On June 21, 2016, after more than 15 years of ongoing deliberations, the U.S. Department of the Treasury (the Dept. of Treasury) issued proposed regulations under Section 457 of the Internal Revenue Code of 1986 (the Code), outlining the rules governing non-qualified deferred compensation plans for state and local governments and tax-exempt organizations, including non-profit hospitals, universities and charitable organizations. These proposed regulations reflect an increased level of scrutiny toward these types of deferred compensation plans and are modeled, in part, on the rules adopted under Code Section 409A, applicable generally to non-qualified deferred compensation plans. This Quick Study will focus on how these proposed regulations (the 457(f) Proposed Regulations) affect those non-qualified deferred compensation plans sponsored by non-governmental tax-exempt organizations that do not meet the deferral and other requirements of an “eligible” plan under Code Section 457(b) (a 457(f) Plan).
Background. The tax treatment of a 457(f) Plan is materially different from the tax treatment of a non-qualified deferred compensation plan maintained by a for-profit employer. Compensation deferred under a 457(f) Plan is included in taxable income on the later of: (i) the date the participant obtains a legally binding right to receive payment of that compensation, or (ii) the date on which the payment is no longer subject to a “substantial risk of forfeiture.” In contrast, deferred compensation under a plan maintained by a for-profit employer is generally included in taxable income at the time such compensation first becomes distributable.
The early income inclusion rule under Code Section 457(f), which is triggered by “vesting” of a payment right, has caused a high level of focus on determining whether a payment is subject to a substantial risk of forfeiture. It has also presented significant design challenges. As outlined below, the 457(f) Proposed Regulations provide guidance regarding: (i) exceptions to the application of Code Section 457, (ii) the conditions under which a non-compete provision will be treated as creating a substantial risk of forfeiture, and (iii) the conditions for a substantial risk of forfeiture to be extended.
It should be noted that the 457(f) Proposed Regulations confirm that the rules under Code Section 457(f) apply separately and in addition to any requirements under Code Section 409A. Thus, it may be possible for a 457(f) Plan also to be a non-qualified deferred compensation plan under Code Section 409A, requiring such plan to satisfy both sets of rules to effectively defer compensation.
Exceptions to Code Section 457(f). The 457(f) Proposed Regulations provide additional guidance regarding exceptions to the general rules under Code Section 457(f).
Bona Fide Severance Pay Plans. Code Section 457(e)(11) provides that payments made under a “bona fide severance pay plan” are treated as not providing for a deferral of compensation for purposes of Code Section 457. For this purpose, the 457(f) Proposed Regulations provide detailed rules outlining what type of arrangement will qualify as a “bona fide severance pay plan,” which are similar to the “two-times” separation pay plan exception under the Code Section 409A regulations. To be a “bona fide severance pay plan,” both of the following requirements must be met:
(a) Benefits may be paid only upon an involuntary severance from employment or pursuant to a window or voluntary early retirement incentive program. For this purpose, “involuntary severance” is any severance from employment due to the employer’s independent exercise of its authority to terminate a participant, other than due to the participant’s implicit or explicit request, if the participant is both willing and able to perform ongoing services. Additionally, an employee’s voluntary “good reason” severance from employment may be treated as an involuntary severance from employment under conditions substantially similar to those provided in the Code Section 409A regulations.
(b) The benefit payments may not exceed two times the participant’s annual compensation, determined as of the end of the calendar year preceding the calendar year in which the severance from employment occurs, and must be paid over a period ending on or before the last day of the second calendar year following the calendar year in which the severance occurs.
The 457(f) Proposed Regulations provide that a “window program” generally provides for separation pay in connection with severance from employment which occurs during a fixed period of time, generally not exceeding 12 months. For employers who sponsor defined benefit plans, the 457(f) Proposed Regulations also permit adoption of a “voluntary early retirement incentive plan” under special rules for those types of plans.
Other Bona Fide Plans. The 457(f) Proposed Regulations also provide exceptions for other forms of “bona fide” plans, including death benefit plans, disability pay plans and sick and vacation leave plans. The benefit of these provisions is that a plan participant will not be required to include the value of the potential benefit plan payment into income until such time as the actual payment is made under the plan’s terms. The 457(f) Proposed Regulations contain fairly detailed requirements for each of these plans. For example, the definition of “disability” used by the 457(f) Proposed Regulations is modeled after the definition currently imposed under Code Section 409A and would require a participant to be unable to engage in any substantial gainful activity for a period of at least 12 months, which parallels the definition for disability under the Social Security Act, a higher threshold than most deferred compensation arrangements would require.
