Proposed Regulations on Deferred Compensation Plans Under Code § 457
The IRS recently issued proposed regulations to revise existing rules and prescribe new rules under Code § 457 relating to the taxation of nonqualified deferred compensation plans established and maintained by state or local governments and tax exempt organizations. The proposed regulations provide long awaited clarification on what constitutes a substantial risk of forfeiture under § 457(f) plans, including guidance on non-compete agreements and rolling risks of forfeiture. A copy is at this link.1
Comments and Public Hearing: The IRS requests comments on all aspects of the proposed rules, including whether special transition rules should apply for plans established (i.e., compensation deferred) before the proposed applicability dates. Comments are due on or before September 20, 2016. A public hearing will occur on October 18, 2016.
Action Needed Now: Sponsors of affected deferred compensation arrangements should assess the potential impact of these regulations, including whether plan design changes are necessary or desirable. Additionally, sponsors should decide whether to submit comments to the IRS.
Section 457 applies to nonqualified deferred compensation plans established by state and local governments and tax-exempt employers (collectively referred to herein as "eligible employers"). There generally are two types of nonqualified deferred compensation plans under § 457 - eligible plans defined in § 457(b) and ineligible plans defined in § 457(f). Generally, if a nonqualified deferred compensation plan maintained by an eligible employer does not satisfy the requirements to be an eligible plan, compensation deferred under such plan is includable in income under the rules of § 457(f).
Compensation deferred under an ineligible plan is includible in the gross income of the participant or beneficiary on the later of the date the participant or beneficiary obtains a legally binding right to the compensation or, if the compensation is subject to a substantial risk of forfeiture at that time, the date the substantial risk of forfeiture lapses. The amount of compensation that is includible in gross income as of the applicable date is the present value of such deferred compensation.
The proposed regulations address the interaction of the rules under § 457(f) and § 409A, noting that the rules under § 457(f) apply to plans separately and in addition to the requirements under § 409A. Thus, a deferred compensation plan of an eligible employer that is subject to § 457(f) may also be a nonqualified deferred compensation plan that is subject to § 409A.
OVERVIEW OF THE PROPOSED REGULATIONS
Generally, the proposed regulations make certain changes to the existing § 457 regulations (which were generally issued in 2003), provide guidance on certain issues not addressed in the existing regulations, and provide additional guidance for section 457(f) plans. Topics addressed include:
Substantial Risk of Forfeiture under § 457(f)
The proposed regulations state that an amount is subject to a substantial risk of forfeiture only if entitlement to that amount is conditioned on the future performance of substantial services, or upon the occurrence of a condition that is related to a purpose of the compensation if the possibility of forfeiture is substantial. Whether an amount is "conditioned" on the future performance of substantial services is determined based on all relevant facts and circumstances, such as whether the hours required to be performed during the relevant period are substantial in relation to the amount of compensation. A condition is "related to a purpose of the compensation" only if the condition relates to the employee's performance of services for the employer or to the employer's activities or organizational goals. The proposed regulations make the following clarifications with respect to substantial risk of forfeitures:
- Likelihood of Occurrence and Enforcement: An amount is not subject to a substantial risk of forfeiture if, based on facts and circumstances, the forfeiture condition is unlikely to occur or unlikely to be enforced. Factors to be considered in determining the likelihood of enforcement include the past practices of the employer; the level of control or influence of the employee with respect to the organization and those responsible for enforcing the forfeiture; and the enforceability of the provisions under applicable law.
- Involuntary Severance from Employment: Under these proposed regulations, if a plan conditions right to payment on an involuntary severance from employment without cause, "that right is subject to a substantial risk of forfeiture only if the possibility of forfeiture is substantial."2 For this purpose, an involuntary severance from employment without cause includes a voluntary severance from employment for good reason, discussed below.
