Section 457(f) Should Not Apply to the Deferred Compensation Plan of a For-Profit Subsidiary of a Tax-Exempt Organization – Right?

Special thanks to Peter J. Dill, a Senior Consultant at Towers Watson (Boston), for his consultation and input on this post.

Treasury Regulations meant to reconcile the “substantial risk of forfeiture” provisions of Code Section 409A and Code Section 457(f) are expected to arrive some day. Those regulations have been in the works since 2007 (see IRS Notice 2007-62), and it will be great to get some uniformity in how the “substantial risk of forfeiture” concept works in the contexts of Sections 409A and 457(f). But we are hoping that the regulations will also address a couple of other issues that have long-afflicted those of us who work with large tax-exempt organizations. In particular, it would be nice to confirm that if a for-profit subsidiary of a tax-exempt organization establishes a nonqualified deferred compensation plan exclusively for its employees, that plan should only have to comply with Code Section 409A and should not be subject to Code Section 457(f).

Code Section 457 governs the income tax treatment of any deferred compensation plan or arrangement maintained by a tax-exempt employer for the benefit of individuals who perform services for that employer. (Section 457 also governs deferred compensation programs of governmental employers, but we will not discuss those here.) For this purpose, a tax-exempt employer is any organization that is exempt from tax under Code Section 501(c). Such an employer may establish a deferred compensation plan under Code Section 457(b) – an “eligible deferred compensation plan” – the benefits of which will be subject to income taxation when the benefits are paid or otherwise made available to the participant or beneficiary. Section 457(b) plans are typically designed to make available an additional elective deferral opportunity to higher paid employees who want to defer pay beyond the limits of the employer’s 403(b) or 401(k) plan.

However, many tax-exempt employers choose to establish deferred compensation programs designed to provide benefits that far exceed the relatively modest annual limits under Code Section 457(b). (Think in terms of a defined benefit style SERP for the chief executive.) Such “ineligible” plans are subject to the much more restrictive taxation regime of Code Section 457(f). Under Section 457(f), deferred compensation becomes taxable to the employee when the compensation ceases to be subject to a substantial risk of forfeiture (i.e., when it vests) regardless of when it is paid out. That’s why most conservatively drafted 457(f) plans will provide for the payment of the benefit upon or within a very short time after vesting. For that reason, a conservatively drafted 457(f) plan will always qualify for the short-term deferral exception under Code Section 409A. All of that is well-established and non-controversial.

Now suppose a tax-exempt employer, a hospital in this case, has a for-profit subsidiary, like a medical practice or a medical management service organization. The employees of the subsidiary are not eligible to participate in the hospital’s 403(b) plan or 457(b) plan, because the subsidiary is not eligible to sponsor such plans. Instead, the for-profit subsidiary maintains its own 401(k) plan and would like to supplement that benefit for highly compensated employees by offering a nonqualified deferred compensation plan analogous to or perhaps more generous than the hospital’s 457(b) plan. It has long been our view that the for-profit subsidiary can maintain such a plan and that it would not be subject to restrictions of Code Section 457(f). Instead, that plan would simply have to comply with the requirements of Code Section 409A, just like any deferred compensation plan of any other for-profit employer. Why do we think this?

Code Section 457(b) defines “eligible deferred compensation plan” as a plan that is maintained by an “eligible employer” and meets the various statutory requirements. That means a for-profit entity cannot sponsor a 457(b) plan. Code Section 457(b) also states that “only individuals who perform services for the eligible employer, either as an employee or as an independent contractor, may be participants” in an eligible deferred compensation plan. One can reasonably ask whether employees working for our hypothetical subsidiary are, at least indirectly, providing services for the tax-exempt parent. But, in general, an employee is presumed to be providing services for its actual employer (the one that issues a Form W-2 and has authority to exercise control over that employee). So the subsidiary cannot sponsor an eligible plan and the employees of the subsidiary cannot participate in the eligible plan of the parent. Code Section 457(f) only applies if an eligible employer – an employer that could sponsor an eligible plan – establishes a deferred compensation plan that does not meet the requirements of Code Section 457(b). So if the for-profit subsidiary is a bona fide business entity the independent corporate existence of which is to be respected, it would appear that Code Section 457(f) should not apply and the subsidiary may provide deferred compensation for its employees just like any other for-profit entity (i.e, in compliance with Code Section 409A). It may be more troublesome to deal with this issue in the case of a pass-through entity, such as a single-member limited liability company, the separate existence of which can be ignored for income tax purposes. But we won’t go there.

For additional comfort, we note that there are other instances in which Treasury Regulations expressly recognize and validate the separateness of a for-profit subsidiary. One great example of this is the regulations under Code Section 410 relating to controlled group testing. Treasury Regulations Section 1.410(b)-6(g) says that a 401(k) plan maintained by the for-profit subsidiary of a tax-exempt entity can be tested for compliance with coverage requirements by excluding the employees of the tax-exempt parent if no employees of the parent are eligible for the subsidiary’s 401(k) plan and substantially all of the employees of the subsidiary are covered by the 401(k) plan.

Finally, there is at least one Private Letter Ruling implicitly supporting the conclusion that the deferred compensation plan of a for-profit subsidiary is not subject to Code Section 457(f). Private Letter Ruling 9810005 blessed a somewhat complex arrangement under which a tax-exempt hospital essentially agreed to provide funding for a nonqualified deferred compensation arrangement indirectly benefitting the employees of a for-profit medical practice owned by the hospital. The payments contemplated were part of a larger service arrangement under which the medical practice provided professional services to the hospital in exchange for payments that would cover all of the overhead of the practice, including compensation and benefits for its employees. The arrangement considered under the ruling called for the hospital to accumulate cash in a trust to fund the deferred compensation arrangement established by the medical practice for its employees, and to pay the funding amounts to the for-profit subsidiary as and when payments were due to the employees of the subsidiary. The IRS held that the for-profit entity would not be taxed on the payments that were held in trust until those payments were received (which was when payments were due to its employees under the nonqualified plan).

So the provisions of Code Section 457 (and the related Treasury Regulations, which we did not cite here) as well as a Private Letter Ruling generally support the conclusions that no part of Code Section 457, including Section 457(f), should apply to the for-profit subsidiary of a tax-exempt entity. But it takes more than a few steps, and a modicum of hand wringing, to reach that conclusion. Wouldn’t it be great if the forthcoming regulations were to confirm this explicitly? Perhaps they will.