Section 457(f) of the U.S. Internal Revenue Code provides a framework for nonqualified deferred compensation arrangements commonly offered by tax-exempt and governmental employers. These plans are frequently used to recruit and retain senior executives and highly compensated employees, particularly in nonprofit sectors, by permitting compensation deferrals that are not subject to the annual contribution limits applicable to qualified retirement plans such as 401(k) or 403(b) arrangements.
Unlike qualified plans, 457(f) plans require careful navigation of income recognition rules, vesting conditions and heightened sensitivity to recent and ongoing regulatory developments at federal and state levels. Because 457(f) plans have no cap on annual amounts accrued, their operation has been highly valued in providing "golden handcuffs" to retain talent such as college presidents and head athletic coaches.
Deferral of Income and the Substantial Risk of Forfeiture Standard
At the core of a 457(f) arrangement is the concept of a substantial risk of forfeiture (SRF). An amount credited under a 457(f) plan is includible in gross income once the SRF lapses, typically when the participant becomes fully vested in the deferred amount. Vesting generally occurs through continued employment over a defined period or upon satisfaction of performance-based milestones. No income is recognized during the service period bound by the SRF, as the accrued funds remain property of the employer until the vesting event occurs.
The IRS defines SRF narrowly. Critically, deferred compensation becomes taxable in the calendar year in which the SRF ends, regardless of whether the deferred amounts are actually paid in that year. The satisfaction of the SRF requirement is typically provided by the executive performing services (or in certain special instances, refraining from the performance of services) for a specified time period. This distinction can result in significant tax consequences if payment is delayed without a corresponding deferral event under a valid SRF. If an arrangement fails to meet the SRF standard, the deferral may be immediately taxed at the time of the promise, eliminating the primary tax-deferral benefit of the plan and potentially subjecting the executive to audit.
Notably, distributions from 457(f) plans are not subject to the 10 percent early withdrawal penalty that applies to many qualified plans; however, all distributions are treated as ordinary income and taxed accordingly upon vesting.
Regulatory Guidance: 2016 Proposed IRS Regulations
In 2016, the IRS released proposed regulations that sought to clarify the circumstances under which deferred compensation would be subject to an SRF. These draft regulations – although used often as informational guidance but still not finalized – are viewed as highlighting the IRS' intent to tighten the interpretation of what qualifies as an SRF.
One area of particular scrutiny is the use of noncompetition agreements to create or extend an SRF. Under the proposed rules, a noncompete may be treated as a valid SRF only if three conditions are met:
- The employer must have a bona fide business interest in enforcing the noncompete.
- The employee must have a realistic opportunity and ability to compete.
- The noncompete must be legally enforceable under applicable state law.
These standards impose a significant evidentiary burden on employers. Courts and regulators will examine not only the text of the agreement but also the surrounding circumstances – including the employee's role, influence and access to confidential information – to determine whether the noncompete creates a legitimate SRF.
In practice, boilerplate or overly broad noncompete provisions may fail to meet these standards, particularly in jurisdictions where enforceability is already limited.
FTC's Final Rule on Noncompete and Emerging Legal Landscape
In April 2024, the Federal Trade Commission (FTC) issued a final rule banning most noncompete agreements across the U.S., including those entered into by highly compensated employees. The rule represented a sweeping shift in employment contract law and, if upheld, would effectively eliminate the use of noncompetes in 457(f) arrangements as a means of establishing SRF.
Although the rule was scheduled to take effect in September 2024, it is currently stayed pending litigation in multiple federal courts. The outcome of these cases will have a direct bearing on the enforceability of noncompete clauses in deferred compensation plans, especially those relying solely on noncompete provisions for favorable tax treatment.
Even prior to the FTC's intervention, several states – including California, Oklahoma and North Dakota – had long-standing prohibitions on the use of noncompetes. Others, such as Colorado, Illinois and Washington, impose specific restrictions based on income thresholds, duration or geographic scope. This patchwork of state laws means that a noncompete clause that may be enforceable in one jurisdiction could be entirely invalid in another, posing challenges for multistate employers and national organizations.
Excise Tax from Tax Cuts and Jobs Act of 2017 and One Big Beautiful Bill Act
Among the changes to nonprofit executive compensation under the Tax Cuts and Jobs Act (TCJA) was the implementation of a 21 percent excise tax under Section 4960 of the Internal Revenue Code on certain executive compensation. The excise tax applies to remuneration of more than $1 million paid in a year by applicable tax-exempt organizations to a covered employee (one of the five highest-paid employees of the organizations or any person who was a covered employee for a taxable year preceding after Dec. 31, 2016). Because the excise tax is applied as essentially a snapshot of compensation for an individual year, this raises implications for deferred arrangements such as 457(f) plans. The application is also unique in that the excise tax is paid by the organization and not the employee.
Since the excise tax accounts for revenue in the year that it is vested (instead of the respective years the funds were accrued), this provides an additional area of care for employers to avoid being blindsided for a tax bill from a balloon payment accrued by an SRF covering an extended period. The passage of the 2025 One Big Beautiful Bill Act (OBBB) significantly expanded coverage of the excise tax by making it applicable to all employees, including former employees employed in 2017 or later years. Boards and compensation committees of nonprofit organizations will now have to do greater planning as to the structure of their retention incentives and deferred compensation plans to address this potential area of tax liability.
Takeaways for Plan Sponsors
In light of the IRS' proposed regulations and the FTC's pending noncompete ban, plan sponsors – including colleges and universities that frequently use 457(f) arrangements in contracts for athletic coaches and senior administrators – face increased compliance risk. These employers must closely assess whether noncompete provisions used to structure SRFs remain enforceable under state law and whether they satisfy the IRS' standard for deferral eligibility.
Given this regulatory uncertainty, employers should consider restructuring their 457(f) plans to rely on alternative SRF triggers, such as:
- time-based vesting (e.g., continued employment for a fixed period)
- performance milestones (e.g., achievement of team, academic or fundraising goals)
- careful structure of deferred risk of forfeiture (e.g., evaluating with counsel the basis of deferral of vesting conditions)
These mechanisms provide more predictable and legally durable alternatives in an evolving legal environment.
Legal counsel should be engaged to review plan terms, evaluate the enforceability of any noncompete clauses and guide compliance with current IRS guidance, tax reporting requirements, implications of the excise tax on executive compensation and the potential implications of changes in the noncompete landscape.
