Can a Tax-Exempt Organization Implement a Nonqualified Deferred Compensation Plan?

Yes. However, nonqualified deferred compensation plans of tax-exempt organizations are subject to special rules per Code section 457(f). This Code section stipulates that ineligible deferred compensation plan benefits are included in gross income in the first taxable year in which there is no “substantial risk of forfeiture” of the rights to such compensation. Thus, these plans are subject to more onerous requirements than plans of for-profit employers, in which benefits aren’t currently taxed as long as they are subject to a substantial limitation on the employee’s ability to reach the plan assets.

Why are plans of tax-exempt organizations subject to more onerous rules? Because they are tax-exempt, there is no disincentive for them to limit the amount of compensation that a participant can defer (i.e., the loss of the upfront tax deduction is meaningless to a tax-exempt employer). Thus, there would be nothing stopping a participant from deferring 100 percent or his or her compensation. Realizing this, Congress implemented special rules for tax-exempt organizations by creating Code section 457(f).

From a practical standpoint, the requirement of a substantial risk of forfeiture (in addition to a substantial limitation on the right to access the benefits) for tax-exempt plans has the following consequences:

  • Salary deferral plans are rarely implemented, because few employees desire to put their own money at risk of being forfeited.
  • Plan benefits are generally not vested until retirement. Vesting them earlier causes immediate income tax consequences at the time of vesting (i.e., the lapse of the substantial risk of forfeiture), regardless if the benefits have actually been paid out.
  • Plans benefits are generally paid out lump-sum at retirement. This is due to the fact that at retirement the substantial risk of forfeiture lapses, resulting in the benefits being subject to income taxation. Therefore, it generally makes sense from the participant’s perspective to pay out the benefits lump sum. Note that if the benefits will be paid out over a period of years, the present value of the periodic payments will be taxable in the year of retirement.

One final comment regarding nonqualified deferred compensation plans of tax-exempt organizations deserves mention. The use of life insurance to finance the plan benefits loses one of its main advantages because of the fact that the employer is tax-exempt–namely; using permanent life insurance (which grows tax-deferred) as an alternative asset to avoid taxation of the investment income if the employer were to instead accumulate taxable assets for the purpose of paying plan benefits. However, the other benefits of using life insurance, such as cost recovery and the ability to provide a pre-retirement death benefit, still apply.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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