Proposed new opportunities and flexibility in tax-exempt organization deferred compensation plan design
On June 22nd, 2016 the Internal Revenue Service (IRS) released proposed regulations under Section 457 of the Internal Revenue Code (Code), providing useful guidance for tax-exempt organizations that sponsor non-qualified deferred compensation arrangements. In short, the new regulations provide added opportunities and flexibility in plan design.
Code Section 457 generally applies to nonqualified deferred compensation arrangements maintained by tax-exempt and governmental organizations. Two types of deferred compensation arrangements exist under Code Section 457, eligible and ineligible plans, commonly referred to as 457(b) and 457(f) plans. These proposed regulations relate specifically to Code Section 457(f) plans.
Under 457(f) plans, compensation may be deferred and will not become taxable to the participant until the year in which the amounts are no longer subject to a substantial risk of forfeiture. An amount is subject to a substantial risk of forfeiture if the individual is required to perform substantial future services to be entitled to the amount. Whether an individual is required to perform substantial future services is generally based on the plan’s vesting provision.
Code Section 457 applies separately and in addition to any requirements under Code Section 409A which governs nonqualified deferred compensation regardless of the tax status of the organization. The proposed regulations align many of the concepts of these two Code Sections, providing greater certainty for tax-exempt organizations maintaining deferred compensation arrangements.
Key provisions contained in the proposed regulations:
- Short term deferrals
The proposed regulations provide for a “short-term deferral exception”, meaning a deferral of compensation is not considered to occur if the employee actually or constructively receives the payment prior to the fifteenth day of the third month (March 15th) following the end of the first taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture. Procedurally, this allows a plan to be designed such that distributions can be made in the first 75 days of the year following the year in which amounts vest, potentially allowing participants to benefit from a lower tax rate.
- Rolling risk of forfeiture
Historically, the IRS has disregarded attempts to extend or add a risk of forfeiture to previously vested 457(f) amounts. The proposed regulations now allow an employer and employee to agree to extend the substantial risk of forfeiture and accordingly further defer taxation, provided the following requirements are met: (1) the present value of the amount to be paid must be 125% of the amount the employee would have received absent the extension, (2) the extension must be based upon the future performance of substantial services, (3) the period of additional substantial services must be at least two years, and (4) the agreement to extend must be in writing before the beginning of the calendar year in which the additional substantial services are provided.
- Covenants not to compete
Under the proposed regulations, a non-compete agreement between a plan participant and the employer may constitute a substantial risk of forfeiture if each of the following are satisfied: (1) An enforceable written agreement exists between the employer and employee, (2) the employer reasonably verifies compliance with the covenant, and (3) the employer has a substantial and bona fide interest in preventing the employee from competing.
- Bona fide severance, sick leave, and vacation pay plans
Code Section 457 excludes from the definition of deferred compensation any “bona fide” severance, sick leave, and vacation pay plans. Prior to the issuance of the proposed regulations, little authoritative guidance existed regarding the definition of “bona fide” for purposes of these pay plans. The proposed regulations directly addressed this issue by providing specific requirements and factors considered to determine the bona fide status for each of these types of plans.
For example, a bona fide severance pay plan requires:
- The benefits under the plan be payable only upon a participant’s involuntary separation from service, under a window program, or voluntary early retirement
- The amount payable under the plan must not exceed two times the participant’s annualized compensation for the preceding year
- The severance benefits must be paid no later than the last day of the second calendar year in which the severance occurs
Although the proposed regulations do not formally apply until finalized, they may be relied upon immediately. Tax-exempt and governmental employers that maintain 457(f) plans should undertake a review of their deferred compensation plans, vacation and sick leave payment plans, and their employment agreements to confirm how these proposed regulations may impact them.