On June 22, 2016, the Internal Revenue Service (IRS) and Treasury Department issued proposed regulations under Section 457 of the Internal Revenue Code, fulfilling a nearly decade-old commitment to provide additional guidance. On the same day the IRS and Treasury also issued proposed regulations under Section 409A. Although there is some coordination between the proposed regulations under Section 457 and 409A, this article focuses only on key changes which are mostly related to the 457 regulations, in part because the 409A proposed regulations were largely clarifying in nature. The proposed 409A regulations are the subject of a separate advisory, which can be accessed through this link.

As previously announced by the IRS, the 457 proposed regulations largely follow the concepts embedded in Section 409A and previously issued regulations under Section 409A. However, there are some unexpected differences that provide unique plan design opportunities. In particular, the proposed regulations are of special interest to tax-exempt employers whose plans utilize non-compete restrictions or “rolling risks of forfeiture,” or who would like to add those features.


Dating back to the 1970’s, Code Section 457 has governed the nonqualified deferred compensation programs of tax-exempt and governmental employers. The addition of Section 409A to the Code in 2005 raised a number of questions about the interplay between Section 409A and Section 457. And as plan sponsors and the IRS began examining the practical ramifications of Sections 409A, tax exempt and governmental employers (and their advisors) began exploring similar questions within the context of Section 457.

In 2007 the IRS began releasing comments on key topics related to nonqualified deferred compensation plans governed by Section 457, and particularly plans governed by Section 457(f). (See, IRS Notice 2007-62.) The IRS also announced its intention to issue additional, more formal guidance, and every year for almost ten years repeated its intention to issue formal guidance “soon.” The 457 proposed regulations finally fulfill that promise. What follows is a summary of the chief changes reflected in the 457 proposed regulations, a short discussion of the associated effective dates, and a list of suggested next steps for plan sponsors. Like the previously issued 409A final regulations, the 457 proposed regulations generally use the more precise terms of “service recipient” and “service provider,” rather than “employer” and “employee.” To enhance readability, this article refers to “employers” and “employees.”

Summary of Chief Changes in the 457 Proposed Regulations

Definition of Bona Fide Severance Pay Plan

Section 457 excludes from the definition of “deferred compensation” any “bona fide severance pay plan.” Neither the Code nor prior regulations provided further clarification of what constitutes a bona fide severance pay plan. The 457 proposed regulations provide a definition that corresponds to the definition in the 409A final regulations issued back in 2007. To constitute a bona fide severance plan, the arrangement must include the following:

  • Benefits must be payable only upon a participant’s involuntary severance from employment or a termination pursuant to a window program or voluntary early retirement incentive plan.
  • The amount payable under the plan may not exceed twice the participant’s annualized compensation, based on the annual rate of pay for services provided in the prior calendar year (or the current calendar year, if the participant had no compensation from the employer in the preceding calendar year).
  • The plan must provide that payment occur no later than the last day of the second calendar year following the calendar year in which the severance from employment occurs.

Definition of Involuntary Severance from Employment and Severance for a “Good Reason.”

In connection with describing the components of a bona fide severance pay plan, the 457 proposed regulations also provide that the existence of an “involuntary severance from employment” is based on all the facts and circumstances of the particular situation, but must be due to the employer’s independent exercise of its authority to terminate the employee’s services, other than as a result of the employee’s implicit or explicit requests, and subject to the following:

  • At the time of the termination, the employee must be willing and able to perform or to continue to perform services.
  • An “involuntary severance from employment” may also include a severance from employment for “good reason,” and a good reason termination exists if it is pursuant to written, pre-specified circumstances involving unilateral action by the employer that results in a material adverse change to the working relationship or conditions of the employee.

The following factors are important in determining whether a voluntary termination is for “good reason,” and therefore treated as an involuntary severance from employment:

  • Whether the employee was required to give notice to the employer of the material adverse change that gave rise to the good reason termination;
  • Whether the employer had an opportunity to remedy the adverse change; and
  • The extent to which payments upon a good reason termination are in the same amount, and paid at the same time, as payments contingent upon an employer-initiated severance from employment without cause.

The 457 proposed regulations also provide a safe harbor definition of what constitutes a “good reason” termination. The safe harbor is substantially identical to the one provided in the 409A final regulations.

