Code Section 457(f): Potential Timing Trap for Nonprofit Employers and Employees

Nonprofit (tax-exempt) employers are treated differently than for-profit employers with respect to how deferred compensation is taxed. Internal Revenue Code Section 457 (Section 457) is the main tool for this. Some of the timing issues under Section 457 may pose a trap for those not familiar with them.

Employees of for-profit employers generally are not taxed on deferred compensation until they receive payment of it, provided Internal Revenue Code rules (particularly under Code Section 409A) are followed. In part, this is because for-profit employers generally cannot take a deduction for the deferred compensation until the employee is taxed on it. (Qualified plans, such as a 401(k), are an exception to this rule.) A for-profit employer therefore has some incentive not to allow deferral of compensation. But for tax revenue purposes, delaying the payment in this situation is roughly neutral — no income tax paid by the employee, but no income tax deduction taken by the employer.

However, tax-exempt employers generally do not pay taxes and so are not concerned about the timing of deductions. Consequently, a tax-exempt employer could allow employees to defer as much of their compensation as they wanted, which in turn would defer when the IRS collects the tax on that compensation — without any offsetting loss of deduction. Section 457 addresses this issue, which is where the potential trap comes in. (Code Section 409A also generally will apply to nonqualified deferred compensation of tax-exempt employers, but a discussion of Section 409A is beyond the scope of this article.)

The default rule of Section 457 is that an employee of a tax-exempt employer will be taxed on deferred compensation in the year in which the employee first has a nonforfeitable right to that compensation, even though it may be paid many years in the future. Having to pay taxes on money not yet received can be an unpleasant surprise for an employee.

The default rule is found in Section 457(f), so arrangements subject to it are often called 457(f) plans. There are several exceptions to the default, including plans designed to comply with the specific requirements of Section 457(b) (hence the term 457(b) plans), Section 401(k) and other qualified retirement plans, and ​“bona fide” death benefit and severance plans. But, unless an exception applies, Section 457(f) will apply to any deferred compensation paid by a tax‑exempt employer, regardless of whether there is plan or agreement that specifically says it is a 457(f) plan.

Consequently, unless a tax-exempt employer’s deferred compensation arrangement is designed to comply with one of the exceptions, the employee will be taxed on the value of the deferred compensation in the first year in which the employee has a nonforfeitable right to it, which many employees may not expect. (At least when the payment actually is later made, the employee will not be subject to additional income tax. This however may be of little comfort to the employee.)

Therefore, tax-exempt employers should carefully review the tax rules before offering deferred compensation to their employees to ensure any arrangement is drafted properly and avoids timing traps.