IRS Proposes Rules Under Section 457 for Deferred Compensation Arrangements Maintained by Tax Exempt Organizations | Practical Law

IRS Proposes Rules Under Section 457 for Deferred Compensation Arrangements Maintained by Tax Exempt Organizations | Practical Law

The Internal Revenue Service (IRS) issued proposed regulations prescribing rules under Section 457 of the Internal Revenue Code for the taxation of compensation deferred under plans established and maintained by state or local governments or other tax exempt organizations. These proposed regulations include rules for determining when amounts deferred under these plans are includible in income and the types of plans that are not subject to these rules.

IRS Proposes Rules Under Section 457 for Deferred Compensation Arrangements Maintained by Tax Exempt Organizations

by Practical Law Employee Benefits & Executive Compensation
Law stated as of 21 Jun 2016 • USA (National/Federal)
The Internal Revenue Service (IRS) issued proposed regulations prescribing rules under Section 457 of the Internal Revenue Code for the taxation of compensation deferred under plans established and maintained by state or local governments or other tax exempt organizations. These proposed regulations include rules for determining when amounts deferred under these plans are includible in income and the types of plans that are not subject to these rules.
On June 21, 2016, the Internal Revenue Service (IRS) issued proposed regulations prescribing rules under Section 457 (Section 457) of the Internal Revenue Code (Code) for the taxation of compensation deferred under plans established and maintained by state or local governments or other tax exempt organizations.
The proposed regulations would generally apply to compensation deferred under a plan for calendar years beginning after the date of publication of the Department of Treasury decision adopting the regulations as final in the Federal Register. The proposed regulations also include special applicability dates for certain plans. Taxpayers may rely on the proposed regulations until the applicability date.

Background

Section 457 provides the framework for deferred compensation arrangements offered by state and local governments and other tax-exempt employers. Section 457 allows these tax-exempt employers to offer their employees:
  • "Eligible" Section 457(b) plans that must meet certain requirements and allow participants to defer taxes on compensation up to a specific limit ($18,000 in 2016) until the amounts are paid.
  • "Ineligible" Section 457(f) plans, which are deferred compensation plans that do not meet the requirements of a Section 457(b) plan and allow participants to defer taxes on an unlimited amount of compensation until the compensation is no longer subject to a substantial risk of forfeiture.
Generally, compensation deferred under an arrangement that is not an eligible plan will be included in income in accordance with Section 457(f) unless an exception to Section 457 applies. (For more information on eligible and ineligible plans, see Practice Note, Executive Compensation for Tax-Exempt Organizations: Section 457(f) Plans and Section 457(b) Eligible Employer Plans.)
The Treasury Department and the IRS had previously issued final regulations under Section 457 (the 2003 final regulations). The proposed regulations issued on June 21, 2016:
  • Include amendments to the 2003 final regulations to reflect subsequent statutory changes made to Section 457 under the American Jobs Creation Act of 2004 (which added Section 409A to the Code), the Pension Protection Act of 2006, the Heroes Earnings Assistance and Relief Tax Act of 2008, the Small Business Jobs Act of 2010, and the American Taxpayer Relief Act of 2012.
  • Provide guidance on certain issues under Sections 457(e)(11) and 457(e)(12) (relating to exemptions from Section 457) that are not addressed in the 2003 final regulations.
  • Provide additional guidance for ineligible plans under Section 457(f).

Proposed Regulations

Amendments to Reflect Statutory Changes to Section 457

The proposed regulations amend the following sections of the Treasury Regulations to reflect statutory changes made to Section 457:
  • Sections 1.457-4(a) and (b) (which currently exclude annual deferrals to an eligible plan from a participant's gross income in the year deferred), to allow an eligible governmental plan to include a qualified Roth contribution program, under which designated Roth contributions are included in income in the year of deferral and qualified distributions from a designated Roth account are excluded from gross income (see Practice Note, Roth 401(K) Plans).
  • Section 1.457-7(b), to provide that distributions to an eligible public safety officer from an eligible governmental plan meeting the requirements of Code Section 402(l) (26 U.S.C. § 402(l)) are excluded from gross income.
  • Section 1.457-2(f), to implement the requirements of Section 457(g)(4), which provides that in the case of a participant who dies while performing qualified military service, an eligible governmental plan must provide that the survivors of the participant are entitled to any additional benefits that would have been provided under the plan if the participant had resumed and then terminated employment on account of death.

Guidance Under Sections 457(e)(11) and 457(e)(12) on Certain Plans that Are Exempt from Section 457

Treasury Regulation Section 1.457-11 provides guidance on:
  • Bona fide vacation, sick leave, compensatory time, severance pay, disability pay, and death benefit plans, which are treated as not providing for a deferral of compensation for purposes of Section 457.
  • Plans paying solely length of service awards to bona fide volunteers or their beneficiaries, which are also treated as not providing for a deferral of compensation for purposes of Section 457.
The proposed regulations include rules for determining whether an arrangement meets the requirements of each of those types of plan. The proposed regulations also provide guidance in a new Section 1.457-12 on other plans that are exempt from Section 457(f).

