Alert
Alert
By Marcus Wu, Jessica Lutrin,
08.09.16
On June 22, 2016, the Internal Revenue Service (IRS) published its long-awaited proposed regulations (the Proposed Regulations) under Section 457(f) of the Internal Revenue Code (the Code). Section 457(f) governs the taxation of ineligible deferred compensation arrangements for employees and other service providers of state and local governments and tax-exempt organizations. The Proposed Regulations clarify nagging uncertainties concerning the Section 457(f) rules, including the requirements for severance, death, disability, and leave plans to be exempt from Section 457(f). Further, the Proposed Regulations provide employers with new planning opportunities for providing deferred compensation. This advisory highlights significant parts of the Proposed Regulations. Governmental and tax-exempt employers should (i) confirm that their existing 457(f) Plans conform to the Proposed Regulations, (ii) confirm that their severance, death, disability, and leave plans qualify for exemption from Section 457(f) under the Proposed Regulations, and (iii) consider the new deferred-compensation planning opportunities offered by the Proposed Regulations.
Background
Section 457(f) governs ineligible deferred compensation plans, or “457(f) Plans.” In short, a 457(f) Plan means an arrangement that is maintained by a government or tax-exempt employer to provide—outside a tax-favored retirement plan—its employees with deferred compensation. “Tax-favored retirement plan” generally means any of the following: 457(b) plan; 401(a) plan, including 401(k) plan; or 403(b) plan.
Under Section 457(f), deferred compensation is taxable to the employee when the compensation is no longer subject to a substantial risk of forfeiture (SROF). In other words, amounts payable under a 457(f) Plan are taxable when they become vested, even if not actually paid until a later date. This substantially differs from the tax treatment of for-profit entities’ deferred compensation arrangements, which if properly designed are taxable not when vested, but when paid. Further, under Section 457(f), amounts under a 457(f) Plan become vested when the employee is no longer required to complete “substantial services” in order to receive the amounts.
The following examples illustrate Section 457(f)’s tax-on-vesting rule:
Arrangements that Constitute 457(f) Plans
When Taxed Under Section 457(f)
Before the Proposed Regulations, the IRS had issued little guidance on Section 457(f), leaving many open questions that employers and advisers have struggled to navigate. Making matters worse, the IRS has promised several times over the past decade to issue guidance, but had not followed through, until now. The Proposed Regulations herald a new era under Section 457(f), clarifying several longstanding ambiguities and presenting governmental and tax-exempt employers with significant planning opportunities and flexibility for designing 457(f) Plans.
Highlights and Effective Date
The highlights of the Proposed Regulations can be categorized as either “compliance clarifications” or “planning opportunities”:
Compliance Clarifications
Planning Opportunities
These items are further discussed below. The Proposed Regulations apply to compensation deferred under a plan for calendar years beginning after the date the IRS adopts the Proposed Regulations as final. Until then, employers may rely on the Proposed Regulations.
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