Nonqualified Deferred Compensation: IRS Proposes New Section 457 Regulations and Section 409A Clarifications

Last week, the Internal Revenue Service (IRS) proposed new regulations under Section 457 of the Internal Revenue Code (Code), which governs nonqualified deferred compensation plans of state and local governments and private tax-exempt entities. At the same time, the IRS proposed clarifications to the regulations under Code Section 409A, which applies to certain nonqualified plans of those entities as well as to nonqualified plans of for-profit entities.

Background

Sections 409A and 457 share certain concepts. In particular, the concept of “substantial risk of forfeiture” is critical under both regimes. Under Section 457(f), deferred compensation of a public or private tax-exempt entity that does not meet the limits on deferrals and other requirements for an “eligible” plan under Section 457(b) is taxable to the employee when the compensation is no longer subject to a substantial risk of forfeiture. Deferred compensation is generally exempt from the Section 409A regime if the compensation is paid within 2½ months after the end of the taxable year in which the compensation is no longer subject to a substantial risk of forfeiture.

In addition, both Section 409A and Section 457(f) contain exemptions for severance pay that meets certain requirements.

Section 409A was enacted after Section 457(f) and contains a more restrictive definition of “substantial risk of forfeiture” and a narrower exemption for severance pay than the prevailing interpretation of Section 457(f). In 2007, the IRS announced that it planned to issue regulations under Section 457(f) conforming the Section 457(f) definition of substantial risk of forfeiture and the Section 457(f) severance pay exemption to the corresponding definition and exemption under Section 409A. Nearly a decade later, the proposed regulations would finally fulfill this promise.

Overview of Section 457 Proposed Regulations

The following is an overview of the numerous topics addressed in the Section 457 proposed regulations.

Substantial Risk of Forfeiture

The proposed regulations’ definition of substantial risk of forfeiture under Section 457(f) closely overlaps with, but is not identical to, the corresponding definition under Section 409A. For example, both definitions are based on the compensation being conditioned on either the future performance of substantial services or the occurrence of a condition that is related to a purpose of the compensation (such as achievement of a performance goal).

However, unlike the Section 409A definition, the Section 457(f) definition also would allow a substantial risk of forfeiture to exist based on an agreement not to perform services, such as a noncompetition agreement, if the following conditions are met:

• The compensation must be expressly conditioned on an agreement that is both written and enforceable.
• The employer must make reasonable and consistent efforts to verify compliance with all such agreements to which it is a party.
• The employer must be able to show that at the time it entered into the agreement, it had a substantial and bona fide interest in preventing the employee from performing the prohibited services, and that the employee has a bona fide interest in and ability to engage in the prohibited services.

The proposed Section 457(f) definition would also depart from the Section 409A definition when it comes to the ability to subject current compensation (such as salary) to a substantial risk of forfeiture, or to extend a risk of forfeiture. Unlike the Section 409A definition, the proposed Section 457(f) definition would allow salary deferrals to be subject to a substantial risk of forfeiture, and would also allow a substantial risk of forfeiture to be extended — i.e., a “rolling risk of forfeiture” — if the following requirements are met:

• The present value of the deferred compensation payable upon lapse of the new or extended substantial risk of forfeiture would need to be at least 25 percent greater than the amount of compensation the employee would have been entitled to receive but for the new or extended substantial risk of forfeiture.
• The new or extended substantial risk of forfeiture could be based only on the future performance of substantial services, not achievement of a performance goal or other occurrence of a condition relating to a purpose of the compensation.
• The new or extended substantial risk of forfeiture must last at least two years, absent an intervening death, disability or involuntary termination of employment.
• The agreement subjecting current compensation to a new substantial risk of forfeiture must be entered into before the start of the year in which any services relating to the compensation are performed (with special allowances for new employees), or at least 90 days before an existing substantial risk of forfeiture would have lapsed, but for an extension.

Practice Note: The gaps between the Section 409A and Section 457(f) definitions of substantial risk of forfeiture mean that, in some cases, deferred compensation may be tax-deferred for Section 457(f) purposes yet not exempt under Section 409A. In those cases, the proposed regulations would clarify that the deferred compensation arrangement would need to be designed to comply with Section 409A.

Severance Pay Exemption

The Section 457 proposed regulations would create an exemption to the Section 457(f) regime for severance pay arrangements that is similar to the “two-times” severance pay exemption under Section 409A. In particular, a severance pay arrangement would be exempt from Section 457(f) as long as:

• the severance was payable solely on an involuntary termination of employment (including a voluntary “good reason” termination that meets certain requirements, and certain window and early retirement incentive programs);
• the total amount of severance did not exceed two times the employee’s annual rate of pay for the year preceding the year of termination; and
• the severance was paid in full before the end of the second year following the year of termination.

