New Deferred Compensation Rules Provide Greater Flexibility to Tax Exempt Employers

John E. Rich, Jr.
Director & Chair, Tax Department
Published: New Hampshire Bar News
February 15, 2017

Unlike private employers, tax-exempt and governmental employers are required to comply with the complex rules of Tax Code Section 457 whenever compensation is payable to employees in arrangements beyond the current tax year such as for executive deferred compensation and severance arrangements.  Deferred compensation plans subject to Section 457(f) plans are subject to a different regulatory scheme than Section 401(k) and 403(b) retirement plans which allow for tax deferral up to, any even beyond, retirement. Because there is considerably less regulatory guidance for 457(f) plans than for 403(b) and 401(k) plans, the tax treatment of certain Section 457(f) plan designs was somewhat unclear. In June of 2016, the Internal Revenue Service (“IRS”) issued long-anticipated comprehensive Section 457 proposed regulations clarifying numerous aspects of Section 457. This article describes several of the key aspects of the 457(f) guidance.

Basic Section 457 Plan Rules

If an arrangement deferring compensation does not meet certain requirements under Section 457(b), including limiting deferred compensation to no more than $18,000 per year, Section 457(f)(1)(A) states that the plan is treated as an ‘‘ineligible 457(f) plan’’ requiring the present value of the benefit to be taxable in the year the amount is no longer subject to a substantial risk of forfeiture (i.e., it is taxed at vesting) regardless of when the benefit is payable. Thus, any plan or arrangement (other than a 401(k), 403(b) or 457(b) plan) designed to promise an employee a future payment has to provide for the substantial risk of forfeiture or fit within narrow exceptions to avoid current year taxation. The typical Section 457(f) plan design will provide for a cash payment well in excess of $18,000 to be made to the employee at a future date so long as he or she works for the employer until that date.  Plans subject to Section 457(f) must also comply with Section 409A which requires, unless an exemption is available, payments to be made only on certain specified events.  Section 409A includes specific definitions for separation from service, change of control, and other payment events.

Guidance on Substantial Risk of Forfeiture and Short-Term Deferrals

Under Section 457(f)(3)(B), a substantial risk of forfeiture exists if the payment of deferred compensation is conditioned on the performance of substantial future services (i.e. continuing to work) for the employer. The proposed regulations provide new guidance on the meaning of substantial risk of forfeiture including the limited circumstances when non-compete agreements create a substantial risk of forfeiture. The proposed regulations also state that under certain circumstances, additional forfeiture conditions can be added to maintain the substantial risk of forfeiture beyond when vesting will occur under the original terms of the arrangement. In order to qualify for this so-called “rolling risk of forfeiture,” 1) benefits must be increased to more than 125 percent of the present value of the amount the employee would have received absent the extended risk of forfeiture, 2) at least an additional two years of future service is required, and 3) the extension must be made in writing 90 days before the substantial risk of forfeiture would have lapsed.  Lastly, the proposed regulations add a short-term deferral exception to Section 457(f) whereby compensation paid before March 15th of the year following the first calendar year in which the right to the payment is no longer subject to a substantial risk of forfeiture is not considered deferred compensation.  So a bonus payment earned by an employee in 2017 but payable on March 1, 2018 would be taxed to the employee when paid in 2018 not when vested in 2017.

Severance Plans Exempt from Section 457

If the requirements under Section 457(e)(11)(A)(i) are met for treatment as a “bona fide severance pay plan” employers may pay certain types of severance and termination pay over multiple years without immediate taxation in the year of termination. The proposed regulations describe the three requirements to qualify as a bona fide severance pay plan. First, the benefits must be payable only upon an employee’s involuntary severance from employment (including “good reason” terminations in certain circumstances), pursuant to a window program or certain voluntary early retirement incentive plans.  A window program is a program established by an employer to provide separation pay in connection with an impending severance from employment that is offered for a limited period of time (typically no longer than 12 months). A program is not offered for a limited period of time (and, therefore, is not a window program) if there is a pattern of repeatedly providing similar programs.  A voluntary early retirement incentive plan is a plan under which payments are made in coordination with a defined benefit pension plan as an early retirement benefit. The second requirement is that the amount payable must not exceed two times the participant’s annualized compensation for the calendar year preceding the calendar year in which the participant has a severance from employment. The last requirement is that the severance benefits 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 under the written terms of the plan.

Tax-exempt employers may rely on the proposed regulations until the IRS adopts final regulations. Given the latitude and additional guidance that the proposed regulations provide, tax exempt employers should examine their programs to determine if the new rules can be used to enhance existing programs or serve as a basis for new deferred compensation or severance programs.