, an eligible employer agrees to transfer property that is substantially vested (within the meaning of § 1.83-3(b)) and has a fair market value equal to a specified dollar amount, to a participant on January 15, 2020. The participant's rights under the agreement are not subject to a substantial risk of forfeiture (within the meaning of section 457(f)(3)(B) and paragraph (e) of this section).
(ii) Conclusion. Because there is no substantial risk of forfeiture (within the meaning of section 457(f)(3)(B) and paragraph (e) of this section) with respect to the agreement to transfer property in 2020, the present value of the amount on the applicable date (December 1, 2017) is includible in the participant's gross income under section 457(f)(1)(A). Under paragraph (a)(4) of this section, when the substantially vested property is transferred to the participant on January 15, 2020, the amount includible in the participant's gross income is equal to the excess of the fair market value of the property on that date over the amount that was included in gross income for 2017.
Example 2.
(i) Facts. Under a bonus plan, an eligible employer agrees in 2021 to transfer property that is substantially nonvested (within the meaning of § 1.83-3(b)) to Participants A and B in 2023 if they are continuously employed by the eligible employer through the date of the transfer (which condition constitutes a substantial risk of forfeiture within the meaning of section 457(f)(3)(B) and paragraph (e) of this section). In 2023, the eligible employer transfers the property to Participants A and B, subject to a substantial risk of forfeiture (within the meaning of § 1.83-3(c)), that lapses in 2025. Participant A makes a timely election to include the fair market value of the property in gross income under section 83(b). Participant B does not make this election.
(ii) Conclusion. The compensation deferred for both Participants A and B is not subject to section 457(f)(1) or paragraph (a) of this section because section 83 applies to the transfer of property on or before the date on which the property is not subject to a substantial risk of forfeiture (within the meaning of section 457(f)(3)(B) and paragraph (e) of this section). Because of the section 83(b) election, Participant A includes the fair market value of the property (disregarding lapse restrictions) in gross income for 2023 under section 83(b)(1). Participant B includes the value of the property in gross income when the substantial risk of forfeiture lapses in 2025 under section 83(a).
(7) Applicable employment retention plan. The portion of a plan that is an applicable employment retention plan as described in section 457(f)(4) with respect to any participant is not subject to the provisions of section 457(f)(1) and paragraph (a) of this section. See also section 1104(d)(4) of the Pension Protection Act of 2006, Public Law 109-280 (120 Stat. 780), regarding the application of the Internal Revenue Code and certain other laws to any plan, arrangement, or conduct to which section 457(f)(2)(F) does not apply.
(c) Amount included in income —(1) Calculation of present value —(i) In general. Except as otherwise provided in this paragraph (c), the present value of compensation deferred under an ineligible plan as of an applicable date equals the present value of the future payments to which the participant has a legally binding right (as described in paragraph (d) of this section). For this purpose, present value is determined in accordance with the provisions of this paragraph (c)(1)(i) by multiplying the amount of a payment (or the amount of each payment in a series of payments) by the probability that any condition or conditions on which the payment is contingent will be satisfied and discounting the amount using an assumed rate of interest to reflect the time value of money.
(ii) Actuarial assumptions —(A) In general —( 1 ) Reasonable actuarial assumptions. For purposes of paragraph (c)(1)(i) of this section, present value is determined using actuarial assumptions and methods that, based on all of the facts and circumstances, are reasonable as of the applicable date, including an interest rate that is reasonable as of that date and other assumptions necessary to determine the present value (without regard to whether the present value of the compensation deferred under the plan is reasonably ascertainable as described in § 31.3121(v)(2)-1(e)(4)(i)(B) of this chapter).
( 2 ) Probability of death before the payment of benefits. For purposes of paragraph (c)(1)(i) of this section, the probability that a participant will die before a payment is made is permitted to be taken into account only to the extent that the payment is forfeitable upon death.
( 3 ) Probability that the payment will not be made. For purposes of paragraph (c)(1)(i) of this section, the probability that payments will not be made (or will be reduced) because of the unfunded status of a plan, the risk associated with any deemed or actual investment of compensation deferred under the plan, the risk that the eligible employer or another party will be unwilling or unable to pay, the possibility of future plan amendments, the possibility of a future change in the law, or similar risks or contingencies are not taken into account.
(B) Payments made in foreign currency. The rules in § 1.409A-4(b)(2)(i) apply for purposes of determining the treatment of payments in foreign currency.
