IRS proposes regulations on deferred compensation for tax-exempt entities

The IRS issued long-awaited proposed regulations (REG-147196-07) on June 21 for deferred compensation plans maintained by tax-exempt entities and state and local governments. These regulations were anticipated since the IRS formally announced in Notice 2007-62 its plan to propose new regulations.

The regulations focus on Section 457(f) plans. The determination of whether compensation is considered part of a Section 457(f) plan and when it vests is critical to the timing of when employees recognize the compensation for income tax purposes. Amounts determined to be inside a section 457(f) plan are subject to income tax when they vest, while compensation outside of these plans is generally not subject to income tax until it is actually received by the employee.  

Definition of deferred compensation and exceptions The proposed regulations define deferred compensation subject to Section 457(f) broadly. Deferred compensation exists when an employee has a legally binding right to compensation during a taxable year that is or may be payable in a later taxable year. Certain compensation arrangements, such as qualified retirement plans and Section 457(b) plans, are excluded. The proposed regulations also exclude several other compensation arrangements from being subject to Section 457(f) even though they fit the broad definition of deferred compensation. As a result, employees who have these arrangements are subject to income tax when the amounts are paid rather than when the amounts become vested.

One of the most notable exceptions is a “short-term deferral.” This exists when an employee receives a payment by the 15th day of the third month following the calendar year in which the payment vests (or, if later, the 15th day of the third month following the employer’s fiscal year in which the payment vests). For example, a bonus for calendar year 2016 that vests on Dec. 31, 2016, and is paid by March 15, 2017, is a short-term deferral. As a result, it is subject to income tax in 2017, when it is paid, rather than in 2016, when it vests. If the employer in this example has a June 30 year-end, the payment could be made as late as Sept. 15, 2017. Notably, even though a payment is made within the required timeframe, the payment cannot be treated as a short-term deferral if the compensation arrangement provides for any circumstance under which the payment could be delayed beyond the required timeframe.

Other notable exceptions include bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay and death benefit plans. The proposed regulations devote considerable attention to defining these arrangements, since the arrangements provide the benefit of deferring income taxation until amounts are paid rather than when they vest.

In particular, the regulations provide detailed rules on severance pay. They define a bona fide severance pay plan as a plan that meets the following three requirements:

  1. Amounts are payable only upon an involuntary severance from employment, pursuant to a window program, or under a voluntary early retirement incentive plan.
  2. The total amount payable to an employee does not exceed two times the employee’s annualized compensation for the calendar year preceding the calendar year in which the severance from employment occurs.
  3. All amounts are paid no later than the last day of the second calendar year following the calendar year in which the severance from employment occurs.

For purposes of the first requirement, the regulations allow a voluntary severance from employment for “good reason” to be treated as an involuntary severance from employment. This occurs when an employee voluntarily severs employment because of a unilateral action by the employer that results in a material adverse change in the working relationship, such as a material reduction in the employee’s duties, working conditions or compensation.

The regulations also create detailed rules on bona fide sick leave and vacation leave plans. These plans are generally treated as bona fide if the facts and circumstances demonstrate that their primary purpose is to provide employees with paid time off from work because of sickness, vacation or other personal reasons. Factors such as accumulating so much leave that an employee could not reasonably be expected to use it would cause the leave not to be bona fide.

Substantial risk of forfeiture Compensation included in a Section 457(f) plan is subject to income taxation upon vesting. The proposed regulations refer to vesting as the lapse of a “substantial risk of forfeiture.” The proposed regulations provide that an amount is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on either of the following:

  • The future performance of substantial services
  • The occurrence of a condition related to the purpose of the compensation, if the likelihood that the forfeiture event will occur is substantial

In Notice 2007-62, the IRS described the rules it intended to use in the proposed regulations to define a substantial risk of forfeiture. The proposed regulations are more lenient in some respects than what was anticipated. The notice indicated that payments contingent on noncompetition restrictions would not be treated as subject to a substantial risk of forfeiture. It also indicated that employee elective deferrals of current compensation, such as salary and bonuses, would not be treated as subject to a substantial risk of forfeiture. The proposed regulations allow these payments to be treated as subject to a substantial risk of forfeiture (thus delaying income taxation) if certain conditions are satisfied.       

