Deferred Compensation Arrangements for Non-Profits: What I’ve Felt, What I’ve Known, Is Not Consistent with the Code
Deferred compensation options for executives of tax-exempt entities are often misunderstood by those organizations who have not previously delved into them. Traditional tax-exempt organizations – think charities and non-profits – are subject not only to the deferred compensation rules of Section 409A of the tax code, but also Section 457 (though note that Section 457 does not apply to deferred compensation arrangements of churches). Section 457-subject organizations without deferred compensation experience are often under the impression that they are able to establish deferred compensation arrangements that are similar to those of for-profit entities, in that the right to deferred compensation can vest now and be taxed at a later date. When such organizations begin moving forward to put a deferred compensation arrangement place, they are often surprised to learn that Section 457 generally limits their ability do so.
The most analogous deferred compensation arrangement for tax-exempt executives compared to a traditional for-profit deferred compensation plan is what’s generally known as a Section 457(f) plan. While there are a number of differences between a Section 457(f) plan and a for-profit deferred compensation plan, the biggest is the timing of the taxation of the deferred compensation. A for-profit deferred compensation plan can be designed so that once the right to deferred compensation vests, it can be taxed (for income tax purposes) on the date that it is paid, which can be many years in the future. With a Section 457(f) plan, once the deferred compensation vests, it becomes immediately taxable, even if the plan provides for payment of the deferred compensation in a future year.
What this means for a for-profit executive is that they can potentially defer the taxation of the deferred compensation until a future year when they may no longer be employed by the organization and are in a lower tax bracket. Meanwhile, a non-profit executive is forced to recognize the taxable income while employed when the deferred compensation vests. Since the non-profit executive will be employed in an executive role upon vesting, the non-profit executive does not have the benefit of deferring the taxation to a future year when they may be in a different role and in a lower tax bracket.
This disparity in the treatment of deferred compensation between non-profits and for-profits is unfortunately unavoidable as the tax code is currently constituted. There are certain techniques that can be used under a Section 457(f) plan to delay vesting (and thus taxation) though they are generally unappealing to most executives and organizations. Additionally, non-profits can put what is known as a Section 457(b) plan in place that allows executives to defer a relatively modest amount of compensation where taxation can be deferred long after the compensation vests. However, Section 457(b) plans have a cap on annual deferrals currently equal to the maximum employee deferral limit for 401(k) and 403(b) plans.
The sections of the tax code governing deferred compensation arrangements are extremely complex, and failure to adhere to all necessary requirements can result in significant adverse tax consequences. Please understand that the content of this blog post is a simplified overview of one the major differences between non-profit and for-profit deferred compensation arrangements. There are numerous other differences and nuances between plans subject to Section 457 and those in the for-profit space subject only to Section 409A that are not covered here. If your organization wishes to put a deferred compensation arrangement in place for its senior leadership, whether it’s a non-profit or a for-profit organization, it is highly advisable that it consult qualified legal counsel before doing so.