Let's face it, finding good help is hard these days. This is especially true for tax-exempt employers. So when such employers find that diamond in the rough, they may try to retain that executive by entering into custom-designed employment and deferred compensation agreements to accommodate the needs of the executive and the exempt organization. In doing so, a tax-exempt employer must keep in mind that these agreements, especially deferred compensation agreements, are generally subject to Section 457(f) of the Internal Revenue Code of 1986, as amended.
Section 457 generally applies to deferred compensation plans/agreements of tax-exempt organizations and state and local governments. Deferred compensation agreements under Section 457 are divided into two types of agreements: eligible and ineligible agreements. Section 457(f) specifically applies to "ineligible" agreements and the remainder of Section 457 applies to "eligible" agreements. A deferred compensation agreement is considered an "ineligible" agreement if it does not meet the eligibility requirements, which include, among other requirements, an annual limitation for the amount that may be deferred under the agreement for each tax year. Most deferred compensation agreements designed for executives will not meet this annual limitation because the limitation is set at the lesser of $18,000 (for 2015), or 100% of the executive's compensation. As a result, most custom-designed deferred compensation agreements are "ineligible" agreements and therefore are subject to Section 457(f).
If a deferred compensation agreement is an "ineligible" agreement, then the compensation deferred under the plan will be taxable to the executive in the first year in which his/her right to the compensation is no longer subject to a substantial risk of forfeiture. An executive's right to the deferred compensation is considered subject to a substantial risk of forfeiture if his/her right is conditioned upon the future performance of substantial services.
In testing whether an executive's right to deferred compensation is subject to a substantial risk of forfeiture, the IRS reviews the circumstances under which he/she would receive the compensation. If an executive is entitled to receive the deferred compensation under almost all circumstances, then that compensation is likely no longer subject to a substantial risk of forfeiture and therefore, is subject to current taxation.
Keep in mind, the deferred compensation may be subject to a substantial risk of forfeiture at the outset of the deferred compensation agreement; but, as an executive's employment continues, depending on the terms of the deferred compensation agreement, the risk of forfeiture may diminish. If the risk of forfeiture diminishes beyond a certain point, the executive may be at risk of being taxed on the deferred compensation. Failure by an executive to timely report such deferred compensation on his tax return may result in the imposition of penalties (and interest). Therefore, it is prudent for tax-exempt employers to regularly review custom-designed employment and deferred compensation agreements for this particular issue.
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