07 July 2016 IRS proposes regulations under Section 457 applicable to deferred compensation maintained by tax-exempt and governmental employers The Department of the Treasury (Treasury) and Internal Revenue Service (IRS) recently issued long-anticipated proposed regulations (REG-147196-07) under Section 457 on deferred compensation plans maintained by a tax-exempt entity (other than a church) or a state or local government (referred to as the "Section 457 proposed regulations"). Three types of nonqualified deferred compensation plans are subject to Section 457: iii. Section 457(f) deferred compensation plans (sometimes referred to as "ineligible nonqualified deferred compensation plans"), which are deferred compensation arrangements maintained by a tax-exempt or governmental entity that do not comply with the Section 457(b) requirements and are subject to the Section 457(f) rules The Section 457 proposed regulations provide long-awaited guidance on the latter type of a plan — an ineligible nonqualified deferred compensation plan that is subject to Section 457(f). Many tax-exempt employers, including hospitals, colleges, universities, nursing homes, and other non-profit organizations, maintain ineligible nonqualified deferred compensation plans and have operated these plans for many years without the benefit of regulatory guidance. In some cases, the new regulations provide more flexibility in plan design and taxation of deferred compensation under Section 457(f) than many tax-exempt employers may have expected. Ineligible nonqualified deferred compensation plans are subject to both Section 457(f) and Section 409A, which applies to all nonqualified deferred compensation arrangements, including those of taxable employers. Final regulations under Section 409A were issued in 2007 and, soon thereafter, the IRS issued Notice 2007-62, announcing that proposed regulations would be issued addressing the coordination of Section 457(f) deferred compensation arrangements with Section 409A. (See Tax Alert 2007-620). These Section 457 proposed regulations provide those coordinating rules. Concurrently with the issuance of the Section 457 proposed regulations, the IRS also issued proposed regulations under Section 409A (REG-123854-12) clarifying certain issues under the Section 409A final regulations, including the coordination with Section 457(f). The Section 457 proposed regulations would also amend the Section 457 final regulations applicable to eligible Section 457(b) plans to bring the regulations into compliance with technical provisions enacted since 2003 when the regulations were finalized. This Alert focuses specifically the application of the Section 457 proposed regulations to ineligible nonqualified deferred compensation plans subject to Section 457(f) and includes a discussion of: (i) what types of plans are excluded from Section 457; (ii) when deferred compensation is no longer subject to a substantial risk of forfeiture and, therefore, included in the employee's gross income; and (iii) how to determine the present value of the deferred compensation to be included in gross income. A list of revisions to the final Section 457 regulations applicable to eligible Section 457(b) plans is provided at the end of the Alert. The Section 457 proposed regulations would apply to compensation deferred under a plan for calendar years beginning after the publication of the final regulations; taxpayers may, however, rely on the proposed rules immediately. Comments are due on the proposed regulations by September 20, 2016. Nonqualified deferred compensation provided to employees of a tax-exempt or governmental entity generally is subject to taxation under Section 457(f), unless the deferred compensation is provided through an eligible Section 457(b) plan, a qualified plan under Section 401(a) or 403(a), an annuity under Section 403(b), a transfer of property under Section 83, a plan that consists of a trust subject to Section 402(b), or certain other arrangements. The taxation of nonqualified deferred compensation under Section 457(f) differs significantly from the taxation of deferred compensation provided to an employee of a taxable entity. Deferred compensation subject to Section 457(f) is included in the employee's gross income on the later of the date the participant has a legally binding right to the compensation or the date that right to the compensation is no longer subject to a substantial risk of forfeiture (i.e., fully vested) regardless of when it is actually paid. In contrast, deferred compensation provided by a taxable employer is included in the employee's gross income in the year that the deferred compensation is actually or constructively received. For deferred compensation provided by a taxable employer, the only exception arises when the terms or operation of the deferred compensation arrangement fail to comply with the Section 409A requirements, in which case the deferred amount is included in the employee's gross income in the year that it is no longer subject to a substantial risk of forfeiture and subject to an additional 20% tax, plus premium interest, on the vested accrued deferred compensation. Tax-exempt