(C) Treatment of payment triggers based upon events —( 1 ) In general. Except as provided in paragraph (c)(1)(ii)(C)( 2 ) of this section, the rules in § 1.409A-4(b)(2)(vii) apply for purposes of determining the treatment of payment triggers based upon events.
( 2 ) Treatment of severance from employment. If the date on which a payment will be made depends on the date the participant has a severance from employment (as described in § 1.457-6(b)) and the participant has not had a severance from employment by the applicable date, then for purposes of paragraph (c)(1)(ii)(A)( 1 ) of this section, the severance from employment may be treated as occurring on any date that is not later than the fifth anniversary of the applicable date, unless this assumption would be unreasonable under the facts and circumstances.
(iii) Unreasonable assumptions. If any actuarial assumption or method used to determine the present value of compensation deferred under the plan is not reasonable, as determined by the Commissioner, then the Commissioner will determine the present value using actuarial assumptions and methods that the Commissioner determines to be reasonable, including the AFR and the applicable mortality table under section 417(e)(3)(B) as of the applicable date. For purposes of this section, AFR means the mid-term applicable federal rate (as defined pursuant to section 1274(d)) for January 1 of the relevant calendar year, compounded annually.
(iv) Account balance plans —(A) In general. To the extent benefits are provided under an account balance plan, as defined in § 31.3121(v)(2)-1(c)(1)(ii) and (iii) of this chapter, to which earnings (or losses, if applicable) are credited at least annually, the present value of compensation deferred under the plan as of an applicable date is the amount credited to the participant's account, including both the principal amount credited to the account and any earnings or losses attributable to the principal amount that have been credited to the account, as of that date.
(B) Unreasonable rates of return. This paragraph (c)(1)(iv)(B) applies to an account balance plan under which the income credited is based on neither a predetermined actual investment, within the meaning of § 31.3121(v)(2)-1(d)(2)(i)(B) of this chapter, nor a rate of interest that is reasonable, within the meaning of § 31.3121(v)(2)-1(d)(2)(i)(C) of this chapter, as determined by the Commissioner. The present value of compensation deferred under that type of plan as of an applicable date is equal to the amount credited to the participant's account as of that date, plus the present value of the excess (if any) of the earnings to be credited under the plan over the earnings that would be credited through the projected payment date using a reasonable rate of interest. If the present value of compensation deferred under the plan is not determined and is not taken into account by the taxpayer in this manner, the present value of the compensation deferred under the plan will be treated as equal to the amount credited to the participant's account as of the applicable date, plus the present value of the excess (if any) of the earnings to be credited under the plan through the projected payment date over the earnings that would be credited using the AFR.
(C) Combinations of predetermined actual investments or interest rates. If the amount of earnings or losses credited under an account balance plan is based on the greater of two or more rates of return (each of which would be a predetermined actual investment or a reasonable interest rate if the earnings or losses credited were based on only one of those rates of return), then the amount included in income on the applicable date is the sum of the amount credited to the participant's account as of the applicable date and the present value (determined under paragraph (c)(1)(i) of this section) of the right to future earnings.
(D) Examples. The following examples illustrate the provisions of paragraphs (c)(1)(i) through (iv) of this section. For purposes of these examples, assume that the arrangements are either not subject to section 409A or 457A or otherwise comply with the requirements of those provisions, and that the parties are not under examination for any of the tax years in question.
Example 1.
(i) Facts. On October 1, 2017, an eligible employer agrees to pay $100,000 to a participant on January 1, 2024, if the participant is alive on that date. The employer determines that the October 1, 2017 present value of that payment is $75,000 based on the second segment rate used for purposes of section 417(e)(3)(C) on October 1, 2017, and using the mortality table applicable under section 417(e)(3)(B) on October 1, 2017.
(ii) Conclusion. The present value has been determined in accordance with paragraph (c)(1)(i) of this section.
Example 2.
(i) Facts. On October 1, 2018, an eligible employer agrees to pay $100,000 to a participant at severance from employment. The assumptions that the employer uses to determine the present value are that the participant will have a severance from employment on October 1, 2023 (the fifth anniversary of the date the participant obtains the right to the payment in accordance with paragraph (c)(1)(ii)(C)( 2 ) of this section) and that the present value will be determined using a rate of 4.5% compounded monthly.
(ii) Conclusion. Assuming, solely for purposes of this example, that the employer's severance from employment date and interest rate assumptions are reasonable, the value included in income on the applicable date (October 1, 2018) is $79,885.
Example 3.
(i) Facts. On October 1, 2017, an eligible employer agrees to pay $100,000 to a participant at severance from employment, but no payment will be made if the severance from employment occurs on or after October 1, 2021.