- Non-Compete Agreement: Compensation that is forfeitable if an employee accepts a position with a competing employer will not be considered subject to a substantial risk of forfeiture unless all of the following conditions are met:
- The right to the compensation must be expressly conditioned on the employee refraining from the performance of future services pursuant to a written agreement that is enforceable under applicable law,
- The employer must consistently make reasonable efforts to verify compliance with all of the noncompetition agreements to which it is a party (including the noncompetition agreement at issue), and
- At the time the non-compete agreement becomes binding, the facts and circumstances must show that the employer has a substantial and bona fide interest in preventing the employee from performing the prohibited services and that the employee has a bona fide interest in engaging, and an ability to engage, in the prohibited services. Relevant factors taken into account include the employer's ability to show significant adverse economic consequences that likely would result from the prohibited services; the marketability of the employee based on specialized skills, reputation, or other factors; and the employee's interest, financial need, and ability to engage in the prohibited services.
- Deferrals Current Compensation & Rolling Risks of Forfeiture: The proposed regulations permit initial deferrals of current compensation (e.g., salary, commissions, and certain bonuses) to be subject to an initial addition of a substantial risk of forfeiture and allow existing risks of forfeiture to be extended (i.e., rolling risks of forfeiture) only if the following requirements are met:
- The present value of the amount to be paid upon the lapse of the substantial risk of forfeiture (as extended, if applicable) must be materially greater than (i.e., more than 125%) the amount the employee otherwise would be paid in the absence of the substantial risk of forfeiture (or absence of the extension).
- The initial or extended substantial risk of forfeiture must be based upon the future performance of substantial services or adherence to a non-compete agreement.
- The period for which substantial future services must be performed may not be less than two years (absent an intervening event such as death, disability, or involuntary severance from employment).
- The agreement creating or extending the substantial risk of forfeiture must be in writing and made, in the case of initial deferrals of current compensation, before the beginning of the calendar year in which any services giving rise to the compensation are performed, or at least 90 days before the date on which an existing substantial risk of forfeiture would have lapsed.
Comments are requested on whether special provisions for newly eligible employees are needed in the context of § 457(f) arrangements, and if so: (i) whether the existing plan aggregation and first year of eligibility rules under the § 409A regulations should apply for § 457(f), and (ii) how to define an aggregated single plan (versus multiple plans) to prevent manipulation of the rules.
The proposed § 457 regulations' recognition that a non-compete agreement can create a substantial risk of forfeiture represents a significant departure from the § 409A regulations, under which a covenant not to compete does not create a substantial risk of forfeiture for purposes of § 409A.
Definition of Deferral of Compensation
Under the proposed regulations, a plan provides for the deferral of compensation for purposes of Code § 457(f) if a participant has a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable in a later taxable year. Generally, a participant does not have a legally binding right to compensation if, based on the terms of the arrangement and relevant facts and circumstances, it may be unilaterally reduced or eliminated by the employer after the services creating the right have been performed.
The proposed regulations provide that a deferral of compensation does not occur with respect to any amount that would be a short-term deferral under the § 409A regulations, substituting the definition of a substantial risk of forfeiture provided under the proposed regulations for the definition of substantial risk of forfeiture under § 409A.3 For example, a deferral of compensation does not occur with respect to any payment that the participant actually or constructively receives by the March 15th following the end of the first calendar year in which the right to the payment is no longer subject to a substantial risk of forfeiture.
Recurring Part-Year Compensation
An arrangement under which an employee receives recurring part-year compensation that is earned over a period of service less than 12 months (for example, a school year comprised of 10 consecutive months) does not provide for the deferral of compensation if it does not defer payment of any of the recurring compensation beyond the last day of the 13th month following the first day of the service period for which the recurring part-year compensation is paid. Additionally, the total amount of the recurring part-year compensation cannot exceed the annual compensation limit under Code § 401(a)(17) ($265,000 for 2016) for the calendar year in which the service period commences.
Certain Plans Not Subject to § 457 or Not Treated as Deferring Compensation
The proposed regulations provide substantial guidance on plans that are treated as not deferring compensation for purposes of § 457. These include bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, and death benefit plans, plus plans that solely pay length of service awards to bona fide volunteers (or their beneficiaries).