A noncompetition requirement will be treated as a substantial risk of forfeiture if all of the following conditions are satisfied:

  • The right to the compensation is expressly conditioned on the employee’s refraining from performing future services pursuant to a written agreement that is enforceable under applicable law.
  • The employer consistently makes reasonable efforts to verify compliance with all of the noncompetition agreements to which it is a party.
  • At the time the noncompetition agreement 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 that the employee has a bona fide interest in engaging, and an ability to engage, in the prohibited services.
In another departure from the anticipated guidance described in Notice 2007-62, the proposed regulations provide that an employee can elect to defer current compensation such as salary or a bonus, and still have it treated as substantial risk of forfeiture if three conditions are satisfied:

  1. The election by the employee to defer the compensation is made in writing before the beginning of the calendar year in which the services giving rise to the compensation are performed.
  2. The employer makes a matching contribution exceeding 25%.
  3. The employee provides substantial services for at least two additional years or agrees not to compete for at least two years.

The proposed regulations also provide that the period in which a substantial risk of forfeiture lapses can be extended (often referred to as a “rolling risk of forfeiture”), and thus the time when amounts are subject to income can be delayed, if all of the following conditions are satisfied:

  • The extension is made in writing at least 90 days before the existing substantial risk of forfeiture lapses.
  • The employee provides substantial services for at least two additional years, or agrees not to compete for at least two years.
  • The original amount that was to be paid is increased so that the present value of the amount that will ultimately be paid is more than 125% of the original amount.   
Present value of compensation When an amount becomes subject to tax under Section 457(f), the amount included in income is the present value of the compensation as of the vesting date. The proposed regulations address how to calculate present value. Highlights include the following:

  • The calculation cannot take into account the probability that a payment will not be made because of the unfunded status of the plan, the risk that the employer may be unwilling or unable to pay, or other similar contingencies.
  • If the present value depends on when a severance from employment occurs and that date is unknown on the vesting date, the severance from employment may be treated as occurring on any date on or before the fifth anniversary of the vesting date, unless, as of the vesting date, it would be unreasonable to use such an assumption.
  • For payments based on formula amounts (e.g., a formula that uses final average compensation and total years of service), the present value calculation must use reasonable, good faith assumptions based on all the facts and circumstances existing on the vesting date.

The regulations acknowledge that an employee might ultimately receive less than the present value amount that was subject to income tax on the vesting date. If so, the employee is entitled to a miscellaneous itemized deduction for the year in which the amount is permanently forfeited under the plan’s terms or is otherwise permanently lost.

Effective date The regulations will go into effect for calendar years beginning after the date on which they are finalized. The regulations will apply to amounts deferred after that date and to amounts deferred prior to that date that have not vested. Special rules delay the effective date for collectively bargained plans and for government plans for which legislation is required to amend the plans. Taxpayers may rely on the proposed regulations prior to their finalization.        
Next steps Employers can start to prepare now for when the regulations become final. They may want to consider how to ensure compensation arrangements are exempt from Section 457(f) so that payments are not subject to income tax until paid, rather than upon vesting. Important considerations include the following:

  • If bonuses and other forms of compensation are not paid out soon enough after vesting to qualify as a short-term deferral, consider changing the payment terms to qualify.
  • Evaluate whether existing severance pay plans qualify for the exemption from Section 457(f), and if not, consider changing the terms to qualify.
  • Evaluate sick leave and vacation leave plans to ensure they qualify for exemption from Section 457(f), focusing on factors that might cause the exemption not to apply (such as leave that can be carried over and accumulated to such a large amount that an employee cannot reasonably be expected to use all of it).
  • Take the necessary steps to ensure noncompetition provisions will be respected as a substantial risk of forfeiture, such as determining whether the provisions can be enforced under applicable law and implementing procedures to verify compliance with the noncompetition provisions.
  • If employees are currently permitted to defer current compensation, such as salary and bonuses, decide whether to make a matching contribution once the final regulations go into effect. If a matching contribution will not be provided, inform employees that when the final regulations go into effect, their deferral elections will not be able to delay income taxation.
  • If rolling risks of forfeiture are currently being used or considered, prepare to make any necessary adjustments so that the extension of the risk of forfeiture is respected under the regulations.
  • Develop procedures to calculate the present value of amounts deferred under Section 457(f) in accordance with the rules in the regulations.
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