(ii) Conclusion. Although paragraph (c)(1)(ii)(C)( 2 ) of this section provides that for purposes of determining when a payment will be made, severance may be treated as if it occurred on the fifth anniversary of the applicable date, that assumption would be unreasonable under these facts and circumstances and would not be permitted under paragraph (c)(1)(ii)(C)( 2 ) of this section. Accordingly, for purposes of determining the present value, an assumption that severance from employment would occur after September 30, 2021 would be unreasonable.
Example 4.
(i) Facts. An eligible employer maintains a supplemental executive retirement plan that provides a subsidized early retirement benefit payable to participants between age 60 and 65. A 60 year old participant becomes vested in the right to the subsidized early retirement benefit on December 31, 2017.
(ii) Conclusion. The assumption under paragraph (c)(1)(ii)(C)( 2 ) of this section would not be permitted for purposes of determining the amount to be included in income because the nature of the subsidized early retirement benefit causes it to decline in value until it becomes worthless upon attainment of age 65. In other words, the value of the subsidized early retirement benefit using the assumption permitted in paragraph (c)(1)(ii)(C)( 2 ) of this section would result in a value of $0 and would be unreasonable under the facts and circumstances.
Example 5.
(i) Facts. On October 1, 2017, an eligible employer agrees to provide compensation to an employee for prior services in an amount equal to $100,000, plus interest at a reasonable rate, with payment to be made at the time of the employee's severance from employment. The participant's right to the compensation is not subject to a substantial risk of forfeiture at any time.
(ii) Conclusion. Because the agreement provides for a reasonable rate of interest, the amount included in income on the applicable date (October 1, 2017) is $100,000.
Example 6.
(i) Facts. The facts are the same as in Example 5 of this paragraph (c)(1)(iv)(D), except that the right is subject to a requirement that the participant continue to provide substantial services for three additional years (which constitutes a substantial risk of forfeiture as described in paragraph (e) of this section). On October 1, 2020, when the substantial risk of forfeiture lapses, the account balance is $116,147.
(ii) Conclusion. The amount included in income on the applicable date (October 1, 2020) is $116,147.
Example 7.
(i) Facts. The facts are the same as in Example 5 of this paragraph (c)(1)(iv)(D), except that the rate of interest credited on the account is 5% above a reasonable rate of interest. On October 1, 2017, the sum of the $100,000 account balance, plus the present value of the right to receive the difference between a reasonable rate of return and the rate of return being credited on the account (from October 1, 2017 until October 1, 2022) is $128,336. The participant has a severance from employment on October 16, 2020, and is paid $135,379 on that date.
(ii) Conclusion. The amount included in income on the applicable date (October 1, 2017) is $128,336. Pursuant to paragraph (a)(5) of this section, the $128,336 is treated as investment in the contract for purposes of section 72 and, pursuant to paragraph (a)(4) of this section, the participant recognizes an additional $7,043 ($135,379, minus the $128,336 that was previously included in gross income for 2017) in income attributable to the payment on October 16, 2020.
Example 8.
(i) Facts. The facts are the same as in Example 5 of this paragraph (c)(1)(iv)(D), except that the employer also agrees to pay the participant an amount that is estimated to be equal to the federal, state, and local income taxes due (based on a fixed percentage that is pre-specified in the agreement) attributable to the amount included in income on the applicable date (October 1, 2017). In exchange for that tax payment, the amount payable upon severance from employment is to be reduced by an amount equal to the federal, state, and local income taxes for the taxable year of payment that the employer estimates would otherwise have been due but for the income inclusion in 2017. In satisfaction of this obligation to make the tax payment, the employer pays the participant $66,667 on April 15, 2018.
(ii) Conclusion. The present value on the applicable date (October 1, 2017) is $100,000, plus the present value of the $66,667 payment to be made on April 15, 2018, minus the present value of the reduction that will be applied at the time of payment (which, if reasonable, may be assumed to be October 1, 2022 in accordance with paragraph (c)(1)(ii)(C)( 2 ) of this section).
Example 9.
(i) Facts. An eligible employer credits $100,000 on December 31, 2017, to the account of a participant under an ineligible plan, subject to the condition that the amount will be forfeited if the participant voluntarily terminates employment before December 31, 2019. The account balance will be credited with notional annual earnings based on the greater of the return of a designated S&P 500 index fund or a specified rate of interest and will be paid on December 31, 2025.