The Section 457(f) exemption would be slightly broader than the Section 409A exemption, in that it would allow severance to be exempt even if the total severance exceeded two times the qualified plan compensation limit for the year of termination ($265,000 for 2016).

Practice Note: The proposed standards for exempt severance pay arrangements are more detailed than those contained in existing guidance (such as the standards for establishing that a “good reason” termination is an involuntary termination). As a result, existing arrangements intended to meet the exemption may need to be modified when the regulations are finalized. The proposed regulations do not address how existing arrangements could be transitioned to comply with the new standards, but that issue will likely be addressed when the final regulations are issued.

Other Exemptions

In addition to severance pay, the Section 457 proposed regulations would also exempt bona fide death benefit, disability pay, sick leave and vacation plans in a manner that is similar to the existing exemptions under Section 409A. To qualify as a disability pay plan, the definition of disability would need to be defined in the same manner as under Section 409A, which generally requires a strict finding of total and permanent disability. 

The proposed regulations would also add some guidance around the facts and circumstances relevant to determining whether a vacation pay plan is considered bona fide. These would include the following:

• Whether the amount of leave provided could reasonably be expected to be used in the normal course prior to termination of employment limits on the ability to cash-out accrued unused leave and the existence of “use-it-or-lose-it” rules
• The amount and frequency of any in-service cash-outs of accrued unused leave
• Whether cash-out of accrued, unused leave is paid promptly following termination of employment
• Whether the leave program is broadly applicable or limited to certain employees

Income-Inclusion Rules

The Section 457 proposed regulations would also clarify how the amount to be included in income under Section 457(f) upon lapse of a substantial risk of forfeiture is to be determined. In general, the amount to be included would be the present value of the deferred compensation, with the present value determined under rules similar to the proposed regulations that would apply for purposes of determining the amount includible in income upon a violation of Section 409A. For a discussion of the Section 409A proposed income inclusion regulations, see our WorkCite article of Dec. 11, 2008.

Short-Term Deferrals

The Section 457 proposed regulations would also clarify that, similar to Section 409A, an exemption exists under Section 457(f) for so-called “short-term deferral” arrangements, i.e., arrangements under which compensation is deferred for no more than 2½ months after the end of the employer’s taxable year in which the substantial risk of forfeiture lapses. (Under Section 409A, the 2½-month period is measured from the end of the employee’s or the employer’s taxable year, whichever ends later, but under Section 457(f) it would be only the employer’s taxable year.) Previously, it was uncertain under Section 457(f) whether deferred compensation that, e.g., vested on Dec. 31 but was payable in January of the following year should be taxable to the employee in the year in which it vested or the year in which it was paid.

Practice Note:  Under the Section 457 proposed regulations, if the deferred compensation were paid more than 2½ months after the end of the employer’s tax year in which the substantial risk of forfeiture lapses, such amount would be taxable in the employee’s tax year in which it vests. However, if the deferred compensation were paid within the 2½ months after the end of the employer’s tax year in which the substantial risk of forfeiture lapses, such amount would be taxable in the employee’s tax year in which it was paid.

Recurring Part-Year Compensation

The Section 457 proposed regulations would also make a clarification to prior IRS guidance under Sections 409A and 457(f) as to “recurring part-year compensation” arrangements, such as arrangements with teachers under which they may elect to spread compensation earned for a 10-month school year over a full 12-month period. The regulations would exempt these arrangements from Section 457(f) as long as the arrangement does not defer compensation more than 13 months after the start of the service period and the total amount of compensation subject to the recurring part-year compensation arrangement does not exceed the qualified plan compensation limit. A similar exemption would apply under Section 409A pursuant to the concurrent Section 409A guidance described below.

Updates to Governmental 457(b) Plan Regulations

The Section 457 proposed regulations would also update existing regulations to reflect changes in law that affect “eligible” governmental 457(b) plans. The changes in law permit the implementation of qualified Roth elective deferral programs, exclude from income inclusion certain accident and health insurance premiums paid to public safety officers, and require certain protections of participants who are on qualified military leave. 

