Tax-exempt employers who wish to offer deferred compensation plans to their executives and key employees are limited by a special provision of the tax laws, specifically section 457 of the Internal Revenue Code.

Section 457 permits tax-exempt employers to offer two types of plans: (1) eligible; and (2) ineligible plans.

Eligible Plans

Under an "eligible plan" (also known as a "457(b) plan"), amounts deferred or contributed to the plan, and earnings, are not taxable under they are actually or constructively received by participants. Thus, participants in an eligible plan are taxed in the same manner as participants in non-qualified deferred compensation plans offered by for-profit employers.

Section 457(b), however, imposes a number of restrictions on eligible plans. These include the following:

• The total amount that can be deferred (or contributed) to a plan is limited to the lesser of: (1) the "applicable dollar amount"; or (2) 100% of includible compensation.

• Participation is limited to employees and independent contractors performing services for the employer;

• Excess contributions are taxable;

• Plan loans are taxable;

• Distributions can only be paid or made available upon severance from employment, the occurrence of an unforeseeable emergency, or age 70-1/2.

• Plans must satisfy the minimum distribution rules of section 401(a)(9) of the Code.

Note: Governmental plans are subject to a number of additional, special rules.

Eligible plans are not subject to the rules of section 409A of the Code.

Ineligible Plans

If a plan is not an eligible plan, it is an "ineligible plan" (also known as a "457(f) plan"). Ineligible plans are exempt from the various requirements applicable to eligible plans, discussed above.

The principal difference between eligible and ineligible plans is that participants in an ineligible plan are taxed on their deferrals and contributions when made, unless they are subject to a substantial risk of forfeiture.

For these purposes, a "substantial risk of forfeiture" requires that the payment be conditioned on the future performance (or refraining from performance) or substantial services, or the occurrence of a condition, and the possibility of forfeiture is substantial. As a general rule, the following do not create a substantial risk of forfeiture:

• Covenants not to compete;

• Consulting agreements;

• "Bad boy" clauses.

Note: Ineligible plans are also subject to the rules of section 409 of the Code, which creates a separate definition of "substantial risk of forfeiture". As a result, ineligible plans must be layered for compliance with both sections 457(f) and 409A of the Code.