The following summarizes key requirements for severance plans and disability plans excepted from § 457:
- Bona Fide Severance Pay Plans: The requirements for severance pay plans are similar to those for separation pay plans under the § 409A regulations. There are three basic requirements for a bona fide severance pay plan:
- The benefits provided under the plan are payable only upon a participant's involuntary severance from employment (including a voluntary separation for "good reason" discussed below), or pursuant to a window program (discussed below), or voluntary early retirement incentive plan (discussed below);
- The amount payable under the plan to a participant must not exceed two times the participant's annualized compensation based upon the annual rate of pay for services provided to the eligible employer for the calendar year preceding the calendar year in which the participant has a severance from employment (or the current calendar year if the participant had no compensation in the preceding calendar year); and
- The written terms of the plan must provide that the severance benefits will be paid no later than the last day of the second calendar year following the calendar year in which the severance from employment occurs.
- Severance from Employment for Good Reason: Under the proposed regulations, an employee's voluntary severance from employment may be treated as an involuntary severance from employment if it is for "good reason." A severance from employment for good reason must result from unilateral action taken by the employer that results in a material adverse change to the working relationship. The conditions for good reason termination must be specified in writing by the time the legally binding right to the payment arises. Avoidance of § 457 cannot be the primary purpose of the provision. The proposed regulations include a "good reason" safe harbor for plans that provide for severance pay upon a voluntary severance from employment after a material negative change. Under this safe harbor, the severance from employment must occur within two years following the initial existence of one or more of the following conditions arising without the consent of the participant:
- A material diminution in the participant's base compensation;
- A material diminution in the participant's authority, duties, or responsibilities;
- A material diminution in the authority, duties, or responsibilities of the supervisor to whom the participant is required to report, including a requirement that a participant report to a corporate officer or employee instead of reporting directly to the board of directors (or similar governing body) of an organization;
- A material diminution in the budget over which the participant retains authority;
- A material change in the geographic location at which the participant must perform services; or
- Any other action or inaction that constitutes a material breach by the eligible employer of the agreement under which the participant provides services.
The participant is required to provide notice to the eligible employer of the existence of any of the applicable condition within a period not to exceed 90 days after the initial existence of the condition(s). Upon receipt of such notice, the employer must be given a period of at least 30 days during which it may remedy the condition(s) before being required to pay any benefits. Also, the amount, time, and form of payment upon severance is substantially the same as the amount, time, and form of payment that would have been made available upon an actual involuntary severance from employment (to the extent such right to payment exists).
- Window Programs: A window program is defined as a program established by an employer to provide separation pay in connection with an impending severance from employment. To qualify as a window program, the program must be offered for a limited period (typically no longer than 12 months). A program is not offered for a limited period if there is a pattern of repeatedly providing similar programs. Relevant facts and circumstances for determining whether a pattern of similar programs exists include whether: (i) the benefits are because of a specific reduction in workforce (or other operational conditions), (ii) there is a relationship between the separation pay and an event or condition, and (iii) the event or condition is temporary and discrete or is a permanent aspect of the employer's operations.
- Voluntary Early Retirement Incentive Plans: A voluntary early retirement incentive plan is described as a bona fide severance pay plan (as defined above) under which payments are made as an early retirement benefit, a retirement-type subsidy, or an early retirement benefit that is greater than a normal retirement benefit and are paid in coordination with a qualified defined benefit pension plan.
- Bona Fide Disability Pay Plan: A bona fide disability pay plan is a plan that pays benefits only in the event of a participant's disability (disregarding the value of any taxable disability insurance payments). A participant is disabled for this purpose if the participant meets any of the following three conditions:
- The participant is unable to engage in substantial gainful activity by reason of a medically determinable physical or mental impairment that can be expected to result in death or last for a continuous period of not less than 12 months;
- The participant is, by reason of any medically determinable physical or mental impairment that can be expected to result in death or last for a continuous period of not less than 12 months, receiving income replacement benefits for a continuous period of not less than three months under an accident or health plan covering employees of the eligible employer; or
- The participant is determined to be totally disabled by the Social Security Administration or the Railroad Retirement Board.
