Aug 2, 2016
New Proposed Guidance for Deferred Compensation Plans of States and Local Governments and Tax-Exempt Entities
Along with proposed regulations under Code Section 409A that were issued on June 22, 2016, the Internal Revenue Service simultaneously published proposed regulations providing updated guidance on deferred compensation plans
under Internal Revenue Code Section 457. The regulations will generally apply to amounts deferred in calendar years after the date they are finalized, and to amounts deferred prior to that date that were not previously included in income. Until finalized, employers may rely on the proposed regulations.
The proposed regulations reflect statutory changes affecting eligible governmental plans that were enacted since existing 457 regulations were finalized in 2003. They also provide guidance on items not addressed in the 2003 regulations, and on the interaction between ineligible plans under Code Section 457(f) and the rules of Code Section 409A.
Code Section 457 is the section of the Code that governs deferred compensation plans of states, local governments, and tax-exempt entities (other than certain non-elective deferred compensation for non-employees).
Amounts deferred to “eligible” 457 plans maintained by tax-exempt entities
are taxable when paid or made available. Amounts deferred to “eligible” plans maintained by eligible government
employers are taxable only when paid. An “eligible” plan is a plan that satisfies the rules of Code Sections 457(b), (c), (d) and (g), as applicable.
A plan that is subject to Code Section 457, but that is not an eligible plan, is an “ineligible” plan that is governed by the rules of Code Section 457(f). Amounts deferred to an ineligible plan are taxable when those amounts are no longer subject to a substantial risk of forfeiture.
Code Section 409A also governs deferred compensation plans, but it is not limited to plans maintained by tax-exempt or governmental entities. Amounts deferred under a 409A arrangement are taxable under constructive receipt principles (i.e.
, generally when paid or made available), but taxation will be accelerated if the arrangement fails to satisfy the rules of 409A in form or operation.
Statutory Changes Affecting Eligible Governmental Plans
The proposed regulations reflect various tax law changes enacted after existing regulations were finalized in 2003 and that affect eligible governmental plans. These provisions will be familiar to sponsors of eligible governmental plans, and include rules regarding Roth contributions, nontaxable distributions to eligible public safety officers to pay qualified health insurance premiums, and compliance with survivor benefit and other rules related to employees performing qualified military service.
Guidance Regarding Certain Exempt Benefits
The proposed regulations provide helpful guidance on various benefits that will not be treated as deferring compensation (and thus will be exempt from Code Section 457), including guidance on exempt severance, sick leave and vacation pay.
- Bona Fide Severance Pay is severance that is payable only upon an involuntary separation or under a window program or voluntary early retirement incentive plan, and must be limited in amount and duration to be exempt. The regulations provide guidance on and a safe harbor for determining when a voluntary separation may be treated as an involuntary separation, and also provide clarity on programs that constitute window programs and voluntary early retirement incentive plans. The proposed regulations, when finalized, will supersede transitional guidance issued in 2000 that applied to non-elective plans of state and local governments in existence prior to December 22, 1999.
- Sick leave and vacation pay will be exempt only if the facts and circumstances demonstrate that the primary purpose is to provide paid time off from work because of sickness, vacation, or other personal reasons – the regulations discuss factors that would be considered in this analysis, including whether the employee could be expected to use the leave before his or her employment ends, limits on the ability to exchange the leave for cash or other benefits and restrictions on accrual of leave, whether payment of accumulated leave at termination is made promptly, and whether the plan is broadly available. The regulations also note that any sick leave and vacation pay plans that are treated as not providing for the deferral of compensation are subject to general tax principles regarding timing of inclusion of income, including the constructive receipt rules.
Taxation of Amounts Deferred to Ineligible Plans
The proposed regulations provide detailed rules for calculating the amounts to be included in income under an ineligible plan once a substantial risk of forfeiture (SROF) lapses. On the date the SROF lapses, the present value of the amount deferred, as well as any earnings accrued as of that date, are included in income. Earnings accruing after that date are includible in income when paid or made available.
- Account Balance Plans. The includible amount in an account balance plan is typically the current account balance as of the date the SROF ends, but that is not the case if earnings under the plan are not based on a predetermined actual investment or a reasonable rate of interest. In that case, the includible amount will be determined using the current account balance and the present value of future projected earnings in excess of a reasonable rate of interest (or in excess of the applicable Federal rate in certain cases). Future projected earnings must also be taken into account if earnings is based on the greater of two or more investments or interest rates.