(ii) Conclusion. Under paragraph (c)(1)(iv)(C) of this section, the sum of the amount credited to the participant's account as of the applicable date (December 31, 2019) and the present value (determined under paragraph (c)(1)(i) of this section) of the right to future earnings based on the greater of the return of the designated S&P 500 index fund or the specified rate of interest must be included in the participant's gross income on the applicable date.
(v) Application of the general calculation rules to formula amounts. With respect to a right to receive a formula amount, the amount or amounts of future payments under the plan, for purposes of determining the present value as of an applicable date, is determined based on all of the facts and circumstances existing as of that date. This determination must reflect reasonable, good faith assumptions with respect to any contingencies as to the amount of the payment, both with respect to each contingency and with respect to all contingencies in the aggregate. An assumption based on the facts and circumstances as of the applicable date may be reasonable even if the facts and circumstances change in the future so that when the amount payable is determined in a subsequent year, the amount payable is a greater (or lesser) amount. In such a case, the increase (or decrease) due to the change in the facts and circumstances is treated as earnings (or losses). For purposes of this paragraph (c)(1)(v), an amount payable is a formula amount to the extent that the amount payable in a future taxable year is dependent upon factors that, after applying the assumptions and other rules set forth in this section, are not determinable as of the applicable date, such that the amount payable may not be readily determined as of that date under the other provisions of this section. If some portion of an amount payable is not a formula amount, the amount payable with respect to such portion is determined under the rules applicable to amounts that are not formula amounts, and only the balance of the amount payable is determined under the rules applicable to formula amounts.
(vi) Treatment of payment restrictions. The rules in § 1.409A-4(b)(2)(v) apply for purposes of determining the treatment of payment restrictions.
(vii) Treatment of alternative times and forms of a future payment. The rules in § 1.409A-4(b)(2)(vi) apply for purposes of determining the treatment of alternative times and forms of a future payment.
(viii) Reimbursement and in-kind benefit arrangements. The rules in § 1.409A-4(b)(4) apply for purposes of determining the present value of reimbursement and in-kind benefit arrangements.
(ix) Split-dollar life insurance arrangements. The rules in § 1.409A-4(b)(5) apply for purposes of determining the present value of benefits provided under a split-dollar life insurance arrangement.
(2) Forfeiture or other permanent loss of right to compensation previously included in income —(i) In general. If a participant has included compensation under a plan in income pursuant to paragraph (a)(2) or (4) of this section, but all or a portion of that compensation is never paid under the plan, the participant is entitled to a deduction for the taxable year in which the entire remaining right to the payment of the compensation is permanently forfeited under the plan's terms or otherwise permanently lost. The deduction to which the participant is entitled equals the excess of the amounts included in income under paragraphs (a)(2) and (4) of this section with respect to the compensation over the total amount of the compensation actually received that constitutes investment in the contract under paragraph (a)(5) of this section.
(ii) Forfeiture or permanent loss of right. For purposes of this paragraph (c)(2), a mere diminution in the amount payable under the plan due to a deemed investment loss, an actuarial reduction, or any other decrease in the amount deferred under the plan is not treated as a forfeiture or permanent loss of the right if the participant retains the right to any payment under the plan (whether or not such right is subject to a substantial risk of forfeiture as described in paragraph (e) of this section). In addition, an amount payable under a plan is not treated as forfeited or otherwise permanently lost if another amount or an obligation to make a payment in a future year is substituted for the original amount. However, an amount payable under a plan is treated as permanently lost if the participant's right to receive payment of the amount becomes wholly worthless during the taxable year. Whether the right to receive payment has become wholly worthless is determined based on the relevant facts and circumstances existing as of the last day of the relevant taxable year.
(iii) Examples. The provisions of this paragraph (c)(2) are illustrated in the following examples:
Example 1.
(i) Facts. On October 1, 2017, an eligible employer establishes an ineligible plan for a participant under which the employer agrees to pay the amount credited to the participant's account when the participant has a severance from employment. The obligation to make the payment is not subject to a substantial risk of forfeiture. The account balance on October 1, 2017 is $125,000, and the participant includes $125,000 in income in 2017. The plan subsequently experiences notional investment losses, and the participant receives $75,000 from the plan in a lump-sum distribution in 2024, when the participant has a severance from employment. The $75,000 lump-sum distribution represents all amounts due to the participant under the plan.
(ii) Conclusion. For 2024, the participant is entitled to deduct $50,000 (the excess of the amount included in income under paragraph (a)(2) of this section ($125,000) over the amount actually received that constitutes investment in the contract under paragraph (a)(5) of this section ($75,000)).
