The tax treatment of nonqualified deferred compensation plans established by tax-exempt and governmental employers is governed by Internal Revenue Code section 457, which applies in addition to section 409A of the Code (covering nonqualified deferred compensation plans more generally). Absent an exception, deferred compensation payable by such employers is includible in income under 457(f) unless it is subject to a substantial risk of forfeiture.
On June 22, the IRS issued proposed regulations that align the 457 rules with the 409A rules in many respects. At the same time, the IRS proposed regulations under 409A to provide further coordination between the two regulatory regimes.
The 457 regulations generally will take effect in the calendar year beginning after the final regulations are issued, but also will affect compensation deferred in prior years that has not been included in income during a prior year. Unless the final regulations are issued in 2016, the earliest effective date of the final regulations would be January 1, 2018. Taxpayers may rely on the proposed regulations until the effective date of the final regulations.
A Special Note About Existing Arrangements: The proposed regulations do not "grandfather" existing arrangements or offer a transition period to conform to the proposed or final regulations. Thus, while new arrangements generally should be designed with an eye to compliance with the proposed rules, decisions about existing arrangements will be more complex.
This summary examines selected key topics covered by the proposed regulations, with a focus on the income inclusion rules under 457(f).
The Initial Question — 457(f) or Not?
In analyzing a compensation arrangement, the threshold question is whether 457(f) applies to the arrangement.
What is a "plan" for purposes of 457?
Under the proposed rules, a "plan" includes any written or unwritten arrangement under which the payment of compensation for services is deferred by salary reduction, nonelective employer contribution or otherwise. Section 457 applies to arrangements covering an individual (including an arrangement in an individual employment agreement) or a group of employees.*
* Section 457 applies to deferred compensation paid to independent contractors (with a limited exception for broad-based, nonelective plans) as well as employees. For ease of presentation, this summary uses the term "employee," but the rules that are described generally extend to payments to independent contractors as well.
When does a plan provide for a "deferral of compensation"?
Generally, a "deferral of compensation" exists if the employee has a legally binding right in one calendar year to compensation payable in a subsequent calendar year. A right need not be vested to be legally binding.
An employee does not have a legally binding right if the employer has retained an unconditional, unilateral right to reduce or eliminate the compensation, unless the employer's discretion to exercise the right lacks substantive significance.
Compliance Tip: Employers should consider whether it is feasible to reserve a substantive unilateral right to reduce or eliminate compensation without sacrificing or otherwise undermining the goal of the arrangement (e.g., recruitment, retention, etc.).
Amending a plan to convert other promises (e.g., benefits under a retiree health care plan) into a deferral of compensation (such as the right to receive future cash benefits in lieu of health benefits) may cause a plan to become subject to 457(f) at the time of amendment.
Compliance Tip: In anticipation of rules implementing the Affordable Care Act's anti-discrimination rules for fully insured health plans, many executive arrangements give the employer flexibility to pay cash in lieu of a health benefit if providing such benefit fails to comply with the ACA's non-discrimination rules. This practice will need to be evaluatedin light of the proposed regulations.
What types of plans are not subject to 457(f)?
A number of plans either do not provide for a deferral of compensation or are otherwise excluded from 457(f)'s application, including:
- "bona fide" vacation leave, sick leave, compensatory time, severance pay, disability pay, and death benefit plans,
- 401(a) and 403(b) tax-favored retirement plans,
- eligible 457(b) deferred compensation plans,
- "short-term deferral" plans,
- eligible recurring part-year compensation plans,
- qualifying reimbursements, medical benefits and in-kind benefits (e.g., subsidized COBRA pursuant to a separation pay plan under 409A),
- plans that provide certain taxable employee tuition benefits, and
- plans established by "steeple" churches and qualified church-controlled organizations.
Is there new guidance on the exclusions for some of these commonly offered benefits, such as leave programs and severance plans?
