IRS Issues Proposed Regulations for Executive Deferred Compensation Plans of Tax Exempt Organizations
On June 21, 2016, the Internal Revenue Service issued long awaited regulations under section 457(f) of the Internal Revenue Code (“IRC”) covering executive deferred compensation plans of tax exempt and governmental organizations. The proposed regulations provide important guidance and clarification in areas that have been unclear for practitioners and the organizations maintaining plans for executives. The regulations address substantial risk of forfeiture and severance as well as providing clarification regarding short-term deferrals and the interaction between sections 457(f) and section 409A.
Many tax exempt and governmental entities provide deferred compensation to key executives in excess of the amounts that can be provided under a tax qualified plan under IRC sections 401(a), 403(b), or 457(b) that covers all employees of the organization. Compensation deferred under these executive plans and under employment agreements is subject to section 457(f) and is taxed when it is no longer subject to a substantial risk of forfeiture, which typically means when it vests (the executive is not required to provide any additional services to the organization to receive the compensation). This rule is very different from the rules for for-profit organizations and frequently not understood by tax exempt organizations. Under the rules for for-profit organizations, which are generally covered by section 409A, executive deferred compensation is not taxed until actually paid or constructively received by the executive, although vesting may have occurred much earlier. Section 457(f) exempts certain types of plans from coverage under these rules; amongst such exclusions are severance pay arrangements, sick pay plans, and vacation pay plans, and the proposed regulations provide clarifying definitions for what constitutes a bona fide plan for this purpose.
The Proposed Regulations
As noted previously, the proposed regulations address issues around what constitutes a substantial risk of forfeiture, and provide clarification regarding which plans are exempt from section 457(f) and additional clarifications that are new. To follow is a summary of the key provisions of the proposed regulations.
Substantial Risk of Forfeiture
The proposed regulations bring in many concepts from the section 409A regulations regarding what will be considered a substantial risk of forfeiture for purposes of section 457(f). This is critical for organizations operating section 457(f) plans as the lapse of a substantial risk of forfeiture still dictates the timing of the taxation of the executive’s benefit. In other words, these regulations do not adopt the concept under section 409A of taxation upon actual payment or constructive receipt. Accordingly, executives of tax exempt and governmental entities will still be taxable in the year that their deferred compensation vests (is no longer subject to a substantial risk of forfeiture) not when it is paid (for a limited exception, see the discussion regarding Short Term Deferrals below).
The new regulations largely adopt the section 409A definition of a substantial risk of forfeiture stating that a substantial risk of forfeiture only exists if “entitlement to the amount is conditioned on the future performance of substantial services, or upon the occurrence of a condition that is related to a purpose of the compensation if the risk of forfeiture is substantial.” A performance condition related to the purpose of the compensation must relate to the executive’s performance of services for the organization.
The proposed regulations contain an exception for non-compete agreements, which is not contained in section 409A. For purposes of 457(f), a non-compete agreement will create a substantial risk of forfeiture if it meets all of the following requirements:
- The right to payment is expressly conditioned upon the executive refraining from the future performance of services under a written non-compete agreement that is enforceable under state law.
- The organization makes reasonable efforts to verify the executive’s compliance with the non-compete agreement.
- At the time the non-compete agreement becomes binding on the parties, the facts and circumstances must show that the organization has a substantial and bona fide interest in preventing the executive from performing the prohibited services and that the executive has a bona fide interest in, and ability to, engage in the prohibited services.
Rolling Risk of Forfeiture
Under the proposed regulations, IRS has provided a concept of a redeferral of amounts due to vest under a plan subject to section 457(f). While this rolling risk of forfeiture provision is not identical to the provision under section 409A, it is very helpful to executives and organizations that are willing to extend the substantial risk of forfeiture. The addition of a substantial risk of forfeiture for current compensation not yet subject to deferral or the extension of a risk of forfeiture for compensation previously deferred will not result in current taxation to the executive if it meets all of the following requirements:
- The present value of the compensation to be paid must be materially greater than the amount the executive would have received absent the addition or extension of the substantial risk of forfeiture. For this purpose the present value of the amount to be paid must be at least 125% of the amount that would have otherwise been received.
- The executive must be required to provide substantial future services or refrain from competing under a non-compete agreement (see above) for a period of at least 2 additional years. For this purpose, the addition of a performance goal does not meet this requirement. Under this rule, vesting and payment may be accelerated upon death, disability, or involuntary termination of the executive.
- In the case of an initial deferral, the election must be made in writing before the calendar year in which the services are to be performed. For an extension of an existing deferral, the written election must be made at least 90 days prior to the date on which the existing vesting requirement would have been satisfied.
