On July 4, President Trump signed his tax and spending bill known as the One Big, Beautiful, Bill Act (OBBA). From my perspective, one of the most important things that makes OBBA beautiful is what it doesn’t do. It doesn’t make changes to retirement plans or deferred compensation. That said, a change it does make with respect to compensation paid by tax exempt organizations triggers an important reminder regarding 457 plans of such organizations. Internal Revenue Code section 4960 (Section 4960) imposes a 21% excise tax on tax exempt organizations, with few exceptions, that pay a “covered employee” compensation over 1 million dollars in a given year (Threshold). The tax only applies to the compensation in excess of the Threshold. The tax is also imposed on any excess parachute payment to a covered employee. An excess parachute payment is basically a payment paid due to an involuntary termination that exceeds 3 times the employees average 5-year annual compensation.

Currently, covered employees are only the top 5 highest paid current or former employees. Beginning next year, OBBBA makes any employee a covered employee. This change triggers an important reminder on how compensation is counted for purposes of the Section 4960 Threshold, especially deferred compensation. Compensation includes any compensation considered wages subject to income tax withholding. However, it also includes any other compensation not paid in the year in question, to the extent it would be considered vested (not subject to a substantial risk of forfeiture) as that term is defined for Internal Revenue Code section 457(f) plan purposes. This would include such things as bonuses, severance pay, and benefits under 457 plans.

457 Plans. There are two types of employers that can adopt a 457 plan, tax exempt organizations and state or local governments (governmental). See, Ten Common Mistakes In 457 Plans of Tax Exempt Organizations–Part 1. It is important to note that governmental organizations are not subject to the Code section 4960 excise tax. It is also important to note that a 457 plan of a tax exempt organization must be a top hat plan primarily for the benefit of a select group of management or highly compensated employees.

There are two types of 457 plans : 457(b) and 457(f) plans. The principle difference between the two is how benefits are taxed. The benefits of a 457(b) plan are subject to income tax when they are paid or otherwise made available. The benefits of a 457(f) plan are subject to income tax when the participant’s right to the benefit is no longer subject to a substantial risk of forfeiture. Thus, benefits under a 457(b) plan may be fully vested without triggering income tax. The other major difference is that the amount of annual contributions that may be credited to a 457(b) plan is limited each year. Currently that amount is $23,500, but it is adjusted for inflation annually. There is no limit to the amount that can be credited to a 457(f) plan.

As mentioned above, compensation that is not paid currently is subject to the Threshold for Section 4960 purposes when vested. Therefore, amounts credited to a 457(b) or 457(f) plan of a tax exempt organization will count against the Threshold when vested. Contributions to a 457(b) plan are usually vested when made. If they are employee salary reduction deferrals they must be fully vested. However, employer contributions are often vested, as well. This means they will count against the Threshold in the year made. Typically, contributions to a 457(f) plan are subject to vesting after a number of years of service to avoid income tax in the year of deferral. Tax exempt organizations must keep this in mind because there could be a substantial account balance that vests in a given year which when counted with the employee’s other compensation for the year, could exceed the Threshold. This should be considered when designing the plan.

Conclusion. The changes by OBBA expand the number of covered employees whose compensation could trigger the Section 4960 excise tax. Tax exempt organizations must keep in mind the vesting rule of Section 4960 when designing 457 plans for their executives.