Substantial Risk of Forfeiture. As explained above, benefits under a 457(f) Plan generally are taxable when they are no longer subject to a “substantial risk of forfeiture.” The 457(f) Proposed Regulations provide that an amount is generally subject to a “substantial risk of forfeiture” only if entitlement to that amount is conditioned on the future performance of substantial services, or a condition that is related to a purpose for which the compensation is granted and if the possibility of forfeiture is substantial. The 457(f) Proposed Regulations provide that an amount is not subject to a substantial risk of forfeiture if the facts and circumstances indicate that the forfeiture condition is unlikely to be enforced. Such facts and circumstances would include whether the employer has enforced forfeiture conditions in the past, the level of control or influence of the employee over the employer, and the likelihood that the forfeiture provisions would be enforceable under applicable law.
Noncompetition Agreements. The 457(f) Proposed Regulations contain guidance which allows a covenant not to compete to create a substantial risk of forfeiture. This is surprising because the Dept. of Treasury has taken the opposite position under the Code Section 409A regulations.
The following requirements must be met in order for a covenant not to compete to be considered as creating a substantial risk of forfeiture:
(a) The right to the deferred compensation must be expressly conditioned on the employee (or other service provider) not engaging in competition pursuant to a legally enforceable written agreement.
(b) The employer must consistently make reasonable efforts to verify compliance with all noncompetition agreements to which it is a party (including the agreement with the particular employee).
(c) At the time the noncompetition agreement becomes binding, the facts and circumstances must demonstrate that the employer has a substantial and bona fide interest in preventing the employee from engaging in competition and that the employee has a bona fide interest and the ability to engage in competition.
As indicated above, a covenant not to compete must be enforceable under applicable law. In some states a covenant not to compete in a deferred compensation agreement may not be enforceable. Consequently, the use of a covenant not to compete to create a substantial risk of forfeiture may not be viable in all states in which participants are employed.
As noted above, because the definition of a “substantial risk of forfeiture” differs under Code Sections 409A and 457(f), it is possible that a payment on vesting (e.g., the expiration of a non-compete period) under Code Section 457(f) may not be a short-term deferral under Code Section 409A and may subject the non-qualified deferred compensation plan to the requirements of Code Section 409A.
Elective Deferrals and Extension of Forfeiture Periods. The 457(f) Proposed Regulations also permit elective deferrals of current compensation to be subject to a substantial risk of forfeiture, which the Internal Revenue Service previously questioned in informal public comments and on audit. Additionally, a 457(f) Plan may permit the initial vesting date for deferred compensation to be rolled forward (resulting in the further tax deferral of the compensation), which the Internal Revenue Service and the Dept. of Treasury had previously described as problematic and which is not permitted under the Code Section 409A regulations. For these provisions to apply, however, four fairly strict conditions must be met:
(a) The present value of the amount to be paid upon the lapse of the substantial risk of forfeiture (whether an elective deferral or an election to roll forward the vesting date) must be materially greater than the amount the employee otherwise would be paid. This generally requires that the amount to be received have a value of more than 125 percent of the amount the participant otherwise would have received.
(b) The initial or extended substantial risk of forfeiture must be based upon the future performance of substantial services or adherence to an agreement not to compete. It may not be based solely on the occurrence of a condition related to the purpose of the compensation award (for example, a performance goal), though that type of condition may be combined with a sufficient service condition.
(c) The period for which substantial future services must be performed must be at least two years (absent an event beyond the control of the employee such as death, disability, or involuntary severance from employment).
(d) The agreement must be made in writing before the beginning of the calendar year in which any services giving rise to the compensation are performed in the case of initial deferrals of current compensation, or at least 90 days before a vesting date in the case of an election to roll forward the vesting date.
Effective Date. Generally, the 457(f) Proposed Regulations will apply to compensation deferred under a plan for calendar years beginning after the date on which the final regulations are published.
Conclusion. The 457(f) Proposed Regulations are far more liberal than earlier pronouncements from the Dept. of Treasury had indicated and will afford more planning opportunities for deferral of compensation for executives of tax-exempt organizations than had been anticipated.