Example 2.
(i) Facts. The facts are the same facts as in Example 1 of this paragraph (c)(2)(iii), except that the plan provides that the participant will receive the deferred compensation in three installments (1/3 of the account balance in 2024, 1/2 of the then remaining account balance in 2025, and the remaining balance in 2026), and that the sum of all three installments is $75,000.
(ii) Conclusion. The participant is entitled to deduct $50,000 in the taxable year of the last installment payment (2026) ($125,000, reduced by the sum of the amounts received in 2024, 2025, and 2026 ($75,000)).
(d) Definition of deferral of compensation —(1) In general —(i) Legally binding right. A plan provides for the deferral of compensation with respect to a participant for purposes of section 457(f) and this section if, under the terms of the plan and the relevant facts and circumstances, the participant has a legally binding right during a calendar year to compensation that, pursuant to the terms of the plan, is or may be payable to (or on behalf of) the participant in a later calendar year. Whether a plan provides for the deferral of compensation for purposes of section 457(f) and this section is determined based on the relevant facts and circumstances at the time that the participant obtains a legally binding right to the compensation, or, if later, when a plan is amended to convert a right that does not provide for a deferral of compensation into a right that does provide for a deferral of compensation. For example, if a plan providing for retiree health care does not initially provide for a deferral of compensation but is later amended to provide the ability to receive future cash payments instead of health benefits, it may become a plan that provides for the deferral of compensation at the time of the amendment. An amount of compensation deferred under a plan that provides for the deferral of compensation within the meaning of section 457(f) and this section does not cease to be an amount subject to section 457(f) and this section by reason of any change to the plan that would otherwise recharacterize the right to the amount as a right that does not provide for the deferral of compensation with respect to such amount. In addition, any change under the plan that results in an exchange of an amount deferred under the plan for some other right or benefit that would otherwise be excluded from the participant's gross income does not affect the characterization of the plan as one that provides for a deferral of compensation.
(ii) Discretion to reduce or eliminate compensation. A participant does not have a legally binding right to compensation to the extent that the compensation may be reduced or eliminated unilaterally by the employer or another person after the services creating the right to the compensation have been performed. However, if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation is available or exercisable only upon a condition, or the discretion to reduce or eliminate the compensation lacks substantive significance, a participant is considered to have a legally binding right to the compensation. Whether the discretion to reduce or eliminate compensation lacks substantive significance depends on all the relevant facts and circumstances. However, if the participant to whom the compensation may be paid has effective control of the person retaining the discretion to reduce or eliminate the compensation, or has effective control over any portion of the compensation of the person retaining the discretion to reduce or eliminate the compensation, or is a member of the family (as defined in section 267(c)(4) but also including the spouse of any member of the family) of the person retaining the discretion to reduce or eliminate the compensation, the discretion to reduce or eliminate the compensation is not treated as having substantive significance. Compensation is not considered subject to unilateral reduction or elimination merely because it may be reduced or eliminated by operation of the objective terms of the plan, such as the application of a nondiscretionary, objective provision creating a substantial risk of forfeiture or the application of a formula that provides for benefits to be offset by benefits provided under another plan (such as a plan that is qualified under section 401(a)).
(2) Short-term deferrals. For purposes of section 457(f) and this section, a deferral of compensation does not occur under a plan with respect to any payment for which a deferral of compensation does not occur under section 409A pursuant to § 1.409A-1(b)(4) (short-term deferrals), except that, for purposes of this paragraph, in applying the rules provided in § 1.409A-1(b)(4) the meaning of substantial risk of forfeiture under § 1.457-12(e) applies in each place that term is used (and not the meaning of substantial risk of forfeiture provided under § 1.409A-1(d)).
(3) Recurring part-year compensation. For purposes of section 457(f) and this section and notwithstanding paragraph (d)(2) of this section, a deferral of compensation does not occur under a plan with respect to an amount that is recurring part-year compensation (as defined in § 1.409A-2(a)(14)), if the plan does not defer payment of any of the recurring part-year compensation to a date beyond the last day of the 13th month following the first day of the service period for which the recurring part-year compensation is paid, and the amount of the recurring part-year compensation does not exceed the annual compensation limit under section 401(a)(17) for the calendar year in which the service period commences.