Clarifying Definitions of Exempt Arrangements
The proposed regulations provide exemptions and guidance for certain arrangements that would otherwise be considered a deferral of compensation under section 457(f). The following types of arrangements are exempt from section 457(f):
- Short-term deferral arrangements
- Bona fide severance pay plans, death benefit plans, disability plans, and sick and vacation pay plans
- Transfers of property under section 83
- 403(b) plans and tax qualified plans and trusts under section 401(a)
- Certain recurring part-year compensation
- Employment retention plans under section 457(f)(4)
- Taxable education assistance benefits solely for an employee under section 127(c)(1)
Below we discuss the exemptions we believe that are the most relevant to our readers.
Short Term Deferrals
The proposed regulations add a provision that is analogous to the short term deferral rule under section 409A. An arrangement is not subject to 457(f) or 409A if the deferred compensation is required (under the terms of the agreement) to be paid and is actually paid on or before the 15th day of the 3rd month following the end of the later of 1) the calendar year or 2) the organization’s tax year in which the executive’s right to the deferred compensation vests (March 15 if both the organization and executive are calendar year tax payers).
This provision provides some flexibility in the timing of actual payment of the deferred compensation, but it should be noted that the written agreements need to specify that the deferred compensation will be paid in this manner.
Severance Pay Plans
The proposed regulations clarify what constitutes a ‘bona fide severance pay plan’ for purposes of section 457(f). The rule is generally the same as provided for under section 409A and requires that:
- Benefits are only payable upon an involuntary termination of employment by the executive.
- The amount payable under the plan does not exceed 2 times the executive’s annualized compensation for the calendar year prior to termination. It should be noted that this limit is different than the limit provided under section 409A, which provides that the limit is the lesser of 1) 2 times annualized compensation or 2) 2 times the annual section 401(a)(17) limit (currently $265,000 annually).
- The terms of the severance arrangement must require that the entire severance amount be paid out no later than the last day of the second calendar year following the calendar year in which the executive terminated service.
Under the proposed regulations, a bona fide plan only pays benefits upon a disability. For this purpose, disability is defined in the same restrictive manner as under section 409A and means (a) a medically determinable physical or mental impairment that can be expected to result in death or to last for at least 12 months, and the impairment either: (i) prevents the participant from engaging in any substantial gainful activity; or (ii) entitles the participant to receive income replacement benefits for at least 3 months under an accident and health plan sponsored by the organization; or (b) the participant is determined to be totally disabled by the Social Security Administration or Railroad Retirement Board.
Determination of Present Value
As discussed previously, under section 457(f) an executive recognizes income tax when he becomes vested (no longer subject to a substantial risk of forfeiture) in his benefit regardless if it is to be paid at a later date. While it is typical for the benefit due under a plan to be paid immediately (since the executive has to pay taxes currently), it is possible that the benefit will not be paid until a future date. For these instances, the proposed regulations provide guidelines for calculating the present value of the benefit to be paid in the future for purposes of determining and reporting the taxable income to the executive in the year of vesting. For account balance plans, the present value is simply the value of the account at the date of vesting. For formula arrangements or severance arrangements, the regulations discuss reasonable actuarial assumptions and proscribe, in general, how these arrangements are to be reasonably valued. And present value for this purpose need not be determined under the same “reasonable” assumptions used to determine FICA taxes.
Interaction of Sections 457(f) and 409A
The proposed regulations clearly state that section 457(f) is to be applied separately and in addition to any requirements under section 409A. Accordingly, plans must be designed and operated to comply with both of these IRC sections and it is possible in operation that an amount must not be recognized as income under section 457(f) but must be recognized under section 409A, and visa-versa. While this is likely to occur only in more complex plan designs, it is imperative that both IRC sections 457(f) and 409A be applied to determine the timing of income recognition by the executive.
The proposed regulations will generally be effective for calendar years beginning after the year in which the regulations are published as final, which should be sometime in 2017, as the comment period expires September 20, 2016 and the public hearing is scheduled for October 18, 2016. Taxpayers may, if they so choose, rely on the proposed regulations immediately. There are separate effective dates for collectively bargained plans and for governmental plans that require legislation in order to be amended.
As anticipated, the proposed regulations more closely align section 457(f) with section 409A and provided much needed guidance in this area. In light of the changes and clarifications, it is important for tax-exempt organizations and governmental entities to review all of their deferred compensation arrangements and employment agreements with executives to develop a strategy for compliance and to take advantage of any additional flexibility that may be beneficial to executives and the organization.