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

  • After completing 10 years of employment, employee is entitled to five annual $5,000 employer payments beginning in year his or her employment ends
  • Under employment contract, employer agrees to provide an executive with a $100,000 bonus, payable in annual installments over three years, if the executive remains employed through December 31 of the current calendar year
  • Employer promises to pay executive $25,000 retention bonus in lump sum on five-year anniversary of date executive completes three years of continuous employment with the employer

When Taxed Under Section 457(f)

  • Present value of all five $5,000 payments taxable in calendar year that employee completes 10 years of employment regardless of whether employee’s employment then ends
  • Present value of $100,000 taxable in current calendar year if executive satisfies December 31 employment requirement
  • Present value of $25,000 taxable in calendar year that executive completes three-year employment requirement

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

  • Section 409A requirements
  • Conditions for existence of SROF
  • Conditions to qualify for Section 457(f) exemption as severance, disability, leave, or death plan

Planning Opportunities

  • Expanded definition of SROF
    • Non-compete covenants
    • Rolling risk of forfeiture
  • Section 457(f) exemptions
    • Short-term deferrals
    • Voluntary window programs

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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