Non-Profit and Government Employers - New Deferred Comp Rules

As we previously reported, in June the IRS published extensive proposed regulations under Code Section 457, the Code section that governs the nonqualified deferred compensation plans of non-profit and government entities.

(The IRS also published in June less extensive proposed regulations under Code Section 409A, the Code section that governs the nonqualified deferred compensation plans of all types of entities, including for-profit entities.)

The regulations will require a review of all current nonqualified deferred compensation plans (including, for example, supplemental retirement plans, severance plans, and deferred compensation provisions of employment or independent contractor agreements) of non-profit and government entities to ensure that the new rules do not cause negative tax treatment under those arrangements.

Besides necessitating this usual compliance drill, the regulations introduce new – and significantly more liberal -- positions on certain plan design issues than those previously taken by the IRS. In particular, the proposed regulations reflect a material shift in IRS thinking from the IRS positions taken in Notice 2007-62 that have restricted 457(f) plan and severance plan design flexibility for the past nine years, and which in many cases required changes nine years ago.

The following are some of the highlights of the proposed regulations.

  1. Changes to Severance Plan Exemption. The proposed regulations contain a significantly broader definition of “bona fide severance plans” that are exempt from the taxation-on-vesting rules of 457(f) than under prior IRS guidance. This change will permit some employers to design (or re-design) severance arrangements for executives in order to have the severance benefits taxed over time, rather than immediately on vesting.

2. Non-Competes as Substantial Risks of Forfeiture. The proposed regulations provide limited (but meaningful) conditions under which non-competes can constitute substantial risks of forfeiture delaying taxation under 457(f). This likely will create very significant planning opportunities for employers that wish to achieve tax deferral beyond termination of employment for classes of employees (such as physicians) with respect to which the employer has significant non-compete interests. Prior IRS guidance generally had prohibited the use of non-competes as risks of forfeiture.

3. Present Value Rules. The proposed regulations contain extensive, and complex, new rules for determining the present value of future 457(f) plan payments that become taxable on vesting. (Although the great majority of 457(f) plans pay benefits in a lump sum on vesting, these new rules will be helpful to those 457(f) plans that pay benefits over time.)

4. Creation of Deduction Rule. The proposed regulations provide that if a 457(f) plan participant has included an amount in income on a vesting event, and all or a portion of that amount is never paid, the participant is entitled to an income tax deduction. This represents a complete reversal of the previous IRS position under Code Section 457(f), and has made the 457(f) tax rule on this issue consistent with the Code Section 409A rule.

5. Voluntary Deferrals by Participants. Although less than clear, it appears that the proposed regulations reverse the IRS’s long-held position and permit voluntary deferrals of compensation into 457(f) plans in some cases, at least by participants who do not have “effective control” over the employer. (Unanswered questions remain concerning this topic which we are investigating.)

6. Short Term Deferral Exception. The proposed regulations create an exemption from 457(f)’s taxation-on-vesting rules for arrangements that satisfy the short term deferral exception under Code Section 409A.

7. Recurring Part-Year Compensation Exception. The proposed regulations create a rather complex exception from 457(f)’s taxation-on-vesting rules for “recurring part-year compensation” that is paid by “the last day of the 13th month following the first day of the service period for which the compensation is paid, but only if the amount of the compensation does not exceed the Code Section 401(a)(17) limit” ($265,000 for 2016). A more limited exception had been included in the final regulations under Code Section 409A, but the 457 and 409A proposed regulations issued in June now both contain this same expanded recurring part-year compensation exception.

8. Extensions of Vesting Periods. The proposed regulations create a rather complex rule that permits employers and 457(f) plan participants to extend for at least two years an approaching vesting/taxation date in certain limited circumstances. (Prior IRS guidance had prohibited vesting/taxation date extensions.)

Non-profit and government employers should consider whether these new rules present them with opportunities to “upgrade” their executive (and other) deferred compensation programs. Please let us know if we can be of assistance in this regard.