entities maintaining deferred compensation arrangements must ensure the arrangements comply with both the Section 457(f) and the Section 409A rules. Section 457(f)(3)(B) provides that a substantial risk of forfeiture exists if an employee's right to compensation is conditioned on future performance of substantial services. Several private letter rulings have cited Section 83 in interpreting substantial risk of forfeiture for purposes of Section 457(f). The Section 83 regulations provide that a substantial risk of forfeiture exists if the right is conditioned on the future performance of substantial services or on the occurrence of a condition related to employment if the possibility of forfeiture is substantial. The Section 83 regulations also provide that a covenant not to compete may constitute a substantial risk of forfeiture in limited circumstances, depending on the facts. Section 409A(e)(5) authorizes Treasury and IRS to disregard a substantial risk of forfeiture when necessary to carry out the purpose of the statute. The Section 409A final regulations provide that a covenant not to compete or other restriction from performing future services is not considered a substantial risk of forfeiture even if it may be likely that the individual may violate the restriction. Furthermore, the addition of any risk of forfeiture after the right to the compensation exists, or the extension of a period during which the compensation is subject to a risk of forfeiture (sometimes referred to as a "rolling risk of forfeiture") is disregarded, unless the present value of the amount subject to the new risk of forfeiture is materially greater than the amount the recipient otherwise could have elected to receive. Before the Section 409A final regulations were issued, tax-exempt entities often structured their Section 457(f) nonqualified deferred compensation arrangements to delay the income inclusion by providing for a rolling risk of forfeiture or a risk of forfeiture conditioned upon a covenant not to compete or other restrictive covenant following termination of employment. Following the issuance of the Section 409A final regulations, the IRS announced in Notice 2007-62 that it anticipated that future Section 457(f) regulations would generally adopt the Section 409A rules, which preclude a post-termination restrictive covenant or a rolling risk of forfeiture from constituting substantial risks of forfeiture that delay income inclusion. Section 457(e)(11)(A)(ii) regards bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay and death benefit plans as not providing for a deferral of compensation for purposes of Section 457. The Section 457 proposed regulations provide tax-exempt and governmental employers with needed guidance on what arrangements are considered deferred compensation plans subject to Section 457 and the determination of the timing and amount of deferred compensation to be included in an employee's gross income. Prior to these regulations, tax-exempt and governmental employers had little authoritative guidance on these matters. A. Excluded plans: bona fide severance pay, sick leave and vacation leave pay, death benefits and disability pay Section 457(e)(11) treats certain arrangements as not providing a deferral of compensation. The Section 457 proposed regulations provide guidance on when an arrangement is not subject to Section 457 because it is treated as a bona fide severance pay, sick leave and vacation leave plan, death benefit arrangement or disability pay. The definitions of a bona fide death benefit plan and disability pay plan track the definitions and guidance provided in the Section 409A regulations. The proposed rules related to bona fide severance pay and sick and vacation pay plans are worth discussing in greater detail. The requirements to determine a bona fide severance pay arrangement for purposes of Section 457 are similar to the rules for separation pay plans under the Section 409A regulations, except as provided below. i. The benefits provided under the plan must be payable only upon a participant's involuntary severance from employment, or under a window program, or voluntary early retirement. The rules under the Section 457 proposed regulations to determine whether a termination from employment is considered an involuntary severance from employment are similar to the involuntary separation from service rules under the Section 409A regulations with the exception that, unlike the rules under Section 409A, the determination must be made based on all of the facts and circumstances, without regard to the characterization of the termination of employment in the written agreement. A window program is a program established to provide separation pay in connection with an impending severance from employment for a limited period (e.g., 12 months). A program is not considered a window program if it is part of a pattern of multiple similar programs. A voluntary early retirement program generally is a program that provides for payments made in coordination with a permitted distribution under a qualified defined benefit pension plan. ii. The amount payable under the plan must not exceed two times