At long last, the IRS has released new proposed regulations under Internal Revenue Code section 457 – anticipated since 2007 — regarding nonqualified deferred compensation arrangements offered by tax-exempt organizations and state and local governments. In a number of respects, the proposed regulations provide more flexible and accommodating rules for the design of deferred compensation arrangements than what IRS Notice 2007-62 had foreshadowed.
Deferred compensation offered under a Code section 457(b) eligible deferred compensation plan is subject to an annual deferral limit (currently $18,000). Nonqualified deferred compensation offered by tax-exempt organizations and state or local government employers, other than under a 457(b) eligible plan (or a 401(a) qualified plan or 403(b) plan), is subject to income tax under Code section 457(f) as soon as it is no longer subject to a substantial risk of forfeiture — even if payment is deferred to a later date. However, certain bona fide vacation leave, sick leave, severance pay, disability pay and death benefit plans are not treated as deferred compensation subject to section 457.
IRS Notice 2007-62 had signaled the IRS’s intent to impose restrictive rules for what constitutes a “substantial risk of forfeiture” under section 457(f), consistent with the rules under Code section 409A. However, the proposed regulations defining a section 457(f) substantial risk of forfeiture are more flexible and accommodating for designing deferred compensation arrangements than had been described in the Notice.
In particular, the proposed regulations allow certain non-compete forfeiture provisions to be considered a substantial risk of forfeiture if:
- the right to payment is expressly conditioned upon refraining from the future performance of services pursuant to an enforceable written agreement,
- the employer makes reasonable efforts to verify compliance with noncompetition agreements,
- the employer has a substantial and bona fide interest in preventing the employee from performing the prohibited services, and
- the employee has a bona fide interest in, and ability to, engage in the prohibited competition.
The proposed regulations would also allow for a deferral of current compensation (e.g., salary or a current bonus) subject to a risk of forfeiture under section 457(f) if:
- the present value of the compensation the employee will receive is at least 125 percent of the amount the employee would have received absent the addition of the risk of forfeiture,
- at least two years of substantial additional service are required, and
- the agreement to defer the compensation subject to a substantial risk of forfeiture is entered into before the calendar year in which the services are performed that give rise to the compensation.
Similar rules would apply to certain “rolling risk of forfeiture” arrangements, if the extension agreement is entered into at least 90 days before the existing risk of forfeiture would have lapsed.
In addition, under the proposed regulations, compensation can be considered subject to a substantial risk of forfeiture under section 457(f) if entitlement to the compensation is conditioned upon the occurrence of a condition that is related to the purpose of the compensation (i.e., where the condition relates to the participant’s performance of services for the employer or the employer’s organizational goals), if the possibility of forfeiture by not fulfilling the condition is substantial. This may apply to many types of long-term incentive plans.
The proposed regulations also offer guidance regarding what constitutes bona fide vacation leave, sick leave, severance pay, disability pay and death benefit plans that are not treated as deferred compensation subject to taxation under section 457(f). In particular, amounts are considered bona fide severance pay only if:
- the benefits are payable only upon an involuntary severance from employment (including resignation by the employee for “good reason”), or pursuant to a window program or voluntary early retirement incentive plan,
- the amount payable does not exceed two times the participant’s annualized compensation, and
- the benefits must be paid no later than the last day of the second calendar year following the calendar year in which the severance from employment occurred.
In addition, the proposed regulations provide some technical guidance for determining the present value of compensation deferred under an ineligible plan that becomes taxable under section 457(f).
The proposed regulations also include some updates and clarifications applicable to Code section 457(b) eligible deferred compensation plans.
Overall, the proposed regulations generally accommodate a number of common current deferred compensation plan designs for tax-exempt organizations and state or local government employers, and present some interesting design opportunities.