(4) Certain other exceptions. For purposes of section 457(f) and this section, a deferral of compensation does not occur to the extent that a plan provides for:
(i) The payment of expense reimbursements, medical benefits, or in-kind benefits, as described in § 1.409A-1(b)(9)(v)(A), (B), or (C);
(ii) Certain indemnification rights, liability insurance, or legal settlements, as described in § 1.409A-1(b)(10), or (11); or
(iii) Taxable educational benefits for an employee (which, for this purpose, means solely benefits consisting of educational assistance, as defined in section 127(c)(1) and the regulations thereunder, attributable to the education of an employee, and does not include any benefits provided for the education of any other person, including any spouse, child, or other family member of the employee).
(5) Interaction with section 409A —(i) In general. The rules of section 457(f) apply to an ineligible plan separately and in addition to any requirements applicable to the plan under section 409A.
(ii) Acceleration of the time or schedule of a payment. Although section 457(f) and this section do not preclude the acceleration of payments, see § 1.409A-3(a) for the general rules and exceptions relating to the acceleration of payments that are subject to section 409A.
(iii) Example. The provisions of this paragraph (d)(5) are illustrated in the following example:
Example.
(i) Facts. On December 1, 2017, an eligible employer establishes an account balance plan for an employee that is subject to section 457(f), under which an initial amount is credited to the account and is increased periodically by earnings based on a reasonable specified rate of interest. The entire account balance is subject to a substantial risk of forfeiture until December 1, 2021. Under the terms of the plan, the account balance will be paid in three annual installments on each January 15, beginning in 2024 (one third of the balance for the first installment, one half of the then remaining balance for the second installment, and the remaining balance for the third installment). However, in 2022, the plan is amended to provide for payments to begin in 2023, such that the plan fails to comply with the requirements of section 409A during 2022. The account balance is: $100,000 on December 1, 2021; $118,000 on December 31, 2022; $120,000 on January 15, 2023 (so that the payment made that day is $40,000 ($120,000/3)); $88,000 on January 15, 2024 (so that the payment made that day is $44,000 ($88,000/2)); and $50,000 on January 15, 2025 (so that the payment made that day is $50,000).
(ii) Conclusion: Federal income tax treatment in 2021. The plan provides for a deferral of compensation to which section 457(f) applies. Under section 457(f) and paragraph (a)(2) of this section, the $100,000 amount of the account balance on December 1, 2021, when the benefits cease to be subject to a substantial risk of forfeiture, is included in the employee's gross income on that date.
(iii) Conclusion: Federal income tax treatment after 2021 —( 1 ) Treatment in 2022 under section 409A. Because the arrangement fails to meet the requirements of section 409A in 2022, the employee has gross income under section 409A equal to the account balance on December 31, 2022, reduced by the amount previously included in income. Accordingly, the amount included in gross income under section 409A is equal to $18,000 (the $118,000 account balance on December 31, 2022, reduced by the $100,000 previously included in income under section 457(f) for 2021). The amount included in gross income under section 409A is subject to an additional 20 percent tax under section 409A(a)(1)(B)(i)(II) and a premium interest tax under section 409A(a)(1)(B)(i)(I).
( 2 ) Federal income tax treatment of first installment payment in 2023 —( i ) Earnings previously included under section 409A. The first $18,000 of the $40,000 payment in 2023 is excluded from gross income under section 409A as a result of the earlier inclusion of that amount in income in 2022 due to the section 409A violation. See § 1.409A-4(f).
( ii ) Deferral of compensation under section 457(f). The amount of the investment in the contract (described in paragraph (a)(5) of this section) allocated to the remaining $22,000 of the installment paid in 2023 is $33,333 ($100,000/3), so no amount is included in gross income for 2023.
( 3 ) Federal income tax treatment of second installment payment in 2024. The employee has unused investment in the contract from 2023 in the amount of $11,333 ($33,333-$22,000). Assuming that the employee elects to redetermine the amount recognized for the current and subsequent years in 2024 pursuant to § 1.72-4(d)(3)(ii), the amount included in gross income for 2024 is $5,000 (the payment of $44,000, reduced by the portion of the remaining investment in the contract that is allocable to the installment, which is $39,000 (($100,000-$22,000)/2)).
( 4 ) Federal income tax treatment of third installment payment in 2025. The amount included in gross income for 2025 is $11,000 (the payment of $50,000, reduced by the remaining investment in the contract of $39,000).
