By Marc Stockwell.
I. Overview and Possible Action Steps for Plan Sponsors
On June 21, 2016, the Internal Revenue Service (IRS) issued proposed regulations prescribing rules under Section 457 of the Internal Revenue Code (“Code”) in connection with the taxation of compensation deferred under plans established and maintained by state or local governments or other tax exempt organizations.
Plan sponsors will want to act now to have their trusted advisors review existing plans and arrangements, which are or could be subject to Section 457, in order to determine if their provisions present any compliance issues as to the proposed regulations. Keeping in mind that in many areas the proposed regulations offer greater flexibility in plan design, plan sponsors may also want to consider amending current plans to take advantage of that flexibility.
In general, the proposed regulations offer welcome clarity to issues including the rules for determining the types of plans that are subject to Section 457 (or not subject to Section 457, as the case may be), rules regarding what can be considered a substantial risk of forfeiture, when amounts deferred under Section 457 are includible in income, and how to determine the present value of compensation deferred under an ineligible Section 457 plan. In addition, the 2016 proposed regulations make certain changes to the 2003 final Section 457 regulations to reflect statutory changes to Section 457 since the publication of those regulations. Consistent with those final regulations, the proposed regulations often use the terms “employee” and “employer” to describe a “service provider” and “service recipient” respectively, without regard to whether the service provider is an independent contractor.
The Section 457 proposed regulations were accompanied by proposed regulations under Code Section 409A and, as discussed herein, the proposed regulations clarify and coordinate the provisions of Section 457 and Section 409A where appropriate. This summary recaps the Section 457 proposed regulations only, except where specific references are made to Section 409A. A separate article discusses in detail the proposed regulations under Section 409A.
II. Regulatory Amendments to Reflect Statutory Changes to Section 457 since the Final Regulations were Released
A. Qualified Roth Contribution Program
The proposed regulations revise the 457 final regulations to allow an eligible governmental plan to include a qualified Roth contribution program, under which designated Roth contributions are included in income in the year of deferral and qualified distributions from a designated Roth account are excluded from gross income. This change is an important opportunity for governmental plans to offer more contribution options.
B. Certain distributions for qualified accident and health insurance premiums
The proposed regulations amend the rules for the taxation of eligible governmental plan distributions to reflect the change made by the Pension Protection Act of 2006 with respect to certain amounts distributed to eligible public safety officers. The amendment provides that distributions from an eligible governmental plan to reimburse a public safety officer for qualified health insurance or long term care insurance premiums are excluded from gross income.
C. Rules related to qualified military service
The proposed rules implement certain provisions of the HEART Act, which require that an eligible governmental plan must provide that in the case of a participant who dies while performing qualified military service, the survivors of the participant are entitled to any additional benefits that would have been provided under the plan if the participant had resumed employment with the employer and then died.
III. Certain Plans that are not Subject to Section 457
A. In General
Section 457 is generally applicable to all arrangements of an eligible employer under which the payment of compensation for services is deferred. The proposed regulations provide guidance on exceptions to the general applicability rule.
In general, bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, and death benefit plans; and plans paying solely length of service awards to bona fide volunteers (or their beneficiaries), as described in the guidance, are treated as not providing for a deferral of compensation for purposes of Section 457.
B. Bona fide severance pay plans
The proposed regulations provide that a plan must meet certain requirements, generally described below, to be a bona fide severance pay plan that is treated as not providing for the deferral of compensation (and therefore not subject to Section 457).
The first requirement is that the benefits provided under the plan must be payable only upon a participant’s involuntary severance from employment or pursuant to a window program or pursuant to a voluntary early retirement incentive plan. Each of the foregoing events is defined in detail beyond the scope of this article in the proposed regulations.
The second requirement is that the amount payable under the plan with respect to a participant must not exceed two times the participant’s annualized compensation based upon the annual rate of pay for services provided to the employer for the calendar year before the calendar year in which the participant severed employment. In the event that the participant had no compensation from an eligible employer in the preceding calendar year, then the current calendar year compensation can be used. In either case, the compensation is adjusted for any increase in compensation during the year that was expected to continue indefinitely if the participant had not severed employment.
The final requirement is that the severance 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 occurs, pursuant to the plan’s written terms.
The rules in these proposed regulations for bona fide severance pay plans are similar to the rules for separation pay plans in the final Section 409A regulations.
C. Bona fide death benefit plan
Another plan that is not subject to Section 457 according to the proposed regulations is a bona fide death benefit plan. A plan providing for death benefits as defined in the Federal Insurance Contributions Act is treated as not providing for the deferral of compensation. The proposed regulations further specify that benefits under a bona fide death benefit plan may be provided through insurance and that any lifetime benefits payable under the plan includible in gross income will not be treated as including the value of any plan-provided term life insurance coverage.
