On 3 October 2008, section 457A was added to the Internal Revenue Code in an effort to limit deferrals of compensation by US taxpayers employed by "tax indifferent" entities. Interim guidance on the application of section 457A was issued on 8 January 2009, but many questions remain unanswered. Corporations have until 1 July 2009 to take advantage of a limited transition rule that may reduce the impact of section 457A on existing deferral plans.

General Rule. Section 457A requires an individual to include compensation deferred under a nonqualified deferred compensation plan of a "nonqualified entity" in income when it is no longer subject to a "substantial risk of forfeiture". If, however, the amount of deferred compensation is not determinable at that time, the amount will be included in income when it becomes determinable, plus a 20% penalty tax and interest at the underpayment rate plus 1%.

Nonqualified entities. Section 457A applies to amounts deferred under a nonqualified deferred compensation plan sponsored by a "nonqualified entity". A nonqualified entity is:

Whether an entity is a nonqualified entity is determined as of the last day of the service provider’s taxable year in which a deferred amount remains outstanding (generally, 31 December of each year).

Substantial risk of forfeiture. A substantial risk of forfeiture exists only if the compensation is subject to a requirement that the individual perform substantial future services (that is, time-based vesting conditions, but not performance-based vesting conditions).

Short-term deferrals. Amounts that are paid no later than 12 months after the end of the corporation's taxable year in which the amount is no longer subject to a substantial risk of forfeiture are not subject to section 457A.

Grandfathered amounts. Section 457A applies to amounts deferred that are attributable to services performed after 31 December 2008. To the extent a deferred amount was vested as of 31 December 2008, section 457A does not apply as long as the individual includes the amount in income in a tax year beginning before 1 January 2018 or the tax year in which the amount is not subject to a substantial risk of forfeiture, if later.

Transition relief. Service recipients may amend their existing deferred compensation plans to treat an on-going vesting condition as having lapsed on 31 December 2008. These amendments must be in writing and effective before 1 July 2009, and must be applied consistently to every service provider participating in the same or a substantially similar arrangement. The interim guidance does not clarify how this requirement will be applied.

Overlap of section 409A. Section 409A may also apply to deferred compensation subject to section 457A, and the interim guidance contains several provisions on this interplay. Generally, an amount will not be subject to section 409A if it is included in income under section 457A when the substantial risk of forfeiture lapses, since the amount will be paid within section 409A's "short-term deferral" rule. Service providers will need to be mindful of the potential impact of any section 457A changes made to deferral arrangements to ensure that they do not inadvertently trigger a section 409A violation.

Section 457A is broader than may appear at first blush and non-US corporations (including US companies with foreign subsidiaries) and US and non-US partnerships should work with their tax and employee benefits counsel to carefully analyse whether section 457A applies to their deferred compensation arrangements. If it does, they should work to identify the best course of action to avoid income inclusion (and potential penalty taxes) for service providers under section 457A.

For more information about section 457A, click here.