the participant's annualized compensation for the preceding calendar year. This differs from the Section 409A regulations, which provide that, for a separation pay plan to be exempt from Section 409A, the payments under the plan must be limited to the lesser of: (a) two times the service provider's annualized compensation for the service provider's tax year preceding the tax year in which separation from service occurs, or (b) two times the Section 401(a)(17) limit (i.e., $265,000 for 2016). The Section 457 proposed regulations do not include the Section 401(a)(17) limit. iii. The severance benefits must be paid no later than the last day of the second calendar year in which the severance occurs. Implications: Because a Section 457(f) deferred compensation plan must comply with both the Section 457(f) and Section 409A rules, tax-exempt employers must carefully consider whether a severance pay plan is exempt under both rules and, if not, it must ensure that the plan complies with the applicable deferred compensation rule. For example, a tax-exempt employer may maintain a severance pay plan that is exempt from Section 457 because it pays two times the executive's prior annual compensation and meets the other requirement. If the amount paid under the severance pay plan exceeds two times the Section 401(a)(17) limit, however, the amount over that limit would not be exempt from Section 409A; in this case, the excess amount would need to comply with the Section 409A payment timing rules. The Section 457 proposed regulations would treat a sick and vacation leave plan as not providing the deferral of compensation if the primary purpose of the plan is to provide employees with paid time off because of sickness, vacation or other reasons. The final determination, however, would be based on the facts and circumstances. Factors used to determine the whether the plan is a bona fide sick and vacation leave plan include: — Whether the amount of leave provided could reasonably be expected to be used by the employee in the normal course and before termination of employment — Amount and frequency of any in-service distributions of cash or other benefits offered in exchange for accumulated and unused leave — Whether the payment of unused sick or vacation leave is made promptly upon severance from employment (or, instead, is paid over time after severance) — Whether the sick leave, vacation leave, or combined sick and vacation leave offered under the plan broadly applies or is available only to certain employees Implications: Many tax-exempt employers permit employees to accumulate significant amounts of unused vacation leave and receive in exchange a cash payment at termination of employment. Tax-exempt employers should review these types of vacation leave arrangements to assess whether they constitute bona fide vacation leave plans in light of the Section 457 proposed regulations. Presumably, vacation and sick leave arrangements that are widely available at the same rate of accrual for employees would continue to be exempt from Section 457(f). The Section 457 proposed regulations would subject payment of compensation to a substantial risk of forfeiture for purposes of Section 457(f) if the right to the compensation were8 conditioned on the future performance of services, or upon the occurrence of a condition that is related to a purpose of the compensation if the possibility of forfeiture is substantial. A condition would be related to the purpose of the compensation only if the condition relates to the employee's performance of services or the employer's activities. Whether the possibility of forfeiture is substantial would be based on the facts and circumstances and include factors such as the employer's past practices and the level of control or influence of the employee. The Section 457 proposed regulations provide for a slightly more flexible definition of a substantial risk of forfeiture than is provided under the Section 409A rules in several respects, including those discussed below. — A special rule permits new employees to elect to cause current compensation (e.g., salary, commissions, and certain bonus) to be treated as subject to a substantial risk of forfeiture and to permit an extension of a substantial risk of forfeiture (i.e., a rolling risk of forfeiture) if all of the following conditions are satisfied: (i) The present value of the amount to be paid upon the lapse of the substantial risk of forfeiture (or the extension) must be materially greater than the amount the employee otherwise would be paid in the absence of the risk of forfeiture. The proposed rules provide that the amount is materially greater only if the present value of the amount to be paid is 125% of the amount the participant otherwise would have received absent the initial deferral election or the extension of the risk of forfeiture. (ii) The initial or extended substantial risk of forfeiture must be based upon the future performance of substantial services or adherence to an agreement not to compete. It may not be based solely on the occurrence of a condition related to the purpose of the transfer. (iv) The agreement related to the substantial