D. Bona fide disability pay plan
Under the proposed regulations, a bona fide disability pay plan is treated as not providing for the deferral of compensation and, accordingly, is not subject to Section 457. A bona fide disability plan pays benefits only in the event of a participant’s disability. For this purpose, the value of any taxable disability insurance coverage under the plan that is included in gross income is disregarded. A participant is considered disabled for purposes of a bona fide disability plan if: (1) they are unable to engage in substantial gainful activity by reason of a physical or mental impairment expected to result in death or last at least 12 months; (2) they are receiving income replacement benefits for at least three months under an accident or health plan on account of a physical or mental impairment expected to result in death or last at least 12 months, or (3) they have been determined to be disabled by the Social Security Administration or the Railroad Retirement Board.
E. Bona fide sick leave and vacation leave plans
Whether a sick or vacation leave plan is a bona fide sick or vacation leave plan, and therefore not subject to Section 457 under the proposed regulations, is determined based on facts and circumstances. A sick or vacation leave plan is generally treated as bona fide, and not as a plan providing for the deferral of compensation, if it can be shown that the primary purpose of the plan is to provide employees with paid time off from work due to sickness, vacation, or for other personal reasons. Because of the wide variety of such plans offered by employers, the proposed regulation specifically provide that the IRS Commissioner may issue additional rules regarding bona fide sick or vacation leave plans in revenue rulings, notices or other guidance.
IV. Ineligible Plans under Section 457(f)
A. Tax Treatment of Amounts Deferred under Section 457(f)
If an ineligible plan provides for a deferral of compensation, the compensation deferred under the plan is includible in the participant’s income, according to the proposed regulations, on the applicable date, which is the later of:
- The date a legally binding right to the compensation is obtained by the participant; or
- The date any substantial risk of forfeiture lapses, if risk applicable at the time the participant obtained the legally binding right to the compensation.
The amount of deferred compensation under a plan that is includible in gross income on the applicable date is, in general, the present value (as of the applicable date) of the amount of compensation deferred, including any earnings thereon.
B. Calculating the Present Value of Compensation Deferred under an Ineligible Plan
The proposed regulations provide rules for determining the present value of compensation deferred under ineligible plans that are account balance plans, as well as of compensation deferred under ineligible plans that are not account balance plans.
- Account balance plans: The present value of an amount payable under an account balance plan, as of an applicable date, is generally the amount credited to the account, which includes both the principal and any earnings or losses through the applicable date; provided that the account balance is determined using a predetermined actual investment or a reasonable rate of interest.
- Non-account balance plans: The present value of compensation deferred under an ineligible plan that is not an account balance plan, as of an applicable date, is the value, as of that date, of the right to receive payment of the compensation in the future. The value must take into account both the time value of money and the probability that the payment will be made. Any actuarial assumptions used to calculate the present value of the compensation deferred must be reasonable as of the applicable date, taking into account all relevant facts and circumstances.
Note: Proposed regulations under Sections 409A and 457 contain similar present valuation calculation and loss deduction rules.
The Section 409A regulations proposed by the IRS concurrently with these proposed regulations contain strikingly similar rules determining the present value. However, unlike the proposed Section 409A regulations, these proposed regulations, provide that income inclusion and present value calculations under Section 457(f) are determined as of the applicable date. Under the proposed Section 409A regulations, income inclusion and the present value calculations are determined as of the end of the employee’s taxable year.
In addition, the proposed regulations contain rules similar to the loss deduction rules in the proposed Section 409A regulations. If a participant includes an amount of deferred compensation in income, but the compensation that is subsequently paid is less than the amount included in income (because the participant has forfeited or lost some or all of the compensation due to death or investment performance, for example), the participant is entitled to a deduction for the taxable year in which any remaining right to the amount is permanently forfeited under the plan’s terms. The deduction allowed for the taxable year in which the permanent forfeiture or loss occurs is equal to the amount that was included in income, less the total amount of compensation actually paid (or made available) under the plan that represents a return of investment in the contract. The available deduction generally would be treated as a miscellaneous itemized deduction, subject to applicable deduction limitations applicable to such expenses for the participant.
C. Definition of Deferral of Compensation
Under the proposed regulations, whether a plan provides for a deferral of compensation is generally based on the terms of the plan and the relevant facts and circumstances at the time the participant obtains a legally binding right to the compensation. In general, Section 457(f) will apply to a plan that provides for a deferral of compensation; that is, a participant has a legally binding right during one taxable year to compensation that is or may be payable in a later taxable year.
D. Short-term Deferral
Under the Section 457 proposed regulations, a deferral of compensation does not occur with respect to any amount that would be a short-term deferral under Section 409A final regulations, but substituting the definition of a substantial risk of forfeiture provided under the proposed Section 457 regulations for the definition under the 409A regulations. Therefore, a deferral of compensation does not occur as to any payment that is not a deferred payment, provided that the payment is actually or constructively received on or before the later of:
- 2½ months following the end of the first calendar year in which the participant’s right to the payment is no longer subject to a substantial risk of forfeiture; or
- 2½ months following the end of the employer’s first taxable year in which the participant’s right to the payment is no longer subject to a substantial risk of forfeiture.
