Insights
Occasional papers from Western CUNA Management School

457(f) Deferred Compensation Plans

While 457(f) plans have been available to credit unions and their Top Hat executives since 1986, they have attained common usage in the industry only in the last five to ten years. These plans do not have limitations on benefits and accordingly are often used to supplement retirement benefits available to executives under a credit union's qualified pension plan. For example, the above discussed "Top Heavy" limitations on a senior executive's participation in a qualified plan often lead to limits on an executive's participation in a qualified plan such as a 401(k) plan. Many executives view this mandatory limitation as a "takeaway" or a "lost" benefit that should have been made available to them. The flexibility of the 457(f) allows the Credit Union to "make up" some or all of those "lost" benefits to the executive on a nonqualified basis.

As 457(f) plans are deferred compensation plans, the arrangement must contemplate future income or bonus (compensation already earned cannot be deferred) and, again, the plan must be "unfunded." However, IRC 457(f) adds a further restriction such the executive must provide "substantial services" and the benefits under the plan must be subject to a "substantial risk of forfeiture" until the date the plan benefits vest. 1 That is, the executive's benefits are forfeited if the executive is terminated or resigns prior to the vesting date. This is a serious risk that executives may or may not wish to undertake. (Indeed, few executives choose the 457(f) approach to defer a portion of their base salary; they use a 401(k) and/or a 457(b) plan instead). However, the risk of substantial risk of forfeiture implicitly creates a "golden handcuffs" upon the executive that works to the advantage of the credit union. That is, to obtain the benefits under such a plan, the executive must work a specified period of time (at least two years), perform substantial services in his or her position with the credit union and the executive must not resign or otherwise be terminated from his or her position.

The IRS in private letter rulings has allowed the substantial risk of forfeiture to be "softened" under certain circumstances. 2 For example, accrued (but otherwise unvested) benefits to the date of an executive's disability or death apparently can be paid to the executive or his or her beneficiary under a 457(f) plan without adversely affecting the substantial risk of forfeiture requirement. The IRS has also signaled that payment of accrued (but otherwise unvested) benefits would also be permissible in the event of a termination "without cause." In other words, substantial risk of forfeiture has been recognized by the IRS in certain cases to include only termination with cause or the executive's resignation from employment prior to a "vesting" date. We suspect that such requirements should not prove too difficult to meet for competent credit union executives who are not seeking to "jump" from position to position.

Options Plans

The third type of plan becoming more popular at credit unions is known as a Section 83 or "options" plan. This type of plan contemplates a credit union's granting an employee an "option" to purchase property (such as a stock or a mutual fund) at a discounted price in the future. Under such a plan, which apparently is not required to be only for Top Hat executives, the employee gains a benefit to the extent that he or she can purchase the stock or mutual fund in the future from the credit union at a discounted price. The discount (the difference between the fair market value of the property and the employee's lesser purchase price) is income to the employee but only at the time the option is exercised. There is a significant advantage in delaying a taxable event for the employee if in fact IRC 457(f) does not apply to such a plan. Although the language of IRC 457(f) suggests that it does not apply to plans under IRC Section 83, the IRS has signaled that it is reviewing the issue and will issue guidance as to the extent that such plans, when used by tax exempt organizations, are governed by IRC 457(f).

Split Dollar Life Insurance

A fourth type of plan available to credit union executives is known as the "split dollar" life insurance arrangement. Under such plans, the employer agrees to pay some or all of the premiums on insurance policy on the life of its executive. The executive agrees to pay the credit union back from the benefits from the proceeds of the insurance whether from death benefits or from withdrawals from the "cash surrender value" of the insurance. The value of such arrangements has traditionally been based on a need for the executive to provide for insurance while also allowing for the benefit of possible growth in the cash surrender value of the insurance.

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¹An additional restriction on 457(f) plans is the requirement that vested benefits under the plan are fully taxable in the year in which they vest. Unlike the 457(b) plan, there is no opportunity to pay out vested benefits over a period of time unless the executive wishes to pay taxes on the full amount of the vested benefits without receiving the benefits until a later date (an unlikely event).

²Private Letter Rulings are pronouncements by the IRS based on a specific set of facts and are binding only on the IRS and the taxpayer in question. They cannot be used as precedent. Even so, Private Letter Rulings provide some indication as to the analysis the IRS is using towards similar plans.