(e) Rules relating to substantial risk of forfeiture —(1) Substantial risk of forfeiture —(i) In general. An amount of compensation is subject to a substantial risk of forfeiture only if entitlement to the amount is conditioned on the future performance of substantial services, or upon the occurrence of a condition that is related to a purpose of the compensation if the possibility of forfeiture is substantial. An amount is not subject to a substantial risk of forfeiture if the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced (see paragraph (e)(1)(v) of this section). If a plan provides that entitlement to an amount is conditioned on involuntary severance from employment without cause (which includes, for this purpose, a voluntary severance from employment that is treated as involuntary under § 1.457-11(d)(2)(ii)), the right is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial.
(ii) Substantial future services. For purposes of paragraph (e)(1)(i) of this section, the determination of whether an amount of compensation is conditioned on the future performance of substantial services is based on the relevant facts and circumstances, such as whether the hours required to be performed during the relevant period are substantial in relation to the amount of compensation.
(iii) Condition related to a purpose of the compensation. For purposes of paragraph (e)(1)(i) of this section, a condition related to a purpose of the compensation must relate to the participant's performance of services for the employer or to the employer's governmental or tax-exempt activities (as applicable) or organizational goals.
(iv) Noncompetition conditions. For purposes of paragraph (e)(1)(i) of this section, an amount of compensation will not be treated as subject to a substantial risk of forfeiture merely because the right to payment of the amount is conditioned, directly or indirectly, upon the employee refraining from the future performance of certain services, unless each of the of the following conditions is satisfied:
(A) The right to payment of the amount is expressly conditioned upon the employee refraining from the future performance of services pursuant to an enforceable written agreement.
(B) The employer makes reasonable ongoing efforts to verify compliance with noncompetition agreements (including the noncompetition agreement applicable to the employee).
(C) At the time that the enforceable written agreement becomes binding, the facts and circumstances demonstrate that the employer has a substantial and bona fide interest in preventing the employee from performing the prohibited services and that the employee has bona fide interest in, and ability to, engage in the prohibited competition. Factors taken into account for this purpose include the employer's ability to show significant adverse economic consequences that would likely result from the prohibited services; the marketability of the employee based on specialized skills, reputation, or other factors; and the employee's interest, financial need, and ability to engage in the prohibited services.
(v) Enforcement of forfeiture condition. To constitute a substantial risk of forfeiture, the possibility of actual forfeiture in the event that the forfeiture condition occurs must be substantial based on the relevant facts and circumstances. Factors to be considered for this purpose include, but are not limited to, the extent to which the employer has enforced forfeiture conditions in the past, the level of control or influence of the employee with respect to the organization and the individual(s) who would be responsible for enforcing the forfeiture condition, and the likelihood that such provisions would be enforceable under applicable law.
(2) Addition or extension of risk of forfeiture —(i) General rule. The initial addition or extension of any risk of forfeiture after a legally binding right to compensation arises, including the application of a risk of forfeiture to a plan providing for deferrals of current compensation (an additional or extended risk of forfeiture), will be disregarded unless the plan meets the requirements of paragraphs (e)(2)(ii) through (v) of this section.
(ii) Benefit must be materially greater. A deferred amount will not be subject to a substantial risk of forfeiture for purposes of section 457 and this section after the date on which an employee could have received the amount, unless the present value of the amount made subject to the additional or extended substantial risk of forfeiture (disregarding the risk of forfeiture in determining the present value of the amount) is materially greater than the present value of the amount the employee otherwise would have received absent the initial or extended risk of forfeiture. For purposes of this paragraph (e)(2)(ii), present value is determined in accordance with the rules described in paragraph (c) of this section as of the applicable date for the amount the employee otherwise would have received absent the initial or extended risk of forfeiture. In addition, an amount is materially greater for purposes of this paragraph (e)(2)(ii) only if the present value of the amount subject to the additional or extended substantial risk of forfeiture is more than 125 percent of the present value of the amount that the employee would have received absent the additional or extended risk of forfeiture. For this purpose, compensation that the participant would receive for continuing to perform services, regardless of whether the deferred amount is subjected to an additional or extended substantial risk of forfeiture, is not taken into account.
(iii) Minimum two years of substantial future services. The employee must be required to perform substantial services in the future, or refrain from competing pursuant to an agreement that meets the requirements of paragraph (e)(1)(iv) of this section, for a minimum of two years after the date that the employee could have received the compensation in the absence of the additional or extended substantial risk of forfeiture. For example, if an employee elects to defer a fixed percentage from each semi-monthly payroll, the two year minimum applies to each semi-monthly payroll amount that would otherwise have been paid. Notwithstanding the two year minimum, a plan may provide that that the substantial future service condition will lapse upon death, disability, or involuntary severance from employment without cause.