Bona Fide Sick Leave and Vacation Leave Plans

Section 457 also excludes from the category of deferred compensation any “bona fide sick or vacation leave plans. As with bona fide severance plans, the Code and previously issued regulations did not go into detail regarding what constitutes a bona fide sick leave or vacation leave plan. The 457 proposed regulations provide a list of factors that would be used to determine whether a plan is a bona fide sick or vacation leave plan. The list includes:

  • Whether the amount of leave could reasonably be expected to be used by the employee in the normal course of employment and before cessation of services;
  • Any limits on the ability to exchange unused accumulated leave for cash or other benefits, and any applicable accrual restrictions (for example a use-or-lose-it rule, as permitted under applicable state law);
  • The amount and frequency of any in-service distributions of cash or other benefits offered in exchange for accumulated and unused leave;
  • Whether the payment of unused sick or vacation leave is made promptly upon severance from employment or, instead, is paid over a period of time after severance from employment; and
  • Whether the sick leave, vacation leave or combined sick and vacation leave offered under the plan is generally applicable to employees, as opposed to being available only to certain employees.

Recurring Part-Year Compensation

The IRS has previously addressed situations involving ongoing arrangements between an employer and an employee in which the employee is paid for services, with the payments extending over a period that is longer than the period of service. (See IRS Notice 2008-62.) The most common example would be a teacher who provides services during a school year comprised of ten consecutive months, but whose pay stretches over 12 months. The IRS previously agreed that these arrangements should not be treated as a deferral of compensation, and therefore would be exempt under Section 457 and Section 409A. Based on comments it received, the IRS has modified the parameters for a “recurring part-year compensation program” to avoid treatment as a program of deferred compensation. Under the 457 proposed regulations, a recurring part-year compensation program does not provide for the deferral of compensation if:

  • The program does not defer the payment of compensation to a date beyond the last day of the thirteen 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 (not merely the amount deferred) does not exceed the annual compensation limit under Code Section 409(a)(17) ($265,000 for 2016) for the calendar year in which the service period commences.

Short-Term Deferral

The 457 proposed regulations provide that a deferral of compensation does not occur with respect to any amount that would be a short-term deferral under the 409A final regulations. The distinction is that in applying the rule, the definition of a “substantial risk of forfeiture” would be the definition provided in the 457 proposed regulations, as opposed to the definition provided the 409A final regulations (specifically in Section 1.409A-1(d)). This is a significant distinction, as described below, because the definition of a substantial risk of forfeiture under the 457 proposed regulations differs from the definition under the 409A final regulations.

Definition of Substantial Risk of Forfeiture

In prior announcements, the IRS said it would likely incorporate the 409A final regulation’s definition of “substantial risk of forfeiture” into any new 457 regulations. The 457 proposed regulations do incorporate much of the 409A final regulations’ definition of substantial risk of forfeiture, but also include a few important twists.

Deferral of Current Compensation Permitted Under Certain Circumstances 

The 457 proposed regulations incorporate a special rule regarding whether initial deferrals of current compensation may be treated as being subject to a substantial risk of forfeiture. For these purposes, “current compensation” is defined as compensation paid on a current basis, such as salary and commissions. Previously, the IRS had informally stated that it did not think current compensation could be deferred subject to a substantial risk of forfeiture. The theory seemed to be that given the fact that employees generally work for current compensation, it did not make economic sense that an employee would subject current compensation to a substantial risk of forfeiture; and therefore any purported substantial risk of forfeiture was likely a contrivance, constructed solely for the purpose of tax deferral. However, under the 457 proposed regulations, a deferral of current compensation will be considered subject to a substantial risk of forfeiture if the following four factors are met.

  1. The present value of the amount to be paid upon the lapse of the substantial risk of forfeiture must be materially greater than the amount the employee otherwise would be paid in the absence of the substantial risk of forfeiture. The 457 proposed regulations provide that an amount is materially greater for this purpose only if the present value of the amount to be paid upon the lapse of the risk of forfeiture, measured as of the date the amount would have otherwise been paid, is more than 125% of the amount the participant otherwise would have received in the absence of the substantial risk of forfeiture. Also, for purposes of measuring the 125% plus threshold, the IRS will ignore any further compensation the employee earns by continuing employment.