risk of forfeiture must be made in writing before the beginning of the calendar year in which services connected to the compensation are provided in the case of an initial deferral or at least 90 days before the date on which the existing substantial risk of forfeiture would have lapsed in the case of an extension. — Another special rule provides that a non-compete or other restrictive agreement may be considered a substantial risk of forfeiture if all of the following conditions are satisfied: (i) The right to the compensation is expressly conditioned, under a written agreement that is enforceable under applicable law, on the employee's refraining from the performance of future services. (ii) The employer consistently makes reasonable efforts to verify compliance with all of its noncompete agreements, including the noncompete agreement applicable to the employee. (iii) At the time the enforceable noncompetition agreement becomes binding, the facts and circumstances must show that the employer has a substantial and valid interest in preventing the employee from competing and that the employee has a bona fide interest in, and ability to, engage in the prohibited competition. Implications: Tax-exempt employers may be comforted that the Section 457 proposed regulations' definition of substantial risk of forfeiture provides some flexibility with respect to initial deferral elections, rolling risks of forfeiture and noncompetition agreements. The Section 457 proposed regulations' risk of forfeiture provisions, however, are narrow and prescriptive; tax-exempt organizations should proceed cautiously to comply with these rules if they plan to include such forfeiture provisions in their nonqualified deferred compensation plans. Furthermore, tax-exempt employers must closely monitor the application of the substantial risk of forfeiture rules for purposes of Section 457(f) and Section 409A. Although there is considerable overlap between the definition of substantial risk of forfeiture for purposes of Section 457(f) and Section 409A, there are also circumstances under which a compensation arrangement may be exempt from Section 457(f) but not exempt from Section 409A. For example, a compensation payment may be treated as exempt from Section 457(f) because the payment is considered a "vest and pay" short-term deferral, but not exempt from Section 409A because the noncompete provision is disregarded as a substantial risk of forfeiture. In this case, the payment would not be subject to Section 457(f), but it would be subject to the Section 409A requirements. The Section 457 proposed regulations set forth for the first time how the present value of the amount deferred compensation should be calculated for ineligible deferred compensation plans subject to income inclusion under Section 457(f). The proposed rules for determining the present value of the deferred compensation for purposes of Section 457(f) are similar to the proposed rules for determining the present value of income inclusion provided in the Section 409A proposed regulations. — For an account balance plan, the present value generally is the amount credited to the account, which includes both the principal and earnings or losses through the date that the amount first becomes fully vested, at which time the fully vested account balance is included in the employee's gross income. If the account balance is not determined using a predetermined actual investment or a reasonable rate of interest, the present value is the amount credited to the participant's account on the vesting date, plus the present value of the excess of the earnings to be credited under the plan after the vesting date over the earnings that would be credited during that period, using a reasonable rate of interest. — For a non-account balance plan, which is any plan that is not an account balance plan (i.e., a plan that pays a fixed amount or an deferred benefit amount that is determined based on the greater of two measures), the value of the deferred compensation as of the date that the amount is fully vested is the value using reasonable actuarial assumptions and taking into consideration the time value of money and the probability that the payment will be made. The Section 457 proposed regulations provide detailed guidance on the assumptions that may be used to determine the present value of the non-account balance deferred compensation, including when the participant may be treated as terminating employment and when the probability of the participant's death may be considered. — For a plan that provides a benefit based on a formula determined by reference to one or more factors that are indeterminable on the vesting date (e.g., a supplemental employee retirement plan (SERP) linked to a defined benefit plan formula that is based on the participant's final average compensation and total years of participation), the proposed rules provide that the present value must be based on reasonable, good faith assumptions with respect to the contingencies. The Section 457 proposed regulations provide that, if a participant includes an amount of deferred compensation in income, but the compensation that