The IRS recently issued long-awaited proposed regulations under Section 457(f) of the Internal Revenue Code, which governs deferred compensation payable by tax-exempt organizations, including many hospitals, schools, colleges and charities. Section 457(f) applies to “ineligible” nonqualified deferred compensation plans. The plans are referred to as ineligible because they do not satisfy the limitations that apply to “eligible” plans under Section 457(b) (such as a maximum annual deferral limit). Generally, under Section 457(f), compensation is taxed when the right to payment from an ineligible plan is no longer subject to a “substantial risk of forfeiture” (i.e., as soon as the compensation vests), not when it is paid.
The proposed regulations expand upon and clarify final regulations under Section 457 that were issued in 2003, in many instances bringing the rules in line with the 2007 final regulations under Section 409A that apply to nonqualified deferred compensation in general. This consistency between the Section 457(f) and Section 409A1 requirements is helpful for tax-exempt employers that need to comply with both rules.
The following are some highlights from the proposed regulations:
PLANS COVERED BY SECTION 457(f): The proposed regulations generally provide that an arrangement constitutes a “deferral of compensation,” and is, therefore, subject to Section 457(f), if the participant has a legally binding right during a calendar year to compensation that, under the terms of the arrangement, is or may be payable to the participant in a later taxable year. The proposed regulations are helpful in that they more clearly define the types of arrangements that are not considered “deferrals of compensation” and thus are exempt from Section 457(f), including:
- Short-Term Deferrals: A payment made within 2 1/2 months after the end of the year during which the right to payment is no longer subject to a substantial risk of forfeiture (i.e., when the right vests) is exempt from Section 457(f). For example, an annual bonus that is paid by March 15 of the year following the year it is earned is exempt. This is the same rule as under Section 409A, except that it applies using the Section 457(f) definition of substantial risk of forfeiture. Therefore, an arrangement can be exempt as a short-term deferral under Section 457(f) but not be exempt as a short-term deferral under Section 409A (for example, in the case of noncompetition agreements, as described further below).
- Severance Pay and Other Exemptions: Severance payable upon an involuntary termination from employment (including certain “good reason” terminations), is exempt, provided that (i) it does not exceed two times the participant’s annual rate of pay for the prior calendar year and (ii) the entire amount is payable no later than the last day of the second calendar year following the calendar year of the termination. This is similar, but not identical, to the severance pay exemption under Section 409A. There is also an exemption for certain window and early retirement incentive programs. In addition, the proposed regulations clarify the statutory exemptions for certain sick or vacation leave plans and death or disability plans. The severance pay and other exemptions noted above apply to ineligible 457(f) plans, as well as eligible 457(b) plans.
SUBSTANTIAL RISK OF FORFEITURE: As stated above, under Section 457(f), compensation is taxed when the right to payment is no longer subject to a substantial risk of forfeiture. The proposed regulations provide that an amount is subject to a substantial risk of forfeiture only if entitlement to the payment is conditioned upon (i) the future performance of substantial services or (ii) the occurrence of a condition that is related to a purpose of the compensation if the possibility of forfeiture is substantial.
Significantly, the regulations provide that compensation payable subject to certain conditions can be considered subject to a substantial risk of forfeiture (and allow for the deferral of tax), including:
- Involuntary Severance from Employment: If entitlement to an amount is conditioned upon an involuntary severance from employment without cause (including certain “good reason” terminations), the right is considered subject to a substantial risk of forfeiture. Thus, severance pay (even if it exceeds the severance pay exception described above) may not be taxable until it is actually paid.
- Covenants Not to Compete: Compensation rights conditioned upon compliance with a noncompetition agreement can be considered subject to substantial risk of forfeiture if (i) the terms of the noncompete agreement are in writing; (ii) the employer demonstrates reasonable continued efforts to confirm the employee is complying with the noncompete; and (iii) the employer has a bona fide interest in ensuring that the employee isn’t performing prohibited services, and the employee has a bona fide interest in, and the ability to compete against, the employer. Under Section 409A, a noncompete condition does not subject an amount to a substantial risk of forfeiture. So, while an amount that is subject to a noncompete condition may not be taxed under Section 457(f) until it is paid (i.e., at the end of the noncompetition period), the underlying arrangement may still need to comply with the payment timing provisions of Section 409A.
- Initial Deferrals of Current Compensation and Rolling Risks of Forfeitures: The proposed regulations permit initial deferrals of current compensation (such as salaries or bonuses) to be subject to a substantial risk of forfeiture and also allow an existing risk of forfeiture to be extended (commonly referred to as a “rolling risk of forfeiture”), but only if the following is true: (i) the present value of the amount to be paid upon the lapse of the substantial risk of forfeiture (as extended, if applicable) is materially greater (more than 125%) than the amount the employee otherwise would be paid; (ii) the initial or extended substantial risk of forfeiture must be based upon the future performance of substantial services or adherence to an agreement not to compete; (iii) the period for which substantial future services must be performed must be at least two years (although earlier payment can be made upon an earlier death, disability or involuntary severance from employment); and (iv) the agreement subjecting the amount to a substantial risk of forfeiture must be made in writing before the beginning of the calendar year in which any services giving rise to the compensation are performed (in the case of initial deferrals of current compensation), or at least 90 days before the date on which an existing substantial risk of forfeiture would have otherwise lapsed (in the case of rolling risks of forfeiture). For new employees, a written agreement to the addition of a substantial risk of forfeiture (e.g., the deferral of current compensation) must be provided within 30 days of hire (as to amounts attributable to services rendered after the addition is agreed to in writing).
CALCULATING AMOUNTS SUBJECT TO TAX UNDER 457(f): Generally, the amount of compensation deferred under a Section 457(f) plan that is includible in a participant’s gross income upon the applicable date (i.e., the vesting date) is the present value, as of that date, of the amount of compensation deferred. The proposed regulations provide rules for determining the present value of compensation deferred, which depend on the type of plan (e.g., an account balance plan or a formula-based plan).
EFFECTIVE DATE: The regulations are proposed to apply to compensation deferred under a plan for calendar years beginning after the date the rules become final, including deferred amounts to which a plan participant’s legally binding right arose in prior calendar years that were not previously included in income. In the interim, tax-exempt sponsors may rely on the proposed regulations.
NEXT STEPS: Tax-exempt sponsors should review their existing deferred compensation arrangements and consider whether they should be amended based on the proposed regulations (for example, to confirm that a vesting condition requires the performance of substantial future services). Further, given that the proposed regulations are more favorable than prior IRS announcements, various planning opportunities that were generally questionable for the past several years are now available.
1 The IRS also issued proposed regulations under Section 409A, which are beyond the scope of this Client Alert.