Section 457(f) Proposed Regulations Provide New Deferred Compensation Rules for Tax-Exempt EmployersFall 2016 – Articles For Your Benefit
On June 22, 2016, the IRS issued proposed regulations under section 457(f) of the Internal Revenue Code, which applies to deferred compensation arrangements maintained by tax-exempt organizations for its key employees.
As previously announced by the IRS, the 457(f) proposed regulations largely follow the nonqualified deferred compensation rules under section 409A of the code. There are, however, some unexpected differences from the section 409A regulations. Tax-exempt employers must keep in mind that the section 457(f) rules are in addition to – and not in place of – the section 409A rules.
The 457 proposed regulations will not become effective until after they are issued in final form; however, taxpayers may rely on the proposed regulations prior to the issuance of final regulations.
Summary of Primary Changes in the Proposed 457(f) Regulations
Bona Fide Severance Pay Plan
The proposed 457 rules define a bona fide severance pay plan, which is not is not treated as deferred compensation under section 457:
- The severance must only be payable upon a participant’s involuntary termination or under a voluntary early retirement incentive plan or window program;
- The amount of severance payable under the plan may not exceed two times the participant’s annualized pay; and
- The severance must be paid in full within two years after the year the participant terminates.
As with the rules under section 409A, an involuntary termination includes certain terminations by an executive for “good reason” pursuant to written, pre-specified circumstances relating to material adverse employment actions taken by the employer.
Bona Fide Sick Leave and Vacation Leave Plans
The proposed 457 rules provide a list of factors that are to be considered in determining whether a vacation or sick leave plan is exempt from the definition of deferred compensation under section 457(f). The rules include limits on the ability to cash out any unused sick or vacation days.
Recurring Part-Year Compensation
The IRS previously addressed the situation, common with teachers, where services are provided over a period of less than 12 months, but pay is received over a longer period. The IRS has concluded that this is not deferred compensation. The proposed 457 rules modify the requirements for a recurring part-year compensation arrangement to be exempt from the deferred compensation rules.
The proposed 457 regulations adopt the short-term deferral exception that is included in the section 409A regulations; however, in applying the rule, a substantial risk of forfeiture is defined under section 457.
Substantial Risk of Forfeiture
Although the IRS had previously announced its intention to follow the section 409A rules in defining a substantial risk of forfeiture, the proposed regulations depart from those rules in a number of ways, including the following:
- Initial Deferral of Current Compensation: The proposed 457(f) regulations permit the initial deferral of current compensation as being subject to a substantial risk of forfeiture if the present value of the amount to be paid upon the lapse of the risk of forfeiture is more than 125 percent of the amount deferred. In addition, the risk of forfeiture must be limited to the future performance of substantial services of at least two years or an agreement not to compete, and the deferral must be made in writing prior to the calendar year the services are performed.
- Rolling Risk of Forfeiture: The proposed 457(f) rules permit the extension of a risk of forfeiture if, at least 90 days prior to the lapse of the forfeiture, the compensation is made subject to the future performance of substantial services of at least two years or an agreement not to compete and the present value of the amount to be paid upon the lapse of the risk of forfeiture is more than 125 percent of the amount of compensation that is being put at risk.
- Noncompete Condition: A noncompete condition may constitute a substantial risk of forfeiture under the proposed 457(f) regulations, provided several requirements are satisfied. The agreement must be in writing and enforceable under applicable law, the employer must make reasonable efforts to monitor compliance with the noncompete agreement and, at the time the agreement becomes binding, the facts and circumstances must show that the employer has a substantial and bona fide interest in preventing the employee from competing and the employee must have a bona fide interest in performing the prohibited services.
Beware of the Application of Section 409A
Tax-exempt employers need to be aware that compliance with the requirements of section 457(f) and the proposed regulations does not assure compliance with the requirements of section 409A and related regulations. As a practical matter, tax-exempt employers should design their 457(f) deferred compensation programs to minimize any discrepancies between the section 457(f) and section 409A requirements.
Tax-exempt employers should review their severance pay arrangements, sick leave plans and vacation plans to ensure that they comply with the proposed rules. In addition, any nonqualified deferred compensation arrangements with noncompete or rolling risk of forfeiture provisions should be reviewed to determine if they will continue to satisfy the rules in the proposed section 457(f) regulations.