is subsequently paid is less than the amount included in income because, for example, the calculation of the present value overstated the actual amount paid, the participant is entitled to deduct the loss. The proposed regulations would treat this loss as a miscellaneous itemized deduction subject to the deduction limitations applicable to those expenses. Implications: Some Section 457(f) nonqualified deferred compensation plans are designed to pay the full amount of the benefit in the year that the deferred compensation is no longer subject to a substantial risk of forfeiture and is included in income. Other Section 457(f) nonqualified deferred compensation plans maintained by tax-exempt employers, however, pay the participant's benefit years after the deferred compensation vested and was included income (e.g., payment beginning at retirement). In this case, tax-exempt employers are advised to carefully assess the present value of the benefit to avoid a circumstance in which the ultimate amount paid out of the plan results in a loss to the participant. Although there may be arguments that such a loss may be offset against taxable income under Section 1341 (claim of right), the current IRS position reflected in the proposed regulations is that such a loss is a miscellaneous itemized deduction, which generally is not a favorable tax result for the participant. Section 457(f) provides that the tax treatment of any amount paid under an ineligible deferred compensation plan is determined under Section 72 related to annuity payments. Section 72 bases the amount of each annuity payment included in income on an "exclusion ratio" that is calculated at the time the annuity begins. The exclusion ratio is the "investment in the contract" (i.e., basis) over the "expected return" in the contract. The exclusion ratio is determined only once at the commencement of the annuity. Implications: Unlike Section 409A, which permits a full recovery of all previously taxed amounts first, distributions from a Section 457(f) deferred compensation plan are subject to the Section 72 basis allocation rules, meaning that at least a part of each distribution will be subject to tax. The Section 457 proposed regulations would make other clarifications regarding the coordination of Sections 457(f) and 409A: (i) Short-term deferrals. The Section 457 proposed regulations would not consider a payment that is considered a short-term deferral under the Section 409A regulations to be a deferral of compensation. For this purpose, a payment would be considered a short-term deferral if it were made by: (1) the later of 2½ months after the end of the calendar year in which the right to the payment is no longer subject to a substantial risk of forfeiture; or (2) the 2½ months following the end of the employer's tax year in which the right to the payment is no longer subject to a substantial risk of forfeiture. In this case, the Section 457 proposed regulations' definition of substantial risk of forfeiture would apply. (ii) Recurring part-year compensation. The Section 457 proposed regulations provide that a deferral of compensation does not occur with respect to an amount that is recurring part-year compensation, as defined in the Section 409A regulations. This provision is helpful for professors and teachers employed by a tax-exempt institution or governmental entity who are paid on an annualized basis but do not work for the entire year. The Section 457 proposed regulations would amend the 2003 final regulations to comply with subsequent legislative changes, including: — Qualified Roth contributions. The proposed rules would amend Reg. Section 1.457-4(a) and (b) to allow an eligible governmental plan to include a qualified Roth contribution. — Certain distributions to public safety officers. The proposed rules would amend Reg. Section 1.457-7(b) to reflect changes made to certain distributions to eligible public safety officers that exclude the payment from gross income. — Rules related to qualified military service. The proposed rules would amend Reg. Section 1.457-2(f) to implement the requirements applicable to a participant who dies while performing qualified military service. Tax-exempt and governmental employers should undertake a review of their deferred compensation plans, including vacation and sick leave, and their employment agreements to confirm how Section 457(f) and various exemptions may apply. Of particular concern are SERPs that are designed to offset defined benefit plans. Tax-exempt employers will need to confirm whether they are reporting the proper amount in income at the proper time under those plans in a manner that is consistent with the Section 457 proposed regulations. Although taxpayers may rely on the Section 457 proposed regulations, it is possible that further changes will be made after the comment period and reflected in final rules; given the length of time that these proposed regulations have been considered at IRS and Treasury and the coordination with Section 409A, however, significant changes are not likely. — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg.
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