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Although Internal Revenue Code Section 457 has applied to non-profit organizations for more than ten years, its effects are not well understood, particularly by smaller organizations.

Section 457 overturns the usual tax rules governing non tax-qualified deferred compensation which are familiar to for-profit companies. The usual rules permit an individual to agree with his employer to defer payment of compensation, with the tax consequence that the compensation is taxed to the individual when paid at a later date. Corporate executives find it attractive to defer income which is not needed for current living expenses to post-retirement periods when their marginal income tax rate may be lower.

Section 457 restricts the amount of annual compensation which non-profits (and state and local governments) may defer for an employee under an "eligible 457 plan" to the lesser of $7,500 (now escalated to $8,000) or a of compensation. (Because the deferred compensation is subtracted from total compensation in applying the a limit, the effective percentage limit is 25%.)

The IRS says that Section 457 applies to any plan or agreement which defers compensation regardless of the method of calculating the benefit. For example, even if an agreement provided for deferred compensation in the form of a defined benefit, e.g., 2% of final pay multiplied by the number of years of service, it is nevertheless subject to Section 457, and the $8,000 or a of compensation limit must be observed by reference to the actuarial present value of annual accruals under the benefit formula.

To make matters worse, another rule in Section 457 requires subtraction from the $8,000 limit of amounts deferred at the employee's election under 401(k) and 403(b) plans.

An eligible Section 457 plan may defer compensation only if a deferral agreement is in place in the month before the compensation is earned, distribution requirements similar to the age 70-= rules for qualified plans must be included, and all deferred compensation must remain the property of the employer (and subject to its creditors) until paid.

Amounts which are deferred under a plan which does not meet the requirements of an eligible Section 457 plan are included in the taxable income of the employee when earned. Thus the tax consequences of failing to observe Section 457 fall on the employee in the form of income taxes, interest and penalties on income earned and deferred in prior years.

The primary exception to the immediate taxation rule under Section 457 applies to deferred compensation which is subject to a substantial risk of forfeiture conditioned upon the future performance of personal services. Forfeiture provisions are acceptable only with respect to employer grants of deferred compensation, however, since employees will not place their own compensation at risk of forfeiture merely to defer it. When the risk of forfeiture expires, the entire lump sum amount of the deferred compensation becomes immediately taxable, so a sequence of payments over years is not practical.

Section 457 is a trap for unwary non-profits looking to inexpensively provide enhanced retirement benefits for their executives. Seek expert counsel to avoid tax entanglements.