  2. The risk of forfeiture must be based upon the future performance of substantial services or adherence to an agreement not to compete, and the risk may not be based solely on the occurrence of a condition related to the purpose of the transfer (for example a financial performance goal for the employer), though that type of condition may be combined with a sufficient service condition.

  3. The period for which the substantial future services must be performed may be no less than two years absent an intervening event, such as death, disability or involuntary separation from service.

  4. The agreement subjecting the amount to a substantial risk of forfeiture must be expressed in writing before the beginning of the calendar year in which the services giving risk to the compensation are performed.

Rolling Risks of Forfeiture Permitted Under Certain Circumstances.

Also related to the concept of substantial risk of forfeiture is something commonly referred to as “rolling risks of forfeiture.” These are situations in which a deferral of compensation is tied to a substantial risk of forfeiture, and prior to satisfying the standard tied to the risk of forfeiture and the amounts becoming vested, the parties agree to an extension or additional risk of forfeiture. Historically, the IRS has said that any extended or added risk of forfeiture would be ignored, and the 409A final regulations expressly incorporate this view; however the 457 proposed regulations permit a rolling risk of forfeiture if the extended or added risk of forfeiture satisfies the four conditions described above in connection with a deferral of current compensation. Note that with respect to the fourth condition, regarding the timing of the extended or added risk being put into writing, the condition must be satisfied at least 90 days before the date on which the existing substantial risk of forfeiture would have lapsed in the absence of the extension or addition.

Non-compete Condition May Constitute a Substantial Risk of Forfeiture.

The final unique twist on the definition of substantial risk of forfeiture under the 457 proposed regulations relates to the ability of an employer to tie a substantial risk of forfeiture to a non-compete. The 409A final regulations expressly state that a non-compete restriction will not constitute a substantial risk of forfeiture. On the other hand, the 457 proposed regulations provide that a forfeiture of benefits upon an employee’s acceptance of a position with a competing employer can constitute a substantial risk of forfeiture if three requirements are satisfied:

  1. The right to compensation must be expressly conditioned on the employee refraining from the performance of future competitive services, which restriction is reflected in a written agreement that is enforceable under applicable law (presumably state employment law).

  2. The employer must consistently make reasonable efforts to verify compliance with all the non-competition agreements to which it is a party, including the non-competition agreement at issue.

  3. At the time the non-competition agreement becomes binding, the facts and circumstances must show that the employer has a substantial and bona fide interest in preventing the employee from performing the prohibited services, and the employee has a bona fide interest in engaging in, and an ability to engage in, the prohibited services. In assessing these factors, the IRS will consider the employer’s ability to show that significant adverse economic consequences 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.

Effective Dates

The 457 proposed regulations will not formally apply until after the regulations have been finalized. Nevertheless, taxpayers may rely on the proposed regulations prior to their applicability date. The applicability date may be delayed beyond the effective date of final regulations in situations where (i) a plan is maintained pursuant to one or more collective bargaining agreements, (ii) a governmental plan requires legislative action to be amended, and (iii) a plan involves “recurring part-year compensation” (as described above).

Next Steps

Tax-exempt and governmental employers that sponsor non-qualified deferred compensation plans should review the 457 Proposed Regs in greater detail to ensure continued compliance. Given that the 457 Proposed Regs are more generous in some instances than what the IRS previously suggested, there may be planning opportunities. In particular, we recommend the following action items:

  1. Review severance pay plans, sick leave, and vacation plans to ensure that the arrangements satisfy the criteria for avoiding classification as non-qualified deferred compensation plans.

  2. Non-qualified deferred compensation plans that have retained a non-competition provision as part of a substantial risk of forfeiture should evaluate whether the plan’s definition of “non-competition” complies with the requirements of the 457 Proposed Regs. In addition, plan sponsors who would like to utilize a non-competition, but were scared off by prior IRS pronouncements, can amend their plans accordingly.

  3. Similarly, plan sponsors who retained a rolling risk of forfeiture should evaluate whether their plan’s definition of rolling risk of forfeiture complies with the 457 Proposed Regs. And for plan sponsors who either eliminated existing rolling risks of forfeitures, in the face of IRS comments, or refrained from adding a rolling risk of forfeiture, may now amend their plans accordingly.