U.S. Internal Revenue Code §457(f) addresses federal income taxation of certain types of “nonqualified” deferred compensation plans and arrangements of entities that are either state and local governments or tax-exempt organizations (under IRC §501(c)). Most of those deferred compensation arrangements also must comply with IRC §409A to avoid tax penalties.
For state and local governments and tax-exempt organizations, the IRC §457(f) rules principally apply to employment agreements and other compensation arrangements for executive level employees and certain highly compensated employees (e.g. physicians). Essentially, under IRC §457(f), deferred compensation is subject to tax when it is no longer subject to a substantial risk of forfeiture. Opportunities for extended deferral of taxation have been very limited.
On June 22, 2016, the IRS issued long promised proposed regulations under IRC §457(f). Coordinating changes were also proposed to the regulations under IRC §409A.
In general, the changes in the proposed regulations will clarify a number of longstanding ambiguities in this area of the tax law, in ways that will be helpful to employers. The following are a few highlights from the proposed regulations:
Substantial Risk of Forfeiture
IRC §457(f) states that a substantial risk of forfeiture will exist if receipt of the deferred compensation is conditioned upon “the future performance of substantial services”. The proposed regulations will clarify the following points:
- In order to be substantial services, the required performance period must be at least two years in length.
- A substantial risk of forfeiture can exist if payment is conditioned upon the employee meeting certain performance goals or it is conditioned upon certain organizational goals being met.
- A bona fide, legally enforceable non-compete can constitute a substantial risk of forfeiture.
- A substantial risk of forfeiture can still exist, even if the deferred compensation is payable upon death, disability or an involuntary termination of employment (including a termination for good reason).
Rolling Risks of Forfeiture
A typical Section 457(f) deferred compensation plan will provide for payment to the employee at the time the risk of forfeiture will lapse (e.g., the end of an employment agreement’s term). That is because it is at that time that the deferred compensation becomes taxable.
The proposed regulations allow for taxation to be deferred to a future date by an agreement that extends a substantial risk of forfeiture into the future (e.g., a contract extension). Conditions for doing so are:
- The agreement must be made in writing and entered into at least 90 days before the original substantial risk of forfeiture lapses.
- For at least two more years, the employee must be required to render substantial services or be subject to a bona fide, legally enforceable non-compete. However, payment can be made upon death, disability or involuntary termination.
- The amount payable at the end of the agreement must be materially greater than the current amount that would be payable to the employee. Specifically, the present value of the amount that will be payable to the employee at the end of the agreement has to at least be at least 25% more than the amount currently payable to the employee.
Deferrals of Current Compensation
The proposed regulations also will allow an employee to make deferrals out of current compensation (e.g. salary deferrals or deferral of a bonus). Conditions for doing so are:
- An agreement in writing to defer the compensation must be entered into before the calendar year in which any services are rendered that give rise to the payment of the compensation.
- For at least two more years from the date of the deferral, the employee must be required to render substantial services or be subject to a bona fide, legally enforceable non-compete. However, payment can be made upon death, disability or involuntary termination.
- The amount payable when the substantial risk of forfeiture lapses must be materially greater than it was at the time the deferral. Specifically, the present value of the amount payable when the substantial risk of forfeiture will lapse has to at least be 25% more than the amount deferred.
Effective Date Concerns
The proposed regulations will be applicable to calendar years beginning after the date that final regulations are published. That could be as early as January 1, 2017.
Importantly, the new regulations will apply to any pre-exiting plans and arrangements that did not have the amounts deferred thereunder previously reported as taxable income. This could cause employees under pre-existing plans or arrangements to be subject to tax as of the effective date of the new regulations.
Accordingly, employers should examine any pre-existing plans and arrangements that are subject to IRC §457(f) to determine if they will be in compliance once the proposed regulations are made final.