- Non-Account Balance Plans. For plans that are not account balance plans, present value is typically the value of the right to receive compensation in the future, discounted using reasonable actuarial assumptions to reflect the time value of money and the probability (as appropriate) that payment will be made. Unlike the rules that apply for FICA tax purposes, if the present value depends upon a future severance from employment or on factors that cannot be presently determined, such as final average compensation or final years of service, taxation is not delayed. Instead, the present value is calculated based on reasonable assumptions regarding the date of severance (any date within 5 years of the determination date can be used) and reasonable assumptions regarding those other factors. Also, unlike the FICA tax rules, if the amount included in income is greater than the amount ultimately received, the taxpayer can deduct the difference as a miscellaneous itemized deduction in the year a permanent forfeiture or loss occurs (subject to applicable deduction limits).
Interaction Between Code Section 457(f) and Code Section 409A
The proposed regulations provide guidance as to when an arrangement provides for a deferral of compensation under Code Section 457(f) that is quite similar to the rules under Code Section 409A. Importantly, the regulations recognize a “short-term deferral” exemption similar to that under 409A, although using the unique 457(f) definition of a SROF (see below). They also contain liberalized provisions regarding recurring part-year compensation so that most persons being paid under those types of compensation arrangements will be exempt from 457(f). However, the regulations make it clear that the rules of Code Section 457(f) are separate from those of Code Section 409A, and that a plan may be subject to both statutory schemes.
One of the primary differences between the two schemes is how a SROF is defined. Under Code Section 457(f), the SROF concept is applied to determine when an amount of deferred compensation must be included in income. It is also a concept that, under both Code Sections 457(f) and 409A, determines whether an amount is a short-term deferral (i.e.
, an amount that is paid or included in income shortly after the vesting event) such that it is exempt from both sets of rules.
- Under Code Section 409A, an agreement to refrain from performing services in the future (a “non-compete agreement”) does not constitute a SROF. Under Code Section 457(f), such an agreement may qualify as a SROF if the agreement is expressed in a writing that is enforceable, the employer makes reasonable efforts to verify compliance under all of its non-compete agreements, and the employer has a bona fide interest in preventing competition and the employee has an interest in and the ability to compete. As a result, a compliant non-compete agreement for tax-exempt and certain governmental employers may successfully defer taxation to a future year, but it will have to comply with 409A rules because the non-compete agreement is not a SROF under 409A and thus cannot qualify under the 409A short-term deferral exemption.
- Under Code Section 409A, it is not generally permissible to subject elective deferrals of compensation to a SROF, nor to extend the date an existing SROF is scheduled to lapse. Under Code Section 457(f), an elective deferral of compensation and the extension of a SROF may be treated as subject to a SROF if (i) the present value of the amount to ultimately be paid is materially greater (i.e., 125% of more) than the amount being deferred, (ii) the initial or extended SROF must be based on the future performance of substantial services of not less than two years (absent an intervening death, disability or involuntary severance) or the adherence to a non-compete agreement (performance goals are not sufficient), and (iii) the agreement subjecting the amount to a SROF is put in writing before the beginning of the year in which the services will be performed (or at least 90 days before an existing SROF will lapse) – a special rule applies for new employees but not for newly-eligible employees. This means properly structured deferrals of salary and other current compensation are still possible. However, those deferral arrangements will need to comply with the rules of 409A (and also with the rules of 457(f) unless payment is made shortly after the SROF lapses).
Tax-exempt and governmental employers will want to work with benefits counsel to review severance, sick and vacation leave, disability and death benefit plans to ensure those arrangements are properly structured to be exempt from Code Section 457. Deferred compensation arrangements should also be reviewed promptly to take advantage of the new rules regarding elective deferrals of compensation and extensions of vesting provisions, if desired. A review of earnings provisions in deferred compensation arrangements is also recommended to ensure calculating taxable amounts will be as simple as possible.
Note that the views expressed above are those of Newport Group and do not constitute legal advice; readers are encouraged to consult their own legal counsel. This release is a high-level summary of a complex subject that is intended for Newport Group’s clients and intermediary partners and should not be understood as providing a comprehensive discussion of all issues or requirements under the regulations or as a guide to compliance.
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