E. Recurring Part-Year Compensation
Consistent with the concurrently proposed Section 409A regulations, the proposed Section 457 regulations provide that a plan or arrangement under which an employee receives recurring part-year compensation (for example, a teacher providing services during a school year that span two calendar years) does not provide a deferral of compensation if both: (1) the plan or arrangement does not defer payment of any of the recurring part-year compensation beyond the last day of the 13th month following the first day of the service period for which the recurring part-year compensation is paid, and (2) the amount of the recurring part-year compensation (the entire amount, not only the amount deferred) does not exceed the annual compensation limit under Code Section 401(a)(17) ($265,000 for 2016) for the calendar year in which the service period begins.
F. Interaction of Section 457 with Section 409A
The proposed regulations specifically provide that the rules under Section 457(f) apply separately and in addition to the requirements under Code Section 409A. Consequently, a deferred compensation plan that is subject to Section 457(f) may also be a nonqualified deferred compensation plan subject to Code Section 409A.
G. Substantial Risk of Forfeiture
Under the proposed regulations, an amount is generally subject to a substantial risk of forfeiture only if entitlement to that amount is conditioned on either: (1) the future performance of substantial services; or (2) the occurrence of a condition that is related to a purpose of the compensation if the possibility of forfeiture is substantial. A condition is related to the purpose of the compensation only if the condition relates to the employee’s performance of services for the employer or to the employer’s tax exempt or governmental activities or organizational goals.
The determination of whether an amount is conditioned on the future performance of substantial services is based on all of the relevant facts and circumstances. For example, if the hours required to be performed during the relevant period are substantial in relation to the amount of compensation, than the amount is conditioned on the future performance of substantial services.
The proposed regulations provide that compensation may be considered subject to a substantial risk of forfeiture if the compensation is conditioned on compliance with a non-compete agreement, and the following requirements are met:
- The right to compensation is expressly conditioned on the employee’s compliance with an enforceable written non-compete agreement.
- Reasonable efforts are made by the employer on a consistent basis to confirm compliance with all of its non-compete agreements.
- The facts and circumstances show that at the time the non-compete becomes binding both: (1) the employer has a substantial and bona fide interest in preventing the performance of the competing services; and (2) the employee has a bona fide interest in performing, and an ability to perform, the competing services.
If the requirements listed below are met, the proposed regulations permit initial deferrals of current compensation to be subject to a substantial risk of forfeiture and also allow an existing risk of forfeiture to be extended:
- The present value of the amount to be paid upon the lapse of the substantial risk of forfeiture must be materially (25 percent or more) greater than the amount that would be paid in the absence of the risk of forfeiture or extension.
- The initial or extended substantial risk of forfeiture must be based on compliance with a non-compete or future performance of substantial services.
- Except in the case of death, disability, or involuntary severance from employment, the substantial future services must be completed for a period of at least two years.
- In the case of initial deferrals, the written agreement that subjects the amount to a substantial risk of forfeiture must be made prior to the calendar year in which any services are performed for the compensation. In the case of extensions, the written agreement must be made at least 90 days prior to the lapse date of the existing substantial risk of forfeiture.
V. Proposed Applicability Dates
A. General applicability date
The proposed regulations will generally apply to compensation deferred under a plan for calendar years beginning after the date of publication of the final regulations in the Federal Register (including deferred amounts to which the entitlement arose during prior calendar years but which were not previously included in income). Publication of final regulations could well take years. Taxpayers may rely on the proposed regulations until the applicability date.
B. Special applicability dates
The proposed regulations also include special applicability dates for provisions regarding specific plans as follows:
- For a plan that is maintained pursuant to one or more collective bargaining agreements, ratified and in effect on the date of publication of final regulations in the Federal Register, these proposed regulations would not apply to compensation deferred under the plan before the earlier of: (1) the termination date of the last of the collective bargaining agreements (determined without regard to any extension thereof after the date of publication of the final regulations in the Federal Register), or (2) the third anniversary date of publication of the final regulations in the Federal Register.
- Taxpayers may rely on either the general applicability rules set forth in these proposed regulations or the rules set forth in Notice 2008-62, in the case of all plans with respect to the rules regarding recurring part-year compensation for periods before the applicability date of these regulations.
- With regard to governmental plans, to the extent that legislation is required to amend such plan, the proposed regulations would apply only to compensation deferred in calendar years beginning on or after the close of the second regular legislative session of the legislative body amending the plan that begins after the date of the proposed regulations’ publication in the Federal Register.
Please contact Marc Stockwell with questionsHuman Capital, Findley Post