With regard to Roth elective deferral programs, the proposed regulations are similar to those set forth under the qualified plan regulations for Roth 401(k) deferrals.  For example, Roth deferrals must be maintained in a separate account from pre-tax deferrals and be separately accounted for as to distributions and investment gains and losses. The proposed regulations also provide that distributions from Roth accounts from governmental Section 457(b) plans are not subject to income inclusion under Section 457. In addition, the proposed regulations would exclude from income distributions from governmental 457(b) plans to participants who are eligible retired public safety officers, provided the amount does not exceed the amount paid for qualified health insurance premiums.

Also, consistent with laws protecting employees who are on qualified military leave, the proposed regulations would require governmental Section 457(b) plans to provide the beneficiaries of participants who die while on such leave any benefits the participant would have been provided had the employee resumed service and terminated on account of death. In addition, the proposed regulations would require governmental Section 457(b) plans to treat certain military service leaves, for distribution purposes, as a severance from employment.

Applicability

The Section 457 proposed regulations would generally apply to any compensation deferred under a plan for any calendar year beginning after the date on which the regulations are finalized and published in the Federal Register. Notably, this would include deferred compensation as to which an employee had obtained a legally binding right in prior calendar years that had not been included in the employee’s income in prior calendar years. Thus, existing Section 457 plans that provide for deferred compensation that has not yet been included in income before the effective date of the regulations may need to be amended to comply with the final regulations.

The proposed regulations may be relied upon until the time at which final regulations become effective. However, the IRS has clarified that the proposed regulations are not intended to create any implications regarding the proper application of Section 457 for periods before final regulations take effect. 

Section 409A Clarifications

The proposed regulations under Section 409A would make 19 targeted and relatively technical clarifications and modifications to the existing Section 409A regulations that were finalized back in 2007. Most significantly, the proposed regulations would rein in the practice of correcting Section 409A errors as to nonvested amounts outside of the formal Section 409A corrections guidance by strengthening the anti-abuse rule to which such corrections are subject.

Some of the other notable clarifications include:

• A payment delayed beyond the normal 2½-month short-term deferral period in order to comply with federal securities laws or other applicable law may still qualify as a short-term deferral.
• The stock underlying otherwise-exempt stock rights (such as options and stock appreciation rights) may be subject to call or mandatory repurchase rights at less than fair market value for terminations for cause or violations of restrictive covenants, and otherwise-exempt stock rights may be granted within 12 months before an employee commences providing services, in each case without causing the stock rights to lose their exemption under Section 409A.
• The “two-times” severance exemption may apply even where an employee is hired and terminates employment in the same year, using the annualized pay for the year of termination to apply the exemption.
• An arrangement reimbursing an employee’s reasonable attorneys’ fees for claims beyond the limited set of claims listed in the final regulations would be exempt from Section 409A.
• A Code Section 338(h)(10) deemed asset sale is not treated as an actual asset sale for purposes of allowing employers to choose whether an employee has experienced a separation from service in connection with the sale.
• An employee who terminates employment but continues to provide services as an independent contractor for the same employer would still be deemed to have separated from service if it is reasonably expected that the hours worked as an independent contractor will be below 20 percent of the average hours worked over the preceding 36-month period.
• The vesting of compensation under a Section 457(f) plan would be treated as a payment for all purposes under Section 409A (not just application of the short-term deferral rules). Similarly, the issuance of restricted stock in satisfaction of a deferred compensation obligation would not be treated as a payment for Section 409A purposes unless the employee makes a Code Section 83(b) election upon receipt of the restricted stock.
• The same rules that apply to payments upon death of an employee, and that allow the acceleration of payment upon the death, disability or unforeseeable emergency of an employee, would also apply to payments to a beneficiary who has become entitled to the payment as a result of the employee’s death. Also, plans could be amended to provide that payments upon death of an employee or beneficiary may be made at any time through Dec. 31 of the year following the year in which the death occurs.
• The special rules that allow extended payments of transaction-based compensation following a change in control would also apply to exempt options and other stock rights without causing such stock rights to provide for an additional deferral feature in violation of Section 409A.
• If an employer terminates a covered plan in a permissible plan termination, the employer would need to terminate all plans of the same type, regardless of whether employees in the first plan actually participate in any such other plans.

The proposed clarifications would generally take effect when published as final regulations, but such clarifications may be relied upon in the interim and the IRS will not challenge positions taken in reliance thereon.

Practice Note:  Employers should review the proposed clarifications to determine whether the interpretations of Section 409A that they have been applying as to their compensation arrangements differ in any respects from the clarifications proposed by the IRS, and if so, what corrective actions may be appropriate.