Yes. Of particular interest to many employers are the provisions on vacation leave, sick leave, severance pay, disability pay, and death benefit plans. Some of these rules were anticipated under earlier guidance (in particular, IRS Notice 2007-62), and others chart new territory. In each case, the facts and circumstances play an important role in the determination of whether a plan satisfies one of these exceptions. Key provisions include:
- A plan is treated as a bona fide sick or vacation leave plan (rather than a deferred compensation plan) if its primary purpose is to provide paid time off from work because of sickness, vacation or other personal reasons. The "primary purpose" determination considers factors such as whether an employee can be reasonably expected to use the amount of leave provided and whether the employee has the ability to cash out unused leave or exchange it for other benefits (including using leave to postpone the date of termination of employment).
- The bona fide severance pay
plan rules are similar to the rules announced in IRS Notice
2007-62 and include the following features:
- The severance from employment must be
involuntary, unless it's a voluntary severance under a
"window program" or on account of certain "good
Something to Note: The IRS uses different terms with different definitions ("severance from employment" for 457 and "separation from service" for 409A), and ancillary rules applicable to the 409A definition do not necessarily apply to the 457 definition.
- The total amount of severance pay must
not exceed a specified cap (generally 2x annualized
Something to Note: A key and helpful difference between the proposed 457 rules and the 409A regulations is that the 457 cap is 2x the employee's annualized compensation, while the 409A cap is the lesser of 2x annualized compensation or 2x the limit on annual compensation under Section 401(a)(17) ($530,000 for 2016).
- The severance pay must be paid no later than the last day of the second calendar year following the calendar year in which the severance from employment occurs.
- The severance from employment must be involuntary, unless it's a voluntary severance under a "window program" or on account of certain "good reason" conditions.
Compliance Tip: While the first 2x of annualized compensation may qualify as exempt from 457(f) under the severance pay plan exception, any amount in excess of the 409A cap (that is, any amount over 2x the 401(a)(17) limit) must be structured to comply with 409A (e.g., paid on specified payment dates following a 409A separation from service) or fit within a separate exemption from 409A (e.g., short-term deferral).
- A bona fide disability plan pays benefits (whether or not insured) only upon disability and must use one of three specified definitions of disability.
- For a bona fide death benefit plan, the proposed regulations borrow from the definition of death benefits under the FICA regulations, except that the death benefits can be provided through insurance.
How does the short-term deferral rule work?
A payment under a plan is treated as a "short-term deferral," and therefore not deferred compensation subject to 457(f), if it is paid by March 15 of the calendar year following the calendar year in which the amount vests (i.e., ceases to be subject to a substantial risk of forfeiture). For employers with non-calendar fiscal years, short-term deferrals must be paid by the later of the 15th day of the third month following the end of the fiscal year in which the deferred compensation vests and March 15 of the calendar year following the year in which the deferred compensation vests. If a payment satisfies this short-term deferral exception, the amount is taxable only when paid.
Something to Note: This is a particularly welcome exception. Historically, most arrangements have been drafted to provide for full payment in the year of vesting because the deferred compensation was included in income in that year. The short-term deferral rule will allow payment/taxation in the following year as long as full payment occurs by the applicable deadline.
Are there new rules for recurring part-year compensation?
Yes. Recurring part-year compensation (e.g., salary for a 9-month service period that can be spread over 12 months at the election of the employee) is not subject to 457(f) if it is paid in full by the last day of the 13th month following the first day of the first month of the service period, as long as the recurring part-year compensation does not exceed the 401(a)(17) annual compensation limit in effect on the first day of the service period ($265,000 for 2016).
Something to Note: This exception may simplify faculty compensation practices put into place by universities, colleges and other educational organizations after IRS Notice 2008-62 was issued. Additionally, for mandatory arrangements where an employee is required to spread part-year compensation over 12 months, the short-term deferral exception may be available as an alternative path to compliance.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.