Bona Fide Severance Pay Plans

Under the proposed regulations, a plan must meet certain requirements to be a bona fide severance pay plan that is treated as not providing for the deferral of compensation and therefore not subject to Section 457:
  • The benefits provided under the plan must be payable only on a participant's involuntary severance from employment or under a window program or voluntary early retirement incentive plan.
  • The amount payable under the plan with respect to a participant must not exceed two times the participant's annualized compensation based on the participant's annual rate of pay for the calendar year preceding the calendar year of severance from employment.
  • 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.
These proposed rules for severance pay plans are similar to the rules for separation pay plans in Treasury Regulation Section 1.409A-1(b)(9) (see Practice Note, Severance Benefits, Plans and Agreements: Overview).
An involuntary severance from employment is generally a severance from employment due to the employer's independent exercise of its authority to terminate the participant's services, other than due to the participant's request, if the participant is willing and able to continue to provide services.
An employee's voluntary severance from employment for good reason may be treated as an involuntary severance from service under Section 457 if it occurs under certain bona fide conditions that are pre-specified in writing and not for the primary purpose of avoiding Section 457. The severance for good reason must result from unilateral action taken by the employer resulting in a material adverse change to the working relationship (such as a material reduction in the employee's duties, working conditions, or pay). Other factors that may be taken into account in determining whether a termination for good reason meets the requirements of an involuntary severance from service include:
  • Whether the good reason severance payments are in the same amount and paid at the same time as payments triggered by a severance from employment by the employer without cause.
  • Whether the employee is required to give notice to the employer of the material adverse change in conditions and provide the employer with an opportunity to remedy the adverse change.
The proposed regulations also include a safe harbor good reason definition.
Under the proposed regulations, the involuntary severance from employment requirement does not apply to window programs (as defined in the proposed regulations) or to an applicable voluntary early retirement incentive plan (as described in Section 457(e)(11)(D)(ii)). The rules described in the proposed regulations will supersede the transitional guidance on severance pay plans in IRS Announcement 2000-1.

Bona Fide Death Benefit Plans and Disability Pay Plans

The proposed regulations include definitions of bona fide death benefit plans and bona fide disability pay plans, as well as a definition of disability. A participant is disabled for purposes of a disability pay plan if any of the following conditions are met:
  • The participant is unable to engage in substantial gainful activity due to a medically determinable physical or mental impairment that can be expected to:
    • last for a continuous period of at least 12 months; or
    • result in death.
  • The participant is receiving income replacement benefits for a continuous period of not less than three months under the employer's accident or health plan due to a medically determinable physical or mental impairment that can be expected to last for a continuous period of at least 12 months or to result in death.
  • The participant is determined to be totally disabled by the Social Security Administration or the Railroad Retirement Board.

Bona Fide Sick Leave and Vacation Leave Plans

Under the proposed regulations, a sick or vacation leave is generally treated as bona fide if the facts and circumstances demonstrate that the primary purpose of the plan is to provide employees with paid time off from work because of sickness, vacation, or other personal reasons. The proposed regulations include factors to be used in determining whether a plan is a bona fide sick or vacation leave plan.

Ineligible Plans Under Section 457(f)

Tax Treatment of Amounts Deferred Under Section 457(f)

Under the proposed regulations, if an ineligible plan provides for a deferral of compensation, the compensation deferred under the plan is includible in the participant's income under Section 457(f)(1)(A) on the applicable date, which is the later of:
  • The date the participant obtains a legally binding right to the compensation.
  • If the compensation is subject to a substantial risk of forfeiture at the time the participant obtains a legally binding right to the compensation, the date the substantial risk of forfeiture lapses.
Generally, the amount of compensation deferred under a plan that is includible in gross income on the applicable date is the present value, as of the applicable date, of the amount of compensation deferred, including any earnings on amounts deferred.

Calculating the Present Value of Compensation Deferred Under an Ineligible Plan

The proposed regulations provide general rules for determining the present value of compensation deferred under an ineligible plan, and also include specific rules for determining the present value of compensation deferred under ineligible plans that are account balance plans. These rules for determining present value are similar to the rules for determining present value in the Section 409A regulations proposed by the IRS concurrently with these proposed regulations (see Legal Update, IRS Proposes Rules Clarifying and Modifying Section 409A Final Regulations and Withdraws and Replaces Provision in Proposed Income Inclusion Regulations). One difference between these proposed regulations and the proposed section 409A regulations is that income inclusion and present value calculations under Section 457(f) are determined as of the applicable date, whereas income inclusion and the present value calculations under Section 409A (26 U.S.C. § 409A) are determined as of the end of the service provider's taxable year.
The proposed regulations note that the Treasury Department and the IRS expect that these regulations will be finalized after the proposed Code Section 409A regulations are finalized and will adopt many provisions of Treasury Regulation § 1.409A-4 for ease of administration.