Calculation of Amount Included in Income
The proposed regulations set forth rules for determining the amount included in income under § 457(f). In general, the amount included in income is the present value of compensation deferred under ineligible plans. The proposed regulations provide specifics as to how the present value is to be determined.
The rules for determining present value under these proposed regulations are similar to the rules for determining present value in the proposed § 409A regulations, including similar loss deduction rules.4 One difference, however, is that income inclusion under § 457(f) and the present value calculation under the proposed regulations is determined as of the applicable date, whereas income inclusion § 409A and the present value calculation under the proposed § 409A regulations is determined as of the end of the service provider's taxable year. Comments are requested on whether it is appropriate to provide any additional exceptions from the application of the rules currently described in the proposed § 409A regulations to amounts includible in income under § 457(f) in order to account for the different manners in which the two provisions apply to an amount deferred.
Other topics covered under the proposed regulations include:
- Qualified Roth Contribution Program: Eligible governmental plans may include a qualified Roth contribution program, as defined in Code § 402A(c)(1), under which designated Roth contributions are included in income in the year of deferral and qualified distributions are excluded from gross income.
- Certain Distributions for Qualified Accident and Health Insurance Premiums: The rules for the taxation of eligible governmental plan distributions now provide that distributions from an eligible governmental plan relating to an eligible public safety officer under Code § 402(l) are excluded from gross income for the taxable year in which they are paid.
- Rules Related to Qualified Military Service: HEART Act5 requirements are adopted for eligible governmental plans to require that, where a participant dies while performing qualified military service, the participant's survivors are entitled to any additional benefits that would have been provided under the plan if the participant had resumed and then terminated employment on account of death. In addition, leave for certain military service is treated as a severance from employment for purposes of the plan distribution rules under eligible plans.
Proposed Applicability Dates
Generally, the regulations will apply to compensation deferred under a plan for calendar years beginning after the date the final regulations are published in the Federal Register; however taxpayers may rely on the proposed regulations until the applicability date. No implication is intended regarding application of the law before the proposed regulations become applicable. Special applicability dates apply in the following situations:
- For a plan maintained pursuant to one or more collective bargaining agreements (CBAs) which have been ratified and are in effect on the date of publication of the final regulations, these regulations would not apply to compensation deferred under the plan before the earlier of (1) the date on which the last of CBAs terminates (determined without regard to any extension thereof after the date of publication of the final regulations) or (2) three years after the date of publication of the final regulations.
- With respect to the rules regarding recurring part-year compensation for periods before the applicability date of these regulations, taxpayers may rely on either the rules set forth in these proposed regulations or the rules set forth in Notice 2008-62.6
- If legislation is required to amend a governmental plan, the proposed regulations will apply only to compensation deferred under the plan in calendar years beginning on or after the close of the second regular legislative session of the legislative body with the authority to amend the plan that begins after the date of publication of the final regulations.
The proposed regulations provide plan re-design opportunities for existing sponsors of § 457(f) plans, and may spur other eligible employers to supplement their current compensation package(s) with one or more new deferred compensation arrangements.
Cheiron pension consultants can assist governmental and tax-exempt employers in understanding the impact of the proposed regulations on their deferred compensation plans and assist with plan design changes.
Cheiron is an actuarial consulting firm that provides actuarial and consulting advice. However, we are neither attorneys nor accountants. Accordingly, we do not provide legal services or tax advice.
1 On the same date, IRS also issued new proposed regulations under Code § 409A, a copy of which is at this link.
2 See proposed § 1.457-12(e)(1)(i).
3 Because there is considerable overlap between the definition of substantial risk of forfeiture for purposes of § 457(f) and the definition of substantial risk of forfeiture for purposes of § 409A, in many cases amounts that are not deferred compensation subject to § 457(f) also are not deferred compensation subject to § 409A.
4 Under those rules, if a participant previously included an amount of deferred compensation in income, but the amount of compensation subsequently paid is less than the amount included in income because of forfeiture or loss, then participant is entitled to a deduction for the amount permanently forfeited or lost.
5 The Heroes Earnings Assistance and Relief Tax Act of 2008.
6 A copy of Notice 2008-62 is here.