What Are the Tax Implications of Section 457A?

Section 457A of the Internal Revenue Code is a tax rule governing nonqualified deferred compensation. It prevents U.S. taxpayers from delaying the recognition of income earned from “tax-indifferent” entities, which are not impacted by the timing of a compensation deduction. The rule eliminates most long-term deferrals by accelerating when the compensation is subject to U.S. income tax.

Entities and Individuals Subject to the Rule

The regulations under Section 457A apply to U.S. taxpayers, including both employees and independent contractors who provide services. The rule targets compensation from a “nonqualified entity,” a term that describes entities not subject to a significant level of income tax either in the U.S. or a foreign jurisdiction. This structure means the entity is indifferent to when it claims a tax deduction for compensation expense.

A nonqualified entity falls into one of two categories. The first is a foreign corporation located in a country that does not have a comprehensive income tax treaty with the United States, including many tax havens. This applies if the foreign corporation’s income is not subject to a comprehensive foreign tax or effectively connected with a U.S. trade or business.

The second category involves partnerships. A partnership is considered a nonqualified entity if a substantial portion of its income is allocated to partners who are not subject to a comprehensive income tax. This includes partners that are foreign persons or organizations that are tax-exempt under U.S. law.

Tax Implications of Deferred Compensation

The main tax consequence of Section 457A is the timing of income inclusion. For compensation deferred with a nonqualified entity, the amount becomes taxable to the U.S. service provider as soon as it is no longer subject to a “substantial risk of forfeiture.” This means the income is taxed when it vests, not when the cash is actually received.

A substantial risk of forfeiture exists if the right to compensation is conditioned on the future performance of substantial services. For example, if an employee must continue working for two more years to receive a bonus, that bonus is subject to a substantial risk of forfeiture. Once the service period is complete, the amount is considered vested and becomes immediately taxable.

Failure to comply with these rules results in penalties. In addition to the regular income tax on the vested amount, a 20% penalty is imposed. Interest charges, calculated at the underpayment rate plus one percent, are also applied as if the income had been included in the correct year.