(iv) Timing. The parties must agree in writing to any addition or extension of a substantial risk of forfeiture under this paragraph (e)(2). In the case of an initial addition of a substantial risk of forfeiture if none previously existed (for example, in the case of a deferral of current compensation), this written agreement must be entered into before the beginning of the calendar year in which any services that give rise to the compensation are performed, and, in the case of an extension of a substantial risk of forfeiture, the written agreement must be entered into at least 90 days before an existing substantial risk of forfeiture would have lapsed. If an employee with respect to whom compensation is made subject to an initial or extended substantial risk of forfeiture was not providing services to the employer at least 90 days before the addition or extension, the addition or extension may be agreed to in writing within 30 days after commencement of employment but only with respect to amounts attributable to services rendered after the addition or extension is agreed to in writing.
(v) Substitutions. For purposes of paragraph (e)(2) of this section, if an amount is forfeited or relinquished and replaced, in whole or part, with a right to another amount (or benefit) that is a substitute for the amount that was forfeited or relinquished and that is subject to a risk of forfeiture, the risk of forfeiture will be disregarded unless the requirements of paragraphs (e)(2)(ii) through (iv) of this section are satisfied.
(3) Examples. The provisions of this paragraph (e) are illustrated in the following examples:
Example 1.
(i) Facts. On January 15, 2017, an employee has a severance from employment with an eligible employer and enters into an agreement with the eligible employer under which the eligible employer agrees to pay the employee $250,000 on January 15, 2018, if the employee provides consulting services to the employer until that date. The consulting services required are insubstantial in relation to the payment. The employee provides the required consulting services for the employer through January 15, 2018.
(ii) Conclusion. The consulting services provided by the former employee do not constitute substantial services because they are insubstantial in relation to the payment. Accordingly, the present value of $250,000 payable on January 15, 2018 is includible in the employee's gross income on January 15, 2017.
Example 2.
(i) Facts. On January 27, 2020, an eligible employer agrees to pay an employee an amount equal to $120,000 on January 1, 2023, provided that the employee continues to provide substantial services to the employer through that date. In 2021, the parties enter into a written agreement to extend the date through which substantial services must be performed to January 1, 2025, in which event, the employer will pay an amount that has a present value of $145,000 on January 1, 2023.
(ii) Conclusion. As of the date the initial risk of forfeiture would have lapsed, the present value of the compensation subject to the extended substantial risk of forfeiture is not materially greater than the present value of the amount previously deferred under the plan ($145,000 is not more than 125% of $120,000) and, therefore, the intended extension of the substantial risk of forfeiture is disregarded under the provisions of paragraph (e)(2) of this section. Accordingly, the employee will recognize income, on the applicable date (January 1, 2023) in an amount equal to $120,000 (the amount that is not subject to a substantial risk of forfeiture on that date, disregarding the intended extension). With respect to the amount that is ultimately paid under the plan on January 1, 2025, the employee is treated as having investment in the contract of $120,000 (pursuant to paragraph (a)(5) of this section).
Example 3.
(i) Facts. On December 31, 2017, a participant enters into an agreement to defer $15,000 of the participant's current compensation that would otherwise be paid during 2018, with payment of the deferred amounts to be made on December 31, 2024, but only if the participant continues to provide substantial services until December 31, 2024. Under the terms of the agreement, the participant's periodic payments of current compensation are reduced, and a corresponding amount is credited (with a 30% employer match) to an account earning a reasonable rate of interest. The present value of the amount payable on December 31, 2024 is 130% of the present value of the amount deferred.
(ii) Conclusion. The amounts deferred are subject to a substantial risk of forfeiture because the plan satisfies the requirements of paragraphs (e)(2)(ii) through (v) of this section.
Example 4.
(i) Facts. Employee A is a well-known college sports coach with a long history of success in a sports program at University X. University X reasonably expects that the loss of Employee A would be substantially detrimental to its sports program and would result in significant financial losses. Employee A has bona fide interest in continuing to work as a college sports coach and is highly marketable. On June 1, 2020, Employee A and University X enter into a written agreement under which Employee A agrees to provide substantial services to University X until June 1, 2023. The parties further agree that University X will pay $500,000 to Employee A on June 1, 2025 if Employee A has not performed services as a sports coach before that date for any other college or university with a sports program similar to that of University X. The agreement is enforceable under applicable law and University X would be reasonably expected to enforce it.
(ii) Conclusion. The $500,000 payable under the agreement is subject to a substantial risk of forfeiture until June 1, 2025, and includible in Employee A's gross income on that date.