Definition of Deferral of Compensation

These proposed regulations define the term deferral of compensation for purposes of determining whether Section 457(f) applies to an arrangement. In general, a plan provides for a deferral of compensation if a participant has a legally binding right during one taxable year to compensation that is or may be payable in a later taxable year under the terms of the plan. Whether a plan provides for a deferral of compensation is generally based on the terms of the plan and the relevant facts and circumstances at the time the participant obtains a legally binding right to the compensation.

Short-Term Deferral

Under the proposed regulations, a deferral of compensation does not occur with respect to any amount that would be a short-term deferral under Treasury Regulation Section 1.409A-1(b)(4), substituting the definition of a substantial risk of forfeiture provided under these proposed regulations for the definition under Treasury Regulation Section 1.409A-1(d). This means that a deferral of compensation does not occur with respect to any payment that is not a deferred payment, provided that the participant actually or constructively receives the payment on or before the later of:
  • 2 1/2 months following the end of the first calendar year in which the participant's right to the payment is no longer subject to a substantial risk of forfeiture.
  • 2 1/2 months following the end of the employer's first taxable year in which the participant's right to the payment is no longer subject to a substantial risk of forfeiture.

Recurring Part-Year Compensation

The proposed regulations provide that a plan or arrangement under which an employee receives recurring part-year compensation (for example, a teacher providing services during a school year of 10 consecutive months that span two calendar years) that is earned over a period of service does not provide a deferral of compensation if both:
  • The plan or arrangement does not defer payment of any of the recurring part-year compensation beyond the last day of the 13th month following the first day of the service period for which the recurring part-year compensation is paid.
  • The amount of the recurring part-year compensation (the entire amount, not just the amount deferred) does not exceed the annual compensation limit under Code Section 401(a)(17) ($265,000 for 2016) for the calendar year in which the service period commences (26 U.S.C. § 401(a)(17)).
A conforming change is included in the proposed Code Section 409A regulations. (IRS Notice 2008-62 previously included an annual deferral limit of $18,000 for 2016 for recurring part-year compensation.)

Interaction of Section 457 with Section 409A

The proposed regulations clarify that the rules under Section 457(f) apply separately and in addition to the requirements under Code Section 409A (26 U.S.C. § 409A). This means that a deferred compensation plan that is subject to Section 457(f) may also be a nonqualified deferred compensation plan that is subject to Code Section 409A. The proposed regulations provide an example of the interaction of Code Sections 409A and 457(f).

Substantial Risk of Forfeiture

The proposed regulations provide that an amount is generally subject to a substantial risk of forfeiture only if entitlement to that amount is conditioned on either:
  • The future performance of substantial services.
  • The occurrence of a condition that is related to a purpose of the compensation if the possibility of forfeiture is substantial. A condition is related to the purpose of the compensation only if the condition relates to the employee's performance of services for the employer or to the employer's tax exempt or governmental activities or organizational goals.
A special rule applies to determine whether initial deferrals of current compensation may be treated as subject to a substantial risk of forfeiture and whether a substantial risk of forfeiture can be extended.
Whether an amount is conditioned on the future performance of substantial services is based on all of the relevant facts and circumstances, such as whether the hours required to be performed during the relevant period are substantial in relation to the amount of compensation.
Under the proposed regulations, compensation may be considered subject to a substantial risk of forfeiture if the compensation is conditioned on the participant's compliance with a non-compete provision if the following conditions are met:
  • The right to compensation is expressly conditioned on the employee complying with the non-compete under a written agreement that is enforceable under applicable law.
  • The employer consistently makes reasonable efforts to verify compliance with all of the non-compete agreements to which it is a party.
  • At the time the non-compete becomes binding, the facts and circumstances show that:
    • the employer has a substantial and bona fide interest in preventing the employee from performing the prohibited services; and
    • the employee has a bona fide interest in engaging, and an ability to engage in, the prohibited services.
The proposed regulations permit initial deferrals of current compensation to be subject to a substantial risk of forfeiture and also allow an existing risk of forfeiture to be extended only if all of the following requirements are met:
  • The present value of the amount to be paid on the lapse of the substantial risk of forfeiture must be materially (at least 25 percent) greater than the amount the employee would be paid in the absence of the substantial risk of forfeiture (or in the absence of the extension).
  • The initial or extended substantial risk of forfeiture must be based on the future performance of substantial services or compliance with a non-compete.
  • The substantial future services must be completed for a period of at least two years (except in the case of death, disability, or involuntary severance from employment).
  • For initial deferrals, the agreement subjecting the amount to a substantial risk of forfeiture must be made in writing before the beginning of the calendar year in which any services for the compensation are performed. For extensions, the agreement must be made in writing at least 90 days before the date the existing substantial risk of forfeiture would have lapsed.

Applicability Dates

These regulations are proposed to generally apply to compensation deferred under a plan for calendar years beginning after the date of publication of the Department of Treasury decision adopting the rules as final regulations in the Federal Register. The proposed rules also include special applicability dates for plans maintained under one or more collective bargaining agreements, plans providing for recurring part-year compensation for periods before the general applicability date, and plans that can only be amended through legislation.
Taxpayers may rely on the proposed regulations until the applicability date.